QUESTION:

Provides an in depth analysis of all types of audit risks and then concludes on the risk level. 3 risks for each IR + CR.

It is January 27, 2016. You, a senior auditor with Johansson and Partners LLP, are meeting with audit partner, Kelly Johansson, to discuss the year-end audit of a new client, Market Appliances Ltd (MAL). Harry Market, CEO and co-owner of MAL, approached Kelly two weeks ago about the audit, and she has since accepted the client.

Mei Fung, a CPA student with the firm that you are supervising, started planning for the engagement last week by calculating preliminary materiality as $135,500, based purely on 6.5% of net income.

Kelly has asked you to make an audit planning memo. She also has asked that you discuss the significant accounting issues, including specific audit procedures to address the risks identified. She would also like a financial statement analysis completed with any questions you would like to ask the client. Further, she would like you to include an assessment of MAL's internal controls.

Kelly has provided you with background information on MAL (Exhibit I), notes from her interviews with Harry and MAL's general manager, Gagan Singh (Exhibits II and III), and the draft financial statements (Exhibit IV).

EXHIBIT I: BACKGROUND INFORMATION

(Prepared by Gagan Singh)

In 1974, John Market founded MAL, a home appliance manufacturing company located in Kingston, Ontario. MAL's reputation was very important to John, who valued quality and customer service above all else. Over the years, the home appliance industry expanded significantly and became more competitive. Five years ago, in response to the industry changes, MAL decided to reduce its product line, and began specializing in niche products while maintaining its focus on customer relationships and quality.

In 2006, John Market retired and transferred ownership of MAL directly down to his three children, Harry, Rachel, and Brian. Rachel is a family doctor and Brian is a chef; with successful careers, their involvement in the business is limited to attending the annual meeting. At the annual meeting, the financial statements are presented by Harry and they go over the previous year's financial results. Brian and Rachel tend to focus on the revenue figures, asking many questions about changes and fluctuations. Annual dividend payments are made at this time.

Three years ago, MAL launched a highly anticipated product called the Flash Freezer. This specialized product is able to freeze items four times faster than conventional freezers, resulting in frozen food that is better tasting and, because fewer nutrients are lost during the freezing process, more nutritious. In its first year on the market, demand for Flash Freezers sky-rocketed, and MAL decided to cut all other product lines.

MAL currently employs 180 people. Until 2015, its customer base consisted of large retail firms that purchase the Flash Freezers on a wholesale basis, and restaurants and other food producers that order custom versions of the freezers. Early in 2015, in an effort to improve sales, MAL decided to expand into e-commerce by developing a website to sell freezers directly to retail customers. The website became fully operational in April 2015, and has been quite successful, significantly offsetting declining margins.

Recently, Brian and Rachel expressed an interest in selling their shares in MAL to Harry. They have begun negotiations and have agreed that the purchase price based on a multiple of 2015 earnings, would be acceptable. The 2015 audit is a direct result of this pending sale. Brian and Rachel requested the audit, and Harry reluctantly agreed that it would be a good idea.

EXHIBIT II: NOTES FROM MEETING WITH HARRY MARKET

(Prepared by Kelly Johansson)

Harry would like to take the company public at some point in the future; as such, MAL transitioned to IFRS in 2015. To realize this goal, Harry plans to put a strategic plan together after he buys out Rachel and Brian. He doesn't feel like going through the hassle of obtaining their approval of the plan. Realizing that the business, and control environment, has changed over the years, Harry has asked for an assessment of MAL's internal controls, along with practical recommendations for improvement. Since 2014, when Brian requested that Harry's son Sean be let go from the company, there has been an increasing level of tension between the owners. Brian didn't think it fair that Sean received a job at MAL while his children did not.

During the last half of 2015, MAL began selling maintenance service contracts. By the end of the year, MAL had sold 200 two-year contracts for $2,500 each. The accounting system is tracking both the parts and labour costs associated with the maintenance servicing as a component of cost of sales. To be kept in running order, Flash Freezers require maintenance every three months. MAL sells the maintenance contracts for regular servicing of the freezers to customers who place custom orders. He presented the idea to Brian and Rachel, who were initially hesitant; they were concerned that customers would not be required to pay for the contract until the end of the term. However, after some convincing, Harry was able to obtain their approval.

Last year, Harry's son Sean incorporated Compressors Inc. (CI), a manufacturing company that produces freezer compressors. Sean was able to set up CI with financial assistance from Harry. Compressors are a key part of the production of freezers. MAL currently purchases all the compressors required for manufacturing blast freezers from CI, and MAL is CI's main customer.

Salespeople at MAL are responsible for managing client relationships with wholesale and custom-order customers. Until recently, salespeople were paid based on a fixed salary scale. When John founded MAL, he wanted to have a no-pressure sales environment for his customers, and therefore did not pay commissions. However, the industry has changed, and in order to retain top performing salespeople, Harry decided to add a commission component to the salespeople's compensation. As such, salespeople receive a 5% commission paid based on the signing of maintenance contracts.

At the same time that the website was developed, MAL also upgraded its computer system. It purchased a top-of-the-line accounting system that significantly improved tracking of sales, accounts receivable, and inventory. MAL performed significant testing on the system when it was implemented, and Harry was very satisfied with the system's accuracy. As such, he decided to reduce the number of inventory counts performed from monthly to quarterly. As a gesture of goodwill to his manufacturing staff, who usually complained about having to work over the holidays, he also decided not to perform a December 31 count.

EXHIBIT III: NOTES FROM MEETING WITH ROBB CHEDZEY

(Prepared by Kelly Johansson)

Wholesale and custom orders, and maintenance contract sales, are entered directly into the system by salespeople. The system then tracks the order's progress, tracking work in progress for custom orders. Because each customer order has different specifications, MAL does not maintain a master price list for custom sales. Instead, salespeople are provided with discretion to set pricing, based on the details of the order. Revenue on custom orders is not recorded until approved by Harry in the system.

Credit is only offered to wholesale and custom order customers. Retail customers are required to pay at the time of ordering, using credit cards. To save time and improve customer relationships, salespeople are responsible for setting credit limits for new customers. Approval from the sales manager is only required on credit limits set for wholesale customers.

As each part is taken out of inventory and moved into production, manufacturing staff scan the item. The system is updated automatically, based on the scanning process. Manufacturing staff is also required to sign in and out of each shift, using a computer located in the warehouse. If a staff member is working on a custom order, project details must be entered when they sign out for the day. The system uses this information to update production costs for direct labour. Inventory generally fluctuates between $400,000 and $900,000, and an inventory write-up is usually required when inventory is counted.

The warehouse manager is responsible for all purchases. For any purchase over $500, a purchase order must be created. One copy of the purchase order is sent to the vendor, and the other copy is sent to the accounts payable clerk. When an invoice is received, it is matched to the purchase order (if there is one), and a cheque is prepared by the accounts payable clerk. Cheques are printed on a printer outside of Gagan's office. All cheques over $5,000 require both Gagan's and Harry's signatures; cheques under $5,000 are signed by Gagan only. Harry keeps a signature stamp with his administrative assistant, in case he is unavailable when cheques need to be signed. For any cheque over $50,000, Harry requires supporting documentation.

QUESTION:

Provides an in depth analysis of all types of audit risks and then concludes on the risk level. 3 risks for each IR + CR.