Case Question:

Huan Scoop is the sole owner of Organic Dairy Company Inc. (ODC), an Ontario maker of premium organic ice cream. Huan started ODC in 1989 with a bank loan, and the company soon took off and became a major competitor in the Canadian ice cream market. ODC offers consumers an assortment of flavours and types of ice cream. All varieties are certified organic and use the highest-quality ingredients from fair-trade suppliers.

Sandra & Tim LLP (ST), a local firm in Ontario with only one office, has been the auditor of ODC for the past 15 years. You, CPA, CA, have worked for ST for three years, and have recently been promoted to assistant manager. It is now June 10, 2019, and you are meeting with the audit partner, Leslie Connor, to discuss Huans concerns.

Leslie begins: There have been a few changes in the business in the past year which are detailed in my notes from meeting with Huan last week (Exhibit 1). I would like you to draft a planning memo for the audit of the financial statements of FSI for the year ending October 31, 2019. The memo should include an assessment of the overall financial statement risk, a discussion of materiality and the audit approach, and a description of the high-risk financial statement items with specific audit procedures to be performed. I have also provided you with carry-forward and summary information on ODC from the audit file (Exhibit 2).

ODC has done very well in the last 10 years, and now has significant excess cash (approximately $3.5 million) that is currently held in a business savings account earning nominal interest. Huan has a great mind for running the ice cream business, but he is not sure what he should do with ODCs excess money. He has considered making a partial acquisition of another business but is also considering a couple of other investment options (Exhibit 2). These changes will be material to the financial statements, so we should also determine the significant audit implications of the proposed transaction on the planning of the audit.

Required: Prepare the memo requested by Leslie. (CPA Ontario, Adapted)

Exhibit 1 Notes from Leslies Meeting with Huan Preferred Shares Huan Scoop owns 100% of the issued and outstanding common shares. In preparation for his eventual retirement, ODC issued five $10,000 non-voting special class preferred shares to his daughter Julia. The shares provide for a 10% cumulative dividend per annum and are redeemable at Julias option after being held for 10 years. Since these are shares in the company, they are currently classified as preferred shares and are presented in the equity section of the balance sheet. Customer Bankruptcy One of ODCs customers in Atlantic Canada went bankrupt because it was found that it was selling products that were not actually organic. The current receivable balance from this customer is $5,000. Loan Guarantee Earlier in the year, Huan provided a guarantee for a $25,000 loan that close family friend required to start her own business. The loan was supposed to be used to purchase equipment and to make leasehold improvements. Unfortunately, most of the money went into the leasehold improvements that cannot be removed easily nor do they have a high resale value. No information has been received from the bank but Huan believes payments for the loan havent been made for at least a few months. The accountant was unsure about how to account for this transaction so has yet to record it.

Bank Loan Refinancing The term of the original bank loan ended on April 30, 2019 and therefore required refinancing this year. Huan decided to refinance so that he could use all the excess cash for his proposed investments. The bank has changed its standard loan agreement since ODCs bank loan and although most of the terms are similar to the previous bank loan, there are new stricter terms than what was required in the past: --The bank loan is now secured by accounts receivable and inventory. --ODC must maintain a debt to equity ratio at each year end of no greater than 1:8 to 1. . Lawsuit A disgruntled former employer and his family are suing ODC for damages alleging that ODC did not provide a safe environment for employees as they had not provided sufficient security and break rooms on the premises. ODCs lawyers have indicated that there are no precedents supporting the claim and do not think it is likely that ODC will be held liable.

Exhibit 2 Information from ODCs Audit File Overall materiality on the ODC audit has been approximately $50,000 for the past several years. Huan prides himself on running the business with strong controls. The controls exist at every level to ensure that the policies and procedures are followed. There is proper segregation of duties within ODC, and Huan has invested a large amount of time and money to ensure ODC operates properly.

The audit fieldwork has always been performed at ODC. ST staff members attend the inventory counts at year-end and perform sheet-to-floor and floor-to-sheet inventory test counts. Measurements from tanks are taken from the computerized measurement system. No discrepancies have been found in recent years. The focus of the audit has traditionally been on inventory since the inputs into the ice cream are complex and require estimation for areas such as overhead and applied labour.

To ensure the ice cream is pure and of the highest quality, ODC has strict quality controls at every stage of production.

ST has been able to plan and execute audits that comprised a combination of tests of controls and substantive tests. This approach has resulted in audit efficiencies and the ability to maintain relatively low audit fees.

Exhibit 3 Investment Options Huan has considered a few different ways to invest the excess cash in ODC. All investments will be held within ODC. It is possible to choose all three investment options, but it is not necessary to recommend which investment Huan should undertake because he will make the final decision. Public Company Stock Huans friend Jennifer Stray is a savvy investor who suggested he invest some of the cash in public company stocks. Jennifer told Huan that the value of ones portfolio could increase through investment in companies with growth potential. All of the companies Jennifer proposed are listed on the TSX and trade a high volume of shares on a daily basis. Government of Canada Bonds Another idea of Huans is to invest a portion of ODCs excess cash in newly issued long-term Government of Canada bonds. Huan likes the idea of being able to secure the long-term financial well-being of the business by earning 2% to 3% yields on bonds. Huan is not interested in playing the market with these bonds since he views them as safe investments and would prefer that ODC hold on to them for the long term. Chocolaty Choice Inc. For several years now, Huan has been in contact with Jonathan Cocoa, an owner of an Alberta chocolate sauce company called Chocolaty Choice Inc. (CCI). Huan met Jonathan through trade conventions, and they have built up a friendship. They now see one another at least four times a year at food industry conventions. ODC and CCI have had limited business transactions; ODC sold excess packaging materials for $400,000 to CCI in 2018 for use in its chocolate sauce containers (the original cost was $200,000).

Recently Jonathan offered Huan a 35% stake in CCI for approximately $1.5 million. Detailed information on the CCI investment opportunity is provided in Exhibit 4 along with CCIs financial statements (Exhibit 5).

Exhibit 4 Information on CCI (from Huans Meetings with Jonathan Cocoa) Background Jonathan started CCI in 2005 due to his lifelong love of chocolate. He has had several businesses in the past, but none of them were successful. To finance the start-up of CCI, he sought investment from four investors. Currently, the shareholder register consists of 100 voting common shares, with the ownership being as follows: Jonathan Cocoa 45 Samantha Sprinkle 15 Bart Buttersworth 20 Carl Cherry 10 Patrick Peanut 10 Total 100 Jonathans offer of 35% of the total common shares of CCI would consist of 20 of his own shares and 15 of Barts shares, since Bart wants to reduce his investment in CCI. The other investors have not objected to this proposal. Aside from Jonathan, none of the owners are involved in the day-to-day operations of CCI, and none attend meetings of the Board of Directors.

Systems and Controls Jonathan leaves the financial and accounting aspects of the business to the accounting staff at CCI, Valerie Mercer and Rakesh Singh. Jonathan hired Valerie, a family friend, straight out of college. Rakesh used to work in the warehouse, but Jonathan wanted to give him a chance, so he was promoted to assistant controller. Valerie signs all cheques and performs most of the high level reconciliation work. If he has the time, Rakesh reviews the reconciliations prepared by Valerie. Rakesh handles the clerical duties related to accounts receivable and accounts payable, and when he has time available, he assists Valerie in various other duties. Inventory is counted when the warehouse employees have time, which usually occurs within two to three weeks of year-end. Inventory shrinkage is discovered at each count date, but since it only amounts to a few thousand dollars so Valerie and Rakesh have not investigated the cause.

Excess cash was invested in publicly traded bonds that paid annual interest, and CCI earned $60,000 of interest income this year.

Exhibit 5 Extracts from CCIs Financial Statements CHOCOLATY CHOICE INC. BALANCE SHEET AS AT DECEMBER 31, 2018 (Unaudited)

ASSETS Current Assets Cash (Note 2) $225,000 Accounts Receivable 3,315,500 Prepaid Expenses 121,000 Inventory (Note 3) 1,750,000 Total Current Assets 5,411,500 Property and Equipment (Note 4) 4,500,000 Total Assets $9,911,500

LIABILITIES AND SHAREHOLDER'S EQUITY Current Liabilities Accounts Payable (Note 5) $2,000,000 Income Tax Payable (Note 6) 1 5,500 Note Payable (Note 4) 1,000,000 Customer Deposits 200,000 Total Current Liabilities 3,215,500 Total Liabilities 3,215,500 Shareholders' Equity Common Shares 2,000,000 Preferred Shares 1,000 Retained Earnings 4,695,000 Total Shareholders' Equity 6,696,000 Total Liabilities and Shareholders' Equity $ 9,911,500

Exhibit 5 Extracts from CCIs Financial Statements (Continued)

Note 1: Basis of Presentation The financial statements have been prepared in accordance with Canadian accounting standards for private enterprises (ASPE). Note 2: Cash CCI has a credit facility that bears interest at a rate of prime plus 0.5%. The line was undrawn as at year-end. Note 3: Inventory Included in inventory is packaging material costing $400,000, which was purchased from Organic Dairy Company Inc. (ODC) during 2018. CCI purchased it from ODC when CCIs regular supplier went out of business. CCI plans to continue purchasing packaging material from ODC in the future.

Note 4: Property, Plant, and Equipment Included in property, plant and equipment is a new chocolate-blending machine that cost CCI $1,000,000 (carried at $950,000 net of $50,000 amortization). The construction of this machine was financed through a three-year-term $750,000 note payable to CCIs bank, which charged 8% interest. The financing was required because the machine took approximately three years to design and build. To date, CCI has paid only interest on the loan. The related interest has been expensed in net income for the year. An up-front financing fee of $90,000 related to costs associated with the financing was also incurred, of which $30,000 was expensed in the year using the straight-line method. Note 5: Accounts Payable Included in accounts payable is $325,000 of trade payables owing to ODC for the purchase of packaging materials in the year. Note 6: Income Tax Payable CCI reports income taxes using the taxes payable method. Due to significant incentives relating to tax deductions on processing equipment, CCIs property, plant and equipment assets have a tax cost $700,000 lower than its accounting cost. Note 7: Preference Shares CCI has 1,000 Class A preference shares issued and outstanding at $1 each and have cumulative dividends of 5%.