Question 2: (35 Marks) na modumr Auto Financing Company (AFC), a um-sized privately owned company, is primarily engaged in the business of lending money to people who want to buy new and used luxury automobiles but cannot obtain the necessary financing. The company is owned by John Layman, the sole shareholder, president, and CEO; John oversees the general operations. The salespeople work with local automobile dealerships to identify potential buyers in need of financing, and the loan processors verify the credit worthiness of the prospective borrowers. A Two years ago, as part of its diversification strategy, AFC purchased a manufacturing firm specializing in small construction equipment and machine parts and merged it into its existing operations. The employees who work in manufacturing are unionized. Due to poor economic conditions and the slowdown in the construction sector, AFC has had to cut back on its hours of operation. During recent union negotiations, AFC's management told the union that it might not be able to meet the union's demands, and wage reductions might be required to maintain the current staffing level of 300 employees. AFC management also felt that a strike would worsen the situation, and AFC might need to close the manufacturing plant altogether. AFC's management asked the union to consider alternative means of compensation, which would be an interim measure until the economy recovered. After much negotiation, they agreed to a profit- sharing plan (five percent of annual net income after tax from the manufacturing business) for the unionized workers for the next two years. Both sides felt that this LO would be a win-win situation and would motivate employees to perform better. One of the terms of the agreement was to have the annual financial statements audited prior to the profit-sharing calculation. This is a cash profit-sharing plan, in which an employee's predetermined share of the profits is paid directly to them as a bonus once the financial statements are audited. The first bonus payout is expected to be in June 20X9, based on the 20X8 net income figure. AFC's financial statements have never been audited before. Janet Maxwell is a fourth-year business degree student majoring in accounting. She works for AFC doing the accounting and bookkeeping. Janet has prepared draft the financial statements for AFC using Accounting Standards for Private Enterprises (ASPE). It is now February 20X9. You are the audit senior on the team assigned to audit the December 31, 20X8, year-end financial statements for AFC. You are preparing to commence the planning of the audit work. John is very agreeable to having the statements audited, as he is planning to use the audited financial statements to ask for a substantial increase in the operating line of credit from the bank. In addition to a flat fee for the audit work, John has offered you (and your audit team's manager and partner) an opportunity to participate in the profit-sharing plan negotiated with the union of five percent of net income upon issuance of a clean audit opinion. I In separate meetings with John and Janet, and based on your preliminary review of the draft financial statements, you note the following points: There are two main lines of businesses: the loan financing and the equipment manufacturing arm. No details are provided for each line of business in the draft financial statements. Janet explains that the administration and legal aspects of the loan financing business are handled by AFC's deal-closing lawyers, Penn & Keaton. A closing statement is kept in each client's files (Exhibit 1). She shows you a sample and tells you that the standard closing legal fee is $300. Bank reconciliations are done by Janet every month. Janet has just completed the reconciliation for the year-end loan account bank statement. Upon review, you discover 15 cheques made payable to Penn & Keaton, totalling $3,500, with the words "refund cheque" in the memo section of the cheques. Janet thinks that these are cheques normally issued to approved loan clients when they have been charged more than the standard closing fee in error. Upon reviewing the bank reconciliation and monthly statements for the last quarter of 20X8, you notice that for the bank statement for October, there were 10 cheques, totalling $1,900, endorsed to Penn & Keaton. You ask Janet whether she thought it was unusual that so many cheques contained dual endorsements (the payee's . endorsement followed by the words "pay to the order of Penn & Keaton" and Penn & Keaton's endorsement, both of which were stamped in red ink). You also notice the words "refund cheque" in the memo section of each of the cheques. Janet is unable to provide an explanation, and she acknowledges that this was something she was going to follow up with John and the lawyers, but it fell to the bottom of her priority list. In December 20X8, John had asked Janet to write down $575,000 of inventory manufactured in the last two years because he believes that it will not be sold. This is approximately 40 percent of all the goods manufactured in the past two years. The allowance for doubtful accounts has increased by 20 percent compared with last year. John explains that this is due to the bad economic times. You also notice that a very large accrual was made for warranty expense in 20X8, but this is also blamed on the economy. Exhibit 1 Closing statement for the Jasen deal Borrower: Sienna and Tom Jasen Closing date: October 9, 20X8 File number: CT-1005 Disbursements: @AU Noor Distribution First Class Auto Dealership Provincial Records JB Garage Penn & Keaton Loan amount Cheque no. 1152 $50,000.00 of collateral 1153 50.00 Vehicle safety inspection 1154 100.00 Attorney closing fee 1155 500.00 $50,650.00 Required You are in the planning stages of the upcoming audit. Your audit manager, David Kwok, CPA, has asked for a memorandum outlining any accounting and audit areas of concern that the team should be aware of in planning the audit and the audit procedures. The memorandum should include any management and business-related advice that you think David should discuss with AFC. Adapted with the kind permission of CPA Canada