Today is February 16, 20X6. Susan Careful, a partner in Young & Careful LLP, Chartered Professional Accountants, has called you, CPA into her office to discuss her client Grover Bicycle Company (GBC). GBC is a private company that has manufactured bicycles for two decades, and Leo Grover is the major shareholder and president. GBC's product lines presently consist of twenty models, ranging from bicycles for children and recreational bicycles for adults to professional racing bicycles. GBC has a reputation for providing high-quality bicycles at a reasonable price. GBC's customers presently consist of retailers that specialize in the sale of bicycles. Summarized financial information for the fiscal year ended December 31, 20X5 is provided in

Exhibit I. Susan says to you: "I want you to attend a meeting that I have scheduled with Leo Grover for this afternoon. Leo wants us to evaluate the internal control at GBC and provide advice about how to improve the internal control. As you know, we have always issued a review engagement report on GBC's financial statements. Leo wants us to issue an audit report on GBC's financial statements for the year ended December 31, 20X5. Leo would like us to explain to him the difference between a review and audit engagement so that he can understand how this change in engagement will affect him and his staff. Leo has advised me that GBC has received a proposal from FloorMart Inc.(FloorMart), a large discount retail chain. FloorMart requires audited financial statements to assess the financial soundness of GBC before it will enter into a contract with GBC; and, Leo wants increased assurance that GBC's financial statements for fiscal 20X5 are reliable. GBC uses ASPE as their basis of accounting." You attend the meeting with Leo Grover and the notes from the meeting are provided in

Exhibit II. After the meeting Susan says to you: "Please a draft report to Leo Grover for my review that analyzes and responds to the requests of Leo Grover. In addition,a memo to me addressing the significant audit issues pertaining to the audit of GBC's financial statements for the year ended December 31, 20X5." As you contemplate the work to be completed, you prepare the following "to do" list to help ensure that your memo to the partner includes the following: a preliminary assessment of materiality, an assessment of engagement risk a control risk assessment and approach to the audit identification of areas that you feel will have a significant risk of material misstatement (IR and CR) and may need more attention than last year the audit procedures that you propose to complete for the significant risk areas (i.e. at the assertion level) identification of other areas of concern you want to raise with your partner. Required: Prepare the report to Leo Grover and the memo requested by the partner. 2 EXHIBIT I GROVER BICYCLE COMPANY SUMMARIZED BALANCE SHEET As at December 31 (in thousands of dollars) 20X5 20X4 Assets Cash $ 280 $ 210 Accounts receivable 1,360 1,290 Inventories 2,760 2,480 Property, plant, and equipment 3,630 4,270 $8,030 $8,250 Liabilities Bank operating loan (1) $1,900 $2,000 Accounts payable and accrued expenses 990 950 Long-term debt 2,200 2,450 5,090 5,400 Shareholders' Equity Common shares 100 100 Retained earnings 2,840 2,750 2,940 2,850 $8,030 $8,250 (1) the bank operating loan had an average interest rate of 6% for 20X5; the loan is limited to a maximum amount calculated as 75% of accounts receivable and 50% of inventories 3 EXHIBIT I (continued) GROVER BICYCLE COMPANY SUMMARIZED INCOME STATEMENT For the year ended December 31 (in thousands of dollars) 20X5 20X4 Sales revenue $10,850 $10,150 Cost of sales (2) 8,030 7,510 Gross margin 2,820 2,640 Operating, selling, and administration expenses, including interest and amortization 2,710 2,220 Income before income taxes 110 420 Income taxes (3) 20 100 Net income $ 90 $ 320 (2) on average, variable manufacturing costs account for 80% of cost of sales, and fixed manufacturing costs account for 20% (3) income taxes are accounted for using the income taxes payable basis 4 EXHIBIT II NOTES FROM THE MEETING WITH LEO GROVER FloorMart Proposal FloorMart has approached GBC to manufacture bicycles for FloorMart that would bear FloorMart's house brand name for sporting goods, "Excellium". A unique feature of the FloorMart proposal is that GBC would deliver bicycles to FloorMart's regional warehouses; however, title to the bicycles would not transfer to FloorMart until bicycles were delivered to FloorMart's retail locations by FloorMart. FloorMart would be required to pay GBC for bicycles transferred to the retail locations within thirty days of the transfer. Bicycles held in FloorMart's warehouses beyond 120 days would become the property of FloorMart and would be required to be paid for within thirty days. FloorMart has the right to return bicycles held in the warehouses to GBC at any time prior to the 120 day limit. The purpose of this arrangement is to ensure that FloorMart does not run short of inventory. FloorMart has indicated to Leo Grover that it expects that GBC's bicycles will, on average, remain in the warehouses for a period of 30 to 60 days before being transferred to the retail locations. In order to support FloorMart's "Everyday Price Slashing" policy, GBC would sell the speciallymanufactured bicycles to FloorMart at a reduced markup than charged to GBC's present customers for comparable bicycles. The "Excellium" bicycles would use the same frame and mechanical components as the GBC models; however, the handlebars, seats, fenders, and tires would be manufactured to meet the specifications for the "Excellium" brand bicycles. Leo commented that manufacturing the bikes for FloorMart made sense since GBC's sales revenue has remained relatively flat for three years with only 6.8% growth in 20X5, approximately 4% after inflation. In addition, he pointed out that GBC was currently operating at about 75% of its present operating capacity of 115,000 units, based on one production shift. FloorMart has proposed a three-year contract whereby FloorMart would make GBC its exclusive supplier of its "Excellium" brand bicycles. The contract would be automatically renewed subsequently on a yearto-year basis unless either party provides three-months' notice to terminate the contract. 5 EXHIBIT II (continued) NOTES FROM THE MEETING WITH LEO GROVER Internal Control at GBC A summary of the conversation concerning the accounting processes is as follows: The accounting department has been severely overworked during the past year because of the loss of two employees who have not been replaced. For the past several months, the accounting department has consisted of the accounting manager and two assistants: one of whom is responsible for the billing, collection, and cash receipts function; for preparing and making bank deposits; and, for handling related customer enquiries; the other is responsible for the purchases, payables, and cash disbursements function; for the payroll function; and, for the general ledger function. The accounting manager tries to prepare the monthly bank reconciliations and to review the monthly financial statements prepared by the employee who has responsibility for the general ledger, but has not had time to do so for the past four months. The receptionist answers the telephone, handles some customer service issues, and opens the mail daily. New desktop computers were purchased in 20X5 for the accounting department. All employees log in using the same login name and password to access the files. The accounting manager is very frustrated with the inventory accounting. He spent many hours trying to reconcile the year-end inventory count to the inventory records as at December 31, 20X5. He is upset because the shipping documents are manually numbered and dated before the inventory is actually shipped; and, when it is really busy the shipping department employee responsible doesn't always remember to record shipments in the shipping log. The last entry in the shipping log was three weeks before year-end. The inventory and cost of sales accounts in the general ledger have been adjusted by $75,000 at December 31, 20X5 to adjust the balance in the inventory account to agree with the inventory amount determined by the inventory count of finished bicycles. The inventory count determined that finished bicycle inventory was less than the amount reported in the accounting records. The accounting manager believes the difference may have resulted from inventory counting errors made by casual help hired to help with the inventory count. Sponsorship Program GBC signed on as one of the sponsors of the "Trillium Racing Team" (TRT), an Ontario-based bicycle racing team that competes in long-distance bicycle tour races around the world. GBC's three-year sponsorship commitment consists of annual cash contributions of $150,000 in each of 20X5, 20X6, and 20X7, and providing the team annually with eight racing bicycles that are designed specifically for use by TRT in each of 20X5, 20X6, and 20X7. In exchange for the cash and bicycle contributions, the GBC logo is predominantly displayed on the team uniforms and support vehicles. The first cash contribution of $150,000 was made on April 1, 20X5, and eight bicycles were provided to TRT at this time. GBC has estimated the cost to manufacture these bicycles to be $200,000. 6 EXHIBIT II (continued) NOTES FROM THE MEETING WITH LEO GROVER Leo Grover believes that this international exposure will translate into sales of GBC's new generation of professional racing bicycles that are presently being developed; and, will provide overall exposure to the "GBC brand" of bicycles. Leo commented that the total cost of $350,000 incurred in 20X5 is presently included in operating, selling, and administration expenses in the year-end draft financial statements. Racing Bicycle Frame Project GBC has been working on the development of a new generation racing bicycle frame that would be used in the manufacture of a new generation of professional racing bicycles. Project expenditures incurred in 20X4, when this project commenced, were expensed because the criteria for deferral were not met by the fiscal year end. Project expenditures incurred in 20X5 are as follows: Materials $ 25,250 Labour 75,750 Overhead allocation (calculated as 20% of labour costs) 15,150 $116,150 Leo Grover stated that he expects that GBC will start selling the new generation of professional racing bicycles in late 20X6 or in early 20X7. Prototypes of the racing frames are incorporated into the bicycles provided to TRT and are being tested by TRT in training sessions. He is confident that there is a significant market for GBC's new racing bicycles in Canada, the United States, Europe, and in Central America. He believes that GBC's sponsorship of TRT will provide GBC with international exposure that will translate into a profitable market for GBC's new generation of racing bicycles. Leo estimates that additional expenditures totaling $100,000 will be incurred in 20X6 to project. He commented that the project expenditures incurred in 20X5 are presently included in operating, selling, and administration expenses in the year-end draft financial statements. Financing Leo Grover indicated that he is concerned that GBC will require additional financing if the FloorMart proposal is accepted. GBC's bank operating loan is subject to a limit based on accounts receivable and inventories, and GBC is required to maintain a total liabilities to equity ratio of below 2 to 1 at each fiscal year end by the bank that has provided GBC with its operating loan and long-term debt