Water Your World (WYW) is a medium-sized, private manufacturing company located near Harrow, Ontario. WYW has a June 30 year end. The chief financial officer (CFO) felt that WYW has outgrown its previous audit firm Jacob and Jacob and asked your firm, Bartle & James (B&J), to perform the annual audit.
It is now August 2, 2020. B&J has performed the necessary client acceptance procedures and is currently working on the year-end audit of WYW. However, Jason Bourne, the senior on the engagement has met his life partner and suddenly left the country to be with her in Bali. He is not available and will be unable to complete the file. You, Justin Case, CPA, have been asked to take over the senior role on the audit. The following information has been provided to help you familiarize yourself with the client:
(Exhibit I) information on WYW, (Exhibit II) a draft income statement prepared by management in accordance with accounting standards for private enterprises (ASPE), (Exhibit III) notes from your firm’s meetings with management and the board chair, and (Exhibit IV) excerpts from the current-year audit file.
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The following week, the audit partner on the file calls you into her office and says, “Now that you’ve had the audit file for a week, can you let me know what financial reporting issues you have found? I want to know if there are any updates needed to our approach in particular our audit plan, any materiality considerations, and what audit procedures are outstanding. In addition, the board chair is wondering what our management letter is likely to contain, what internal control improvements can be made, and if there are any suggestions to the board for improving their oversight.”
Prepare the memo to the audit partner in proper memo format.
Information on Water Your World
WYW manufactures water irrigation units for the agricultural industry. The units include sprayers and fans to distribute the water equally. The units are very popular with the traditional greenhouse operators as well as the emerging cannabis growers. The technology was invented by Gene Yus, the current chief executive officer (CEO). WYW holds a number of patents and is protective of its proprietary technology. Seed capital was generated from the sale of shares to Gene’s friends and family members, to employees, and through bank financing.
As the company grew, Gene recognized the need for a CFO, particularly because he is more involved with research and development and manufacturing operations. It was difficult to recruit someone to come to Harrow, which is so small it lacks a Tim Horton’s, so Gene decided to recruit someone with the right skill set, regardless of location. Two years ago, WYW hired Dan Dadealer, who works out of Tilbury, and spends about one week per month in Harrow, Leamington and Kingsville. The bookkeeper, Rita Richard, works in Harrow and reports to Dan. Even though Dan was hired as the CFO, he really enjoys sales and marketing. Dan has been instrumental in WYW’s rapid sales growth because he is willing to travel extensively throughout North America to meet potential customers. With Dan involved in sales, Gene says he considers himself more of a chief operating officer (COO) than a CEO. He completely trusts Dan, and defers most decisions, other than those related to manufacturing, to Dan.
A venture capital firm, VC Ventures (VC), obtained a 20% interest in WYW three years ago. Gene owns 40% of the outstanding common shares of the company, while Dan holds 15%. The remaining shares are held by Gene’s friends and family members, and by WYW employees. Two directors of VC sit on WYW’s board, along with Gene, Dan, and one other member of WYW’s management. The board also functions as the audit committee.
VC and WYW’s management have been actively pursuing a buyer for the company. In the past year, WYW entered into negotiations with one company; however, the deal was not completed and is no longer being pursued. A second potential buyer has now been identified and has started some preliminary due diligence, and there has been significant interest from other potential parties. The current year’s earnings are expected to be a key part of the determination of the purchase price.
Draft income statement prepared by management
Water Your World
For the year ended June 30, 2020
Sales $ 16,973,450
Cost of sales 7,012,495
Gross profit 9,960,955
Administrative expenses 6,123,560
Selling and marketing expenses 487,988
Interest on long-term debt 624,333
Amortization of fixed assets 369,421
Amortization of intangibles 48,709
Earnings before income taxes 2,306,944
Income taxes 647,065
Net earnings $ 1,659,879
Notes from meetings with management and board chair
Bookkeeper: Rita Richard — Rita has been co-operative, but Dan has asked that she checks with him before giving us information. Dan is often on the road, so this correspondence can be slow. Rita mentioned that she had taken a course at Odette called
“implementing effective internal controls” and had been keen to make suggestions from the course. When Rita had suggested the changes to Dan, he said “why fix something that isn’t broken,” so no changes were made. Rita mentioned that one of the vendor invoices had the same address as Dan’s, but Dan said that it must have just been a mistake and he would take care of it.
Board chair: David Webb of VC — The board has not met regularly as a group for most of the past year because Dan has been unavailable. David has also not received the monthly reports promised to him by management. David finds Dan difficult to contact and instead has asked the audit partner to update him weekly on the audit status. He thinks it will be easier than trying to get an explanation from Dan.
CEO: Gene Yus — Gene is proud of the products WYW produces. He prefers dealing with product development and is grateful that, except for manufacturing, Dan has taken over almost everything, including sales. It also helps that Dan is very reliable and never takes vacation. With Dan on the road a lot, they decided that it made more sense to pay vendors electronically, instead of dealing with cheques, so that Dan could make the payments himself remotely. WYW is not only selling more products, but its gross margin, which was around 50%, has increased. With these results, Gene is happy to continue to focus on the products and to let Dan deal with everything else.
CFO: Dan Dadealer — Dan has indicated that he has achieved increased sales due in part to the new Early Order Program, which provides a 15% discount to buyers who commit to purchases in advance. Any purchase orders placed by June 15 and accompanied by a 10% deposit were eligible for the program, with delivery of the units to occur within four months. The units are kept in inventory until they are delivered. The program was highly successful, resulting in total sales of $500,000 being recognized. In addition, this year, WYW started selling demonstration units (demos) to customers. The customer pays for the demo up front but has the option to return it within six months if the customer is not satisfied with its performance. $400,000 of demos were sold and delivered to customers fairly evenly throughout the year. Based on his estimate of returns of regular units over the past two years, Dan has recognized 80% of the items as sales. Dan was not happy to hear that the board chair was contacting us directly. He has asked that we deal directly with him and save the reporting to the board for the final audit meeting.
Excerpts from the current-year audit file
Board minutes — No board minutes were available for review because the board met only once during the year, and no secretary was appointed to take the minutes.
Materiality — Preliminary materiality was calculated using 5% of net earnings before tax and came to $115,000 (rounded).
Approach — No approach had been documented in the audit file, but our firm likes to use tests of controls wherever possible to cut down on the substantive testing required.
Accounts receivable confirmations — The sample size was calculated based on a preliminary materiality. A number of confirmations received were initially returned with
discrepancies. One customer indicated that four of the units confirmed, worth approximately $25,000 each, were demos and would be returned. For other outstanding confirmations, Dan followed up with those customers, and the confirmations were received by him shortly thereafter. He also dealt with confirmation discrepancies related to the Early Order Program, as customers seemed unsure whether or not to include these purchases in the amounts confirmed. Accounts receivable includes approximately $450,000 related to the Early Order Program.
Inventory count — A junior audit team member attended the inventory count in Harrow on June 30, 2020. During the count, the staff noted four returned demo units on hand.
Journal entry review — We asked Dan for a listing of the general ledger journal entries. He has provided us with a sample of journal entries that he has selected from the first half of the fiscal year. No work has been performed to date on them.
Merger and acquisition costs — WYW has capitalized $350,000 of costs related to legal and other expenses for the first offer to purchase. While the first offer is no longer active, much of the work done on the first offer can be leveraged for future offers. Most of the costs incurred related to preparing the company for purchase, thus greatly improving its marketability.
Expense testing — The disbursements selected for testing included a number of Dan’s expense reports. The expense reports had not been approved by anyone other than Dan. It was also noted that there were a few errors, as it appeared that Dan often forgot to deduct his wife’s airfare from the attached receipt. The errors appeared insignificant, so no further investigation was noted.