ERT Ltd. is one of the largest Canadian manufacturers of silicon chips. The company grew quickly but because of the large amounts of money that it had to invest, its cash reserves were quickly exhausted. ERT therefore applied for, and obtained, sizable grants from the various levels of government anxious to foster the development of high-tech companies. However, the grants were accompanied by conditions that the company must comply with annually for a 5-year period starting January 1, 2006. If, at the end of a fiscal period, the conditions are not met, ERT will have 5 years to repay all grants obtained.

These conditions, while known and accepted by the board of directors when the agreements were signed, are a little worrisome to the companys vice-president of finance. These conditions affect certain areas of the companys operations that have always been weak, as identified below.

The following two conditions are especially troubling to the vice-president of finance. 1.Art. 15(a) Inventories The corporation shall at all times maintain raw material and finished goods inventories at market value equal to or greater than 50% of the total amount of grants obtained. 2. Art. 18(c) Other expenses The corporation shall exercise control over its expenses other than those directly related to manufacturing. These expenses include the salaries of senior executives, all managers except production managers, and administrative staff. They also include the companys financial expenses. These expenses cannot exceed 45% of total expenses and costs of any type incurred by the corporation for a given fiscal period.

As a management auditor for the company, you are well aware of the weaknesses that worry the vice-president of finance and you entirely share his concern regarding the companys ability to meet the conditions laid down by the granting agencies. During the past year, ERT has experienced several stock-outs that resulted in the loss of a number of large clients. Despite the efforts made by the sales department, the company has not been able to win back some clients who switched to ERTs competitors. You are reviewing the annual audit plan and you realize that the audit of finished goods inventories might cause you a problem. The most valuable items are generally too small to be counted manually and you will therefore have to use specialized equipment to determine the value of these inventories. Another problem is that all the items appear similar, whereas their values may differ considerably.

When questioned on this subject, the vice-president of production tried to reassure you:

We already have the equipment needed to determine the value of the inventories. In fact, I am surprised that you were not aware of this, considering that we have been using this equipment for more than 5 years. You can stop worrying; I know the value of every item produced in this plant.

As to the reduction of expenses, you have no idea where to begin. The other-expenses-to-total-expenses ratio is currently 53%, and an 8% reduction seems impossible to you. Also, you have noticed that since it was announced that grants had been obtained, other expenses have risen substantially.

The chief audit executive (CAE) is well aware of the problems that could result from a failure to meet the conditions imposed by the different granting agencies. She therefore advised management to introduce performance incentive programs for the managers responsible for activities that may affect other expenses. The board of directors quickly agreed to the CAEs suggestion and approved a remuneration policy for the managers concerned. Here is an excerpt from the new policy:

As a special bonus, the vice-president of production will be granted a lump sum equal to 20% of her regular salary if, at the 2006 fiscal year end, inventories of raw materials and finished goods are equal in value to at least 50%, and no more than 55%, of the grants obtained by the company. The bonus is valid only for the 2006 fiscal year and is not proportional. As a special bonus, the vice-president of purchasing will be granted a lump sum proportional to the reduction in the other-expenses-to-total-expenses ratio. The bonus will be calculated by applying, to the regular salary of the vice-president of purchasing, a percentage equal to the percentage reduction in the other expenses ratio. The bonus paid cannot exceed 10% of the regular salary. The bonus is valid only for the 2006 fiscal year.

You are surprised by the speed with which this new policy was implemented and you wonder whether all its possible effects have been identified and analyzed by management and submitted to the board of directors for approval. As well, you do not know whether this new policy is adequately supported by existing policies and procedures. You also wonder about the possible impact the policy might have on the internal audit of the units concerned. The CAE, to whom you have confided your concerns, considers it essential to amend the annual audit plan to ensure that the conditions imposed by the granting agencies are met. However, before the plan is amended, she would like you to write a memorandum proposing a series of criteria and procedures for ensuring that the objective of complying with the conditions is met. She would first like you to develop the audit criteria and procedures that would apply to the following:

1.Production 2.Inventory management 3.Purchasing 4.Administrative expenses 5.Remuneration management 6.Treasury As well, the CAE would like your opinion on the effect the remuneration policy might have on the companys employees. In closing, the CAE reiterates that the criteria and procedures you propose must focus strictly on elements that relate to compliance with the conditions associated with the grants.

Required Write the memorandum to the CAE.