Question 3 ( 28 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 LFIs directors decided to pursue an initial public offering (IPO) on the Toronto Stock Exchange.

In late 2017 LFI received a bank loan. The loan agreement stipulates that LPI must obtain an annual audit of their financial statements and 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 Big 4 LLP to undertake 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. LFIs 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 Big 4 LLP Tom had a reputation to be a real go getter who always made his clients happy. He always found a way to justify clients accounting policies, no matter how aggressive they were.

Tom thinks an audit opinion from the public accounting firm of Big 4 LLP 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 See Exhibit I). Susan has met with Tom at LFIs head office. She has sent you her notes from her meeting in Exhibit II.

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 months 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.

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

• 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 SUSANS NOTES FROM HER 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 dont 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 LFIs 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. 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 its facilities and most of its 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.

4. Tom offered to provide each Big 4 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.

5. Tom mentioned the importance of Big 4 LLP issuing a clean audit opinion to Lux Fitness Inc.

Required

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 risk. (1/2 mark for the case fact giving rise to the risk, mark for correctly indicating if the factor increases or decreases RMM, mark for correctly stating the type of risk and 1/2 mark for the explanation as to why the factor increases the RMM).

EXHIBITI - EXTRACTS - LUX FITNESS FINANCIAL STATEMENTS - 6 MONTHS ENDED Lux Fitness Inc. For the 6 months ended Draft Income Statement in thousands of dollars) Note 31-Dec-17 31-Dec-16 lunaudited) (unaudited) Sales 1 $ 73,539 $ 47,800 Operating expenses Cost of sales 2 415 249 Wages and salaries of gym staff 22,062 19,120 Operating lease expenses 7,354 5,230 Depreciation 1,471 1,618 Other selling and administrative expenses 24,267 16,987 55,569 43,204 Operating income 17,970 4,596 Exceptional Costs in relation to proposed IPO 1,002 Interest expense 1,471 1,560 Earnings (loss) before taxes 15,498 3,036 Income taxes expense (recovery) (3,100) (607) Net income (loss) $ 12,398 $ 2,429 Lux Fitness Extracts from balance sheet - stated in 000's For 6 months ended December 31st Note 2017 2016 (unaudited) (unaudited) Accounts receivable (net of AFDA) 1 6,437 Inventories 2 311 125 Deferred revenue (credit balance 8,825 4,780 1 Total Liabilities Total Equity 52,621 101,195 35,299 88,247 Case fact which impacts RMM at OFSL level Does this factor increase or decrease risk Type of risk (control risk or inherent risk) Rationale for why this factor increases risk | EXHIBITI - EXTRACTS - LUX FITNESS FINANCIAL STATEMENTS - 6 MONTHS ENDED Lux Fitness Inc. For the 6 months ended Draft Income Statement in thousands of dollars) Note 31-Dec-17 31-Dec-16 lunaudited) (unaudited) Sales 1 $ 73,539 $ 47,800 Operating expenses Cost of sales 2 415 249 Wages and salaries of gym staff 22,062 19,120 Operating lease expenses 7,354 5,230 Depreciation 1,471 1,618 Other selling and administrative expenses 24,267 16,987 55,569 43,204 Operating income 17,970 4,596 Exceptional Costs in relation to proposed IPO 1,002 Interest expense 1,471 1,560 Earnings (loss) before taxes 15,498 3,036 Income taxes expense (recovery) (3,100) (607) Net income (loss) $ 12,398 $ 2,429 Lux Fitness Extracts from balance sheet - stated in 000's For 6 months ended December 31st Note 2017 2016 (unaudited) (unaudited) Accounts receivable (net of AFDA) 1 6,437 Inventories 2 311 125 Deferred revenue (credit balance 8,825 4,780 1 Total Liabilities Total Equity 52,621 101,195 35,299 88,247 Case fact which impacts RMM at OFSL level Does this factor increase or decrease risk Type of risk (control risk or inherent risk) Rationale for why this factor increases risk |