ADMS 4590 M Professor Narmin Multani

Transcription

1 ADMS 4590 M Professor Narmin Multani Date: September 12, 2007 To: Partner, A&B From: CA, A&B Re: Audit engagement and other issues of Curls and Slaps Inc (CSI) for the year ended August 31, 2007 Curls and Slaps Inc. (CSI) is a private company engaged in the business of providing ice hockey and curling activities to professionals and families, as well as other ice-rink related services. A&B has been requested to provide a financial statement audit for the year ended August 31, 2007, as well as to provide advice on a proposal, tax issues, and other issues within the company. CSI has provided statements for the years ended August 31, 2006 and Using this information, we have addressed client concerns as well as prepared a planning memo for the engagement. Management is requesting audited financial statements in accordance with ASPE for a bank, a primary user. As a key user, the bank is interested in CSI s cash position and compliance with loan covenants. The two founding shareholders of CSI are also interested in CSI s financial statements and cash position as they have each provided financing in the amount of $50,000 in common shares and $75,000 in long term debt. Finally, the main shareholder and manager of CSI, Wayne Greatgretsk, is concerned about profitability and the performance of the company, especially regarding CSI s cash position. Engagement Risk We have assessed engagement risk as high due to the following factors: First Time Audit Since this is the first time audit of CSI, engagement risk increases, as we are unfamiliar with CSI s operations. Further, CSI has never been audited or reviewed since the controller has not arranged for an audit since the company s inception. Therefore, there is a concern for the accuracy of financial statements as they may not be in accordance with ASPE and opening balances may contain errors. Management Integrity and Competency Concerns CSI has issued dividends of $120,000 during the year ending August 31, 2007, even though this has brought the company into a negative cash position (the cash account closed at a balance of $-11,300). We must review shareholder meeting minutes or look into dividend payments to see how the dividends were distributed and what basis was used to determine dividend payments. We suspect that the dividends were issued because management relied on the high net income and the cash balance to be positive by the end of the period. However, there seems to be a bigger problem regarding revenue recognition. Due to the revenue recognition policies selected by the controller, CSI appears to have overstated revenue for the last two years. We have recalculated the true net income for the past two years, and we have determined that

2 revenue was recognized too early, or was not supposed to be recognized at all. We provide the calculations to this decision below. This leads us to question the competency and the integrity of management. Management should have noticed earlier that cash levels are not at expected levels and should have held back dividends in 2007 as the depleted cash position became more evident. CSI may be able to argue that the company is in the beginning stages, which would explain the negative cash balance (as starting up operations does tie up cash flows for the first few years). However, management should be aware of this as well, and should have reconsidered issuing dividends when cash is expected to be needed. The concern of management competence or integrity will increase the engagement risk. The use of aggressive revenue recognition policies also raises the engagement risk. In addition, the competency of Mats Sundin, controller of CSI, is under question. Regarding the revenue recognition policies, the financial statements were not prepared in accordance with Accounting Standards for Private Entities (ASPE). Tax returns for CSI have not been filed in 2006 and 2007, and, although a financial statement audit was required by the bank as one of the conditions for a loan, Mats Sundin has neglected to get an audit for the last year ending August 31, These omissions suggest that Mats Sundin does not have the competence required for one of his positions, and that the financial statements may contain more errors. This increases the engagement risk. As a result of CSI not filing its tax return for the year ending August 31, 2006, CSI may also be facing penalties from the Canada Revenue Agency. As a result of not requesting a financial statement audit in 2006, the bank may consider one of its covenants breached and may request immediate repayment of the outstanding loan. These actions may tie up CSI cash flows, or may threaten the continuing operations of the business. This is another factor that increases engagement risk. Financial Difficulties and Liquidity Crisis Due to the current revenue recognition policies, the Revenue and Receivables accounts are overstated. However, when recalculated using appropriate recognition policies, Revenue is considerably less. Due to the nature of the Jabber Football Club Inc. contract, it is inappropriate for CSI to record as much Receivable as they have. If CSI bases cash disbursement decisions off of this basis, then the liquidity of CSI is under threat. CSI has severely restricted cash flows due to a share investment account that obligates CSI to give refunds to customers at any time the customer decides to cancel his or her membership. In addition to this, CSI has bank loan obligations. Should CSI for any reason not meet the bank s covenants (such as the requirement for audited financial statements for the period ending August 31, 2006, which was not neglected by the controller), the company may be required to repay the loan. At the moment, neither cash flow restriction can be met, and this may threaten future operating possibilities of the company. These risks increase the engagement risk. Furthermore, since CSI currently has a negative cash balance, with some other potential issues, it may be likely that CSI may not have the ability to pay A&B for the audit performed. This increases the engagement risk, and makes the engagement less appealing. High Fixed Costs and Low Variable Costs CSI currently has high fixed costs and low variable costs. This indicates that if the company does not meet revenue targets for the year, they still have to incur the fixed costs, 1

3 which can result in a substantial loss in earnings. This may also threaten the profitable continuation of the company, which increases engagement risk. Reliance on Jabber Football Club Inc (JFC) On September 1, 2006, CSI entered into a five year management contract with JFC. Wayne has expressed that the reason for positive earnings in fiscal 2007 is due to the commitment with JFC. Without the contract, CSI would have reported a loss. This indicates that CSI may be overly dependent on JFC and in the event that JFC withdraws their contract, CSI would face significant losses, increasing our engagement risk. Duckflac Insurance Company (Duck) Proposal CSI is considering a proposal by Duck to operate an ice rink located on Duck s premises. There is uncertainty regarding the proposal, especially since cash flows at CSI may be restricted and profits are not guaranteed, as with all new business ventures. This uncertainly raises the client business and engagement risks. Contingency - Lawsuit CSI has been advised of a potential lawsuit regarding the unauthorized use of pictures of a well-known Canadian former hockey player. The lawyer active for the complainant has advised that no legal action will be taken if CSI publicizes a charity with which the individual is associated, makes a donation of $100,000 to this charity, and ceases to use the promotional material that contains images of the hockey broadcaster. This increases our engagement risk as there may be potential lawsuit charges which may cause cash outflows, contributing further to the negative cash balance. This may also result in the recognition of a liability, which will increase total liabilities and may bring CSI to breach its bank covenants. Materiality The primary user of the financial statements is the bank that has provided CSI with a loan on the condition that an annual financial audit is done and total liabilities remain below $1.5 million. The two founding shareholders of CSI also rely on financial statements for CSI s cash position as they have each provided financing in the amount of $50,000 in common shares and $75,000 in long term debt. Wayne is also a shareholder, and he is unsure of what is happening to CSI s net income figures and cash flow position. As all three users are concerned about cash flows, we will set planning materiality based on the net income in fiscal 2007, adjusted based on our calculations using appropriate revenue and expense recognition procedures. Since this is our first time auditing CSI, considering the heavy reliance of users on audited financial statements and the high engagement risks and probabilities of material misstatements, we will use the lower 5% of the adjusted net income ( of $136,108). The calculations for the adjusted net income are provided in a section below. $136,108 x.05 = $6,805. Therefore $6,805 will be our planning materiality. We will also take into consideration performance materiality due to high risks associated with some accounts such as receivables, inventory, and cash. A performance materiality range of 25% to 50% lower than planning materiality will be chosen. However, we will set performance materiality at 50% of planning materiality since the bank relies heavily on statements and CSI is considering the acceptance of a new business proposal by Duck. 2

4 Audit Approach Due to the high engagement risks and control risks identified in CSI s control environment, we will use primarily (100%) substantive procedures to conduct our audit. There will be no reliance on controls. The audit work will be performed with greater due care and professional skepticism, especially since this is the first time we are auditing CSI and must verify the opening balances for accuracy. The areas of concern will be overstatement of revenue and net income and accuracy of cash balance. Due to the management integrity issues mentioned, we will also be conducting some increased audit procedures in those areas. All results will be communicated to management of CSI. Accounting Issues Revenue Membership Fees Revenue Recognition for the Year Ended August 31, 2006 CSI has recognized $1.2 million of revenue from membership fees as of August 31, This includes $900,000 in founder memberships and $300,000 in regular memberships. This may be acceptable considering that the amount of founder memberships and regular memberships sold is reasonable. According to ASPE, revenue may be recognized if the amount to be realized is known and measurable. Measurability criteria for revenue recognition appear to be met. Furthermore, ASPE states that revenue can be recognize if CSI can estimate potential refunds. However, due to the nature of founding memberships, in the first year of membership, the entire amount of $4,500 (per member) is fully refundable if members cancel within the year. According to ASPE, revenue can be recognized if collectability of the amount is reasonably assured. Since the founder memberships are fully refundable in the first year, collectability of this amount is not guaranteed, indicating that the collectability criteria under ASPE for revenue recognition have not been met. For the regular memberships, $150,000 ($1,500 per member) belongs to the share investment refundable amount. This amount can be claimed by a member at any time, so collectability is also not assured. CSI has included this amount as revenue. Since the share investment amount of $150,000 is refundable, the collectability criteria for revenue recognition have not been met according to ASPE. Therefore, CSI should only recognize the amount of revenue they are assured to collect for the year. This will be a conservative policy and will protect the company from financial statement errors due to premature revenue recognition. CSI should derecognize the $900,000 of founding membership revenue and defer recognition until the membership expires after three years, since only then shall collectability be assured (or if a member asks for a refund in the second or third year, which also assures collectability, but for a lesser amount). CSI should also derecognize $150,000 of regular membership revenue and include it a liability account for share investment. We do not consider this account to be unearned revenue due to the nature of the transaction. Once a member cancels his or her membership (which can be done at any time), he or she will be able to get $1,500 refunded, regardless at what point he or she decides to quit. Essentially, this $1,500 will never be earned, because it always has the potential to be refunded. It does not seem like unearned revenue, and should be classified as a current liability. The full amount of revenue that should be stated on CSI s income statement is $1,200,000 balance $900,000 founder membership fees $150,000 regular membership share investment fees = $150,000. 3

5 Financial Statement Impact By recognizing revenue before recognition criteria are met, revenue is overstated by $1,050,000 ($1,200,000 balance - $150,000 actual amount to be recorded as calculated). If CSI de-recognizes the amounts as discussed above and recognizes revenue when all criteria are satisfied, revenue for membership fees will be reduced. This reflects the actual position of CSI in regards to revenue earned and net income. The drastically reduced net income should impact CSI s decisions on cash outlays, and expectations for the next year. Procedures 1. Since revenue for membership fees were overstated, we will need to test for the occurrence of membership fee revenue. We should inquire with management about revenue recognition policies and if they have a provision for membership refunds. 2. Obtain the founder and regular membership agreements to verify the actual amount fees included and review the terms of the agreements to ensure refund policies are correctly stated. 3. Select a sample of membership fee entries in the sales journal and examine invoices relating to those amounts to ensure they are correct. Revenue Recognition for the Year Ended August 31, 2007 CSI has recognized $570,000 of revenue in regular membership fees as of August 31, 2007, and has included refunds in the revenue line for both founding and regular members. This may be acceptable considering that the amount of regular memberships sold and refunds for these memberships are measurable. According to ASPE, revenue can be recognized if the amount to be realized is known and measurable. In this case, the measurability criteria for revenue recognition appear to be satisfied. Further, ASPE states that revenue can be recognized if CSI can estimate potential refunds. However, the share investment portion of the regular memberships is fully refundable if members cancel, so collectability of this amount is not assured. According to ASPE, revenue can be recognized if collectability of the amount is reasonably assured. Since the share investment portion of regular memberships is fully refundable, collectability of this amount is not guaranteed, indicating that the collectability criteria under ASPE for revenue recognition have not been met. Therefore, CSI should recognize the amount of revenue they are assured they will collect for the year as this is conservative and will not result in financial statement errors. Since CSI sold 190 regular memberships, CSI should only recognize $285,000 of regular membership revenue, and the remaining ($285,000) as a share investment since collectability will never be assured. For the fiscal year 2006, 20 founding members had cancelled their membership, so $90,000 in founding memberships was refunded and CSI recognized the refund. However, since the founder membership fees will not be recorded as collectability is not assured, CSI should not include the refund of $90,000 this year. The full amount of revenue that should be recorded on CSI s income statement is $570,000 balance $285,000 regular membership share investment fees = $285,000. Financial Statement Impact By recognizing revenue before recognition criteria are met, revenue is overstated by $285,000 ($570,000 balance - $285,000 actual amount to be recognized as revenue). This 4

6 reflects the actual position of CSI in regards to revenue earned and net income. The drastically reduced net income should impact CSI s decisions on cash outlays, and expectations for the next year. Procedures 1. Since revenue for membership fees was overstated, we will need to test for the occurrence of membership fee revenue. We should inquire with management about revenue recognition policies and if they have a provision for membership refunds. 2. Obtain the regular membership agreements to verify the actual amount of fees included and review the terms of the agreements to ensure that refund policies are correctly stated. 3. Select a sample of membership fee entries in the sales journal and examine invoices relating to those amounts to ensure they are correct. Revenue Recognition JFC Management Fees CSI has recognized $647,000 of net revenue for management fees pertaining to JFC as of August 31, CSI has a lease term with JFC whereby JFC must pay a $50,000 base management fee for five years and an incremental fee of the greater of 8% of JFC s annual membership revenue and $37,500. CSI has recognized the full five years of base management fees in the gross amount of $250,000 and incremental management fees amounting to $185,700. This may be acceptable under ASPE, as the amount of management fees to be received are measurable and are collectible, since they are no cancellation or refund terms for the five year lease term. Under ASPE, the measurability and collectability criteria are met, which states that revenue can be recognized if sale amounts are reasonably known and measurability and collectability is assured. However, the terms of the agreement indicate that the incremental fee is payable beginning November 30, 2007 and should not be accrued for the year ending August 31, Further, the incremental fee is calculated as the greater of 8% of JFC s annual membership revenue or $37,500. If 8% of JFC s annual membership revenue in future years is greater $37,500, then CSI will have to include this amount as incremental management fee revenue. Since CSI is uncertain as the actual amount of incremental fee that could be realized in the future, measurability of this amount is uncertain. In this case, the measurability criteria of revenue recognition under ASPE has not been met regarding incremental fees. Moreover, ASPE states that revenue from service contracts should be recognized when the service is performed. CSI has only provided one year of management service rather than services for the next four years, indicating that the performance criteria for revenue recognition under ASPE has not been met. Recommendation: Therefore, CSI should derecognize the full incremental fee of $187,500 and recognize these fees when they have been earned annually, and the amount is measurable. CSI should also derecognize $200,000 of management fee revenue. This revenue can only be recorded as service is performed every year. The full amount of management fee revenue that should be recorded on CSI s income statement is $647,000 balance $200,000 management fee revenue (four years remaining in the lease term) $187,500 five year incremental management fee = $259,500. 5

7 Financial Statement Impact By recognizing revenue before recognition criteria are met, revenue is overstated by $387,500 ($647,000 balance - $259,500 actual amount to be recorded as calculated). If CSI derecognizes the amounts discussed above, revenue for JFC management fees will be reduced. Again, this will show the actual net income position of CSI, and may show management that there is currently an issue with cash. Procedures 1. Since revenue for JFC management fees were overstated, we will need to test for the occurrence of management fee revenue. We should inquire with management about revenue recognition policies for management fees and the reasons behind recognizing full management fee and incremental management fee amounts. 2. Examine the sales records to verify if actual management fee amounts were recorded. 3. Obtain the contractual agreement and confirm with JFC to verify the actual amount of fees included and review the terms of the agreements to ensure that conditions are outlined as stated. Rent Leased Premises On September 1, 2006, CSI entered into a ten-year lease agreement to lease its premises and is required to pay $245,000 in rent fees for nine years. CSI has negotiated to lease the premises rent-free for the first year of the lease, which is the fiscal year CSI has recorded $180,000 of rent expenses related to the leased premises in fiscal 2006 and This is not in accordance with ASPE, which states that expenses should be recognized when incurred. Since the 2006 rent was free, CSI should not record rent expense in the amount of $180,000. CSI has incurred rent expense of $245,000 in Therefore, CSI should derecognize $180,000 of rent for fiscal 2006 since it was negotiated to be rent free for the first year. CSI should recognize $245,000 of rent expense for fiscal 2007 as this is the first year it has incurred the rent expense. Financial Statement Impact: Rent expense for leased premises is overstated by $180,000 as of August 31, 2006 and understated $65,000 as of August 31, 2007 ($180,000 balance - $245,000 actual amount to be recorded as calculated). If CSI recognizes $245,000 of rent expense for fiscal 2007, rent for leased premises will be increased, thereby reducing net income in Procedures: 1. Since rent for leased premises was understated in 2007, we will need to test for the completeness and accuracy of rent expense pertaining to this ten-year agreement. 3. To test for accuracy, we should examine the contractual agreement and review the detailed amounts and dates on which CSI should pay the rent fees. 4. Ensure that the first year of rent fee has indeed been waived by confirming with the lessor. 5. To test for completeness we should obtain the invoice for the rent payments for both 2006 and 2007 fiscal years and trace it to expense records and general ledger account to see if complete rent amount has been included. 6. We should also inquire with management about the reasons for including $ as rent expense for both years. 6

8 Rent Leased Equipment On September 1, 2005, CSI entered into a five-year contract to lease equipment. CSI has recognized rent expense of $ in fiscal 2006 which includes the initial fee of $ and annual rent payment of $ CSI has also recognized the annual rent fee of $ in fiscal CSI has not accounted for the leased equipment on its balance sheet as at August 31, 2006 and August 31, This is not in accordance with ASPE which states that leases must be classified separately on the balance sheet if it is a capital lease, rather than treated as an off-balance sheet item. A leased property is considered a capital lease if at least one of the following criteria is met: 1. All the risks and rewards of ownership are transferred to the lessee. 2. There is reasonable assurance that the lessee will obtain ownership of the leased asset by the end of the lease term. 3. The lessee has the option of purchasing the asset at a bargain price. 4. The lease term is greater than or equal to 75% of the economic life of the leased asset. 5. The present value of rent payments is equal to 90% or more of the fair value of the property at the beginning of the lease term. A leased property is considered an operating lease if it does not satisfy the criteria for a capital lease if at least one of the following criteria is met: 1. Risks and rewards are not transferred and title of the property remains with the lessor after the end of the lease term. 2. Lessee has option to purchase the property at its fair market value at the end of the lease term. According to the contract, risks and rewards of ownership have not been transferred to CSI as the lessor retains ownership of the equipment during the lease term of five years. Further, CSI has not stated whether it is probable or likely that they will purchase the equipment at the end of the lease term, so we do not have reasonable assurance that CSI will obtain ownership at the end of the lease term. CSI also has the option of purchasing the leased equipment at the end of the five-year lease term at its fair market value. Since CSI does not have the option to purchase the equipment at a minimal amount less than its fair market value at the end of five years, it is not considered a bargain purchase. If CSI does not purchase the equipment at the end of the lease term, then they will expect to benefit from the use of the equipment for 5 years. In this case, the economic life of the equipment, which is 5 years, will be equivalent to the length of the lease term. However, if CSI purchases the equipment, it will expect to receive benefits for over 5 years, meaning that the lease term will be less than 75% of the economic life of the equipment. In assessing the final criteria to be classified as a capital asset, we must determine the present value of the lease payments. We must discount the rental payments of $150, 000 including the guaranteed residual value of $125,000 according to ASPE in order to determine present value. The interest rate to be used to discount the cash flows will be the lower of the borrowing rate or the interest rate stated in the lease contract, under ASPE. Since they are equivalent, the rate of 9% will be used for the five-year lease term: 7

9 $150,000/1.09 = $ $150,000/ = $ $150,000/ = $ $150,000/ = $ ($150,000+$125,000)/ = $ Total = $646, Since the amount of $66,250 was paid on September 1, 2005, it is a separate cost from the lease payments and should be added to the present value. Therefore, the present value of the leased equipment is $730, ($646, $66,250). This constitutes 97.45% ($ /$750,000) of the fair value of $750,000 at the beginning of the lease term, which is greater than 90%. Therefore, since the final criteria is met, the leased equipment should be classified as a capital lease and be capitalized as an asset and a corresponding obligation, according to ASPE. At inception of the lease agreement on September 1, 2005, the amount of $ should have been presented separately from other assets as Leased Equipment and separated from long-term obligations as Leased Obligations. According to ASPE, subsequent to initial recognition, leased assets must be amortized over the lease term using straight-line amortization and interest expense must be recorded. For the year ended August 31, 2006 and 2007, CSI must record amortization expense and accumulated amortization of $ ($ /5 years). The carrying value of the leased equipment on the fiscal 2006 balance sheet should be $ and $ in fiscal 2007, net of accumulated amortization. According to ASPE, subsequent to initial recognition, leased obligations must be adjusted for interest expense. The interest expense is calculated using the same interest rate of 9% that was used to compute the present value of lease payments and computed using the effective interest method. At August 31, 2006, the interest expense and interest payable to be recorded in current liabilities is $ ($ x.09). The lease obligation balance at the end of 2006 is then $ [$ ($ $ )]. At August 31, 2007, the interest expense and interest payable to be recorded in current liabilities is $ ($ x.09). The lease obligation balance at the end of 2007 is then $ [$ ($ $ )]. Therefore CSI should recognize the following amounts on its financial statements as at August 31, 2006 and 2007 as follows: Assets: Leased Asset, net $438, $584, Liabilities: Interest Payable, current liabilities $58, $65, Leased Obligation, long-term liability $554, $646, Income Statement: Amortization expense, leased equipment $146, $146, Interest expense, lease obligation $58, $65, Financial Statement Implication 8

10 CSI has motivation to decrease liabilities since the bank set a limit of $1.5 million on the loan given to CSI. Recording the interest payables and lease obligation will increase liabilities and CSI may not be able to meet the bank covenant. CSI may also be unable to meet obligations due to a decreasing cash position. Procedures 1. Inquire of CSI management and the leasing company if the lease rent payments are fixed and if they foresee any changes pertaining to rent payments that would decrease the present value and bring it below 90% of beginning fair value. 2. Review the lease agreement and inquire the likelihood of CSI purchasing the equipment at the end of the lease term or if they are certain they will purchase the equipment. 3. Confirm the fair value of the equipment at $750, Inquire of CSI and the lessor if there will be changes to the contract that will indicate that CSI record it as an operating lease instead (i.e. if the criteria for capital lease are no longer satisfied). Contingency Lawsuit CSI is advised of a potential lawsuit due to the unauthorized use of pictures of a former Canadian hockey player to promote their products. The hockey player s lawyer has informed CSI that the legal action will not be pursued if CSI donates to a charity with which the hockey player is associated in the amount of $100,000 and immediately stops the use of this individual s pictures to promote its products. CSI can disclose this information in the notes to financial statements since this is a potential and possible lawsuit, and there is no indication of the probability of the lawsuit occurring. However, if in fact the lawsuit occurs, the damages incurred by CSI and costs will likely be greater than the donation that the lawyer is seeking. If CSI decides to make the donation, it can record $100,000 as a donation expense which will decrease income tax, due to charitable donation credits. The company will also save itself the time and cost of dealing with a lawsuit that it may or may not win. Further, the lawsuit seems likely to occur and the amount to settle the matter is determinable ($100,000). Therefore, if lawyers advice that this lawsuit will be lost, CSI should donate the $100,000 to the charity and report this amount as a donation expense and accrue the liability. However, since the year has ended, and the matter has not been settled with the hockey player, it may be possible to record the expense in This means that since CSI has fallen net income in 2007, it would make more sense to reduce the income of next year, if this is possible under ASPE standards. CSI should also disclose the details of the expense in the notes to financial statements. Financial Statement Impact: By recording the expense of $100,000 and corresponding contingent liability, expenses and will increase, which will decrease taxable net income, and may save cash outflows for taxes in CSI will have to recognize an expense and a payable in the amount of $100,000, further decreasing the adjusted net income and increasing total liabilities. This is a concern because any transaction that increases Total Liabilities may cause the company to breach a bank covenant and may cause the loan to be repaid. 9

11 Procedures: 1. Since the lawyer s condition is that CSI must stop using the individual s pictures in promotional material, some inventory with this individual s picture may still exist with CSI. In this case, CSI will not be able to sell the pictures and inventory may become obsolete. We need to test for inventory obsolescence and verify the lawsuit. Here we are concerned about valuation of inventory. 2. Review the legal billings and correspondence to assess the probability of the lawsuit occurring and confirm with the lawyer. 3. Seek legal counsel and obtain written confirmation about the liability of expense amount. 4. Inquire of management about the identification of inventory to be written down and their future plans of addressing obsolescence of the products with the individual s picture. Audit Issues We have reviewed the documentation provided to us by CSI and have identified the key processes and controls. Based on our review of CSI s documentation of its processes, we believe the following matters should be considered in ensuring the integrity of the financial data and results. Cash It is evident that CSI is experiencing liquidity issues as their cash account currently has a negative balance. Therefore, it is important that we test controls on the cash balance to ensure that the balance is correct and match with internal documentation. Procedures: 1. To test for the accuracy of cash and effectiveness of internal controls, we will need to contact the Bank to confirm the cash balance. 2. Review the transactions to see if there are any suspicious or unusual transactions, especially near year end. 3. Review cheques to ensure that they have properly been deposited and authorized. Other Revenue CSI generates other revenues from operating a restaurant and bar and also selling hockey supplies. CSI has used average bar and hockey supplies revenue per member and average number of members to calculate the fiscal 2007 other revenue amounts. Management has not indicated the reasons for using average revenue and average members when the actual number of members is given. There is a risk that the other revenue amounts may be misstated and inaccurate. Procedures: 1. To assess reasonability of the averages selected, we should follow-up with the management and inquire if any adjustments have been made to the average revenue per member and number of members. 2. Inquire with management on what models and procedures were used to identify the average revenue per member and number of members. Membership Refunds 10

12 Refunds will be examined to ensure that supporting documentation exists and that the proper customer accounts were credited. Cancelled cheques may also be examined for endorsement by the customer to ensure that the billing clerk is not writing refund cheques to him/herself and then cashing the cheques. CSI should ensure that supporting documentation exists for all returns before issuing the refund, and management approval should be obtained before the refund is processed. Procedures: 1. Review supporting documentation for member refunds such as cancellation documents, and match it to pay-outs cheque stubs. Long-Term Debt CSI currently has $150,000 of interest free long term debt. We want to verify that this amount is accurate and that it is not understated. Procedures: 1. To determine the accuracy and completeness of long term debt, we should confirm the terms of the debt with the lenders (i.e. the two silent shareholders). 2. Ensure that the loan is in fact interest free by obtaining confirmation with lenders. If the loan is interest free, then we should ensure that it is recorded as a taxable benefit in the corporate income tax return. Equipment and Leasehold Improvements CSI currently has not amortized its equipment and leasehold improvements. The amortization amount should be $150,000 in 2007 and 2006, and should be recorded under the expense line on income statement. We are concerned that amortization expense has been understated. Procedures: 1. To test for completeness of amortization expense, we will need to compute the amortization amount and match with CSI s amortization amount to ensure that they are comparable. 2. Ensure that the amortization schedule prepared for CSI is appropriate and in accordance with GAAP. 2. Assess the reasonableness of the balance of the equipment and leasehold improvements based on remaining depreciable lives and estimated net salvage values. Management Salaries CSI has paid $75,000 to Wayne and $45,000 to each of the two club managers. We want to verify that this amount is reasonable, correct and that it is not understated. Procedures: 1. To determine completeness of salaries, we can check the Board of Directors meeting minutes to verify the salaries of management. 2. Obtain a copy of the payroll journal to ensure that the correct amount of money is deposited into management s bank accounts. Dividends CSI has paid $120,000 in dividends in 2007 and $50,000 in dividends in We want to verify that the amount of dividends declared in its income statement is the actual amount of 11

13 dividends paid to the shareholders and ensure that the amounts of dividends declared has been recorded in the company s books in full. Procedures: 1. To determine occurrence and completeness of dividends declared, we can check the Board of Director s meeting minutes to verify the amount of dividends declared to shareholders. 2. Review and compare the percentage of dividends declared last year versus this year. We notice that there is a 140% increase in dividends paid this year. We will need to question management as to why this is happening. 3. Determine if the dividends declared is consistent with the company s profits. Since we are aware that the company is operating with a negative cash balance, we need to question as to management s intention of declaring dividends this year. Billing and Collections CSI provides accounting services for JFC which may include billing and collecting on behalf of JFC. The risk associated is that CSI does not have competent accounting staff to perform these services and as a result there could be a potential misstatement of revenue amounts. There would be a problem if revenue was understated as CSI currently receives the greater of 8% of JFC s revenue or $37,500. CSI wants to ensure that controls are in place to ensure that the billings are complete and accurate. Controls around the collection of cheques and proper posting of sales and receipts from the credit card company are essential. Procedures: 1. To determine the effectiveness of internal controls, CSI s controls around the billings and collections processes will be tested. This is to ensure that all unusual adjustments are approved by someone more senior to the clerk, that all billings are accurately posted, and that receipts are properly applied to the correct customer account. A sample of transactions will be chosen and reviewed for accuracy of postings to the cash receipts journal and customer accounts. Overdue Accounts We are unsure as to when accounts receivable are followed up. We recommend that they should be followed up after 30 days. Accounting Systems CSI s current accounting system is computerized. The system keeps track of billings to members and disbursements and performs accounting and financial statement functions. The concern here are the potential errors that computerized system may contain. Management has not informed us of appropriate controls over the accounting system to ensure errors do not occur. Procedures: 1. To determine the effectiveness of internal controls, we should inquire with management whether they have controls in place over the accounting system. Then, we will use test transactions and process them through the system and then compare the results to predetermined results. This will show whether the system has been creating errors or not in the past two years. If it is determined that errors were created, we will need to inform management and ensure that appropriate actions are taken to fix the problem. Recalculation of Net Income 12

14 As requested by Wayne Greatgretsk, we have recalculated the Net Income for the periods ending August 31, 2006 and 2007, as this would explain the current cash shortage. We must adjust for the inappropriate accounting and recognition of revenue and expenses, to find out the true net income of CSI Notes 2006 Notes Net Income before adjustments $567,000 $509,750 Adjustments Revenue Membership fees Founder Memberships $270,000 1 $(900,000) 2 Regular memberships $(285,000) 3 $(150,000) 4 Refunds Founder Memberships $90,000 5 Regular memberships $30,000 6 Management Fee - FJC Base management fee $(200,000) 7 Incremental management fee $131,500 Leases Amortization of leased equipment and 9 9 $(146,187) $(146,187) leasehold improvements Interest Expense $(58,205) 9 $(65,784) 9 Net adjustments $(430,892) $(1,261,971) Adjusted Net Income before tax $136,108 $(752,221) Conclusion Unadjusted net income was just over $500,000. With adjustments for proper revenue and expense recognition, there is a net loss in the first year, and there is a positive net income in the year ending August 31, This shows that the company is profitable, at least what can be conveyed from the past two years of operation, however the considerable decrease in net income would explain the negative cash position that CSI is currently facing. Notes to the calculations 1. $270,000 is recognized in the 2007 income for one year of the founder membership fees. 2. No revenue can be recognized for the founder memberships in 2006 because the full amount is refundable in the member cancels in the first year. 3. and 4. The share investment of part of the regular membership price is refundable at any time the member chooses to cancel the membership. It may not be recognized as revenue, but rather as a liability because it may be paid back to the customer. There were 190 new members in 2007, so $285,000 must be recognized as a liability. There were 100 new members in 2006, so $150,000 will be recorded as a liability. 13

15 5. and 6. These refunds of share investment fees are added back because the amounts should not have been included as revenue in the first place, but as liabilities. 7. Only one year s worth of base management fees can be recognized in 2007 because the deal with JFC is over a five year span, and we must wait until CSI has performed the service before recognizing the revenue. 8. Only one year s worth of incremental management fees can be recognized in 2007 because services have not been performed for the next 4 years, so no revenue beyond what has been earned may be recorded. Only $56,000 may be recognized in CSI s leased equipment amortization is determined by the calculation in the Accounting Issues. Projected Cash Flow Statement for 2008 Wayne Greatgretsk has requested calculations to show that the negative cash position is only temporary. To address this request, we have created a projected cash flow statement using financial data that was provided. This calculation takes into consideration current customer estimates and prices, so it is not an absolute expectation, but rather a reasonable estimate. This calculation will show whether CSI will regain a positive cash flow position in the period ending August 31, Cash Flow from Operations Notes Membership fees New clients (including share investments ) $300,000 1 Returning clients $405,000 2 Management fees $87,500 3 Rent Revenue from JFC $282,000 Other Revenue $400,000 4 Other expenses for Bar and Rental $(240,000) 5 Operating costs $(220,000) 6 Lease costs $(180,000) Rent for leased equipment $(150,000) Administrative costs $(100,000) Management Salaries $(120,000) Donation pay-out $(100,000) 7 Total cash flow from operating activities $364,500 Cash flow from Investing Activities - Cash flow from Financing Activities - Interest $(40,000) Net Change in Cash $324,500 Beginning Cash Balance $(11,300) Ending Cash Balance $313,200 Conclusion 14

16 Using data and estimates available to us, we expect CSI to reach a positive cash position, of $413,200 in 2008 and the cash shortage at August 31, 2007 is only temporary. However, we must note that these are only estimates of a positive nature. We recommend using an expert to evaluate market trends for a higher quality understanding of customer levels. Notes to the calculations 1. $3,000 x 100 new clients (as was estimated by CSI, and this would reach capacity). Membership was calculated as the average of members for August 31, 2007 (450) and for August 31, 2008 (550). This amounted to 500 members in total, on average. 2. $1,500 x 270 new clients 3. $50,000 of the rental fee + $37,500 of the management fee. For the latter, we used the minimum amount CSI would get from JFC ($37,500) because we want to remain conservative with this estimate 4. We assume the revenue estimates of $600 for food per member and $200 in supply revenue per member will remain the same in 2008, on average (500). $800 per member x 500 members = $400,000 will be the estimated cash flows from restaurant and supply revenue. 5. We assume the estimates of $360 for restaurant expenses and $120 for supply expenses per member will remain the same in 2008, and multiplied by the average members for the year (500), we calculate the estimated cash outflows for other costs ($480 per member x 500 members) = $240, We assume that the operating costs remain the same, at an average of $400 per member. We calculate the expenses for 550 members (maximum capacity), and so the estimated operating costs in 2008 are $220,000 ($400 per member x 550 members). 7. We are assuming that the amount that is owed to the hockey player that is threatening to sue CSI ($100,000) will be likely paid out sometime during the period ending August 31, Tax return calculations for CSI The purpose of the calculations below is to determine the amount of income tax owing to the Canadian Revenue Agency from Curls and Slaps Inc. for the years ended August 31, 2006 and Notes Accounting Pre-Tax Net Income $(752,221) $136,108 Add backs: Depreciation $146,187 $146,187 Charitable Donation $100,000 1 Deductions: Capital Cost Allowance $(146,187) $(146,187) 2 Net Income (Loss) for Tax Purposes $(752,221) $236,108 Division C Deductions Charitable Donation $(100,000) 3 Non-Capital Loss Carryforward $(136,108) 4 15

17 Taxable Income (Loss) $(752,221) $0 Taxes Payable $0 $0 Conclusion Based on the analysis above, because of the 2006 net loss, and the use of Division C deductions to minimize income in 2007, CSI does not have any taxes owing for 2006 and Notes on Calculations 1. We are assuming that CSI will accept the offer from the promotional material lawsuit and donate $100,000 to charity. 2. We do not have enough information in the case to determine which part of the $1,150,000 is equipment and which is leasehold improvements. Therefore we are assuming that there are no differences between depreciation for accounting purposes and CCA for tax purposes. 3. The Division C deduction for charitable donations is limited to 75% of Net Income for Tax Purposes, which is $117,375 in The whole charitable donation of $100,000 can therefore be deducted from 2007 Net Income for Tax Purposes. 4. The balance of the net-capital loss carryforward from 2006 at the end of 2007 is $616,113. Proposal from the Duckflac Insurance Company Wayne Greatgretsk has also asked for us to assess a potential proposal from Duckflac Insurance Company (Duck). We have provided our qualitative and quantitative analysis and provided a suggestion to assist Wayne in making the decision. We will address the qualitative aspects first, followed by further calculations, and conclude on the proposal. Qualitative factors Duck has provided CSI with a proposal for CSI to operate an ice rink located in Duck s premises complex. The rink would be open within 6 months by March 1, The agreement between Duck and CSI will be for a five year period, and renewal of the agreement will be determined by future negotiations between Duck and CSI. There are various advantages and opportunities for CSI in accepting Duck s proposal: Duck would provide the ice rink for CSI to operate rent free, so CSI will save costs and increase cash inflows. CSI would be able to sell external memberships to the ice rink, allowing CSI to generate revenue from Duck and from normal customers, increasing potential cash inflows. The proposal could enhance CSI s reputation, making CSI better known to potential customers, and increase the number of CSI s customers and cash inflows in the future. The proposal will help move CSI toward its goal of expansion, possibly increasing brand recognition as needed for franchising or CSI owned clubs, increasing potential cash inflows in the future. Duck will provide an interest-free loan of $700,000 to CSI that must be used to pay for CSI s share of the cost of the leasehold improvements and the ice rink equipment, allowing CSI the costs later if it does not currently have the cash flows to take on the cost now. 16

18 Duck will pay a guaranteed annual fee of $120,000 to CSI for 200 employee memberships, meaning CSI is guaranteed a payment for reserving the 200 memberships for Duck s employees, even if not all 200 are used, providing a guaranteed cash inflow each year of the contract. Duck and CSI will share equally in any profits earned by the ice rink in excess of the amount required to provide CSI with a 15% return on its investment in the ice rink, meaning CSI will be able to keep all of the profit up to 15% of the investment, increasing cash inflows for CSI. Duck s location may be more convenient to some of CSI s present members, so customers may spend more time there. This includes visiting the restaurant and using CSI various services more often, increasing cash inflows for CSI. There are various disadvantages and risks for CSI in accepting Duck s proposal: CSI would have to operate the rink and take on the various costs related to running it, which could be more than expected, increasing cash flows less than expected. CSI should try to determine all costs related to setting up and operating the rink. Duck would still own the rink, so at the end of the contract could prevent CSI from using it anymore, cutting off a source of revenue for CSI. CSI should assess if the contract is likely to be renewed before the contract ends in five years, to prepare in the event it is not likely. The ice rink would be available for use by Duck s employees and families on the weekend at no cost to them, meaning CSI is losing potential revenue and is still taking on costs for Duck s employees. CSI can charge more for services on the weekend to make up some of the cost. Duck will pay a fee of $600 per employee, which is only 30% of the annual fee CSI would charge for a regular full family curling and hockey membership, so CSI is not receiving 70% of the revenue it would get from normal customers, meaning less cash inflows. CSI can charge more for services to make up some of the lost revenue. Duck will pay 50% of the cost of leasehold improvements to set up the ice rink to a maximum of $300,000, which was the amount estimated by Duck, and CSI would have to pay the excess amount over $300,000, increasing cash outflows. CSI should assess the total leasehold cost beforehand to determine if it is $300,000 or less and try to make sure leasehold improvement costs do not go above $300,000. Duck will pay 50% of the cost of the ice rink equipment to a maximum of $400,000, which was the amount estimated by Duck, and CSI would have to pay the excess amount over $400,000, increasing cash outflows. CSI should assess the cost of ice rink equipment beforehand to determine if it will be $400,000 or less. Duck will receive 50% of the proceeds received from sale of this equipment when it is disposed of, so CSI will only have 50% of the proceeds so spend on new equipment and other costs, increasing cash outflows in the future. Duck will provide an interest-free loan of $700,000, but CSI will make an annual payment of $140,000 over the five years of the contract to repay the loan, meaning CSI will have to start paying back the loan in the first year when CSI has to spend money to set up the rink, and may not have the cash inflows to begin paying back the loan. CSI should try to negotiate with Duck to start paying back the loan later if CSI will not be able to make the $140,000 payment each year. 17