Question 1

Gerald and Ezio became friends when they both worked part-time at Loblaws while in University. Since they graduated, for the past five years they have owned and operated their own franchise grocery store, Gerald and Ezio’s Kwality Foods Inc. (GEKF).  Kwality Foods Inc., the franchisor, is well known for its low prices and simple (but clean and orderly) stores.

GEKF has experienced increased competition over the past five years as nearby retailers have expanded their operations into groceries and produce.  Over the same time, food costs have increased. This is due to a number of factors, including droughts, decreasing production of some items they sell and the depreciation of the Canadian dollar to the United States Dollar and Mexican Peso (as much of GEKF’s produce is imported from these countries, this has resulted in lower margins and a decline in revenue growth).

Osti & Shwartz LLP were approached to be the auditor of GEKF as their previous auditor had experienced some staff retirements and turnover and were not able to do the audit this year. Based on discussion with the prior auditor, there had been no major misstatements identified during the previous audit, with the only concerns raised were weaknesses with inventory and pricing controls. The previous auditor identified that Gerald and Ezio’s strong involvement and oversight in all aspects of the business has ensured the successful operation of the business.  Based on this, Osti & Schwartz LLP agreed to be the auditors.

The audit is a requirement of franchise agreement with Kwality Foods Inc. The franchise agreement, stipulates a variety of clauses that give Kwality Foods Inc. (the franchisor) the right to cancel the agreement. Kwality Foods Inc. has only used these cancellation clauses in the past for franchisees that did not pay the correct franchise fee on time and for franchisees experiencing significant declines in their profit margins. 

The audit is also a requirement of the bank that loaned money to GEKF to fund recent store renovations. The loan has a covenant that GEKF must maintain at least a 1.5:1 current ratio (current assets divided by current liabilities) or the loan is payable in full to the bank.  Gerald and Ezio also identified a new partner to join them in the business in early 2020 and expect to use a percentage of fiscal 2019’s audited net income to determine the amount that the new partner will pay into the business.  

Gerald and Ezio met with the Osti & Shwartz LLP audit team to start this year’s audit process. The following points were raised by Gerald and Ezio:

• GEKF primarily hires part-time high school and university students as employees. They were fortunate that until the most recent year, employee turnover was low. This year they had to hire a number of new employees. As there has not been time to give them formal training on store procedures, the new staff were making a number of mistakes, which was expected to decrease as they get more experience.

• To encourage customer loyalty, in 2019 GEKF started selling a $400 store membership card. The membership card is valid for one-year from the time of purchase and gives holders access to exclusive store coupons and 2% off their purchases. The purchase of the membership card is non-refundable, but Gerald and Ezio have granted some refunds to a few individuals with special circumstances (such as moving out of town). Other than this new program, revenue recognition is very simple as customers pay cash, credit card or debit card to purchase goods and returns and exchanges are not permitted.

• Kwality Foods Inc. established an internal audit function that started doing audits of franchisees. They performed a payroll audit of all franchise locations after a number of employees made complaints to the company. GEKF’s payroll controls were identified as operating effectively.

• During the year, a customer slipped in the store on a puddle of water and broke their leg. The customer was a postal service employee and sued GEKF for damages relating to lost wages and time and suffering. GEKF is currently negotiating a settlement with the customer to avoid going to trial over the matter. While GEKF did not set up a contingent liability for the lawsuit, they are keeping Kwality Foods Inc. updated.

Gerald & Ezio were excited to start working with the Osti & Shwartz LLP audit team and indicated that if the audit goes well, they would be willing to hire the firm for additional consulting engagements to see if operations can be made more cost efficient. While the previous auditor generally took eight-weeks to do the audit, they were hoping this year the audit could be done in six weeks so that they can finalize the purchase agreement with the new partner soon. In addition to providing the audited financial statements, Gerald & Ezio were hoping that the audit team could provide a listing of control deficiencies identified by the audit team during the audit with recommendations to improve them. They were also hoping that the audit team would meet with the new buyer and discuss how buying into GEKF is a solid investment.

Osti & Shwartz LLP were provided extracts of GEKF’s financial statements (Exhibit 1).

Required

a) Determine overall planning materiality and performance materiality. (Explain the rationale for all components of the calculation and support your analysis with calculations

The needs of the financial statement users are considered when determining materiality.  The expected users of GEKF’s financial statements are as follows:

Bank – the banks objective is to determine if they believe that GEKF will be able maintain his current ratio of 1.5:1, which he is, his current ratio is 3.32, so his loan is not payable in full as per agreement with the bank.  Net income would also indicate company’s future earnings potential and its ability to generate cash.

Gerald and Ezio – the owners objective is to evaluate operations and make strategic decisions.  Net earnings are the figure that he would use to assess the overall performance of the company and would provide owners with amount needed to be contributed into the business by the new partner. They are also requesting a list of control deficiencies with recommendations.

Potential investors – will use the financial statements to determin the value of the company.  Valuation often based on earnings and assets.

Overall Materiality:

Recommendation use NI before taxes for the base given most users are concerned with this figure.

Since this is a first year engagement and given the objectives listed above, the users would be sensitive to errors recommend using the lower percentage – 3% of net income.

Net income before taxes $575,590

@3%      $17,268

@7%      $40,291

Recommended $17,000

Performance Materiality:

Performance materiality is an amount set below overall materiality to reduce the risk that undetected misstatements that when aggregated exceed overall materiality.  Given it is a first time audit and based on preliminary assessment that there is a high level of anticipated errors (new employee’s mistakes, lawsuit liability, strong involvement of owners in oversight in all aspects of business), set performance materiality at 60% of materiality -$10,200.

b) Identify four case facts that impact the risk of material misstatement (inherent risks or control risks) at the overall financial statement level (OFSL).  For each factor identified, indicate if the factor increases or decreases risk, the type of risk (inherent or control) and provide your rationale for why the factor increases or decreases risk.

c) Identify four case facts that increase/decrease the risk of material misstatement at the account balance and assertion level.  For each case fact identified indicate: the account balance and assertion affected, whether the factor increases or decreases risk, the type of risk (inherent or control) affected and provide your rationale.