Written Response Question - Auditing Case - Discount Golf Mart Ltd - Please write your answers in point form on this exam. (32 Marks)

Discount Golf Mart Ltd (DGML) was founded in 1995 by five golfing fanatics and sells brand name golf equipment, apparel, and accessories at discount prices. DGML has eight retail outlets located in Manitoba, Saskatchewan and Alberta. A central warehouse in Winnipeg is responsible for supplying the retail outlets.

DGML is privately owned and managed. The owner-managers are very hands on and work well as a team. DGML has an excellent working relationship with a private lender who has financed the expansion and growth of the company over the years. DGML also has a history of profitability and the owners have grown accustomed to receiving generous bonuses and living a certain lifestyle as a result.

DGML's financial statements are audited by the firm of Pitch & Putt, LLP which is made up of five partners and a staff of 20 accountants. The firm provides assurance and non-assurance services to small and medium sized private businesses and is not economically dependent on any single client. The audit partner has been responsible for the audit for the past 8 years and is very knowledgeable about the company. The partner and the owners of the company are also involved together in developing a local golf course and condominium project. The partner is planning on retiring in the next few years and has just recently informed the other partners in the firm of his involvement in the project and his plans to retire. The owners are also interested in selling some of their shares in the company as a means of raising additional funds to finance the project. In addition, the private lender who is very ill, has asked the owners to make alternative arrangements to obtain financing when the current term of the loan expires in the next 12 months.

All of this comes at a time when the economy in Saskatchewan and Alberta has been in a significant downturn due to a decline in oil and gas prices in recent years. The number of golfers has also been steadily declining in recent years and the company has been facing stiff competition from its competitors who are fighting to maintain market share in the face of uncertain times. In addition, it has been getting more difficult to obtain discount goods for resale at a reasonable price due to the bankruptcy of a couple of major suppliers within the golfing industry which has been struggling to adapt to changing consumer preferences and demographics. In an effort to boost sales and improve the company's bottom line which has become stagnant in recent years, the owners introduced an employee bonus plan which is based on pre-tax net income during the current year. DGML also offered to buy customers' used golfing equipment as a means of encouraging them to buy new equipment, which was something it had previously been very reluctant to do.

Past experience with the client supports the audit team's assessment of an effective internal control environment and system of controls in place to prepare the financial statements. There is also no history of significant errors or fraud and the audit team has not identified any significant fraud risk factors (i.e. red flags) in the past. The partner told the audit team during the team planning meeting that "he absolutely trusts the owners and would know if there was anything out of the ordinary going on and that it isn't necessary to question the owners or management about whether they have any knowledge of fraud or suspected fraud". The audit firm also provided a staff member who is on the audit team to replace a member of the company's accounting staff who was temporarily away on maternity leave during the current year.

A new comptroller was hired during current year to replace the previous comptroller who left abruptly without any explanation, after having worked for the company for the past 15 years. The partner asked the owners about the reasons for the departure and was told "there was nothing to worry about and that there is a confidentiality agreement signed as part of the comptroller's severance package which prevents both parties from discussing the reasons for the departure with anyone". The owners have asked the new comptroller to assist them in securing new financing and finding investors who would be willing to purchase a minority interest in the company (and they have promised the comptroller a significant bonus if he is successful in doing so). The comptroller has told the auditors that it is very important that the financial statements present the company in the best light possible and that he is expecting the auditors' full cooperation in doing so.

At the same time, the comptroller, in an effort to cut costs, has been pressuring the partner to reduce the audit hours and fees, and to complete the audit much sooner than usual for the current year. The comptroller also mentioned the possibility of hiring the audit firm to assist it in replacing its existing accounting system which is becoming unstable and obsolete (due to the fact that the software is no longer being supported by the supplier and the system does not support on-line sales which is rapidly transforming and becoming a major part of the industry). In addition, the comptroller offered to provide the members of the audit team with a free membership for one year at the new golf course that is being developed, if the company is successful in attracting new investors (which has some of the younger audit team members very excited).

Exhibit I - Preliminary financial statements (in $000):

Discount Golf Mart Ltd

Balance Sheet (in $000)

As at December 31^st

Assets

2019

Unaudited

2018

Audited

$

%

$

%

Current assets:

Cash and cash equivalents

589

1,411

Inventories

8,478

6,842

Prepaid expenses

773

474

9,840

8,727

Property, plant and equipment

3,468

2,905

Accumulated amortization

(1,477)

(1,412)

1,991

1,493

Total assets

11,831

10,220

Liabilities and Shareholder's Equity

Current liabilities:

Accounts payable and accrued liabilities

3,440

3,633

Current portion of long term loan

153

132

3,593

3,765

Long term loan

2,398

1,991

5,991

5,756

Shareholder's Equity:

Common shares

1,500

1,500

Retained earnings

4,340

2,964

5,840

4,464

Total liabilities and shareholder's equity

11,831

10,220

Discount Golf Mart Ltd

Income Statement (in $000)

Year Ended December 31^st

2019

Unaudited

2018

Audited

$

%

$

%

Sales, net of returns

32,566

32,333

Cost of goods sold

20,809

21,979

Gross Profit

11,757

36%

10,354

32%

Expenses:

Selling expenses

8,078

7,619

Administration and general expenses

1,334

1,211

Amortization

186

267

Interest expense

193

154

9,791

9,251

Net income before income taxes

1,966

1,103

Income tax expense

590

441

Net income

1,376

662

Retained earnings, opening

2,964

2,302

Retained earnings, ending

4,340

2,964

Exhibit II - Selected financial information (in $000) from the audit file:

1. Sales, net of returns:DGML recognizes revenue from the sale of its products at the point of sale on transactions with consumers at its retail locations. Revenues from gift cards are deferred and recognized when the cards (which have no expiration date) are redeemed. The new comptroller recognized the entire amount of the deferred revenue from gift cards as revenue for 2019 since he thought it was pointless to wait to recognize the revenues once the customers had paid for the goods.

DGML also records a provision (i.e. liability) for anticipated sales returns in the period that the related sales are recorded. Sales returns are estimated based upon historical returns ratios and current economic trends. The comptroller decided to record the sales returns on a cash basis since he felt it was too much work to estimate the amount of the sales returns. The comptroller reversed the provision for the anticipated sales returns as at December, 2019.

2.Inventory and cost of goods sold:The comptroller negotiated special payment terms with a new supplier for a large purchase of discount goods just in time for the Christmas season. The supplier agreed to allow the company to delay paying for the goods purchased until 90 days after receipt of the goods. The goods were received by the company at the start of December but the comptroller did not record the payable until two months after the end of the year, exactly 90 days after the goods were received. The unsold portion of the goods on hand as at December 31, 2019 were included in the inventory count at year-end.

3.Property, plant and equipment:Property, plant and equipment are recorded at cost less accumulated amortization. Amortization is computed using the straight-line method over the estimated useful lives of the assets as follows:

Buildings and leasehold improvements .................................................................. 10-30 years

Machinery and equipment......................................................................................... 5-15 years

Office equipment and computers ............................................................................ 3-10 years

Repairs and maintenance costs are expensed as incurred. Estimated remaining useful lives and salvage values are reviewed at the end of each reporting period and any necessary adjustments are recognized on a prospective basis as a change in accounting estimate. The comptroller decided to arbitrarily double the estimated remaining useful lives of the assets during the current year, since he felt that the previous estimate was "too conservative", which he had been told by his accounting professors was "no-no" under the accounting rules.

4.Income tax expense:The comptroller reduced the income tax rate used to calculate the income tax expense for 2018 from 40% to 30%. He was told (in confidence) by his local member of parliament that the federal government was planning to reduce the income tax rate for private businesses in the upcoming federal budget to be announced in the spring of 2020.

5.Other expenses:Selling expenses for both years include bonuses of $500 paid to the owners for tax planning purposes (which is in addition to their regular remuneration). The administrative and general expenses for 2019 include a non-recurring one-time severance payment of $150 paid to the previous comptroller.

6.Long term loan:The comptroller did not show the loan as current or disclose the fact that the current term of the loan expires in 2020 (and will not be renewed by the current lender) in preparing the financial statements. He thought that if he did so it might scare away any new investors who might be interested in purchasing a minority interest in the company if they knew the company was looking for a new lender.

Required:

1. Assessment of Threats to Independence and Safeguards -Please identifythreethreats to independence for Pitch & Putt, LLP. For each threat identified, state the type of threat identified and how the threat might be eliminated or reduced to an acceptably low level.(6 Marks)
3. Assessment of Risk of Material Misstatement, Audit Risk and Fraud Risk (21 Marks in total)

1. Please identifyfourinherent or control risk factors that could result in a material misstatement in the financial statements and indicate whether the factors identified increase or decrease the risk of material misstatement. Please also indicate whether there are anyincentives or pressurespresent for management to engage in earning manipulation/fraudulent financial reporting to make the financial statements appear more favorable?(6 Marks)
3. Please conclude on the overall risk of material misstatement (i.e. audit risk) for the financial statements as a whole and provide a brief explanation (i.e. what factors did you consider) to support your assessment. Please also indicate how will your audit risk assessment affect your overall audit approach and suggest two procedures that the auditor can take to reduce the audit risk to an acceptably low level?(6 Marks)
5. Please identifythreefinancial statement balance sheet or income statement accounts where a risk of material misstatement may exist at theassertion leveland provide a brief explanation to support your risk assessment (for example: The company is experiencing increasing difficulty in collecting its receivable due to an economic downturn - there is a risk that accounts receivable may be overstated - this relates to the valuation assertion).(6 Marks)
7. Please state whether youagreeordisagreewith the comments made by the audit partner during the audit team planning meeting in terms of assessing the risk of fraud for the current year's audit and briefly explain your reasoning. Please also identifytwoprocedures the auditor should perform to evaluate the risk of fraud during the planning phase of the audit.(4 Marks)

1. Determination of Preliminary Materiality Level (4 Marks in total)

1. Please identify the main users of the financial statements and what their needs are. Are there any other potential users of the financial statements?(2 Marks)
3. Please select a base to determine materiality and state why the base selected is appropriate. Please also identify whether there are any unusual or non-recurring items that need to be "normalized" or adjusted for in the base and calculate the preliminary materiality level for the audit for 2019.(2 Marks)