Charm Studios Inc. is a hair salon owned and operated by Jennifer. Jennifer had worked as a stylist in a high-traffic salon for over 10 years, and then on July 1, 20X5, she decided that the time was right to open her own salon, so she took out a loan for the initial costs of setting up her salon. Over the last year, the salon's business has grown so much that, in order to extend the salon's business hours to include evenings and all weekends, Jennifer has hired one full-time and two part-time stylists, as well as a part-time receptionist who will help manage the front desk. In addition, an esthetician operates her own company, Nail Art - an entity separate from Charm
- in a room within the salon.
As the salon premises are being fully used and the salon's clientele is continuing to grow, Jennifer is hoping to expand her storefront and is seeking an additional loan to do this. The bank has requested audited statements for Charm in accordance with ASPE for its most recent fiscal year end (June 30, 20X6). Jennifer has provided the draft income statement for the year ended June 30, 20X6, in Appendix 1.
In July 20X6, Jennifer approached Tracey, a CPA, to inquire whether her firm, Connolly, Drake and Associates (CDA), could complete Charm's financial statement audit. Tracey is one of four partners at CDA. Jennifer has been Tracey's hair stylist for years. They have become close friends and have often chatted about their mutual friends, and Jennifer has sought Tracey's opinion on some accounting matters such as the correct accounting treatment for Charm's expenditures over the last year. Jennifer has implemented some of Tracey's recommendations.
Jennifer uses an off-the-shelf software package used by many salons. The software package allows for easy input of sales transactions. As a sale is made, it is automatically recorded in both the sales subledger and the general ledger. The software can quickly generate reports by customer, type of service, and total purchases for each period, although Jennifer has said she never has time to do this. She uses a laptop to track everything, which she is hoping to replace soon because it sometimes crashes.
Jennifer is a skilled hair stylist and a natural leader, but she will be the first to admit that she had a lot to learn about running her own business. She is usually prompt at paying bills and she waits until invoices are paid before recording them. Once she records payments, they are updated in the general ledger. Lately she has been so busy that sometimes bank deposits don't even get made for up to a few days at a time.
Appendix 2 shows extracts from the monthly income statements for March to June 20X6; Jennifer would like you to review the impact of the changes to operations during these months on revenues and costs. Appendix 3 contains the notes from Tracey's meeting with Jennifer. Appendix 4 contains the memo that Jennifer has prepared to describe the sales process at Charm.
Required:
1. Identify any threats to independence that would prevent CDA from accepting Charm Studios Inc. as a client. Discuss how each threat could affect independence and how, if possible, CDA can mitigate each threat. (7 marks)
2. Perform the planning analytical review for Charm's revenues. In particular, use the information related to the number of services that Charm has provided, and distinguish between full-time and part-time staff revenues. Include any supporting calculations. Interpret the results from the analytical review. Which accounts and related assertions will be most impacted by the results of your analytical review? (16 marks)
3. Discuss whether there is any evidence to support the possibility of fraud occurring at Charm. Discuss the auditor's responsibility with regards to detecting fraud at Charm. If fraud did occur, discuss what steps CDA should take now. (10 marks)
4. Complete the preliminary planning of the audit by determining the level of audit risk, and support your analysis by discussing seven risk factors associated with the engagement. Indicate what type of risk (inherent risk or control risk) is associated with each factor. (8 marks)
5. Calculate overall planning materiality and performance materiality for the 20X6 fiscal year-end audit. Provide both quantitative and qualitative analysis supporting your
assessment of preliminary materiality. (8 marks)
6. Identify nine different risks at the financial statement level. For each risk, identify a relevant substantive audit procedure and the specific audit assertion that is being tested. Ensure that these audit procedures you identify are specific to the case facts. Use a chart like the one below to structure your response. (27 marks)
Financial statement risk Substantive audit procedure Related assertion
7. Jennifer has asked you for some business advice related to controls. Describe at least eight weaknesses in Charm's business processes, explain the implications of each weakness, and provide recommendations to reduce or eliminate the weaknesses. Use a chart like the one below to structure your response. (24 marks)
Weakness Implication Recommendation
APPENDIX 1: DRAFT INCOME STATEMENT FOR THE YEAR ENDED JUNE 30, 20X6
Year ended June 30, 20X6
Unaudited
Notes
Revenues - full-time staff 212,150
Revenues - part-time staff 30,300
Product sales 13,825
Total revenues 256,275
Cost of goods sold 8,485 1
Products used in services 4,828 2
General and administrative 7,547 3
Wage expense 79,771
Interest expense 1,554 4
Rent expense 9,000 5
Total expenses 111,185
Total income before taxes 145,090
Notes:
1. This includes hair products purchased from Nova Scotia Beauty, which Charm normally sells to customers at a 50% markup.
2. Products used in hair services are mostly made up of hair colour, shampoo and conditioner. Sometimes a client will need two colour treatments, depending on their hair length and type of colour method.
3. Jennifer has used $5,000 of her own money to purchase new lights, painting and custombuilt supply cupboards for the salon, which is included in general and administrative expense. Sometimes she uses her personal credit card to buy supplies for Charm, and then takes money out of the cash register to reimburse herself for these purchases. She has kept all of the receipts for these items in a separate envelope.
4. Interest expense relates to the $100,000 loan that Jennifer took out to finance the initial costs of setting up the salon. The loan must be paid back over five years. There are covenants on the loan that require Charm to maintain specific ratios, including a current ratio of 1.5 to 1 and a debt-to-equity ratio of 1.2 to 1.
5. Charm is required to remit 5% of its gross sales to the lessor in addition to a monthly rental amount of $1,000. No amount has been recorded for this yet; it will be done when the financial statements are finalized.
6. Charm is being sued by a customer who had a severe allergic reaction after having her hair coloured at the salon - most of her hair fell out within 24 hours of the treatment. The customer was supposed to get married three days after her hair service, but her fiancé decided not to proceed with the nuptials due to the incident.
Jennifer always completes a profile on each new customer as required by The Cosmetology Association. In the profile, there is a section where the client must indicate
whether they have any allergies and the client signs to acknowledge that they understand that there are risks involved with chemicals used in hair colouring. After the incident occurred, Jennifer couldn't find a profile created for this customer. The Cosmetology Association has the ability to cease operations of any stylist or esthetician found to be in violation of their guidelines.
APPENDIX 2: EXTRACTS FROM MONTHLY FINANCIAL STATEMENTS
Monthly income statements for March to June 20X6
March April May June
Revenues - full-time staff 17,450 17,700 17,500 17,350
Revenues - part-time staff 7,200 8,500 7,600 7,000
Product sales 1,000 1,300 900 800
Total revenues 25,650 27,500 26,000 25,150
Cost of goods sold 700 910 630 560
Products used in services 399 557 337 285
General and administrative expense 247 342 378 457
Wage expense 9,224 9,224 9,224 9,224
Interest expense 125 118 145 154
Rent expense 1,000 1,000 1,000 1,000
Total expenses 11,695 12,151 11,714 11,680
Total income before taxes 13,955 15,349 14,286 13,470
APPENDIX 3: NOTES FROM TRACEY'S JULY 20X6 MEETING WITH JENNIFER
Charm staff consists of Jennifer, Meryna, who is another full-time stylist, and three part-time employees, Sherri, Marjan and Kaitlin. There is a full-time esthetician, Ayana, who operates a spa called Nail Art within Charm, but she is not on Charm's payroll because her business is a separate entity from Charm. Nail Art is owned 100% by Ayana.
Nail Art shares Charm's cash register. Ayana rings in services and products sold using a certain code to distinguish Nail Art's sales from Charm's sales. Jennifer and Ayana have a verbal agreement that Charm will collect 20% of Nail Art's revenue in lieu of charging rent. There appears to be some tension between Ayana and Jennifer in the salon.
In March of this year, Sherri and Marjan had come to Jennifer looking for employment. Jennifer hired them both on the spot because they seemed to have the trendy appearance she thought was important for stylists to have in her salon. Jennifer was so excited about not having to search for new stylists and was so eager to have Sherri and Marjan start right away that she did not ask for their Cosmetology Association member numbers to verify that they were licensed.
Sherri and Marjan are best friends and they told Jennifer that they had just graduated from Choice Hair Academy and were eager to work for Charm because they both have big student loans. They always seem to have many friends in the store, and Jennifer is hoping this will lead to a new under-20 clientele base. They all want their hair to look just like Star Sims, a popular teen celebrity.
Jennifer had always answered the phones and booked appointments herself until two months ago, when she hired Kaitlin to take on this role. When clients book an appointment, it is entered into a master schedule, which is maintained electronically so that a historical record is available for each client. Jennifer has been so impressed with Kaitlin that she has also tasked her with doing the bank deposits and handling clients' transactions when their services are complete.
All Charm employees have access to process the salon's payment transactions so they can help out when Kaitlin is busy, to ensure that customers are not kept waiting after their service is complete. Also, Ayana often processes payment transactions for Charm's services and products sales, since her clientele is still growing and she often is not busy. Likewise, Kaitlin will sometimes process Nail Art's payment transactions when Ayana is busy.
Jennifer is seeking a loan to expand Charm's storefront location. Charm currently has a three year lease. Jennifer is not happy with the amount of rent Charm is being charged - a rate of 5% of Charm's monthly sales in addition to the $1,000 fixed rent amount per month. The lessor had provided an upfront incentive of free rent for the first three months because there had been some robberies in other stores at the strip mall.
Charm has a loan with covenants tied to working capital ratios. The bank requires the audited financial statements to be provided within two months of the year end. A breach of the covenants means that the loan will become payable on demand. Jennifer does not have sufficient cash flows to repay the loan if the bank were to call it.
Jennifer purchases 85% of her products from Nova Scotia Beauty, a local beauty supply shop. Charm sells these products in the salon and uses them during client services. Jennifer pays her employees a 10% commission on the sale of each product. On the employees' pay stubs, the total commission amount is shown separately, recorded as part of wage.
APPENDIX 4: MEMO ON DESCRIPTION OF SALES PROCESS FROM JENNIFER
Memo
To: Tracey
From: Jennifer
Date: July 15, 20X6
Re: Description of Sales Process at Charm
I try to keep Charm product sales separate from Nail Art's product sales, but lately, I've noticed that the inventory records have reflected more product on hand than what is actually in stock when we are looking for items.
The new customer loyalty card that Charm implemented a few months ago has been a huge success. Customers earn one point for every $1 spent, and once they have earned 750 points, they can redeem their points for a free hair service or merchandise worth up to $50. The cash register tracks points by customer. The only customers who have not signed up for the loyalty card are walk-in customers, so I estimate that 90% of customers use the loyalty card.
I'm thrilled that the amount of customer bookings has been increasing so quickly. I'm actually kind of surprised that the bank deposits aren't higher. Given the number of appointments we've had, and the amount of hair colour we've gone through since hiring the new part-time staff, I had expected sales to be even higher.
A women's haircut costs $50, and a colour service can range from $100 to $200 depending on the hair length and type of service. The average charge for a colour service done by the parttime staff has been $125. Right now, the new part-time staff are charging $40 per haircut to try to encourage business, which seems to be working - they are busy all the time!
Charm is open from Tuesday to Sunday, and is closed on Mondays. Meryna and I have decided to each work four days per week because the part-time staff work two full days on the weekends and three evenings. During the four days Meryna and I work per week, we are booked 100% of the time. Normally we each do five haircuts and two colour treatment services per day. The two new part-time staff could do the same number of haircut and colour services on the weekends as Meryna and I do each day through the week, and sometimes more. In the three evenings that they each work, the schedule that Kaitlin keeps shows them as being busy, each doing five haircuts and one colour treatment service on most evenings.
I'm kind of surprised that we have constantly been running out of colour needed for hair dyeing. I used to know how much product I would go through each month, but for the last few months I have been consistently running out of product, especially a particular brand that has become popular after Star Sims started doing advertisements for the manufacturer. It's a great product but it's really expensive compared to the other brands. I really should count inventory more often; it seems like it's the last thing I have time for after my salon bookings, running the store and doing all the bookkeeping myself.
At the salon franchise where I worked previously, the payment system had product and service codes that employees could not change at the register. I don't really want to get into that because I trust my employees; they can override the standard price and input the price they feel is most appropriate to charge. I want my regular clients who followed me from my last employer to be happy, so I give some of them discounts on services.