You are the senior auditor in charge of the December 31, 2015, year-end audit for Cleo Patrick Cosmetics Inc. (CPCI). CPCI is a large, privately held Canadian company that was founded in 1996 by one of Canada's best known hair stylists, Cleo Patrick. Cleo Patrick is a famous celebrity hair stylist who has appeared on a variety of television shows such as Entertainment Tonight , and has been the chief stylist for the Oscars and Emmys. The company includes: (1) a small chain of 10 upscale salons situated in major cities in Canada and the United States; and (2) its well-known signature line of professional hair products that are available at select drug stores and retail chains. The core of its business is its signature hair products line, Cleo Patrick True Professional . The True Professional line represents 85 percent of the company's total revenue. During the planning phase of the audit, you performed various planning activities and met with CPCI's managementteam. You obtained the following information.

1. Your fi rm has audited CPCI since 2002, when Cleo sold 25 percent of her company to a group of private investors. The investors receive quarterly dividends that are calculated based upon a combination of sales and net income. The investors, all experienced businesspeople, serve as Cleo's board of directors and give her advice on the strategic direction of the company.

2. Your fi rm has not had any major disputes with CPCI management over accounting issues; however, last year it recommended that CPCI improve the organization of its accounting department-which is understaffed.

3. High-priced mass-market hair products represent a highly competitive supersaturated market. Large multinationals make up about 70 percent of the market, with niche companies such as CPCI making up the remaining 30 percent. Management does not consider multinationals to be a threat. "Unlike our competitors, we are a truesalon heritage brand backed by an active celebrity stylist."

4. From your review of the 2014 audited fi nancial statements and the 2014 third quarter unaudited fi nancial statements, you noted the following information:

5. Cleo plans to expand into Europe and is negotiating contracts with drug stores in the United Kingdom and Germany. In order to fund this expansion, CPCI's bank has agreed to increase CPCI's operating line of credit. As part of the agreement, CPCI is required to maintain a minimum quick ratio of 1:2 and a positive net income. In addition, CPCI is required to provide the bank with audited fi nancial statements.
6. Your fi rm has an employee who reads and saves articles about issues that may affect key clients. You read an article that says that two of CPCI's top-selling products recently made "The Dirty Dozen" list. The list, developed by an environmental research foundation, highlights those cosmetic products that have toxic chemicals (some of which are cancer-causing). CPCI claims that all its products safe and meet the provincial and federal health and safety guidelines. You discuss the issue with CPCI management and fi nd out that it is working on reformulating both products, which should be ready in 2016. CPCI is offering large rebates to retailers in order to encourage sales of its older products. The two "dirty" products currently make up about 20 percent of CPCI's current inventory of $45 million.
7. William Kirk was hired recently as the chief operating offi cer (COO) to provide closer oversight of the company. Due to all the new products and expansions, Cleo does not have time to spend monitoring the daily operations. Kirk is attempting to bring in a greater emphasis on controls around fi nancial reporting and monitoring (as recommended by your firm in the past). Kirk started in June 2015 and one of the fi rst things he did was to replace the chief fi nancial offi cer (CFO), who was not very organized and tended to delay handling problems. Kirk also implemented a new bonus plan based upon sales growth and profi tability targets. He told you he thinks it is working out really well and sales are growing. However, Kirk has not had a chance to implement all his plans-such as hiring additional accounting staff and performing a formal assessment of the quality of internal controls.
8. In early 2015, CPCI launched two new collections, Ultimate Moisture and Moisture Gloss. These two products placed an extensive strain on the company's cash fl ow. CPCI had spent $15 million in product development and $10 million on advertising. However, sales were much lower than predicted. Management had anticipated 2015 sales for the two products to be $9 million to $10 million. However, as of October 2015, actual sales were only $2 million. When you inquired about the low sales, the new CFO explained that the buyer had purchased inappropriate raw materials. This was not discovered during the inspection process when the materials were received. As a result, the fi nished product did not meet quality standards and was destroyed, and the new product arrived in stores much later than planned. The CFO stated that the salespeople were working really hard at trying to get product demand back on track by year-end and were offering new contracts, with very favourable terms, to potential customers.
Required
a. Based on the above information, identify factors that affect the risk of material misstatement in the December 31, 2015 fi nancial statements of CPCI. Indicate whether the factor increases or decreases the risk of material misstatement. Also, identify which audit risk model component is affected by the factor.
Factor.......Effect on the Rist of Material Misstatement(Increase/Decrease)...Audit Risk .......................................................................................Model Component
b. Make an acceptable audit risk decision for the current year as high, medium, or low, and support your answer.
c. Make a preliminary judgment of overall materiality for the CPCI audit, show your calculations, and provide your rationale for choice of benchmark and percentage.
d. What would you set performance materiality to be? Explain why.

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Nine Months Ended Sept. 30 Year Ended Dec. 31, 2014 2015 (unaudited (audited) (thousands of dollars) 450 000 1 500 30 000 25 000 (thousands of dollars) Sales Net income Cash Accounts receivable $350 000 1000 25 000 25 000 45 000 165 000 40 000 Property, plant, and equipment Total assets Current liabilities 160 000 285 000 280 000 45 000 40 000