Caitlyn Pierce and Steve River are the two founding audit partners for Higgins and River LLP (H&R). In June 20X6, they accepted a new audit client, Baby's Edge (BE), a private enterprise owned by two sisters, Kathleen and Christine.
BE's mission is to provide eco-friendly and sustainable baby products to parents throughout eastern Canada. BE works with local and international manufacturers to buy environmentally friendly products at the best prices possible. BE's owners pride themselves on their ability to provide "affordable eco-freshness." BE's head office is in Halifax, Nova Scotia; however, it has small stores across the Maritimes. The company also distributes some of its clothing lines to specialty stores with similar missions and values in Toronto. BE operates from rented premises. BE has one warehouse, in Halifax, from which all of its goods are shipped.
BE has operated successfully for several years, but over the past nine months it has had a significant reduction in profit. This is causing concern for Kathleen and Christine.
In May 20X6, BE's purchasing manager resigned, leaving the operations at the warehouse very disorganized. Remaining staff members have been unable to keep up with product sourcing and store distribution. Recruitment for a permanent replacement is underway; in the meantime, the company is using other staff members to perform the manager's duties. To keep the disruption minimal, Christine and Kathleen authorized the store managers to make product purchases directly to the store, rather than through head office. Kathleen is concerned that the inventory on hand may be piling up, as there is little oversight.
BE has a December 31 year end. It is October 13, 20X6, and you are an audit manager with H&R assigned to work on the year-end audit for BE. Steve will be the lead audit partner for the audit engagement. Steve met with Kathleen in August 20X6 to discuss the year-end audit. (Notes from the meeting are in Appendix 1.) At this meeting, Kathleen also provided BE's financial performance for the nine months ended September 30, 20X6, along with the prior year audited financial statements (Appendix 4).
Kathleen and Christine believe BE's control environment is strong. They have been working to ramp up procurement and warehouse controls as suggested by their predecessor auditors. Kathleen has provided a description of the purchases system and the control activities that have been implemented in the purchasing and shipping department (Appendix 2).
On September 30, 20X6, one of the new staff accountants from H&R attended BE's inventory count. This work is documented in Appendix 3.
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Required:
1. Describe the client acceptance and continuance procedures/considerations that H&R should have made when deciding to accept Baby's Edge as an audit client.
2. Perform the planning analytical review for the financial statements of BE, analyzing the key movements. Include all supporting calculations.
3. Identify the audit risks and explain how each audit risk could result in a material misstatement in the financial statements. Design the audit approach for each significant audit risk identified.
4. Calculate planning materiality for the 20X6 fiscal year-end audit. Provide both quantitative and qualitative analysis supporting your figure for preliminary materiality.
5. Identify the control activities present in BE's purchases system and the audit procedures that H&R can perform to test the effectiveness of BE's control activities. Use the wording of control techniques such as "observe, inspect, inquire and reperform." Present these items in a table with the following column headings: "Control activity" and "Test of control."
6. Evaluate the audit work done by the audit junior on the weekly inventory counts.
7. Outline additional procedures that should be performed by the audit team for inventory counts (and the related assertion).
8. Provide eight audit procedures that should be performed by the audit team for accounts receivable. Provide one related assertion for each audit procedure.
APPENDIX 1: NOTES FROM MEETING WITH KATHLEEN
When Kathleen and Christine started their families, they found that the market for eco-friendly baby products was underdeveloped, particularly in Eastern Canada. After a significant amount of research and with the support of their friends and family, Kathleen and Christine opened their flagship store in Halifax. Since then, they have opened four more stores in Eastern Canada and a warehouse in Halifax to supply other affiliated specialty stores located in the Greater Toronto area.
Kathleen explained that BE operates in a very competitive, high-demand, low-margin industry. Since they opened their first store together in 20X1, the market for sustainable and eco-friendly baby products has been expanding very rapidly as parents become increasingly concerned about the dangers of harmful chemicals in their children's clothing, food and toys.
The cost to procure eco-friendly products is higher than for generic and other brand name non-sustainable products. Most of BE's competitors of a similar size mark up their products by higher margins than BE does; however, BE's mission has always been to provide these products to all parents, and not to operate as a "high-end" baby store.
Recently, the sustainable products market has been hit by the recession and BE has had to further reduce margins on most of its lower margin products. The high-volume food lines, diapers and diaper accessories took the biggest hit, but Kathleen and Christine felt that it was better to take a small margin hit on high-volume items as well. The in-store and online customer base has recognized stable prices as an incentive and has remained loyal to BE. Despite this loyalty, BE is still finding that its sales volume is much lower than planned for the year.
In Toronto, a few of BE's long-time specialty store customers have gone into liquidation due to over-saturation of the market in the area. These customers have not been replaced. The majority of BE's specialty store customers have been stretching their credit terms with BE, despite being chased by the credit department.
Many large chain retail stores are also starting to offer products marked as "eco-friendly." These stores are buying lower quality materials than BE and can charge significantly lower prices. Given the lack of regulation in this industry, BE is unable to compete with these lower priced products, except by explaining the differences in quality to parents.
In order to generate new business, Kathleen is planning to expand distribution to mainstream grocery stores on long-term sales contracts. To entice the grocery stores to carry BE's products, BE is offering them enhanced rates to ensure sales contracts are for a longer period of time. Although one new long-term grocery contract has been agreed with a customer, nothing has been delivered yet. Delivery will occur before February 20X7.
The warehouse and the Fredericton store locations were affected by major flooding when the snow melted in the spring of 20X6. Flooding caused approximately $1,200,000 of damage to the warehouse and stores. The company has made an insurance claim, but the insurers have disputed it, saying BE is only covered for sewage backup, and not flooding, as this is associated with a natural disaster. These amounts have yet to be recognized in the 20X6 financial statements.
Some of the inventory in the warehouse was damaged in the flood, but it was not a complete write-off. Kathleen thinks that this inventory can be sold in bulk to a large discount retailer.
BE requires audited financial statements as a condition of its lending agreement with the bank. As part of the loan agreement, BE is required have a current ratio no lower than 1:1; however, the industry average is 2:1. BE's accounts receivable and inventory are pledged as collateral for the loan. BE follows accounting standards for private enterprises (ASPE).
APPENDIX 2: NOTES REGARDING THE PURCHASES AND PAYABLES CYCLE FOR BABY'S EDGE
Together with the purchasing managers, store managers are responsible for maintaining sufficient inventory levels for their stores. Each store manager was carefully picked by Kathleen and Christine as they wanted to ensure that the managers could be trusted and that the right "vibe" is given off in the store.
When any of the stores need to order inventory, the store manager sends an inventory request form (IRF) to the purchasing manager, who reviews the request. The IRFs are prenumbered, standardized forms provided by head office. The purchasing manager reviews the order to see the inventory being ordered for the store. All order requests are tracked so that market and sales volume metrics are available for each store. Kathleen and Christine believe these reports are critical to their decision-making process, and therefore they review them at the end of every month.
The purchasing manager checks to see whether the warehouse has sufficient quantity to fill the request. If so, the purchasing manager forwards the signed and approved IRF to the warehouse, where one of two staff process the orders. One signature is required to approve the shipment at the warehouse, and another signature from the store manager is required when the goods arrive on site.
If the inventory is not on hand in the warehouse, the inventory levels at the remaining locations are reviewed. Any slow-moving inventory is transferred to the requesting store. If there is no inventory available to move between the stores, the purchasing manager gives the request to one of two purchasing clerks, who sources the product from a preapproved vendor list. One of two clerks reviews the IRF to ensure it has been signed by the purchasing manager. The clerks must place orders through an approved vendor list. Purchases that are larger than $25,000 must be reviewed, signed and approved by Christine.
Once the supplies have been ordered, copies of the IRF are forwarded to the accounting department and the receiving department at the distribution warehouse. When supplies are received, the receiving department will agree the shipping slip to the IRF. The shipping slip and the IRF are then sent to the accounting department. The goods are then shipped to the specified store. When the accounts payable clerk receives the slip and IRF, these documents are filed under the vendor's name. Once the invoice from the vendor is received, accounts payable processes the invoice for payment by stamping the invoice as "paid" and posts the entry to the general ledger.
Inventory counts
Every other week, the inventory system automatically selects a sample of inventory items that must be counted at each store. The system ensures that all items are counted at least twice a year. Each store manager reviews slow-moving inventory on a monthly basis and provides a report to head office for updating of the inventory system.
A standard report with inventory count details is automatically sent to the warehouse and store locations every other Monday. The report provides a list of the product lines that are to be counted. The report also contains detailed instructions on how to carry out the inventory counts to ensure that they are properly controlled. Counts are carried out that day at the warehouses and individual stores, and the results are emailed to head office.
A member of the finance department at head office compares the count results to the level of inventory recorded on the inventory system; all differences are followed up with the store manager, the results are documented and the inventory system is corrected where required.
APPENDIX 3: NOTES REGARDING THE INVENTORY WORK PERFORMED
The staff accountant randomly attended a sample of the store inventory counts.
The following is a summary of the inventory held by BE as at September 30, 20X6. Included in the summary is a breakdown by number of product lines, the approximate value of inventory held at each location and the locations where the accountant attended the inventory count.
|
Information on inventory holdings Location
|
Number of
product lines
|
Approximate
value of inventory
|
Attended count
|
|
Halifax
|
962
|
$1,050,000
|
Yes
|
|
Fredericton
|
467
|
$95,000
|
No
|
|
Bedford
|
765
|
$818,000
|
No
|
|
Warehouse
|
546
|
$904,500
|
Yes
|
|
Charlottetown
|
335
|
$168,000
|
No
|
|
Toronto
|
250
|
$145,000
|
No
|