Savita Kapur, CEO, founded Absent Clothing Company (ACC) in 2005. ACC sells practical athletic wear to service the yoga and Pilates market. Savita originally created ACC with the intention of limiting the capital investment to her own resources. To achieve this, ACC only sells products through its website and outsources most major functions. For example, ACC outsources all production to Cordoba Manufacturing Inc. (CMI), while maintaining leased warehouses for storage in Toronto, Montreal and Vancouver.

In 2007, ACC issued 25,000 common shares to Jack Alder crest, a private investor, to meet the need for increased working capital. Savita owns the remaining 50,000 outstanding common shares. Savita makes all the final decisions on sales, marketing and accounting and would like to continue to do this. As Jack is not active in the operations of ACC, he requires an annual financial statement audit. Consequently, ACC has been audited by Mills & McBeath LLP (MM), a regional accounting firm, since the year ended January 31, 2008. ACC has always received an unqualified audit opinion.

It is now February 12, 2011. You, CA, work for MM. The engagement partner, William Jones, has asked you to a meeting to discuss the fiscal 2011 ACC audit.

“I‘m sure you‘re aware that the audit manager for the ACC engagement left the firm before completing the planning for this year‘s audit. I would like you to take over the audit right away. I have gathered some information on ACC for you (Exhibit I). Please prepare a memo to discuss our overall audit strategy for the ACC audit, which should include an analysis of the risk of material misstatement at the financial statement level, a discussion of preliminary materiality and overall approach. Also, please make sure you include an analysis of the appropriate accounting treatment of any new issues arising in fiscal 2011, including the identification of specific audit procedures to address those issues.”

“Savita has had aggressive plans for ACC‘s future growth. Starting this summer, she plans to make her products available to customers in the United States. She hopes to eventually take the company public in fiscal 2013. ACC adopted International Financial Reporting Standards beginning in fiscal 2010 as a result of Savita‘s plans.”

“I met with Savita last week and summarized the notes that I took during the meeting (Exhibit II). Savita mentioned that ACC implemented an automated sales and order system in July 2010 and provided details of the new Sable system (Exhibit III). Savita didn‘t bother telling us about the implementation sooner because she didn‘t think it would impact the audit.”

“Savita also informed me that ACC entered into an agreement with Kampkin Fabrics Limited (KFL) for the rights to use a new breathable fabric developed by KFL. KFL requires a report from ACC‘s auditor providing assurance over the sales of all products made using the new fabric, since the agreement includes reference to gross revenue from product sales. Savita agreed to provide such a report, but does not know what options are available.”

“Finally, to fund the company‘s expansion into the United States, Savita is planning to sell some of her common shares, and have ACC issue preferred shares in fiscal 2012. She wants to understand how this will impact the company‘s growth strategy and her objective of retaining control of ACC.”

Required:

Please write a report in good form to the audit partner that addresses 3 financial accounting issues. Also discuss the engagement audit strategy and one audit step or procedure you propose for each issue identified.

EXHIBIT I

ACC BACKGROUND INFORMATION

ACC purchases proven fabrics and the right to use clothing processes or fabrics instead of conducting its own in-house research and development. ACC finds that fabrics and processes change as customer tastes change; consequently, ACC is always trying to keep current. Savita finds that product life cycles in athletic apparel, while longer than in other fashion areas, are still only three to five years. ACC's gross margin is typically 50% of sales.

Over the first several years of operations, ACC incurred significant losses as it established the credibility of its brand as a high-quality athletic wear provider. This investment in branding began paying off as ACC had its first annual profit in the year ended January 31, 2011. Savita expects profits to increase significantly in fiscal 2012 and beyond as she moves to lower-cost guerrilla marketing techniques from more traditional marketing methods. ACC‘s new advertising campaign focuses on using viral videos with the Absent label subtly included.

Prior to the implementation of the Sable system, ACC manually compiled customer orders and manually selected the most appropriate sourcing warehouse before sending the order information to pickers at a warehouse level.

In the warehouses, orders were assembled manually and picked up daily for delivery by a national courier company. Once delivered by the courier company, a delivery confirmation was sent to ACC head office in Toronto. The accounts receivable clerk then matched the delivery confirmation to the original order and recognized the revenue. Order processing took up to five days, with delivery taking an additional three to seven business days, depending on customer location.

Inventory levels were monitored at each of the warehouses and orders were sent to suppliers separately by each warehouse manager. Due to the difficulty in forecasting demand and relatively long supplier lead times, product stock outs were common and represented a key source of customer dissatisfaction.

© Copyright 2011 ICAO School of Accountancy

EXHIBIT II

NOTES FROM MEETING WITH SAVITA KAPUR

Ontario Post

On September 1, 2010, ACC secured its largest corporate sale to date. Ontario Post ordered $900,000 of light-weight breathable shirts, personalized with the Ontario Post logo. To facilitate the sale, ACC agreed to store the personalized shirts until they were needed by Ontario Post. Ontario Post paid a 20% deposit on September 1, 2010. Ontario Post agreed to be billed monthly for the shirts that were delivered to them from ACC. However, the delivery of the first 20% of product would not be billed and would be deducted from the deposit.

ACC received the completed order from its manufacturer on September 30, 2010. The shirts are being stored in the Toronto warehouse.

By January 31, 2011, 15% of Ontario Post‘s shirts had been delivered. ACC recorded the full $900,000 of revenue relating to this contract in fiscal 2011.

Patent

Savita personally owned an indefinite life patent for a specialized process used for the production of ACC‘s yoga pants and shorts. In anticipation of forming ACC, Savita purchased this patent for $75,000 in 2008 from a clothing manufacturer seeking to exit the athletic wear market. To compensate Savita for use of the patent, ACC paid Savita 5% of gross sales arising from the patented production process. Due to increased sales in yoga apparel in recent years, Savita decided that the patent was essential to ACC‘s future and sold the patent to ACC on February 1, 2010 for $400,000. ACC recognized the $400,000 as an intangible asset with an indefinite life.

Sable system

With the new Sable system, ACC receives real-time information on customer orders. Now that the company has more timely order information, ACC began recording revenue when the order was placed online by the customer. Online orders are paid for by credit card before being processed by ACC.

EXHIBIT II (continued)

NOTES FROM MEETING WITH SAVITA KAPUR

Stolen laptop

In late December 2010, the laptop of ACC‘s marketing manager was stolen from her car while she was attending a dinner meeting. Savita was concerned about the theft since the marketing manager‘s laptop is not password protected. Further, the marketing manager had been working on a detailed analysis of ACC‘s fiscal 2012 marketing plans using customer information that is now available to all system users from the new Sable system.

The marketing manager was still sifting through and understanding the available information, but she knew it contained customer names, addresses and sales history. She was unsure whether the customer data file also contained user names, passwords or payment information.

Rights purchase

In early February 2010, ACC bought the North American rights to manufacture clothing made from a new breathable, waterproof fabric from Kampkin Fabrics Limited (KFL). The North American rights were exclusive and granted for a 99-year period to ACC. Savita believes this purchase positions ACC well for sales growth.

To preserve liquidity for the expansion to the United States, Savita negotiated a purchase agreement that provided an up-front payment of $100,000 combined with a variable payment for the next five years. For the variable payment, ACC is required to pay KFL $100,000 in each of the next five years or 10% of gross revenue from product sales using the new fabric, whichever is greater on an annual basis. ACC has recorded an intangible asset of $600,000 and a liability for $500,000. No amortization on the intangible asset was recorded in fiscal 2011.

Proposed share transactions

In January 2011, Savita agreed to sell 10,000 of her common shares to CMI, ACC‘s principal production supplier, in April 2011. The selling price of the common shares will be increased upward by three times the amount that fiscal 2011 pre-tax profit exceeds fiscal 2010 pre-tax profit.

At the same time, ACC reached a tentative agreement to issue 300 cumulative, 12%, non-voting, preferred shares to CMI in April 2011. Each preferred share can be converted into 100 ACC common shares at any time at the option of CMI.

EXHIBIT III

SABLE SYSTEM

• The Sable system was implemented on July 31, 2010 after six months of planning and pilot-testing. The system conversion went smoothly with very few customers reporting any problems with delivery or products.

• The new system contains an auto-fulfillment function that automatically routes orders to the most appropriate warehouse based on a matrix of information, including customer location and inventory availability. The Sable system integrates with inventory management at the warehouse level to predict inventory needs and place orders with suppliers on a timely basis to avoid product stock outs.

• The Sable system also provides real-time sales information that allows timely analysis of customer patterns and marketing effectiveness, leading to quicker and more effective marketing changes.

• Under the new system, 99% of orders are processed by the warehouse within one to two days of placing the order, with delivery taking an additional two to five business days. The faster delivery is a result of the improved logistics planning with the auto-fulfillment function. By December 2010, product stock outs were reduced by 80%, while inventories were reduced by 10% due to automated monitoring of inventory levels.