Activa Leisure Co. (ALC), a retailer of high-quality activewear, has been considering a number of different expansion opportunities in recent years. One option is to purchase Quantum Athletics (Quantum), a manufacturer and distributor of sporting good equipment. The company's sole shareholder is Mike. Quantum's manufacturing facility is in Winnipeg, and it has sales and distribution branches in Mississauga, Ontario, and in Montreal.

ALC is considering the acquisition to expand into this market. However, before moving any further with this idea, ALC has requested an audit of Quantum.

Clarke and Lunn Chartered Professional Accountants (CL) have been engaged to perform the year-end audit. You, CPA, are the audit manager on the Quantum year-end audit and are meeting with Mike to discuss the results for the year.

Mike has brought the company's draft financial statements to your office (see Exhibit I).

Mike: It has been a challenging year. Most of our customers are in Ontario and Quebec. This year, we began selling into the United States (U.S.) and Brazil. We attended major trade shows in the U.S. and Brazil early in the year to promote our company and products. It was the first time we had attended these types of events, and the related travel and advertising costs were over $40,000.

We received a number of orders, and in anticipation of the increased demand, we purchased raw materials. Things were looking great and then there was a financial crisis. Demand for sporting equipment fell dramatically. In order to remain competitive, we had to reduce our selling prices; even so, a number of our customers have gone bankrupt or are having significant difficulty. I have been really busy and have not spent much time following up with customers and reviewing their outstanding balances.

At the same time, the bank imposed a new covenant requiring that the debt-to-equity ratio remain below 1.0. To avoid any staff reductions, the administrative staff agreed to take a week off without pay and forgo raises for the year. In addition, although I received a $75,000 bonus last year, I didn't take a bonus this year. Unfortunately, one of our main pieces of manufacturing equipment unexpectedly broke down during the year, and we incurred close to $30,000 in costs to repair it.

Required

You are beginning the risk assessment for the upcoming audit of Quantum. Identify accounts that are at a risk of material misstatement and would warrant further investigation during the audit, given the changes in ratios and considering the provided case facts. In addition, include a procedure to address the identified risks.

Quantum Athletics Balance sheets As at December 31 (Prepared in accordance with ASPE) Current year (draft - prepared by management) Prior year (audited) Assets Current assets: Cash $1,140 $16,635 252,477 Accounts receivable Inventory Prepaid expenses 377,602 283,906 26,744 195,632 30,611 689,392 495,355 Property, plant, and equipment (net) 1,788,420 1,840,415 $2,529,807 $2,283,775 $65,100 Liabilities and shareholders' equity Current liabilities: Demand bank loan Accounts payable and accruals Income taxes payable Current portion of term bank loan $61,600 319,720 295,793 402 638 28,000 389,531 28,000 409,722 658,000 1,067,722 Term bank loan 686,000 1,075,531 1,000 Share capital Retained earnings 1,000 1,207,244 1,461,085 $2,529,807 $2,283,775 Prior year (audited) $2,705,030 1,379,658 1,325,372 Quantum Athletics Statements of income and retained earnings For the years ended December 31 (Prepared in accordance with ASPE) Current year (draft - prepared by management) Sales $2,791,275 Cost of sales 1,396,238 Gross profit 1,395,037 Expenses: Amortization 214,105 Bad debts 11,060 Interest and bank charges 83,748 Professional fees 34,221 Repairs and maintenance 70,530 Salaries and wages 527,063 Selling, general, and administrative 142,242 Income before taxes 312,068 Income taxes 58,227 249,866 14,004 93,488 5,060 20,535 553,040 189,273 200,106 34,088 Net income 166,018 253,841 1,207,244 1,041,226 Retained earnings, opening Retained earnings, closing $1,461,085 $1,207,244 Quantum Athletics Balance sheets As at December 31 (Prepared in accordance with ASPE) Current year (draft - prepared by management) Prior year (audited) Assets Current assets: Cash $1,140 $16,635 252,477 Accounts receivable Inventory Prepaid expenses 377,602 283,906 26,744 195,632 30,611 689,392 495,355 Property, plant, and equipment (net) 1,788,420 1,840,415 $2,529,807 $2,283,775 $65,100 Liabilities and shareholders' equity Current liabilities: Demand bank loan Accounts payable and accruals Income taxes payable Current portion of term bank loan $61,600 319,720 295,793 402 638 28,000 389,531 28,000 409,722 658,000 1,067,722 Term bank loan 686,000 1,075,531 1,000 Share capital Retained earnings 1,000 1,207,244 1,461,085 $2,529,807 $2,283,775 Prior year (audited) $2,705,030 1,379,658 1,325,372 Quantum Athletics Statements of income and retained earnings For the years ended December 31 (Prepared in accordance with ASPE) Current year (draft - prepared by management) Sales $2,791,275 Cost of sales 1,396,238 Gross profit 1,395,037 Expenses: Amortization 214,105 Bad debts 11,060 Interest and bank charges 83,748 Professional fees 34,221 Repairs and maintenance 70,530 Salaries and wages 527,063 Selling, general, and administrative 142,242 Income before taxes 312,068 Income taxes 58,227 249,866 14,004 93,488 5,060 20,535 553,040 189,273 200,106 34,088 Net income 166,018 253,841 1,207,244 1,041,226 Retained earnings, opening Retained earnings, closing $1,461,085 $1,207,244