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You, a senior auditor, have recently joined Palmer & Associates LLP, a mid-size firm based in Ontario serving mostly manufacturing companies. Today is December 1,

You, a senior auditor, have recently joined Palmer & Associates LLP, a mid-size firm based in Ontario serving mostly manufacturing companies. Today is December 1, 2020. Your audit manager, Mina Fong called you into her office to discuss the work that needs to be performed on a repeating audit client, Fit-for-Life Inc. (FFI). The firm has been FFL's auditors since 2017. The company has a December 31, 2020 year-end. Required: Prepare a planning memo. The memo should include a preliminary assessment of RMM at the overall financial statement level and suggest a basis for determining overall materiality. The memo should also include a risk assessment for the sales and accounts receivable cycle as well as the inventory cycle. Draw up some preliminary ideas on sampling for accounts receivable confirmations and audit procedures for the upcoming inventory count. You should refer to the notes below collected when Mina Fong met with the client (Exhibit 1). The notes below describe changes that happened in 2020"

Exhibit 1

Notes written up by Mina from the meeting with the client

Below is a summary of information collected during meeting with Angela:

  • Cotton is the main raw material used in the manufacturing. FFL mitigates fluctuations in cotton prices by purchasing cotton futures (sold in U.S. dollars). While cotton futures prices have been quite stable in 2019 and most of 2020, in November 2020 the costs of cotton futures declined and Elizabeth and Angela decided to reduce selling prices in order to pass on the cost reductions to its distributors. Due to a miscommunication between Angela and Elizabeth, Elizabeth reduced the selling prices when negotiating a new sales agreement with the wholesale distributors for 2021 before the reduction in cotton prices was realized.

When Elizabeth reduced the selling prices many customers complained that they had recently purchased large quantities of product at the historical price. Many customers threatened to find a new supplier and since FFL offers a right to return up to 30 days, they threatened to return the merchandise. Elizabeth provided relief to these customers by offering all distributors a price concession for orders they placed and delivered up to 3 months prior to the price change coming into effect. All customers were issued credit notes for the difference between the new selling price and the price they had paid for the merchandise.

Elizabeth made this decision unilaterally without consulting Angela. This is one of the main reasons why Angela feels she can no longer work with Elizabeth. Elizabeth has a tendency to make unilateral decisions without consulting Angela.

It was this decision that caused the current ratio of the company to decline to 1.29.

This error has caused a significant disagreement between Elizabeth and Angela and, as a result, Angela doesn't feel that she can continue to work collaboratively with Elizabeth anymore. She is considering triggering a buy-out clause in the shareholder's agreement. The clause allows her to purchase Elizabeth's shares for 5 times net income. Once Angela places this offer, Elizabeth must either accept the offer or counter the offer with a 30% premium.

  • Angela confirmed that the credit approval process has not changed from last year and gave us the aging report for the period ending November 30th 2020 to facilitate planning. The sales and payment pattern will be more or less the same in December.

Inventory count procedures are as follow below,

  • Inventory consists mainly of raw materials and finished goods. FFL continues to use average cost as the costing method to value inventory. Inventory counts will take place on December 31st as in prior years. The client will provide an inventory report listing all inventory items by product number for the period ended December 31, 2020. For each product number the following information is provided: the average cost, the quantity on hand, the total cost (quantity x average cost), the most recent selling price, the total number of units sold in the past fiscal year, the date the item was last produced.

  • The warehouse will be closed on December 31st and all items will be tagged in numerical sequence. Counters work in pairs and recount the other's work. Angela will prepare detailed count instructions and will supervise the count. At the end of the count Angela will ensure all tags are accounted for. The results will then be entered into the system and an exception report will be used to identify all products which have discrepancies between the count quantity and the quantity recorded in the perpetual records. All discrepancies of greater $20,000 will be recounted.

  • One area of the warehouse is maintained to hold slow moving items. When trends change and styles are discontinued Angela ensures that the items are protected from getting damaged and stores them in the slow-moving section. She saves the items in anticipation of the trend for that particular item or colour will comeback in fashion.

  • Inventory in another area of the warehouse will be marked "Hold - Do not count". Elizabeth has recently received a large order from a corporate customer for customized t-shirts. The t-shirts will be finished printing by December 23rd but the customer has requested the client to hold the inventory until January 8th for shipping because their office will be closed for holidays.

Exhibit 2

Internal controls Accounts receivables credit approvals. FFLs credit risk for trade accounts receivable in the wholesale business is highly concentrated as the majority of its sales are to a relatively small group of wholesale distributors. FFLs ten largest customers constitute 61% of total trade receivable and its largest customer, Print and Go Inc. accounts for 20% of total accounts receivable. Many of FFLs customers are highly leveraged and rely on FFL providing favourable credit terms. Most customers receive 45-day terms and longstanding customers receive 60-day terms. Terms greater than 30 days are standard in the industry because of the time lapse between when the wholesale distributer will ultimately receive collection from the end consumer. On the other hand, credit risk for corporate customers is relatively low because they are required to put down a 50% deposit when the orders are placed with the remaining balance to be paid in full within 30 days. Corporate customers made up about 5% of the total balance in accounts receivables. Extending credit to customers involves considerable judgment. FFL has a dedicated credit manager, Nancy Tight, who evaluates each customers financial condition and payment history. It is her responsibility to prepare recommendations for customer credit limits and payment terms. Nancy reviews external credit ratings (if available), the customers financial statements and obtains bank and other references. In the case of existing customers she also reviews the customers past payment history. Based on this analysis she prepares a recommendation and forwards it to Angela for approval. Angela is very conservative when it comes to granting credit to new customers or increasing credit limits of existing customers. She diligently reviews the research conducted by Nancy. She often requires Nancy to reduce her recommended limits and has often denied extending credit to potential customers despite Nancys recommendation. Historically, due to this stringent process, FFL has had insignificant bad debts.Once new customers are approved Nancy enters the new customer details and agreed upon terms into the companys ERP system. Nancy and Angela are the only employees who have access rights to add new customers and make changes to credit terms. The system requires that Angela approve all changes. At the end of each week the system generates a report noting all changes to the customer Masterfile. This report is reviewed by both Angela and Elizabeth. When customer orders are received, they are entered into the system by a customer order clerk. The system automatically validates the order and performs a check to ensure the order value plus the current customer balance is below the authorized credit limit. When goods are shipped, the system automatically generates the sales invoice and the sales is recorded. Standard sales terms are FOB shipping point.

The accounts receivable aging for the period ended November 30th, 2020 is as follow

Range of balance number of customers number of customers in this category total balance current 30-60 days 60-90 days over 90 days
less than 0 7 (750,000) (750,000)
0-50,000 157 16 4,335,524 2,341,183 1,885,953 65,033 43,355
50,001 to 100,00 200 20 4,231,475 2,284,997 1,840,692 63,472 42,315
100,001 to 150,000 303 61 5,990,625 3,294,859 1,198,130 599,065 898,598
greater than 150,00 10 21,814,114 8,071,222 13,742,892 -
677 35,621,765 15,242,260 18,667,667 727,570 984,268

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