You are the senior auditor in charge December 2016 year-end audit for Cleo Patrick Cosmetics Inc (CPCI). CPCI is a large privately-held Canadian company that was founded in 1995 by one of Canada's most well-known hair stylists, Cleo Patrick. Cleo Patrick, is a well-known celebrity hair stylist who has appeared on a variety of television shows such as Entertainment Tonight, and has been the chief stylist for the Oscars and Emmys. The company includes: (1) a small chain of ten upscale salons situated in major cities in Canada and the US and (2) its well-known signature line of professional hair products that are available at select drug stores and retail chains. The core of its business is its signature hair products line, Cleo Patrick True Professional. The True Professional line represents 85% of the company's total revenue.
During the planning phase of the audit, you performed various planning activities and met with CPCI's management team. Here is what you learned:
Your firm has audited CPCI since 2001, when Cleo sold 25% of her company to a group of private investors. The investors receive quarterly dividends that are calculated based upon a combination of sales and net income. The investors, all experienced business people, serve as Cleo's board of directors and give her advice on the strategic direction of the firm.
Your firm has not had any major disputes with CPCI management over accounting issues; however, last year it recommended that CPCI improve the quality of its accounting department - which is understaffed and not well organized.
High-priced mass-market hair products represent a highly competitive super-saturated market. Large multi-nationals, make up about 70% of the market with niche companies such as CPCI making up the remaining 30%. Management does not consider multinationals to be a threat.
From your review of the 2015 annual report and the 3rd quarter 2016 financial statements, you noted the following financial information:
| |
Nine Months Ended
Sept 30, 2016
(unaudited)
(thousands of dollars)
|
Year Ended
Dec 31, 2015
(audited)
(thousands of dollars)
|
|
Sales
|
mce_markernbsp; 350,000
|
$ 450,000
|
| |
|
|
|
Net Income
|
1,000
|
1,500
|
| |
|
|
|
Cash
|
25,000
|
30,000
|
|
Accounts Receivable
|
25,000
|
25,000
|
|
Inventory
|
45,000
|
40,000
|
|
Property, Plant, and Equipment
|
165,000
|
160,000
|
| |
|
|
|
Total Assets
|
285,000
|
280,000
|
| |
|
|
|
Current Liabilities
|
mce_markernbsp; 45,000
|
mce_markernbsp; 40,000
|
Cleo plans to expand into Europe and is negotiating contracts with drug stores in the UK and Germany. In order to fund this expansion, CPCI's bank has agreed to increase CPCI's operating credit line of credit. As part of the agreement, CPCI is required to maintain a minimum quick ratio of 1.2 and a positive net income. In addition, CPCI is required to provide the bank with audited financial statements.
Your firm has an employee who reads and saves articles about issues that may affect key clients. You read an article that says that two of CPCI's top-selling products recently made "The Dirty Dozen" list. The list, developed by an environmental research foundation, highlights those cosmetic products that have toxic chemicals (some of which are cancer-causing). CPCI claims that all its products are safe and meets the provincial and federal health and safety guidelines. You discuss the issue with CPCI management and find out that it is working on re-formulating both products, which should be ready in 2017. CPCI is offering large rebates to retailers in order to encourage sales of its older products. The two "dirty" products currently make up about 20% of CPCI's current inventory of $45 million.
William Kirk was hired recently as the Chief Operating Officer to provide closer oversight of the company. Due to all the new products and expansions, Cleo does not have time to spend monitoring the day-day operations. Kirk is attempting to bring in a greater emphasis on controls around financial reporting and monitoring (as recommended by your firm in the past). Kirk started in June and one of the first things he did was to replace the CFO (the previous CFO was not very organized and tended to delay handling problems). He also implemented a new bonus plan based upon sales growth and profitability targets. He told you he thinks it is working out really well and sales are growing. However, he has not had a chance to implement all his plans - such as hiring additional accounting staff and performing a formal assessment of the quality of internal controls.
In early 2016, CPCI launched two new collections, Ultimate Moisture and Moisture Gloss. These two products put an extensive strain on the company's cash flow. CPCI had spent $15 million in product development and $10 million on advertising. However, sales were much lower than predicted. Management had predicted 2016 sales to be between $9 million to $10 million but, as of October 2016, sales were only $1 million. When you inquired about the low sales, the new CFO explained that the buyer had purchased inappropriate raw materials. This was not discovered during the inspection process when the materials were received. As a result, the finished product did not meet quality standards and was destroyed and the new collections arrived in stores much later than planned. The CFO stated that the sales people are working really hard at trying to get product demand back on track by year-end and are negotiating new contracts with their customers.
Required:
Based upon the above description, provide three key business risk factors that could increase the risk of material misstatement in CPCI's financial statements. Explain which account(s) each of these risk factors could affect and the type of misstatement(s) that the risk might cause. Ensure to include in this discussion the most relevant assertions and the potential misstatement for the account. Use the table below and on the next page to complete your answer. (9 marks)
|
Identify and describe key business risk
|
Account, most relevant assertion(s) Potential Misstatement
|
|
|
|
What would you set acceptable audit risk (high, medium-high, medium, low-medium, or low) for the CPCI audit engagement? Explain why.
Calculate planning materiality for the CPCI audit. Ensure to include a rationale for the appropriate materiality benchmark (base) and the related appropriate percentage.