Auditing

Question 5 (13 marks)

My Chatr Inc. (MCI) is a medium sized private company in the business of developing, manufacturing and distributing wireless Internet devices. These devices permit users to browse the Internet and to send and receive e-mail while mobile. MCIs niche is in commercial Internet devices, which are more durable than retail consumer versions. MCIs special keyboard, the most advanced in the industry, is very small, easy to use and durable.

According to a leading market research firm, the market for this segment is growing at 70% per annum. Competition in this segment is fierce. MCI operates in an industry characterized by heavy expenditures in research and development and products that are regularly updated and revised. Recent innovations by one of MCIs rivals suggest that the industry is in a period of intense competition. Most of MCIs production is exported.

The company was founded by Linda Scott, CPA, CA and was incorporated in March 2005. MCI obtained a $5 million bank loan that was personally guaranteed by Scott. According to the loan agreement MCI must maintain a current ratio of 2:1 at all times otherwise the loan becomes payable. The company has a December 31 year end. Cotton & King LLP (C&K), a large public accounting firm, had been the auditors since 2005. In November 2015 MCI decided to hire your accounting firm, Lewis and Frydman LLP (L&F) to undertake its audit for the year ended December 31, 2015 based on the fact your firms audit fee was the lowest compared to all other firms who submitted a bid to do the audit.

MCI operates out of a single location in Canada and has 72 employees. The company has grown rapidly with annual revenue growth of approximately 40%. This was less than the forecasted 80% annual growth.

Shares of high technology companies have taken a major plunge over the last year. On the positive side, the tremendous shortage of high tech employees, which had hurt MCI, has eased due to widespread layoffs in the industry and the downturn in the economy.

Cash flow has been tight recently, but MCI in most cases has been able to pay suppliers on time. Management is looking at various options of obtaining additional financing over the next year. One of the considerations is to go public and to issue an initial public offering. Management is aware that if the company goes public that governance will be more important than it is now.

You are a recently qualified CPA,CA with L&F and have been assigned to the audit team for the audit of MCIs financial statements for the year ending December 31, 2015. It is now February 10, 2016 and you have been assigned to start the planning for the year-end audit. In preparation for the audit planning you obtained the following information:

• MCIs key financial information for the past two years was:

(thousands)

2015 2014

Revenues 19,061 14,044

Net loss before taxes 1,800 230

Total assets 15,631 8,908

• During March 2015, Scott authorized a change in credit policies. Previously, customers were granted credit based upon the credit ratings developed by MCIs credit manager, which took into account the outstanding balance of the customers account and an analysis of its financial condition. Due to the recent downturn in the economy Scott decided that MCI must use a more lenient credit policy to keep sales flowing.

Accordingly, as a cost cutting measure, the credit manager was laid off in February 2015. Scott now evaluates each customer contract or purchase order

individually to determine whether credit should be granted. As a result of this

new policy, no customer orders were declined for poor credit since February

2015.

• In August 2015, the company was sued by a supplier in California for breach of contract related to the cancellation by MCI of a firm order for software. MCIs U.S. lawyers have said that they can probably drag out the case until at least February 2016. The order was for $1,280,000 and this is the amount of the claim. Scott believes the company should be able to settle for about half of that amount.

Required

• Describe four industry and environmental factors that increase MCIs business risk. Explain why the factor increases business risk. Link the business risk factors you identified to specific risks of material misstatements (RMM). Use the table on the following 2 pages to complete your answer. (8 marks)

Describe industry and environmental factors that increase MCIs business risk. Explain why the factor increases business risk (1 mark).	Link to Risk of Material Misstatement (1 mark)
1.
2.
3.
4.

b) State the dollar amount you would consider an appropriate materiality level for the 2015 MCI financial statement audit. Justify your recommendation with supporting reasons. (5 marks)