I need to prepare memo and letter for audit case for Skye Heating and Cooling

Skye Heating and Cooling (SHC) was founded in 2006 in a city just north of Toronto, ON. SHC specializes in the manufacturing and installation of gas fireplaces and BBQs both indoors and out. SHC has a very large production facility on the same parcel of land as head office and a second large production facility located in St. Johns, Nfld. SHC products are sold both in Canada and the United States. Sales overseas are limited to only a few countries due to production differences (Hook-up regulations are different).

During their expansion in 2018 to St. Johns, the Founder of SHC, Owen Horton, decided to take the company public. The initial public offering (IPO) went smoothly. Owen retained 60% of the outstanding common shares of SHC, 20% of the shares issued were bought by one investor and the other 20% of the common shares are widely held.

Your firm has audited SHC since they went public in 2018. Your partner has been the lead engagement partner since that time and you, PA, were the staff accountant during 2019 and 2020. It is now February 2022, and you are now the lead senior accountant on the engagement for the audit of the financial statements of SHC for the year ended December 31, 2021.

All audit planning was done by you, and materiality was correctly established at $450,000. This was decreased from the previous year due to the increased users, namely the bank and the preferred shareholders. Exhibit #1 thru #7 contains information regarding the current years audit.

You are currently at the client and you are well into this years audit. A number of issues have arisen this year and you are unsure of how to address them. As a result, you phoned the partner for some advice. In preparation for a meeting with her, you have been asked by your partner to prepare a memo that discusses any of the issues you have found to date along with any implications, follow-up audit procedures or anything else you deem important. This includes next steps, if necessary. Given some of the issues that have arisen, your partner wants to take a look at the current summary of accounting and audit differences and has asked you to prepare one as she is concerned that you may be approaching materiality. In addition, your partner has also asked you to prepare a draft management letter. Your draft letter should be organized as: Weakness, Implication(s) and Recommendation(s). Required: Prepare the required memo and letter

Exhibit #1 Audit information

In 2019, Owen decided he needed more money to expand the production facilities at the Ontario plant to keep up with the increasing demand for fireplaces and BBQs. Not wanting to reduce his ownership further, Owen made the decision to issue preferred shares and obtain a long-term bank loan to finance the expansion. Nothing happened with respect to the expansion during 2019 or 2020 as Owen worked on the details.

On June 30th, 2021, SHC obtained a $1,800,000 loan from the Button Bank. The loan will be used to construct an additional manufacturing facility that will be able to produce customer specific products. Details of the loan can be found in Exhibit #2.

10,000 preferred shares were issued on April 1, 2021, for $100 per share. The preferred shares pay a dividend of $5 per share. In addition to the dividend, SHC enticed investors by including several other provisions into the release of the preferred shares. In any year, if net income does not exceed $1,000,000 before tax SHC will immediately pay a $5 special dividend to the preferred shareholders. This is in addition to any regular dividend that may be paid. In addition, if net income before tax fails to exceed $1,000,000 in three successive years, the preferred shareholders may, at their option, force SHC to buy back their shares.

There was an error posted on last years summary of accounting and auditing differences (SAAD) in the amount of $150,000. The office building in St Johns was painted during year end last year. The invoice was dated January 5th, 2021. Further research revealed that the work was done on December 21, 2020. The year-end SAAD entry posted by your firm for the 2020 audit was:

Dr. Maintenance Expense $150,000

Cr. Accounts Payable $150,000

SHC was not asked to correct this error as the cumulative errors for the 2020 audit did not exceed materiality.

Exhibit #2 Other Information

SHC signed a contract with Homeward Outdoors (HO) for the delivery of an exclusive outdoor fire pit. The production of the pit requires a specially designated production line. The contract was signed on December 1st , 2021, and production of the fire pits began December 15th. The contract called for production of 125,000 pits with a total contract price of $2,500,000. Excerpts from the contract can be found in Exhibit 4;

SHC produces small portable gas BBQs for Muskoka Back County (Muskoka) that are specially branded. These are consumer camping specific BBQs. In an attempt to get ahead of potential orders, SHC produced 15,000 special Muskoka BBQs in August 2021. The price SHC sells these BBQs to Muskoka for is $80. Each BBQ costs 50% of the selling price. Muskoka is under no obligation to buy the BBQs but the normal expectation is that they buy all that SHC produces. In September 2021, Muskoka changed its name to Algonquin Outdoors (Algonquin). Algonquin does not want to buy the BBQ stock given that it has the old name on it. While Owen tried to negotiate with the newly branded Algonquin, a review of the contract by SHC by the company lawyers revealed that there is no contractual obligation for Algonquin to purchase them. When Owen was asked about the issue, he maintained that he was doing his best to sell them to a discount company at about 40% of cost.

You have been conducting your audit fieldwork at the Ontario office. Yesterday you came to work and found fire trucks at the back of the property. By midmorning you found out that one of the temporary storage facilities being used to store some of the inventory burned to the ground.

The loan from the Button Bank calls for interest only repayments until 2022. The loan carries interest at a rate of 4.5% with principal repayments at a rate of $100,000 per year beginning in 2023.

Your inventory count completed on December 31st needed to be done twice due to some counting irregularities. SHC hired a new inventory management supervisor in October 2021 after the retirement of their previous supervisor. While the new supervisor is slowly gaining an understanding of the system, your junior staff member that attended the count called you with problems over count instructions and segregation of inventory. As a result you ordered a recount which ultimately was satisfactory. In January you discussed the issue with the new supervisor and determined that they felt that written count instructions would not be necessary in the future as it simply slowed the process down.

Exhibit #3

Partial Unaudited Financial Statement Amounts (from SHC's Trial Balance)

Account 2021 Amt

Inventory 4,532,450.00

Property, Plant and equipment 25,436,897.00

Construction in Progress¹ 976,460.00

Accumulated Amortization - 12,345,678.00

Accounts Payable 996,000.00

Unearned Revenue 0

Long-term debt (Sharp Button Bank) 1,800,000.00 ²

Other Debt 3,400,000.00

Preferred Shares 1,000,000.00

Common Shares 1,200,000.00

Net Income (before tax) 1,500,000.00

Retained Earnings (including NI above) 1,400,000.00

¹ Details can be found in Exhibit #5 [W/P T-5] where your junior accountant completed an audit working paper

² No interest has been accrued on the loan as of year end

Exhibit #4 Excerpts from Homeward Outdoors

Total contract price $2,500,000 specially designed fire engine red fire pit in honour of HOs 75th Anniversary. Delivery is for 125,000 fire pits;

HO agrees to pay $300,000 on signing of the contract and $200,000 at the end of each month beginning December 31, 2021, with the full remaining balance due and payable June 30, 2022, subject to certain conditions;

SHC agrees to have 10,000 units produced by December 31, 2021, ready to be shipped.

Shipping is FOB shipping point;

HO reserves the right to inspect the first 30,000 units for quality and adherence to appropriate colour and specifications. HO has the right to return the first 30,000 units at its discretion with the balance of returns after the first 30,000 based on specified defect

To auditors of Skye Heating

We can confirm the following progress payments for the construction of the expanded facilities for Skye Heating:

Progress payment #1 $150,000

Progress payment #2 $486,500

Progress Payment #3 $339,960

Progress payments are determined and calculated by us based upon our review and approval of work done to date by the construction company. A holdback equal to 10% of each progress payment is calculated in order to account for any construction deficiencies. While the holdback will be payable by Skye Heating, it has not been included in the above progress payments.

If you have any questions please dont hesitate to contact us.

HoHoHo Architects

- Agreed to invoice and cheque details. Results satisfactory

Exhibit #6 Other Information

A review of subsequent events by the junior accountant revealed that there were payments made after year end for invoices and related events that occurred in early 2022. The junior accountant noted that these amounts, totaling $124,000 had been set up as a payable and an expense in 2021. When he asked the accounts payable supervisor, she noted that she wasnt really sure how to deal with some of the payments coming in after yearend and so she guessed at some of them. You had the junior accountant expand their work as a result of this but found no other invoicing cutoff errors;

The substantive work on accounts receivable involved confirming several balances. The book value of the balances was $567,000. The audit value after all confirmations and alternative procedures was done was $525,000. The total value of receivables for SH is $867,000;

Your audit work on capital assets revealed that there was $85,000 of expenditures capitalized that were in fact repairs and maintenance. When you questioned the fixed asset clerk, you found out that there have been some accounting policy discussions at SH about what threshold level should be used when capitalizing expenses. Since there was no final decision, she opted to capitalize these amounts;

SH is considering leasing several large pieces of production equipment next year as a means of keeping these assets and obligations off of the financial statements.

For Auditing, that's all the information