Canadian Hydraulics Inc. (CHI) is a distributor of hydraulic fluid used in heavy-duty commercial applications. The company was incorporated 20 years ago, beginning with one retail facility in Edmonton. CHI has expanded rapidly to include locations in Winnipeg, Regina, and Tulsa, Oklahoma, over the past four years. The Tulsa location filled the necessity of establishing a presence in the United States. A growing portion of the CHI's purchases are from U.S. wholesale suppliers and sales to U.S. customers are also increasing; all of these transactions are in U.S. dollars.

Many of CHI's customers are well-established companies in the transportation and automotive industries. As is typical for the industry, business tends to be steady during the year, with reduced activity in December and January due to weather considerations.

Given ongoing improvements in additives for the hydraulic fluid, it typically has a five-year product shelf life in this industry. The hydraulic fluid is stored in large tanks as well as smaller containers for transportation.

CHI is owned equally by Fred Draper and Martin Wong, both of whom are actively involved in the business. Fred is responsible for overseeing the sales, administrative, and finance areas. Martin is responsible for inventory management and marketing. Martin is currently planning to sell his shares to Alex Lee, an unrelated party. Fred has also expressed interest in selling some of his shares, should the "price be right."

It has been a challenging year for CHI. Autoworld Inc., a very successful multinational corporation, entered the marketplace recently and through its excellent array of products and large distribution network, has rapidly garnered a large share of the North American market for hydraulic fluids. It saw a well-established market with many financially healthy businesses that would make great customers.

The shareholders and the management team are all very proud of CHI's ability to succeed in the face of such stiff competition. In response to the challenge, CHI saw the need to change its policies and reduce costs. Commissions paid to sales staff were increased by approximately 3.5% of sales. Sales staff was given greater flexibility in negotiating contracts. The credit manager function was eliminated and credit granting responsibilities were reassigned to the sales manager.

Department managers now receive a bonus based on net income and are encouraged to "think outside the box" in order to maximize success. Recently, in order to increase sales, CHI reached an agreement with one of its suppliers, Quality State Inc., whereby CHI would also begin selling certain transmission fluids and brake fluids. As CHI does not have experience with these products and does not know the optimal product mix, Quality State agreed to provide $90,000 worth of transmission fluid and brake fluid product on consignment. CHI plans to begin selling this consignment product in 2020. Consignment inventory is new to the company; this inventory is stored separately from CHI's products.

CHI's loans with its bank are nearing renewal. Under its existing loan agreement with the bank, CHI must maintain a debt-to-equity ratio no greater than 1.3:1 and a minimum current ratio of 1.5:1. The bank requires audited annual financial statements, as the accounts receivable and inventory are used as collateral for the bank loan. The bank is especially concerned with the inventory balance at December 31 in light of the consignment inventory now being held at CHI. Audited financial statements must be provided to the bank by March 15.

CHI hired a new controller in September 2019. The previous controller, Adam Clarke, had been with CHI since day one. There was also turnover of clerical staff in the accounting department. The accounts receivable and accounts payable clerks left in December 2019. The turnover in staff was due to the stress of being understaffed and unable to keep up with the daily work load. As a result, staff were falling behind with many important duties, such as following up on accounts receivable.

The previous internal auditor resigned in September 2019 in order to enter the CPA program. His role has been taken over by the assistant controller, who now spends approximately 25% of his time on internal audit duties.

Severance costs incurred in the years amounted to $70,000. The shareholders have opted to receive dividends this year, in lieu of their normal annual salaries of $50,000 each.

It is now February15, 2020. CHI's former auditors have recently resigned, and Fred Draper and Martin Wong have approached your firm to take over the audit engagement.

Appendix I

Canadian Hydraulics Inc.

Balance sheet

As at December31

(Unaudited)

2019

(Audited)

2018

Assets

Current

Cash

$

$88,123

Marketable securities

51,768

Accounts receivable

214,750

178,860

Due from shareholder

18,000

20,000

Inventory

237,254

184,577

Prepaid expenses

99,555

61,450

569,559

584,778

Property, plant, and equipment

481,835

355,335

$1,051,394

$940,113

Liabilities and shareholders' equity

Current

Bank indebtedness

$ 60,897

$

Accounts payable and accrued liabilities

197,787

228,755

Income taxes payable

58,000

Current portion of long-term debt

55,270

75,270

371,954

304,025

Long-term debt

216,454

216,454

588,408

520,479

Shareholders' equity

Share capital

10

10

Retained earnings

462,976

419,624

462,986

419,634

$1,051,394

$940,113

Appendix I (continued)

Canadian Hydraulics Inc.

Statement of income and retained earnings

Year ended December31

(Unaudited)

2019

(Audited)

2018

Sales

$3,462,728

$3,353,021

Gain on sale of marketable securities

5,000

3,467,728

3,353,021

Cost of sales

1,900,890

1,896,551

Gross profit

1,566,838

1,456,470

Expenses

Advertising and promotion

129,673

162,818

Amortization

58,201

61,178

Automobile

38,780

29,941

Bad debts

15,520

26,128

Commissions

352,455

227,790

Insurance

28,556

21,110

Interest on long-term debt

24,544

36,070

Office

30,836

30,701

Professional fees

18,791

32,458

Property taxes

18,228

25,890

Rent

94,790

76,440

Repairs and maintenance

22,792

46,594

Salaries and wages

442,780

377,690

Telephone

16,090

10,346

Travel and entertainment

17,890

14,674

Utilities

55,560

42,600

1,365,486

1,222,428

Income before taxes

201,352

234,042

Income taxes

58,000

51,200

Net income

143,352

182,842

Retained earnings beginning of year

419,624

236,782

Dividends

100,000

Retained earnings end of year

$462,976

$ 419,624

Part B

Based on the narrative and financial statements, determine the most effective approach for the CHI audit. Consider both the inherent and control risks at CHI.