ndies Medicinal Chemicals and Botanicals (Andies) audit strategy along with an overview of the business and economic environmental risks of material misstatement due to:

External business factors

Nature of the client (operations and organizational structure)

Business risks related to Andies stated objectives and strategies

Managements financial performance measures

2. Identify factors that affect Andies control risk.

3. Differentiate an emerging growth company as defined in Section 2(a) of the Securities Act of

1933, modified by the Jumpstart Our Business Start-ups Act of 2012 (the JOBS Act), section

4

107 with a company compliant with public company effective dates for new or revised

accounting standards.

4. Identify additional financial reporting risks encountered by an emerging growth company.

5. Identify the risks that an audit firm must consider when it auditing a company with foreign

operations.

PART 2: Understanding the risks of material misstatement due to either fraud or errors in the

The Case

Identifying Business and Financial Risks in the Cannabis Industry

Andys Medicinal Chemicals and Botanicals

In October 2018 the Cannabis Act was adopted in Canada and regulated by Health Canada, an oversight and regulatory body, under the authority of the Cannabis Regulations (CR). The legislation permits individuals over the age of 18 to purchase, possess, and cultivate limited amounts of cannabis.

Andys Medicinal Chemicals and Botanicals (Andys), one of the initial licensed dealers of cannabis in Canada, supplies high-quality cannabis products to adult consumers in twelve countries and Canada. Andys is a U.S. based corporation (Delaware) with principal executive offices in Vancouver, B.C. On April 15, 20X3, Andys completed an Initial Public Offering (IPO) on the NASDAQ exchange and in December sold $410 million of bonds. The primary purpose of the IPO and debt issuance is to increase liquidity and raise capital to further develop their cultivation and processing facilities and future acquisitions. With the legalization of cannabis in Canada and many parts of the United States, the cannabis industry is rapidly expanding. Andys operations are currently indoors but they have plans to expand cultivation outdoors.

Andys has experienced significant growth that they attribute to their global expansion strategy, their multinational supply chain and distribution network, and commitment to innovative research, product quality, and operational excellence. Andys has developed a reputation for producing pure and predictable medical-grade products. Despite their rapid growth, premium product quality and pristine reputation, Andys has generated net losses over the past three years.

Andys has operations located in Canada, Australia, and Germany. Their operations comply with the CGMP (Current Good Manufacturing Process) regulations. The CGMP regulations for drugs contain minimum requirements for the methods, facilities, and controls used in manufacturing, processing, and packing of a drug product. The regulations make sure that the product is safe for use, along with the appropriate ingredients with the intended strength of the drug. Andys has plans to expand into the U.S. market. Initially, Andys plans to expand into the United States setting up cultivation and recreational dispensary facilities in the state of Massachusetts.

Cannabis Industry

While cannabis is legal in Canada, authorities still have regulators limiting the amount of medical marijuana inventory a medical marijuana center may cultivate and have on hand (typically based on reasonable factors including sales history and number of patients registered). First movers in this industry are visionary entrepreneurs with a high tolerance for risk. As the industry develops and consolidation businesses are better capitalized, there are better systems and operations, more experienced personnel and overall improved developed the legitimacy of the industry. While early ERP systems were overwritten from other industries, there are current systems specifically built for the challenges of the cannabis industry. This has helped internal controls around inventory as sales employee turnover is very high.

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In Germany cannabis is medically legalized and recreational decriminalized. In early 2018 Germany began importing medical marijuana from Canada as part of an extended program. Potential cultivators are vying for government licenses.

The legalization of marijuana for medicinal purposes is continually developing in the United States therefore laws and regulations vary greatly by state. In addition to legalization, agricultural and health regulations are still developing slowly in the U.S. as the business is currently illegally federally. Auditors need to also review the design and operation effectiveness of agriculture regulatory processes (IIIA whitepaper). While U.S. federal banks refuse to work with the industry, local credit unions have embraced the industry. These banking issues are not relevant in internal businesses that have legalized cannabis for medical (and/or recreational) purposes.

Management team and employees

As of September 30, 20X3, Andys employed 702 total employees, 688 are full-time employees located in Canada, Australia, and Germany. Four hundred and seventy-five employees are engaged in research, product development (horticulture and culinary), engineering, and logistics, 80 employees in general and administrative, and 135 employees in sales and marketing, and 12 employees in the accounting department.

The core leadership team consists of individuals with degrees in mathematics, international law, medicine, engineering, economics, and finance. The average age of the leadership team is 42 years old. The Board of Directors is comprised of four directors including Andys CEO/President. See Appendix B for the organizational chart and Board of Directors.

Understanding obtained from discussions with management

In order to determine the availability and relevance of audit evidence and identify risks we have performed the following planning procedures:

Discussion with Jeff Gnomes (CEO/President) (10/3), Annie Rice, CFO (10/3), and Joanne Smith, Sales Manager (10/7).

Read minutes of quarterly board of director meetings, including quarterly financial statements, annual budget, and sales project reports.

Based on management discussions and documents reviewed we have noted the following:

Banking continues to be no concern at the time for international operations. The company can transact using all currencies including credit and debit cards.

Company management uses the following measures to monitor the Companys financial performance:

Cash on hand, receivables and payables. This gives management a quick assessment of liquidity.

Sales, gross margins, inventory turnover. This is a typical measure of company performance.

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Inventory balances fluctuate with sales and regulations. Sales and inventory balances are monitored to estimate demands.

A full inventory count is performed every month on the last business day of the month at all locations.

As an international company domiciled in the United States, each international subsidiary is set up to comply with international and U.S. tax standards so that no U.S. taxes are incurred on foreign operations. U.S. taxes (280E) will become important when operations begin locally but will be immaterial for 20X3.

Andies U.S. expansion plans involving beginning operations in Massachusetts state planned for opening in December, 20X3.

Recent industry developments in Canada involve consolidation. In addition average market returns have been declining as the industry develops, but sales have been increasing.

In discussions with sales manager she noted the sales and marketing team has had a problem with turnover as operations continue to grow.

Financial Statements and Related Information

See Appendix A for the Budget and Actual financial statement information.

Cash and cash equivalents: are comprised of cash and highly liquid investments that are readily convertible into cash with original maturities of three months or less.

Investments: Investments consist of equity securities. The equity securities represent ownership interests in entities which do not have significant influence or controlling interests. The securities are recorded at fair value through net income.

Inventory: consists of raw materials, finished goods, and work-in-process. Work-in-process includes pre-harvested cannabis plants and by-products to be extracted. Labor, utilities, nutrition, and irrigation costs are capitalized into inventory until the time of harvest.

Inventory is stated at the lower of cost or net realizable value, determined using weighted- average cost. Costs include raw materials, packaging, direct labor, overhead, shipping and the depreciation of manufacturing equipment and production facilities determined at normal capacity. Manufacturing overhead and related expenses include salaries, wages, employee benefits, utilities, maintenance, and property taxes.

Recently, Andys discovered a material misstatement of Inventory. Andys process for inventory cost calculations is a manual process using complex spreadsheet-based models.

Property and equipment: are recorded at cost net of accumulated depreciation. Assets held under capital leases are capitalized at the beginning of the lease term at the lower of the present value of the minimum lease payments or fair value. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. The estimated useful life of the building is

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20 years and the estimated useful life of property and equipment ranges from three to seven years.

Bonds payable: On October 1, 20X3 Andys issued $410 of bonds at an effective interest rate of 12% paid semi-annually to mature in 20 years.

Revenue: is generated from the following channels:

1. Sales to patients through the medical program under the Cannabis Regulations.

2. Wholesale of bulk and finished product to other Licensed Producers under the Cannabis

Regulations.

3. Wholesale of finished product to provinces and provincially regulated distributors under

the Cannabis Act and applicable provincial legislation.

4. Export sales to third-party distributors.

Revenue is recognized based on contractual agreement, which can be upon shipment or delivery to the customer.

Andys products include whole flower, ground flower, broad spectrum cannabis oils and capsules, and purified cannabis oils and capsules. Andys plan is to launch beverage and edible products in the future.

Performance-based Stock Compensation and Cash Awards: Performance goals are based on company-wide performance. Stock-based compensation is comprised of non-cash costs for the fair value of compensation charges related to stock options and restricted stock units (RSUs) that are issued to employees and directors. The costs are amortized over the expected life of the options and RSUs. The weighted average expected life of the options and RSUs is 8.2 years.

Assignment

Your firm recently retained Andys Medicinal Chemicals and Botanicals (Andys) as an audit client and as part of the audit strategy and planning process you have been tasked with writing an Audit Strategy Memorandum that will be included in the audit working papers.

PART1: Business and operations risk assessment. Prepare an Audit Strategy memorandum to the audit files; you are to identify Andys business and economic environment incorporating risks of material misstatement. At a minimum you should include in your memorandum

1. Identify and document Andies Medicinal Chemicals and Botanicals (Andies) audit strategy along with an overview of the business and economic environmental risks of material misstatement due to:

External business factors

Nature of the client (operations and organizational structure)

Business risks related to Andies stated objectives and strategies

Managements financial performance measures

2. Identify factors that affect Andies control risk.

3. Differentiate an emerging growth company as defined in Section 2(a) of the Securities Act of

1933, modified by the Jumpstart Our Business Start-ups Act of 2012 (the JOBS Act), section

4

107 with a company compliant with public company effective dates for new or revised

accounting standards.

4. Identify additional financial reporting risks encountered by an emerging growth company.

5. Identify the risks that an audit firm must consider when it auditing a company with foreign

operations.

PART 2: Understanding the risks of material misstatement due to either fraud or errors in the financial statements; materiality level for the financial statements overall and for specific accounts and disclosures. For part 2,

1. Develop an audit plan to assess financial reporting quality including financial performance and measurement (KPIs) risks.

2. Calculate and document appropriate materiality. Include potential benchmarks and calculations, benchmark chosen, dollar value chosen, and document why.

PLANNING MATERIALITY

Potential Bases Planning Materiality Calculation Account $ Amount Percentage Estimate

3. Apply substantive analytical procedures including trend analysis, ratio analysis, and analyzing common-size financial statements for the past three years. Ratio analysis should include the following ratios: current ratio, quick ratio, total asset turnover, receivable turnover, inventory turnover, days of inventory on hand, gross profit margin, return on assets, return on equity, and debt-to-equity.

4. Identify two to three (2-3) accounts with heightened risk of material misstatement that warrant further investigation, including why you think it represents a risk by identifying the audit implications and responses to this years audit (for EACH identified risk factor identified be sure to include the risk type (fraud or financial statement), audit response, and possible effect(s) on audit).

Summary of Written Deliverables Memo must be no more than 4 pages of written text (12 pt. Times New Roman Font, 1 inch margins all around), and an additional three pages of tables for part 2.3. One Word document including all requirements from Parts 1 and 2 must be submitted, see sample format in Appendix C.

PART 3: Audit team presentation. You will be in groups of three and will present your findings to the audit engagement partner. The presentation should be in PowerPoint or some other professional presentation software.

a.

b.

c.

Financial Statement Materiality

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APPENDIX A FINANCIAL STATEMENTS

Andys Medicinal Chemicals and Botanicals (Andys) Balance Sheets

(in thousands)

Budge te d

YTD Q3

Years ended December 31

Assets

Current Assets

Cash and cash equivalents Short-term investments Accounts receivable

20X3

438,866 -

30,000

20X3

311,371 45,512 120,265

20X2

14,047 - 54,060

20X1 20X0

28,617 28,837 - - 35,210 17,670

Inventory 23,000

26,685

20,347 3,018 2,753

Prepaid and other current assets Total current assets

Property and equipment, net

Intangible assets, net

Investments 85,000

Other assets

Total assets

Liabilitie s

Current liabilities: Accounts payable

492

692,808

70,000

750

492,616

750

504,584

111,350 6,766 75,490 492

698,682

73,051

750

89,204

32,900 3,557

-

492

126,153

44,417

600 600

67,445 49,860

34,450 36,000 1,007 580

- -

472 310

103,374 86,750

18,108 5,000

108,000 6,700

Accrued expenses and other current liabilities 58,000

45,912

26,285 18,630 9,455

Accrued obligations under capital lease Total current liabilities

Accrued obligations under capital lease Deferred tax liability

Bonds payable

Total liabilities

Stockholders' equity (deficit)

Common stock, par value $0.001 (750,000,000 shares authorized, 195,000,000 issued and outsanding

Additional paid-in-capital

Accumulated deficit

Total liabilities and shareholders' equity (deficit)

1,000

129,000

21,000 -

410,000

560,000

18 190,000 (57,210)

692,808

1,000

119,963

21,000 -

410,000

550,963

19 213,281

(65,581)

698,682

1,000

71,702

22,000 -

-

93,702

50,000 (17,549)

126,153

1,000

37,738

23,000 -

-

60,738

50,000 (7,364)

103,374

-

14,455

25,000 -

-

39,455

50,000 (2,705)

86,750

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Andys Medicinal Chemicals and Botanicals (Andys) Statements of Net Loss and Comprehensive Loss (in thousands)

Budge te d

YTD Q3

For the years ended

20X3 20X3 20X2 20X1 20X0

Revenue 60,000 94,255 50,426 30,248 17,670

Cost of sales 33,000 53,124 27,893

Gross margin 27,000 41,131 22,533

17,343

10,016

12,905

7,654

Research and development expenses Sales and marketing expenses General and administrative expenses Stock-based compensation expense

Operating loss

Foreign exchange loss (gain), net Interest expense, net

Other (income) expense, net Loss before income tax recovery Current income tax expense

Net loss

5,600 5,790 24,000 25,960 21,000 30,260 15,000 18,300

(38,600) (39,179) (500) 7,290 11 12 1,550 1,550

(39,661) (48,032) - -

(39,661) (48,032)

4,714 12,500 15,810

-

(10,491) (1,856)

1,550

(10,185) -

(10,185)

1,896 6,290 9,340 -

(4,621) (1,512)

1,550

(4,659) -

(4,659)

1,105 3,275 6,180 -

(2,906) (201)

-

-

(2,705) -

(2,705)

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Andy's Medicinal Chemicals and Botanicals (Andys) Statements of Cash Flows

(in thousands)

YTD Q3

Years ended December 31

Operating activities

Net loss

Non-cash adjustments

Stock-based compensation

Depreciation

Changes in working capital accounts

Accounts receivable

Inventory

Prepaid and other current assets

20X3

(48,032)

18,300 1,550

(66,205) (6,339)

-

20X2

(10,185)

1,550

(18,850) (17,329) (150)

20X1

(4,659)

1,550

(17,540) (265)

-

Accounts payable

28,634 26,309

13,108

Accrued expenses and other current liabilities Net cash used in operating activities

Investing activities

Purchase of property and equipment

19,627

(52,464)

(80,000)

7,655

(11,000)

-

9,175

1,369

-

Purchase of intangible assets

(3,209)

(2,550) (427)

Purchase of short-term and long-term Investments Purchase other assets

Net cash used in investing activities

Financing activities

Payments on capital lease

Proceeds from issuance of bonds Proceeds from issuance of common stock Net cash provided from financing activities

Increase (decrease) in cash Beginning cash and cash equivalents Ending cash and cash equivalents

(121,002) -

(204,211)

(1,000) 410,000 145,000

554,000

297,324

14,047

311,371

-

(20)

(2,570)

(1,000) -

-

(1,000)

(14,570)

28,617

14,047

-

(162)

(589)

(1,000) -

-

(1,000)

(220)

28,837

28,617

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APPENDIX B ORGANIZATIONAL STRUCTURE AND BOARD OF DIRECTORS

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APPENDIX C SAMPLE MEMO FORMAT WITH REQUIRED COMPONETS

Memorandum Overall Audit Strategy

To: Audit Files 20X3

From: Your Name

RE: Andys Medicinal Chemicals and Botanicals (Andys) 20X3 Audit Strategy

1.1 ENGAGEMENT OBJECTIVES (external, operations, objectives, performance) 1.1a. External Factors

1.1b. Operations and Organizational Structure Factors

1.1c. Objective and Strategy Factors

1.1d. Financial Performance Factors

1.2. CONTROL RISK FACTORS

1.3/4. EMERGING GROWTH COMPANY RISKS

1.5 INTERNAL OPERATIONS RISKS

2.1. FINANCIAL PERFORMANCE & MEASUREMENT RISKS

2.2. PLANNING MATERIALITY

2.3 ANALYTICAL REVIEWS

2.3.1 RATIO ANALYSIS (Embed Excel Table)

2.3.2 COMMON-SIZE FINANCIAL STATEMENTS (Embed Excel Table 3 years) 2.4 SIGNFICANT RISKS

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