2 (26 marks) The Natural Cleaning Company (NCC) is a privately-held Canadian company that was founded in 2009 by Mindy Jrewl. Mindy owns 60% of the company and the remaining 40% was owned by her father, Jim, who provided Mindy money to start the business. Jim was totally hands-off from NCC and let Mindy make all operating decisions. To fund his retirement, Mindy's father recently sold his stake in NCC to a private equity firm. Your firm of Leung & Metzer (L&M), CPAs is made up of 30 staff members, including four audit partners. After previously being audited by a different firm, your firm was approached for the first time to conduct the audit of NCC as one of the firm's partners is a close friend of Mindy. Mindy specifically requested that her friend be on the audit to help make the whole audit process easier for her. Your firm was appointed to conduct the financial statement audit of NCC for the year ending December 31, 2021. Mindy mentioned that the prior auditor used to complete the audit within six weeks of year end and she requires the same from L&M. She also requested that L&M come with her to meet the bank once the audit report is complete to help support NCC in its requirements to meet certain conditions of their operating line of credit. As senior of the audit, you have made the following notes: Analyzing the Entity and Environment and Analytical Procedures 1. NCC owns three stores in the Greater Toronto Area that sell organic household cleaning products to consumers. They have been successful as they offer high-end products that consumers cannot find anywhere else. Continued growth of the Canadian economy has NCC hopeful that they can continue to open more stores across the GTA. 2. To help finance future growth, NCC obtained a secured line of credit from a local bank in 2019. The loan is secured against NCC's inventory and a condition of the line of credit is that the amount of money borrowed by NCC from the bank cannot exceed its inventory balance. NCC has currently borrowed $2 million dollars from the bank while its inventory balance is $1.8 million. 3. NCC owns a retail store in Toronto and sells a range of hair care beauty products to wholesalers and retailers. NCC invoices the wholesalers and retailers when products are delivered to them with payment terms of full payment in 30 days. NCC is looking to use funding obtained from the bank to expand its operations into other beauty products such as nail care. In order to keep prices lower than the competitors, NCC buys in bulk and encourages its store customers to use cash as payment by offering a 5% discount. This has worked well and on average, 60% of its store sales are paid by cash, the remaining 40% are paid by debit or credit cards. 4. Based on correspondence with the predecessor auditor, you learn that previous audits of NCC have taken a substantive approach to the audit as the auditors did not feel controls were operating effectively throughout NCC. Other than specific changes to the companies operation (identified below) no changes were made to NCC processes during the year. 5. You have conducted fieldwork to update your knowledge about both NCC and its industry. NCC appears to be in good financial condition as assessed from a comparison of the firm's financial ratios with those of other companies in its industry. Your firm was also engaged for the financial statement audit prior to the year-end inventory count, which you were able to attend. Based on observation and reperformance of the count, there were no concerns identified. Obtaining an Understanding of A Perfect Shine Inc's Processes 6. Mindy has recognized the need to offer regular promotions to keep customers. In April 2021 a new program was developed to encourage customer loyalty. The program features a Privileged Customer card (PC card) and is available to all customers. It provides privileges such as discounts, event invitation and sales promotion notices. The PC cards are sold for $100 each and are valid for one year from purchase date. The controller has directed the accounting staff to record the PC card fees as revenue when the cards are sold, even though on preliminary analysis it appears that revenue recognition criteria has not been met at that time. 7. A "Do Not Pay for Six Months" (Do Not Pay) offer was extended to PC cardholders for purchases over $200. Many cardholders took advantage of this offer and purchased items under the Do Not Pay offer. As the response to both of these initiatives was positive, so far 1,800 PC cards have been sold. Mindy has noted it is important to continue to sell these cards since it enables NCC to connect with the PC card members regularly, to alert them about promotions and as a result there has been an increase in customer visits to the store. Significant Events During the Fiscal 2010 Year Under Audit 8. NCC hired an external auditor to review the controls it implemented around the calculation and application of PC card discounts on sales to gain comfort that the system was applying these appropriately. The audit identified no deficiencies with the controls in place. 9. There have been a significant amount of PC cardholder outstanding balances that have come due in the last month, but these customers have not paid the amounts due, despite being contacted repeatedly by NCC. Mindy is not concerned about the unpaid balances since the controller has stated that these customers will return to purchase other products and can be contacted about the payments at the time of their return. As a result, no follow up has been performed with these customers 10. In May 2021, NCC purchased $250,000 of a newly released shampoo product, Flow Hair, from its largest supplier, Sure Hair Inc. (SHI). Flow Hair is a shampoo for people who are suffering from hair loss. SHI claims that Flow Hair increases the density of existing hair. Since the introduction of this shampoo in the marketplace, many incidents have been reported of it causing excessive scalp dryness. Also, many users are complaining that after one month of product use, they have not experienced increased hair density. Mindy has spoken to representatives from SHI and they indicated that these are isolated events. NCC's two largest wholesale customers are demanding refunds for their Flow Hair purchases and have hinted at exploring legal options as Flow Hair has not delivered to the product claims made by NCC or SHI. 11. The controller highlighted that a review of 2021's transactions identified consistent errors relating to sales and accounts receivables. Specifically, sales were not recorded for many sales orders for wholesalers and retailers that were shipped and delivered to their warehouses, as the signed delivery orders were misplaced. This was due to challenges associated with an employee's medical emergency that required other employees to take over the collection and storage of delivery orders over several weeks, which each employee develFFIng their own process for doing this. The Controller is confident they identified and recorded all missing transactions. You reviewed a summary of key financial information of NCC as of December 31, 2021. Statement of Earnings Unaudited Audited Dec. 31,2021 Dec. 31,2020 Revenue Sales Revenue 4,019,500 3,244,000 Other income 94,500 0 4,114,000 3,244,000 Costs and expenses Cost of Goods Sold 2,001,250 1,700,300 Administrative 310,000 285,000 Interest expense 115,000 85,000 2,426,250 2070,300 Earnings before income taxes 1,687,750 1,173,700 Income taxes 337,550 234,740 Net earnings 1,350,200 938,960 Extracts - Statement of Financial Position Closing Inventory (net) 1,780,000 900,000 Accounts receivable 1,251,100 740,198 Accounts payable 1,148,573 818,524 Bank Loan (Operating line of credit) 2,000,000 0 Shareholders equity - common stock 500,000 500,000 Required: a) Identify two potential threats to independence for L&M (1/2 mark each). For each threat, identify the type of threat that exists (1/2 mark each) and a safeguard to eliminate or reduce the threat (1 mark each). (Total 4 marks) i) Situation that causes a threat to independence ii) Type of independence threat iii) Safeguard to eliminate or reduce the independence threat b) Identify three case facts that impact the risk of material misstatement (inherent risks or control risks) at the overall financial statement level (OFSL, 1/2 mark each). For each factor identified, indicate if the factor increases or decreases risk (1/2 mark each), the type of risk (inherent or control, 1/2 mark each) and provide your rational for why the factor increases or decreases risk (1/2 mark each). (6 marks) i) Case fact which impacts RMM at OFSL level ii) Does this factor increase or decrease risk iii) Type of risk (control risk or inherent risk) iv) Rationale for why this factor increases or decreases risk c) Identify three case facts that increase/decrease the risk of material misstatement at the account balance and assertion level (1/2 mark each). For each case fact identified indicate: the account balance and assertion affected (1 mark each), whether the factor increases or decreases risk (1/2 mark each), the type of risk (inherent or control) affected (1/2 mark each) and provide your rationale (1/2 mark each). (9 marks) i) Case fact which impacts RMM at the account balance level ii) Account balance and assertion iii) CR or IR? iv) Increase or decrease risk v) Rationale for why this factor decreases/increases RMM d) Determine overall (planning) materiality for NCC' 2019 financial statement year end audit. Ensure to include quantitative calculations as well as qualitatively explain why you chose the bench mark and explain the reasoning for the area within the threshold you selected for your calculation ( 5 marks, 1 mark for each valid point). e) Determine performance materiality for NCC' 2020 financial statement year end audit. Ensure to provide calculations as well as an explanation of the factors you consider in determining the appropriate percentage for performance materiality ( 2 marks)