Mike and Laurie have owned and operated a small grocery store for many years. For the past five years, they had a franchise agreement with Fresh Foods and operate under the franchise name Mike and Laurie's Fresh Foods. Fresh Foods is a franchise known for its low prices, made possible by offering a basic shopping experience to its customers. Over the last five years, Mike and Laurie have experienced increased competition from larger discount stores offering a greater variety of grocery items. This competition has resulted in lower margins and a decline in revenue growth, as some customers find it more convenient to complete all of their shopping in one store. Moreover, food prices have been on the rise due to changes in the climate and the economy. It is predicted that food prices will continue to rise over the next few years. This has negatively impacted the quantity of items that customers are buying. Many customers have a fixed amount of disposable income to spend on groceries, so they are purchasing fewer items. In December 20X6, Mike and Laurie approached mile, a CPA, to inquire whether he could complete their financial statement audit for the current year. Notes from the meeting with Mike and Laurie are in Appendix 1. mile is one of five partners with Richie and Wrights LLP (R&W). Mike and mile are good friends; they often cheer on their children, who play on the same soccer team. During their children's soccer games, Mike has informally asked mile for accounting advice ? specifically, how to record certain transactions. mile has a good reputation within the firm and would not let his relationship with Mike bias his professional judgment. The financial statements have previously been audited by Chan, Carter & Singh LLP (CCS). Mike and Laurie have decided that they want to change auditors, as they feel that CCS has not shown an adequate understanding of their business. There has been little consistency in the audit team members over the last four years. "Each year, the audit team wastes our time by asking us the same questions." Laurie claims that "it is like they do not understand the grocery store business at all. I don't understand why CCS has to use our business as training experience for new junior staff members. You would think that the staff would be properly trained before working on our audit." Mike has been disappointed that more advice is not being provided to him based on the audit findings. He just cannot understand how so much money could be spent on the audit without practical suggestions being provided on how to improve the operations. Mike and Laurie have provided extracts from the financial statements for the years ended December 31, 20X5, and December 31, 20X6, in Appendix 2. They have also provided a memo on their concerns regarding the inventory system in Appendix 3.

APPENDIX 1: NOTES FROM DECEMBER MEETING WITH MIKE AND LAURIE Mike and Laurie explained that, every year since signing the franchise agreement, they have seen declines in revenue growth and profits due to significant competition for customers' limited funds. Traditionally, revenue growth has been 5% per year. The mandatory minimum hourly payroll wage increased this year. Most of the store's part-time staff are students earning minimum wage trying to earn enough money to pay their university tuition and housing costs. Mike and Laurie do not believe the minimum wage increase will result in a corresponding increase in consumers' disposable income and increased sales. The minimum wage increase is just not substantial enough to help customers feel they have more money in their pockets to spend. Mike and Laurie have a good relationship with the franchisor, as they have always paid their monthly franchise fees on time. In the last few years, the franchisor has revoked a number of other franchise agreements with other franchisees, citing concerns related to late payments and declining franchise fees as the key reasons for closing down the franchises. When Mike and Laurie started their franchise, they obtained a 10-year loan to purchase some assets to set up their store. The loan has covenant requirements and requires the audited financial statements to be provided within three months of year end. A breach of the covenants means that the bank loan will become payable on demand. Mike and Laurie do not have sufficient cash flows to repay the loan if the bank were to call it. Traditionally, Mike and Laurie have been paid through a combination of dividends and salary. During 20X6, Mike and Laurie decided not to declare their usual $100,000 of total dividends. The cash can be put to better use by paying suppliers. With the rising food costs, it has been challenging to make timely payments to their suppliers.

APPENDIX 2: EXTRACTS FROM FINANCIAL STATEMENTS Extract from the income statement Year ended Year ended December 31, 20X6 December 31, 20X5 (in '000s) (in '000s) Notes Unaudited Audited Revenue $3, 188 $3,114 Cost of goods sold 1, 2 (2.509) (2.377) Gross profit 679 737 Selling, general and admin. 3, 4 (609) (601) expenses Operating income 70 136 Interest expense 5 (33) (36) Earnings before income taxes 37 100 Income taxes (13) (36) Net income $ 24 64 Notes: 1. Mike and Laurie pay a fixed percentage of 6% of gross sales to the franchisor. The franchisor requires payments to be made on a monthly basis, due on the 15th of the following month (for example, payment for December sales is due January 15). Failure to pay the franchise fee on time results in penalties. Repeatedly failing to pay the franchise fee on time results in cancellation of the franchise agreement by the franchisor. 2. Mike and Laurie entered into an agreement with a key supplier in 20X6. The supplier is offering volume rebates for purchases made in the year. Purchases must be made between January 1 and December 31 to be eligible for a volume rebate. The higher the total purchases, the higher the rebate percentage. Purchases Rebate Up to $200,000 1% $200,001 to $500,000 3% $500,001 to $750,000 5% $750,001 and over 7%Concern Explanation Recommendation Mike and Laurie feel that there has been little consistency in the audit team members over the last four years. Laurie doesn't understand why she and Mike need to train CCS's junior staff on their business segment, and expects that staff would be properly trained before working on their audit. Laurie feels that the audit team wastes their time by asking them the same questions each year. Mike has been disappointed that more advice is not being provided based on the audit findings. Audit and Assurance Project 1 Concern Explanation Recommendation Mike does not understand how so much money could be spent on the audit