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 FFLs auditors since 2017. The company has a December 31, 2020 year end. Mina briefed you about the client, FFL is a Toronto based company that designs, manufactures and distributes undecorated sportswear (t-shirts, shorts, track pants and jackets) in large quantities. The company was founded in 2010 and is equally owned by Elizabeth Shearer and Angela Robson. Both owners are actively involved in the day-to-day operations of the business. Elizabeth oversees the sales and administrative areas, while Angela oversees finances and inventory management. For more information about the company, you can refer to last years working papers (see Exhibit 1) I would like you to prepare for me 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 actual materiality calculation can wait until we receive the preliminary draft financial statements. The memo should also include a risk assessments for the sales and accounts receivable cycle as well as the inventory cycle. Last year, we used a combined approach and most likely we will follow the same approach this year. If we are to rely on controls, please identify the controls that need to be tested for the sales and accounts receivable cycle based on the provided information. . Please also 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 I collected when I met with the client yesterday (Exhibit 2). The notes describe changes that happened in 2020. Mina reminded you that the firm stresses audit efficiency, therefore, it is important to identify the assertions that are of higher risk in the cycles and think about procedures to address those specific assertions. Since this is your first client with the firm, you want to impress Mina by being as thorough as possible to support your preliminary assessments and proposed test procedures. UNIVERSITY OF TORONTO SCHOOL OF CONTINUING STUDIES External Auditing 2331 Exhibit 1 Excerpts from last years file on the audit for year ended 2019 Overview of the business FFL is a profitable company and since 2015 it has experienced tremendous growth. In 2017, FFL purchased a manufacturing facility in Whitby Ontario. The purchase was financed by a $7 million bank loan. The terms of the loan require FFL to maintain a current ratio of above 1.3 and the manufacturing facility is pledged as collateral for the loan. The bank loan also requires that FFL provides audited financial statements in compliance with ASPE within 60 days of year end. FFL targets two types of clientele: wholesale distributors and corporate customers. Wholesale customers account for 90% of FFLs sales and corporate customers accounts for the remaining 10%. Wholesale distributors buy blank sportswear from FFL and in turn decorate the products with designs and logos and sell the imprinted sportswear and FFLs active wear products are often used for work or school uniforms, athletic team wear or company promotional materials. FFL produces approximately 150 different product styles and each style is offered in a variety of colours and sizes (approx. 3600 different combinations of style and colour). Every year FFL introduces approximately 50 new styles and colours and discontinues the same number of styles. Corporate customers order customized sportswear from FFL. FFL has a small printing division housed in the same manufacturing facility in Whitby that specializes in complex designs and specifications that regular wholesale distributors find inefficient to produce. The service began in 2017 when the company moved into the new facility. While the profit margin is higher in this line of business because of FFLs ability to negotiate higher sales price, quantity per order tends to be small and the sales are often under $50,000 per order. While Elizabeth would like to keep this service and potentially expand in the future, Angela felt that the efforts did not justify the small sales volume. The industry for undecorated active wear is highly competitive. Maintaining a product line that is consistent with current fashion trends is one of FFLs main competitive advantages. However, the classic T-shirt and the various colours and sizes has been a standard item in the product line since inception. The classic T-Shirt normally constitutes 30% of the inventory balance at any point in time. 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 UNIVERSITY OF TORONTO SCHOOL OF CONTINUING STUDIES External Auditing 2331 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. UNIVERSITY OF TORONTO SCHOOL OF CONTINUING STUDIES External Auditing 2331 Exhibit 2 Notes written up by Mina from the meeting with the client Below is a summary of information collected during my 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 new sales agreement with the wholesale distributors for 2021 before the reduction in cotton prices were realized. When Elizabeth reduced the selling prices many customers complained that they had recently purchased the 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 doesnt feel that she can continue to work collaboratively with Elizabeth anymore. She is considering triggering a buy-out clause in the shareholders agreement. The clause allows her to purchase Elizabeths 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 period ending November 30th 2020 to facilitate planning. The sales and payment pattern will be more or less the same in December. I also talked to the warehouse manager with regard to the inventory count procedures: 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. UNIVERSITY OF TORONTO SCHOOL OF CONTINUING STUDIES External Auditing 2331 The warehouse will be closed on December 31st and all items will be tagged in numerical sequence. Counters work in pairs and recount the others 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. UNIVERSITY OF TORONTO SCHOOL OF CONTINUING STUDIES External Auditing 2331 Exhibit 3 The accounts receivable aging for the period ended November 30th, 2020 is as follows: Range of Balances Number of Customers # of new 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 $ $100,000 200 20 4,231,475 2,284,997 1,840,692 63,472 42,315 $100,001 to $150,000 303 61 5,990,652 3,294,859 1,198,130 599,065 898,598 greater than $150,001 10 21,814,114 8,071,222 13,742,892 - - 677 35,621,765 15,242,260 18,667,667 727,570 984,268