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 Lauries 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 childrens 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 dont 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 stores 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.

In 20X6, Mike and Laurie made purchases of $490,000 from the supplier. Once the supplier verifies the total amount purchased, a rebate cheque of 3% will be sent to Mike and Laurie. No amount has been accrued because the supplier has not verified the amount of purchases made.

3. In December, a customer slipped and fell in the parking lot due to snow and ice buildup near the entrance. The customer has sued Mike and Lauries Fresh Foods. No amount has been accrued in the income statement for the possible losses from the lawsuit.

4. During 20X6, Mike and Laurie renegotiated their lease, extending it for 10 years. As an inducement to enter into the 10-year lease, the landlord waived the first six months of lease payments. Without the landlord waiving payments, Mike and Laurie would have only entered into a four-year lease agreement. Mike and Laurie did not record any payments for the rent-free period.

5. The interest expense relates to the 10-year loan that Mike and Laurie took out to finance the initial costs of setting up their store. There are covenants on the loan such as maintaining specific ratios, including a current ratio of 1.5 to 1 and a debt-to-equity ratio of 1.2 to 1.

APPENDIX 3: MEMO FROM MIKE AND LAURIE REGARDING INVENTORY SYSTEM

To: Richie and Wrights LLP

From: Mike and Lauries Fresh Foods

Date: December 12, 20X6

Subject/Re: Inventory

To lower operating costs, during 20X6 we decided to count inventory at the end of the year only. In 20X5 we completed monthly inventory counts.

We are thinking of changing the year-end count date beginning next year (20X7). We found that it was difficult for staff to attend the year-end inventory count, since it falls on December 31 and most staff have other social commitments they feel are more important. Completing the count on January 1 is also not feasible, as our workers are generally not in any condition to focus on completing an accurate count.

To remain competitive, this year (20X6) we started price-matching with our local competitors. The franchisor does not require us to do so; however, we feel that if we do not match the local competitors prices, our customers will continue to shop elsewhere.

We have noticed that we frequently run out of specific products. This has resulted in lost sales opportunities. We cannot seem to figure out how to ensure we have a sufficient number of goods that customers want on hand.

Produce and baked goods that are near their best-before date have traditionally been sold as clearance items with special prices of up to 50% off the original sticker prices. We have noticed that even with these markdowns, the products are not selling well. This year, we decided to donate these items to the local soup kitchen to support those in need, as there has been a higher level of unemployment in the community. The soup kitchen staff show up promptly at 10 a.m. each day to see if we have anything to donate. We make sure that most days there are items to donate, but often this is done at the last minute. Whichever staff member is available will pull any available produce and baked goods directly from the shelf. We are not sure if the staff have been properly making note of the quantities of items that have been donated to the soup kitchen.

In 20X6, we adopted a scanning code of practice. If the scanned price of an item is higher than the shelf price, then the customer will get the first item free up to $10. We thought it would be a great way to show our customers that we would never overcharge them. However, we are finding that we have been giving away more free products than we anticipated.

Question:

1. Perform the planning analytical review for the income statement. Analyze the key ratios/variances for at least four income statement areas. Discuss possible explanations for the analyzed variances and provide recommendations on how R&W should investigate the variances. Include all supporting calculations.

2. Assess the level of inherent risk for the 20X6 fiscal year-end audit. Support your analysis by discussing at least four risk factors associated with the engagement.

3. Calculate overall planning materiality and performance materiality for the 20X6 fiscal yearend audit. Provide both quantitative and qualitative analysis supporting your assessment of materiality levels.

APPENDIX 2: EXTRACTS FROM FINANCIAL STATEMENTS Extract from the income statement Year ended Year ended December 31, 20x6 (in '000s) Unaudited December 31, 20X5 (in '000s) Audited Notes Revenue $3,188 $3,114 (2.509) 679 Cost of goods sold Gross profit Selling, general and admin. 1, 2 (2.377) 737 3, 4 (609) (601) expenses Operating income Interest expense 136 70 (33) (36) 100 Earnings before income taxes Income taxes 37 (13) 24 (36) 64 Net income 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 $200,001 to $500,000 $500,001 to $750,000 $750,001 and over 1% 3% 5% 7% APPENDIX 2: EXTRACTS FROM FINANCIAL STATEMENTS Extract from the income statement Year ended Year ended December 31, 20x6 (in '000s) Unaudited December 31, 20X5 (in '000s) Audited Notes Revenue $3,188 $3,114 (2.509) 679 Cost of goods sold Gross profit Selling, general and admin. 1, 2 (2.377) 737 3, 4 (609) (601) expenses Operating income Interest expense 136 70 (33) (36) 100 Earnings before income taxes Income taxes 37 (13) 24 (36) 64 Net income 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 $200,001 to $500,000 $500,001 to $750,000 $750,001 and over 1% 3% 5% 7%