Barbados Spirits Inc. It is October 15, 2014 and your employer ABCD LLP, an international accounting firm, has recently relocated you to their offices in Barbados. The ABCD Barbados office handles audit, accounting and tax advisory services to clients throughout the Caribbean region. Your first assignment is the audit of Barbados Spirits Inc. ("BSI') a distiller in Barbados. BSI is an 80% owned subsidiary of Johnny Richards International ("URI"), a large private company and a conglomerate in the business of distilling beer and spirits head-quartered in Toronto, Ontario. The minority shareholdings are held by some of the middle management of BSI and other private investors that are residents of Barbados. JRI has subsidiaries in the United States, South America and the Caribbean. JRI is one of the largest clients of the Toronto office of ABCD LLP generating fees from extensive tax advisory and audit services. BSI is the single largest client of the ABCD Barbados office. ABCD provides guidance to accounting staff of JRI and the subsidiaries in the preparation of note disclosure and the income tax provision. BSI has a December 31st year end. A deadline of February 20, 2015 is set for the completion of the fieldwork on the 2014 audit as the financial statements of BSI are needed for consolidation purposes in Toronto. The audited financial statements of BSI are also required for corporate tax filings in Barbados and for the information of the minority shareholders. The statements follow International Reporting Standards and are audited using Canadian Auditing Standards. A leading product produced by BSI is Pirate Cove Rum which has won international awards. Up until the current fiscal year Pirate Cove Rum was sold within Barbados and exported directly to distributors throughout the Caribbean, Canada and parts of the United States. Late in 2013 ABCD LLP's tax advisory services advised that a sister company be incorporated in St. Lucia for tax planning purposes. The sister company - JR Management Inc. ("JRMI") is a 100% subsidiary of Focus planning purposes. The sister company - JR Management Inc. ("JRMI') is a 100% subsidiary of JRI and is incorporated under the International Business Corporation Laws of St. Lucia. JRMI commenced operations in 2014. An International Business Corporation ("IBC") is often used as a tax planning mechanism for offshore companies. The primary advantage to being an IBC is having little to no tax on profits as the corporate tax rate is only 1%. However corporations are not allowed to conduct business in the country of incorporation. This effectively draws a fence separating domestically engaged The case situation is based on a real case. The actual location of the subsidiary company BSI was in another Caribbean country and the case facts have been disguised to protect the identity of the actual company and the company's auditors. 1 companies taxed at 30% and offshore companies taxed at 1%. JRMI does not have operating facilities or employees in St. Lucia and thus qualifies as an IBC paying tax at 1% of any profits. In the current fiscal year all export sales of Pirate Cove Rum are now sold through JRMI the St. Lucia IBC. As before the rum does not transit through St. Lucia but is rather exported directly to distributors in the Caribbean, Canada and the United States both for logistical reasons and so as to not jeopardize JRM's status as an IBC. BSI invoices JRMI and then JRMI invoices the customers. T Focus The price charged by BSI per case of Pirate Cove Rum, before freight charges, is $200 for domestic sales and $150 for sales to JRMI. The production facilities of BSI were expanded in early 2014 when production facilities of a failing plant of another subsidiary of JRI in Puerto Rico were physically transferred to BSI in Barbados. For tax purposes the Puerto Rico's assets were sold at net book value of $14 Million to JRMI the St. Lucia IBC and re-sold by JRMI to BSI for $20 million. In 2014 BSI reported capital additions of $20 Million to be depreciated on a straight line basis over a ten year useful life. In order not to put a strain on cash flows BSI financed the purchase with JRMI with a corresponding twenty-five year amortized loan at a fixed interest rate of 12%. Beginning in 2014 JRMI also charged a management fee of 5% of sales to BSI. Over the years JRI has invested heavily in marketing all of the brands internationally. In order to better reflect the economic benefits of this branding JRI has traditionally charged a royalty of 3% of gross sales. Beginning in 2014 BSI's share of this royalty payment was paid to JRMI rather than JRI. Planning has been completed for the audit of the consolidated financial statements of the parent company JRI. The plan provides some guidance for the audit of the BSI subsidiary including performance materiality of 2% of the net profit. The parent company audit plan provides no guidance on the audit of related party transactions noting that the related party transactions will be eliminated upon consolidation". A review of the 2013 tax advisory file of ABCD reveals the following: A copy of an agreement between JRMI and BSI outlining the $150/case price to be charged. The tax file documented an explanation for the reduced sale price from BSI to JRMI for the rum: "BSI sells to JRMI at a reduced price on a special large customer discount basis. JRMI utilizes JRI's extensive distribution channels that allow for the efficient and effective access by BSI to JRI's world-wide markets. As well JRMI assumes all credit risks associated with sales to these markets." A copy of the management fee agreement between BSI and JRMI documenting the 5% management fee. The agreement outlines that the management fee charged by JRMI is for "production process know-how, marketing and financial management advice". 2 The $20 million addition to production facilities is supported by a contract from JRMI. The contract explains that that these production facilities are "highly customized and specialized to fit into the existing production line. The $20 million loan is supported by a financing agreement between JRMI and BSI. A copy of a royalty agreement between JRI (with rights assigned to JRMI in 2014) and BSI outlining the charge for branding rights of 3% of sales. The agreement is supported by a comprehensive report of valuation of intangibles prepared by an independent international accounting firm. The balance sheet and statement of operations for BSI are provided in Figures 1 and 2 respectively. As the audit planning was underway you were approached by Eldon Crankfort BSI's sales manager and owner of a 2% minority shareholding. Eldon was concerned about a declining profitability of BSI which has resulted in a discontinuance of dividends. He expressed the following concerns: > Domestic sales have increased by 5% and export sales of Pirate Cove Rum is projected to increase from 300,000 cases in 2013 to 350,000 cases by the end of 2014 yet the profitability of BSI is declining. Much of the production equipment shipped in from the closed plant in Puerto Rico was out of date and some of it remains unassembled and is considered junk. BSI had almost paid off the ten year loan at 8% on the former production line, which is still the primary production equipment in use, and now have to service the new $20 million loan from JRMI. > Eldon once tried to call on the offices of JRMI for assistance and found that the number was answered by a law firm in St. Lucia and that they explained that they were merely agents of JRMI who had no employees. Eldon has heard from an associate at another manufacturing plant that the tax authorities of Barbados are planning tax audits on all manufacturing facilities in 2015. Eldon is concerned that other minority shareholders have no idea why the profitability of BSI is declining when sales are increasing. Given Eldon's concern regarding an upcoming tax audit you quickly research the Barbados Income Tax Act and come across a general tax anti-avoidance section (see Figure 3). The corporate tax rate in Barbados is 30%. You also review the draft of the related party note in the financial statements (see Figure 4). The partner in charge of the BSI audit wants an audit planning memo that documents your audit risk analysis and a discussion of any possible material misstatements at either the financial statement or the assertion level in the financial statements of BSI. Figure 1 Barbados Spirits Inc. Balance Sheet as at September 30, 2014 with comparative figures for December 31, 2013 (in thousands of Dollars) Unaudited September 2014 December 2013 983 Current Cash Accounts receivable Inventory 3,807 9,902 8,630 22,339 7,113 6,003 14,099 Property, Plant and Equipment 49,977 32.065 Total Assets 72.316 46,164 Liabilities Current Liabilities Trade and other payables Income tax payable Current portion of long term debt 7,003 145 3,456 7,229 299 2.865 Current portion of long term debt 3,456 10,604 26.154 36,758 2.865 10,393 10.597 20,990 Long term debt Total Liabilities Shareholders' Equity Share Capital Retained Earnings Total Shareholders' Equity 10,000 25.558 35,558 10,000 15,174 25,174 Total Liabilities and Shareholders' Equity 72,316 46.164 Figure 2 Barbados Spirits Inc. Statement of Operations statement or uperations for the nine months ended September 30, 2014 with comparative figures for the year ended December 31, 2013 (in thousands of Dollars) Unaudited 9 months 2014 2013 Sales 108,352 143,866 Cost of Sales 67.178 41,174 79,126 64,740 Operating Expenses: Royalties Management Fees Depreciation General and Administrative 3,251 5,418 4,088 11.232 23.989 17,185 4,316 0 3,451 14,646 22.413 42,327 Operating Profit 960 Interest Expense Profit before income tax 2.351 14,834 41,367 Income tax expense 4,450 12.410 Net profit for the period 10,384 28,957 Figure 3 Barbados Income Tax Actu Related Party Transactions Involving Liability to Tax Where a resident corporation carries on business with a non-resident corporation and by reason of the relationship between such corporations the course of business between them has been so arranged that the business done by the resident produces less profits than those which could be expected to arise from that business if such relationship had not existed, the Tax Department may determine in a reasonable fashion whether any additional profits should be deemed to be assessable income of the resident corporation. Figure 4 Related Party Transactions The company is an 80% controlled subsidiary of Johnny Richards International of Toronto Ontario, Canada. The company has the following transactions with JR Management Inc. of St. Lucia which is a 100% subsidiary of Johnny Richards International: The company exported 40% of the company's sales to JR Management in the ordinary course of business. The company purchased $20 Million of production equipment during the year from JR Management which was financed with a loan from JR Management. The company pays a management fee of 5% of sales to JR Management. The company pays a royalty of 3% of sales to JR Management for branding fees. Q1. Required - Prepare the complete audit planning memo Engagement issues (5 marks) List any threats to independence and propose possible safeguards Overall Risk Assessment (10 marks) List 5 risks at the financial statement level Conclude on the riskiness of the engagement (Hi, Medium, Low) Users (15 marks) 6 List three users, what decisions they will be making (that are informed by the financial statements), what those decisions will be based on (in the financial statements), and how sensitive they are to misstatements of the financial statements Materialit (2n marke List three users, what decisions they will be making (that bare informed by the financial statements), what those decisions will be based on in the financial statements), and how sensitive they are to misstatements of the financial statements Materiality (20 marks) Make two calculations and average them Calculate performance materiality Approach (10 marks) Discuss timing Discuss Control Environment Specific Procedures (40 marks) Discuss 5 Specific procedures o FS line item o Assertion o Risk o Procedure Barbados Spirits Inc. It is October 15, 2014 and your employer ABCD LLP, an international accounting firm, has recently relocated you to their offices in Barbados. The ABCD Barbados office handles audit, accounting and tax advisory services to clients throughout the Caribbean region. Your first assignment is the audit of Barbados Spirits Inc. ("BSI') a distiller in Barbados. BSI is an 80% owned subsidiary of Johnny Richards International ("URI"), a large private company and a conglomerate in the business of distilling beer and spirits head-quartered in Toronto, Ontario. The minority shareholdings are held by some of the middle management of BSI and other private investors that are residents of Barbados. JRI has subsidiaries in the United States, South America and the Caribbean. JRI is one of the largest clients of the Toronto office of ABCD LLP generating fees from extensive tax advisory and audit services. BSI is the single largest client of the ABCD Barbados office. ABCD provides guidance to accounting staff of JRI and the subsidiaries in the preparation of note disclosure and the income tax provision. BSI has a December 31st year end. A deadline of February 20, 2015 is set for the completion of the fieldwork on the 2014 audit as the financial statements of BSI are needed for consolidation purposes in Toronto. The audited financial statements of BSI are also required for corporate tax filings in Barbados and for the information of the minority shareholders. The statements follow International Reporting Standards and are audited using Canadian Auditing Standards. A leading product produced by BSI is Pirate Cove Rum which has won international awards. Up until the current fiscal year Pirate Cove Rum was sold within Barbados and exported directly to distributors throughout the Caribbean, Canada and parts of the United States. Late in 2013 ABCD LLP's tax advisory services advised that a sister company be incorporated in St. Lucia for tax planning purposes. The sister company - JR Management Inc. ("JRMI") is a 100% subsidiary of Focus planning purposes. The sister company - JR Management Inc. ("JRMI') is a 100% subsidiary of JRI and is incorporated under the International Business Corporation Laws of St. Lucia. JRMI commenced operations in 2014. An International Business Corporation ("IBC") is often used as a tax planning mechanism for offshore companies. The primary advantage to being an IBC is having little to no tax on profits as the corporate tax rate is only 1%. However corporations are not allowed to conduct business in the country of incorporation. This effectively draws a fence separating domestically engaged The case situation is based on a real case. The actual location of the subsidiary company BSI was in another Caribbean country and the case facts have been disguised to protect the identity of the actual company and the company's auditors. 1 companies taxed at 30% and offshore companies taxed at 1%. JRMI does not have operating facilities or employees in St. Lucia and thus qualifies as an IBC paying tax at 1% of any profits. In the current fiscal year all export sales of Pirate Cove Rum are now sold through JRMI the St. Lucia IBC. As before the rum does not transit through St. Lucia but is rather exported directly to distributors in the Caribbean, Canada and the United States both for logistical reasons and so as to not jeopardize JRM's status as an IBC. BSI invoices JRMI and then JRMI invoices the customers. T Focus The price charged by BSI per case of Pirate Cove Rum, before freight charges, is $200 for domestic sales and $150 for sales to JRMI. The production facilities of BSI were expanded in early 2014 when production facilities of a failing plant of another subsidiary of JRI in Puerto Rico were physically transferred to BSI in Barbados. For tax purposes the Puerto Rico's assets were sold at net book value of $14 Million to JRMI the St. Lucia IBC and re-sold by JRMI to BSI for $20 million. In 2014 BSI reported capital additions of $20 Million to be depreciated on a straight line basis over a ten year useful life. In order not to put a strain on cash flows BSI financed the purchase with JRMI with a corresponding twenty-five year amortized loan at a fixed interest rate of 12%. Beginning in 2014 JRMI also charged a management fee of 5% of sales to BSI. Over the years JRI has invested heavily in marketing all of the brands internationally. In order to better reflect the economic benefits of this branding JRI has traditionally charged a royalty of 3% of gross sales. Beginning in 2014 BSI's share of this royalty payment was paid to JRMI rather than JRI. Planning has been completed for the audit of the consolidated financial statements of the parent company JRI. The plan provides some guidance for the audit of the BSI subsidiary including performance materiality of 2% of the net profit. The parent company audit plan provides no guidance on the audit of related party transactions noting that the related party transactions will be eliminated upon consolidation". A review of the 2013 tax advisory file of ABCD reveals the following: A copy of an agreement between JRMI and BSI outlining the $150/case price to be charged. The tax file documented an explanation for the reduced sale price from BSI to JRMI for the rum: "BSI sells to JRMI at a reduced price on a special large customer discount basis. JRMI utilizes JRI's extensive distribution channels that allow for the efficient and effective access by BSI to JRI's world-wide markets. As well JRMI assumes all credit risks associated with sales to these markets." A copy of the management fee agreement between BSI and JRMI documenting the 5% management fee. The agreement outlines that the management fee charged by JRMI is for "production process know-how, marketing and financial management advice". 2 The $20 million addition to production facilities is supported by a contract from JRMI. The contract explains that that these production facilities are "highly customized and specialized to fit into the existing production line. The $20 million loan is supported by a financing agreement between JRMI and BSI. A copy of a royalty agreement between JRI (with rights assigned to JRMI in 2014) and BSI outlining the charge for branding rights of 3% of sales. The agreement is supported by a comprehensive report of valuation of intangibles prepared by an independent international accounting firm. The balance sheet and statement of operations for BSI are provided in Figures 1 and 2 respectively. As the audit planning was underway you were approached by Eldon Crankfort BSI's sales manager and owner of a 2% minority shareholding. Eldon was concerned about a declining profitability of BSI which has resulted in a discontinuance of dividends. He expressed the following concerns: > Domestic sales have increased by 5% and export sales of Pirate Cove Rum is projected to increase from 300,000 cases in 2013 to 350,000 cases by the end of 2014 yet the profitability of BSI is declining. Much of the production equipment shipped in from the closed plant in Puerto Rico was out of date and some of it remains unassembled and is considered junk. BSI had almost paid off the ten year loan at 8% on the former production line, which is still the primary production equipment in use, and now have to service the new $20 million loan from JRMI. > Eldon once tried to call on the offices of JRMI for assistance and found that the number was answered by a law firm in St. Lucia and that they explained that they were merely agents of JRMI who had no employees. Eldon has heard from an associate at another manufacturing plant that the tax authorities of Barbados are planning tax audits on all manufacturing facilities in 2015. Eldon is concerned that other minority shareholders have no idea why the profitability of BSI is declining when sales are increasing. Given Eldon's concern regarding an upcoming tax audit you quickly research the Barbados Income Tax Act and come across a general tax anti-avoidance section (see Figure 3). The corporate tax rate in Barbados is 30%. You also review the draft of the related party note in the financial statements (see Figure 4). The partner in charge of the BSI audit wants an audit planning memo that documents your audit risk analysis and a discussion of any possible material misstatements at either the financial statement or the assertion level in the financial statements of BSI. Figure 1 Barbados Spirits Inc. Balance Sheet as at September 30, 2014 with comparative figures for December 31, 2013 (in thousands of Dollars) Unaudited September 2014 December 2013 983 Current Cash Accounts receivable Inventory 3,807 9,902 8,630 22,339 7,113 6,003 14,099 Property, Plant and Equipment 49,977 32.065 Total Assets 72.316 46,164 Liabilities Current Liabilities Trade and other payables Income tax payable Current portion of long term debt 7,003 145 3,456 7,229 299 2.865 Current portion of long term debt 3,456 10,604 26.154 36,758 2.865 10,393 10.597 20,990 Long term debt Total Liabilities Shareholders' Equity Share Capital Retained Earnings Total Shareholders' Equity 10,000 25.558 35,558 10,000 15,174 25,174 Total Liabilities and Shareholders' Equity 72,316 46.164 Figure 2 Barbados Spirits Inc. Statement of Operations statement or uperations for the nine months ended September 30, 2014 with comparative figures for the year ended December 31, 2013 (in thousands of Dollars) Unaudited 9 months 2014 2013 Sales 108,352 143,866 Cost of Sales 67.178 41,174 79,126 64,740 Operating Expenses: Royalties Management Fees Depreciation General and Administrative 3,251 5,418 4,088 11.232 23.989 17,185 4,316 0 3,451 14,646 22.413 42,327 Operating Profit 960 Interest Expense Profit before income tax 2.351 14,834 41,367 Income tax expense 4,450 12.410 Net profit for the period 10,384 28,957 Figure 3 Barbados Income Tax Actu Related Party Transactions Involving Liability to Tax Where a resident corporation carries on business with a non-resident corporation and by reason of the relationship between such corporations the course of business between them has been so arranged that the business done by the resident produces less profits than those which could be expected to arise from that business if such relationship had not existed, the Tax Department may determine in a reasonable fashion whether any additional profits should be deemed to be assessable income of the resident corporation. Figure 4 Related Party Transactions The company is an 80% controlled subsidiary of Johnny Richards International of Toronto Ontario, Canada. The company has the following transactions with JR Management Inc. of St. Lucia which is a 100% subsidiary of Johnny Richards International: The company exported 40% of the company's sales to JR Management in the ordinary course of business. The company purchased $20 Million of production equipment during the year from JR Management which was financed with a loan from JR Management. The company pays a management fee of 5% of sales to JR Management. The company pays a royalty of 3% of sales to JR Management for branding fees. Q1. Required - Prepare the complete audit planning memo Engagement issues (5 marks) List any threats to independence and propose possible safeguards Overall Risk Assessment (10 marks) List 5 risks at the financial statement level Conclude on the riskiness of the engagement (Hi, Medium, Low) Users (15 marks) 6 List three users, what decisions they will be making (that are informed by the financial statements), what those decisions will be based on (in the financial statements), and how sensitive they are to misstatements of the financial statements Materialit (2n marke List three users, what decisions they will be making (that bare informed by the financial statements), what those decisions will be based on in the financial statements), and how sensitive they are to misstatements of the financial statements Materiality (20 marks) Make two calculations and average them Calculate performance materiality Approach (10 marks) Discuss timing Discuss Control Environment Specific Procedures (40 marks) Discuss 5 Specific procedures o FS line item o Assertion o Risk o Procedure