Question 1 ( 29 marks)

Lux Fitness Inc.(LFI) operates 50 athletic resorts in major urban centers across the United States and Canada. Each LFI location offers a wide range of services including: fitness facilities, fitness classes, tennis, squash and swim programming. LFI also offers services such as personal training, weight loss programs and spa services.  The company head office is based in Toronto and is owned by a group of private equity investors.  The investors purchased the company 5 years ago with the intention of expanding the company and taking it public.  LFI has experienced exceptional growth in the past 5 years - opening 5 new locations every year. After significant consultation with industry and legal experts, the LFI's directors decided to pursue an initial public offering (IPO) on the Toronto Stock Exchange.

LFI has been audited since its inception by a local firm, Small & Smaller LLP, operating out of an office in a Toronto suburb. LFI requires an audit in order to comply with bank imposed loan requirement for audited financial statements. The loan agreement also stipulates that LPI must maintain a debt to equity ratio that does not exceed 50%. LFI has always prepared statements in compliance with IFRS and has a June 30th year-end.

It is now January 2018 and you are an audit manager at Big 4 LLP and you just left a meeting with Susan Liu an audit partner of your firm.  Susan told you that Tom Lee the VP Finance from LFI recently contacted her about the opportunity for Big4 LLP to take over the audit of LFI. You know Tom, before LFI he was an audit partner at your firm and he left the firm last year to join LFI.  LFI's offer was too good to pass up, Tom was offered a competitive salary and was offered a 5% equity stake in the business. As part of his employment contract he is also eligible for an additional 5% equity stake if LFI achieves certain sales and income targets within 1 year.  While at the Big4 LLP Tom had a reputation to be a real go getter who always made his clients happy. He always found a way to justify client's accounting policies, no matter how aggressive they were.

Tom thinks an audit opinion from a large international public accountancy firm like Big4 would add creditability to the financial statements for the upcoming IPO.  Tom provided Susan with the six months ended December 31st income statement and extracts of the December 31st balance sheet. Susan  met with Tom at LFI's head office. She has sent you her notes from her meeting in Exhibit II. 

 

 

 

 

 

 

 

 

 

EXHIBIT I - EXTRACTS - LUX FITNESS FINANCIAL STATEMENTS - 6 MONTHS ENDED

Note 1 - Revenue, Deferred revenue & Accounts Receivable

LFI offers its customers a variety of options for membership payments. These include:

-       Standard Members - Members pay a monthly fee of $120 per month and can cancel at any time without penalty. The initial payment is made on the day the member signs up with the gym and is a prepayment for the first month's service. Each subsequent monthly payment is made exactly one month later. Deferred revenue for standard members is related the number of days of service at month end that are still owed to the customer.   For example if a customer joins on December 20th, on December 31st twenty days remain in deferred revenue.

-       Diamond Members - Customers pay a $2,000 initiation fee upfront and pay a nominal monthly fee of $12. The initiation fee entitles the member to a lifetime membership with reduced monthly fees equaling 10% of the standard member. If a Diamond member fails to pay the monthly fee for longer than 4 months they will revoke their entitlement to Diamond Member status and are no longer lifetime members. The $2,000 initiation fee is deferred and recognized over the estimated expected membership life which LFI has determined to be 26 months.

-       Corporate Members - In the current year, LFI began selling corporate memberships. Corporations purchase standard memberships for their employees and pay on behalf of their employees. LFI extends credit to corporate clients and membership dues are not payable upfront. Corporate clients pay for monthly services on the 15th of the subsequent month. (Ex. membership fees for September are payable on October 15th).

Note 2 - Inventory & COGS

LFI sells various nutritional products and supplements. The products include vitamins, healthy shakes and snacks. Inventory and COGS relates to these products.  

 

 

 

EXHIBIT II - SUSAN'S NOTES FROM MEETING WITH TOM LEE

1.    Tom operates a very lean finance department with only 5 employees.  The extensive growth of LFI has increased the workload for accounting staff and they were often struggling to keep up with their duties. During very busy times, such as month-end closing, staff fall behind with account reconciliations but are able to catch-up when things slow down. Tom reviews account reconciliations when there are significant reconciling items. He asks his staff to inform him when there is a significant reconciling item and he reviews it at that time. He is rarely notified by staff members to review the reconciliations since significant reconciling items don't occur very often.

2.    In September, LFI implemented a new sophisticated ERP system which helped to reduce the amount of manually driven tasks and reduce the accounting staff work load. LFI outsources its IT department to Tech Pro Inc. Tech Pro manages all of the LFI's IT needs. Tom is quite happy with the new system because sales and cost information from each of the gyms locations is automatically uploaded into the general ledger every evening. The new system requires each user to sign in with a unique user i.d. and password and each user is restricted access only to their specific job responsibilities.  He is especially glad that the system allows him to easily record year-end adjusting entries. He finds this helpful since his staff do not have sufficient experience to record journal entries for more complex financial accounting issues. For example, Tom prepares and records all adjustments related to the calculation of deferred revenue.

 

 

 

 

 

 

 

 

 

3.    Small and Smaller LLP is a 2 partner firm and that employs two staff accountants. LFI is their largest client and constitutes 75% of the total firms' revenue. The two staff accountants conducted most of the audit work for LFI and were supervised directly by the partner on the engagement. Since LFI is their only IFRS client, Small and Smaller's staff and partner have limited experience with IFRS, they sometimes struggle with understanding the differences between ASPE and IFRS. They often question Tom on basic differences between the two standards and Tom spends a great deal of time explaining IFRS.    

 

4.    Tom knows that there are several new IFRS standards that will come into effect in 2018. He anticipates that the new lease standard will have a significant impact on LFI because it leases all of it's facilities and most of it's equipment. Currently all leases are treated as operating leases and he understands that the new standard will require that they are treated as capital leases.

 

 

5.    Tom offered to provide each Big4 LLP audit team member with a free one-year membership to LFI.  He suggested that the audit team use the fitness centers in order to assist in their understanding of the business operations.

 

6.    Tom mentioned the importance of  Big4 LLP issuing a clean audit opinion to Lux Fitness Inc.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Required: 

Susan has asked you to begin the work on the LFI audit and has asked you complete the following items:

a)    Identify and explain (using case facts) three threats to independence for Big4 LLP to consider before they accept this engagement. What safeguards should they put in place to address the threat of independence-( 6 marks)

b)    Determine overall planning materiality and performance materiality. (Explain the rationale for all components of the calculation and support your analysis with calculations). (9 marks)

c) Identify 4 case facts that impact the risk of material misstatement (inherent risks and/or control risks) at the overall financial statement level (OFSL). For each factor identified, indicate if the factor increases or decreases risk, the type of risk (inherent and control) and provide your rational for why the factor increases or decreases risk. (1/2 mark for the case fact giving rise to the risk, ½ mark for correctly indicating if the factor increases or decreases RMM, ½ mark for correctly stating the type of risk and 1/2 mark for the explanation as to why the factor increases or decreases the RMM). (8 marks)

d)  Identify three different account balances, which have a high risk of material misstatement. For each account balance state: the account and assertion(s) at risk (1 mark), an analysis using case facts explaining the rational for the increased risk.  (include the case specific facts in your analysis)  (6 marks)