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Auditing in the New CAS Environment

Modern Tasting Inc.


Background Information
December 31, 2010
You have been engaged to perform the audit of Modern Tasting Inc. (MTI) for the year ended
December 31, 2010. Although your office has been auditing MTI for several years, you have not
been involved in the audit, and therefore you anticipate spending some time planning the audit
and getting to know the client.

You set up a meeting to visit the president of MTI, Donald Witt and take him out for a leisurely
lunch. During your conversation, Mr. Witt not only told you about MTI, but also gave you several
pieces of information, such as an organizational chart and some systems flowcharts and
descriptions. Being an auditor who takes pride in good documentation, you took notes during
your meeting and your lunch. Your conversation went something like this:

CA: So, Donald, tell me a bit about this business of yours. How did it all begin?

DW: Well, I was going to be an accountant, at least that was what my folks wanted, you know,
secure profession, and all, but I never could see myself in a green visor, and, pardon me
for saying, but I never could get excited about numbers and such. Now selling, that was
a different story. I put myself through school selling lamps at The Bay, and I realized
nothing energized me more than dealing with people and making those sales. So I
switched my major to marketing and started to learn as much as I could about
housewares. I felt that housewares were kind of a timeless item, something everyone
needed. I got pretty high up in The Bay's organization before I realized that I wanted to
run my own show. So, over 15 years ago, I incorporated my company, federally, in case
I “go national” some day, and the rest is, as they say history.

CA: Let’s talk a bit about that history - so you started this business all on your own?

DW: The business yes. But I needed capital, so I approached an old university buddy of mine
and he put up some capital for a piece of the action - Tim Silent - he owns 49%. My
lawyer, Bob Springsteen, is the third director along with Tim and me. They keep in touch,
but pretty well let me run the show.

CA: And the show is ...just lamps?

DW: Oh no, we also do a lot of business in cutlery and dinnerware. About 40% of it is
imported, nice quality stuff, and that’s reflected in my customer base, too. I’ve got my old
buddies from The Bay as my biggest customer, about $2,500,000 a year. Also Sears,
Walmart, Bowrings, Birks - I've made a list of suppliers and customers for you - you
auditors always want to know this stuff for some reason. (Appendix A)

CA: Thanks, Donald. I guess we’re the curious type. How do you find the importing business
these days?

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Auditing in the New CAS Environment

DW: Well, if it wasn’t such nice stuff, I might reconsider. In fact, we started importing a new
line of marble table lamps from Italy this year. Allan Hart, MTI's sales manager, is
responsible for this line and he can fill you in later. Exchange rates are always going
crazy, and this impact my costs with a lot of my suppliers in Europe. I’m always having
to check my pricing policy to make sure I’m not taking a bath. Also, the Canadian
Standards Association has some pretty stringent rules on electrical wiring, so I have to
get the warehouse guys to rewire the imported lamps. But, the stuff sells…

CA: How’s the competition?

DW: These days, things are tough. I have lots of competitors, but like I said, the imported
stuff is a hot seller, and a lot of these guys are still scared of the “global economy”. I
guess my degree in marketing has helped me see the bigger picture. I am thinking of
starting to use my web site for more than providing information. I have approached a
company who will provide me with the technology and support to handle Internet sales.

CA: Are you operating out of Toronto?

DW: No, no - we own or rent warehouses in Windsor, London, Calgary, and Antigonish.
Actually, we are just leasing the Toronto warehouse and office, but the building is only
five years old and suits us just fine. We got a good deal when we bought the Windsor
land and we built the warehouse there over 10 years ago. Our suppliers ship to all
locations and we try to maintain a degree of inventory control across Canada, but it is
difficult. We use the Windsor location to complete some administrative functions and it is
the largest location.

CA: And how is business overall?

DW: Well, about the same as last year in a lot of ways. The main issue has been a decrease
in sales but we have not lost any major customers. I would like to get the bank off my tail
a bit - they are the ones who really need the audit, although Ted Silent likes to keep an
eye on things, too. I would like to start some kind of budget system, you know, but there
just never seems to be enough time to do all these things.

But that bank! They have forced me to sign a $500,000 personal guarantee on the loan.
Makes you a bit nervous in tough times - you know, like they’re going to come and take
your house away if you don’t watch out.

CA: Well, it seems that you have a very steady business going here. Many times the bank
just wants that extra security blanket.

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DW: Oh, you know, something else we did this year? Last year, your guy, Don Moovdon,
wrote us a really good letter about internal controls. He was concerned with our shipping
and invoicing system. Well, we took the advice to heart, especially since he said it could
save us audit time and money if you could rely on our controls. We installed what we
think is a very efficient control system over the accounts receivable and shipping system.
I assume you’ll want to review and test it?

CA: You bet. We really can save time by looking at your controls in that area, particularly
since they have been operating for a while.

DW: You auditors seem to want to know more and more about stuff besides numbers - I
figured you’d just want to meet Ted Flunton, my controller, and start those adding
machines. Sounds like I should also introduce you to my V.P., Fred Bolts, and my Sales
Manager Allan Hart, so you can meet the whole MTI family.

CA: Are there any other significant changes since last year?

DW: Yes, as a matter of fact there is. We implemented a new accounting software package in
June. We found the old system could not handle the multiple exchange rates. We went
with an "off-the-shelf" package with a few minor adjustments. We ran parallel for a one-
month period, then we went live. While there were still some problems, we could not
afford to keep both systems running.

CA: You have provided me with a lot of information and I have enjoyed our meeting. Let me
get the bill.

Included in the information given to CA is the following:

Appendix A - Breakdown of major suppliers and customers

Appendix B - Organization Chart

Appendix C - Financial Statements of Modern Tasting Inc.

Appendix D - Internal Control Evaluation Guide

Appendix E - Additional Information

Appendix F - Information on Computer Conversion

Appendix G - Notes from Discussion with Allan Hart, Sales Manager

Appendix H - Sales/Shipping System Flowchart

Appendix I - Excerpts from 2009 Audit Working Paper File

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Auditing in the New CAS Environment

Appendix A
Breakdown of Major Suppliers and Customers
MTI's major suppliers and approximate annual purchase volumes are as follows:

Beth Housewares $200,000


Copco Inc. $450,000-$500,000
Diana Scissors $325,000
Figgers Housewares $225,000
Hoycorp Inc. $300,000-$400,000
Kostell $150,000
Rosti Plastics $275,000-$325,000

In all, MTI has about 25 regular suppliers, both in Canada and Europe.

Major Customers are:


Balance
Annual Sales 2010

The Bay $2,500,000 300,000


Sears $275,000 23,000
Walmart $325,000 30,000
Bowrings $100,000 9,000
Birks $175,000 $ 15,000
$ 377,000

In total, the company has about 1,600 active customer accounts, ranging from small
businesses to national chains such as those mentioned above. The number of invoices
issued per year is approximately 6,000.

Accounts receivable aging is as follows:


2010 2009
Current $ 815,576 $ 889,281
30 days 421,915 353,408
60 days 258,593 183,249
90 days and over 176,931 143,981
Total $1,673,015 $1,569,919

Inventory purchases aging is as follows:


2010 2009
Current $ 725,924 $ 649,440
30 days 317,592 278,331
60 days 302,468 197,151
90 days and over 166,358 34,792
Total $1,512,342 $1,159,714

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Appendix B

Modern Tasting Inc.


Corporate Organization Chart
President
(Donald Witt)

Sales
Vice President Controller
Manager
(Fred Bolts) (Ted Flunton)
(Allan Hart)

Purchasing Order Accounts Accounts


Warehouse Sales Staff
Dept. Department Receivable Payable
Manager (16)
(2) (3) (2) (2)

Warehouse
Staff
(12)
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Appendix C

December 31, 2010

Extracts from the Draft Financial Statements for

Modern Tasting Inc.

(with comparative amounts (audited) at

December 31, 2009)

For the purposes of this case study, please ignore any transitional accounting issues
and note that management prefers the use of the future income taxes method.

Please also make the assumption that the current environment applies
regardless of the dates used for this case study.

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Auditing in the New CAS Environment

DRAFT
MODERN TASTING INC.
Balance Sheet
For the year ended December 31

ASSETS
Draft Audited
2010 2009
Current
Cash $83,917 $77,741
Accounts receivable
- trade, net of allowance of $312,000
(2009-$261,000) 1,361,015 1,308,919
- other 42,817 131,983
Income taxes recoverable 243,418 -
Inventories 1,512,342 1,159,714
Prepaid expenses 12,084 11,308
3,255,593 2,689,665

Property, Plant and Equipment (note 2) 1,567,408 1,602,018


Other assets, at cost 19,600 17,450
$4,842,601 $4,309,133

LIABILITIES AND SHAREHOLDERS' EQUITY

Current
Bank indebtedness (note 3) $1,362,836 $720,000
Accounts payable (including HST
of $62,505 (2009 $41,674))
- trade 1,312,806 893,481
- other 72,975 61,464
Income taxes payable - 42,607
Scheduled repayments for long-term
debt (note 4) 49,611 48,512
2,798,228 1,766,064

Long-term debt 919,737 969,348


Future income tax liability 108,400 100,300
3,826,365 2,835,712

SHAREHOLDERS’ EQUITY
Capital stock 50,000 50,000
Retained earnings 966,236 1,423,421
1,016,236 1,473,421
$4,842,601 $4,309,133

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Auditing in the New CAS Environment

DRAFT

MODERN TASTING INC.


Statement of Income and Retained Earnings
For the year ended December 31

Draft Audited
2010 2009

SALES $6,115,852 $7,260,296

COST OF GOODS SOLD 4,464,564 4,780,502

GROSS PROFIT 1,651,288 2,479,794

EXPENSES
Selling 730,513 669,159
Warehousing 516,672 473,917
Administration 823,648 753,460
Financial 317,840 182,154
2,388,673 2,078,690

Income (loss) before


income taxes (recovery) (737,385) 401,104

Income taxes (recovery)


- current (288,300)
159,800
- future 8,100 10,200
Net income (loss) for the year (457,185) 231,104

Retained earnings, beginning of year 1,423,421 1,192,317

Retained earnings, end of year $ 966,236 $1,423,421

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Auditing in the New CAS Environment

DRAFT
MODERN TASTING INC.
Statement of Cash Flows
For the Year ended December 31, 2010

2010 2009
OPERATING ACTIVITIES
Net income (loss) (457,185) 231,104
Adjustments to reconcile net income to cash
provided by operating activities:
Amortization 76,274 71,243
Future income taxes 8,100 10,200
Changes in non-cash operating
working capital balances (372,811) 312,547

(Increase) Decrease in accounts receivable 37,070 (43,214)


(Increase) in income taxes recoverable (243,418) -
(Increase) Decrease in inventories (352,628) 43,416
(Increase) Decrease in prepaid expense (776) 214
Increase (Decrease) in accounts payable and
accrued liabilities 430,836 (48,540)
Increase (Decrease) in income taxes payable (42,607) (20,104)

CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES (544,334) 244,319

INVESTING ACTIVITIES
Purchase of computer equipment (18,429) -
Purchase of truck (25,385) -

CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES (43,814) -

FINANCING ACTIVITIES
Increase (decrease) in bank indebtedness 642,836 (189,598)
Repayment of long-term debt (48,512) (43,416)

CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES 594,324 (233,014)

NET INCREASE (DECREASE) IN CASH 6,176 11,305


Cash at beginning of year 77,741 66,436
CASH AT THE END OF THE YEAR $ 83,917 $ 77,741

(Note: Information on interest and taxes paid in notes to the financial statements)

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DRAFT
MODERN TASTING INC.
Schedules of Expenses

2010 2009
SELLING
Salaries and commissions $392,931 $376,912
Advertising 165,609 107,612
Promotional material 74,307 76,509
Travel and entertainment 51,793 57,014
Employee benefits 10,318 12,019
Sundries 35,555 39,093
$730,513 $669,159

WAREHOUSING
Salaries $165,082 $199,412
Packaging materials 55,143 44,093
Amortization - building 36,746 34,812
Taxes and utilities 46,672 31,849
Freight 41,296 17,909
Occupancy costs 80,000 80,000
Repairs and maintenance 60,012 29,011
Amortization - trucks 15,016 18,711
Employee benefits 7,517 7,016
Sundries 9,188 11,104
$516,672 $473,917
ADMINISTRATION
Salaries
- office $276,808 $256,097
- management bonus 236,503 256,912
Office and general 34,093 22,517
Insurance 28,394 29,411
Telephone 24,095 22,919
Employee benefits 33,242 21,011
Professional fees 21,593 14,600
Occupancy costs 30,000 30,000
Automobile 19,098 21,912
Amortization
- other 14,842 15,302
- building 9,670 11,604
Travel and entertainment 34,085 15,631
Deferred profit sharing plan 21,667 14,000
Taxes and utilities 8,057 10,616
Sundries 31,501 10,928
$823,648 $753,460
FINANCIAL
Interest on long-term debt $129,360 $131,811
Interest on short term borrowings 114,379 67,908
Bad debts (recovered) 74,101 (17,565)
$317,840 $182,154

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Auditing in the New CAS Environment

DRAFT
MODERN TASTING INC.
Notes to Financial Statements
Period ended December 31, 2010

(Note: Not all notes have been included)

1. Significant Accounting Policies:

These financial statements have been prepared in accordance with Canadian


generally accepted accounting principles for private enterprises.

(a) Inventories

Inventories of goods held for resale are valued at the lower of cost and net
realizable value. Cost is determined on a first-in, first-out basis.

(b) Property, Plant and Equipment

Property, plant and equipment are stated at cost less accumulated


amortization. Amortization is provided at the following annual rates:

Building 4% straight line


Vehicles 30% declining balance
Furniture and fixtures 20% declining balance

2. Property, Plant and Equipment


Accumulated Net Book Value
Cost Amortization 2010 2009

Land $ 545,625 - $ 545,625 $ 545,625


Building 1,160,400 $ 278,496 881,904 928,320
Vehicles 128,612 69,725 58,887 51,018
Furniture & fixtures 117,451 36,459 80,992 77,055

$1,952,088 $ 384,680 $1,567,408 $1,602,018

3. Bank Indebtedness.

The Company's bank indebtedness bears interest at prime plus 2% and is secured
by a charge against the company's receivable and inventory, as well as the
personal guarantees of the shareholder.

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Auditing in the New CAS Environment

4. Long Term Debt


2010 2009
5% first mortgage loan secured
by land and building.
Repayable in monthly
instalments of $13,979
to May 31, 2014 $ 969,348 $1,017,860

Less current portion 49,611 48,512

$ 919,737 $ 969,348

Estimated principal repayments over the next four years are as follows:

2011 49,611
2012 54,932
2013 58,010
2014 806,795

5. Related party transactions

A shareholder of the Company has guaranteed the Company’s bank loan to a


maximum of $500,000.

6. Commitment:

The company has operating leases for office and warehouse premises, which have
a total minimum annual base payment $210,000 per annum expiring in 2014.

7. Financial instruments:

The Company has a comprehensive risk management framework to monitor,


evaluate and manage the principal risks assumed with financial instruments. The
risks that arise from transacting financial instruments include interest rate risk,
liquidity risk, and market (other price) risk. Price risk arises from changes in interest
rates, foreign currency exchange rates and market prices.

The company enters into forward exchange contracts to manage the exposure of
foreign exchange risk on the purchase of inventory, if considered necessary.

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Auditing in the New CAS Environment

Appendix D
(extracted from: Anderson, The External Audit)

Internal Control Evaluation Guide


Environment Controls
(Small Audit Engagement)

Current Year
2009
Client: Modern Tasting Inc.
Evaluation
(Yes/No/N/A)
Done by Done by
Employees Manager
1. Does the manager (and owner, if not the manager) review
the accounting records regularly? *ü
2. Is there fireproof storage, safe from theft, for accounting
records? ü
3. Are employees in control areas competent and are their
duties and responsibilities defined and understood? ü
4. (a) Have all employees in control areas had holidays
within the past 12 months? ü
(b) Are their duties performed by others in their
absence? ü
5. Is there adequate fidelity insurance? ü
6. Has the division and rotation of duties been developed to
the fullest possible extent within the framework of the
business? ü
7. Is there adequate authorization of executive remuneration
and profit sharing? ü
8. (a) Are cash and operating budgets prepared? No
(b) Are they reviewed by the manager? *N/A
(c) Are changes authorized? *N/A
(d) Are variations analysed and approved? *N/A
9. (a) Are interim financial statements and reports prepared
regularly? ü
(b) Is the form and content reasonably useful and
understood by the manager? ü
(c) Are they reviewed and acted upon by the manager? ü

NOTE: If the manager is not the owner, include the file overall assessment of owner’s control
over manager.
* Functions marked with an asterisk should be performed by the manager.

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Appendix D (cont’d)
(extracted from: Anderson, The External Audit)

Internal Control Evaluation Guide


Environment Controls
(Small Audit Engagement)

Current Year
2009
Client: Modern Tasting Inc.
Evaluation
(Yes/No/N/A)
Done by Done by
Employees Manager
1. Are the general ledger, books of original entry and
subsidiary records balanced and posted monthly? ü
2. Are journal entries:
(a) properly supported? ü
(b) approved by the manager? *ü
3. Do records appear:
(a) adequate? ü
(b) well kept? *ü
4. If books of account are prepared by computer, are there
adequate controls; consider:
(a) control totals of input data reconciled to output? No
(b) manually-maintained control accounts for bank,
receivables, payables, etc. balanced to output? ü
(c) cross-reference on output data to source
documents? ü
(d) adequate “audit trails”? ü
(e) adequate master file controls? No
(f) adequate controls over access to computer
terminals? ü

NOTE: If the manager is not the owner, include the file overall assessment of owner’s control
over manager.

* Functions marked with an asterisk should be performed by the manager.

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Appendix E

ADDITIONAL INFORMATION
• Review of banking agreement indicates the following:

(a) audited financial statements to be provided by February 28, 2011

(b) working capital ratio shall be maintained at greater than 1.5:1

(c) debt to equity ratio shall be maintained not to exceed 3:1

(d) bank operating line will not exceed $1,300,000 and is secured by 60% of
accounts receivable less than 90 days, 40% of inventory and a floating charge
over all other assets of the company, and a personal guarantee of the major
shareholder to a maximum of $500,000.

• Financial analysts are predicting a steady but slow increase in consumer confidence. The
fourth quarter for retail sales looks much brighter than 2009.

• The Bank of Canada rate was in the 3.0% range for 2010 and no major changes are
expected for the first half of 2011.

• Exchange rates are as follows for the end of the 2010:

Cdn. $ = $ 1 U.S.
Cdn. $ = $ .75 EU

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Appendix F

INFORMATION ON COMPUTER CONVERSION


• The system was implemented June 30, 2010.

• The new software is an off-the-shelf software package called Real Exchange.

• The software was developed by a reputable software company with a reputation for good
support and training.

• The package is menu drive, and Donald chose the package because of its user-friendly
nature.

• Presently, only one of the accounting staff - the accounts receivable clerk, is trained on the
system. User manuals have been provided.

• Passwords exist, but are not presently being used. The software is compatible with Novell,
the network software presently in use by MTI. MTI has a series of IBM computers in a
network configuration.

• Information with respect to inventory levels and shipments is transmitted to head office in
Toronto via modem. All centralized accounting functions are performed at head office.

• Prior to the conversion, the client ran parallel for one month. These were some minor
discrepancies but the client went to the new system July 1 as planned, as the company did
not see the merits of running two systems for a prolonged period of time.

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Auditing in the New CAS Environment

Appendix G

Notes from Discussion with Allan Hart,


Sales Manager
CA: Hi Allan, Donald tells me you're the key man with respect to the new line of marble
lamps. Can you tell me a bit about the new line?

Allan: Well, we import these very expensive lamps from Italy. We pay for them in U.S. dollars
via a letter of credit. Terms are 30 days from shipping notification.

CA: Can you tell me what the consumer reaction has been so far?

Allan: Well, it's probably too early to tell. While we have had these lamps since March of
2010, it usually takes consumers a year to identify with the fashion trend.

CA: Can you tell me the inventory amounts, and sales figures so far?

Allan: I believe we have $350,000 on hand with another $150,000 sitting in Buffalo waiting to
clear customs, so I'm not sure what the sales figures are.

CA: I see. What do you project the 2011 sales to be for this line?

Allan: We are projecting a good year. We estimate sales for the lamps to be approximately
$800,000.

CA: Anything else about this new line?

Allan: Oh yes. When we signed the contract with the Italian supplier we wanted to sew up an
exclusive arrangement with them. Therefore, we had to commit to taking $1,000,000 of
product annually for the next three years.

CA: Thanks Allan, you've been a big help.

SECTION 2-17
Appendix H

Modern Tasting Inc. – Sales/Shipping System Flowchart

Balanced
Batch Daily
Control
Tape
Sales
Phone Report
Order
Customer
Purchase
Order
1
Shipping 2 With Goods Shipping
Shipping
Order 3 C.P.U.
Shipping
Order 4 Order
Order

Matched 1
2
Price
List 3
Unmatched
4
Documents Sales
Report Invoice

C.F.
SECTION 2-18

To Customer
By By
Alpha Numeric
S.O.# S.I. #
Auditing in the New CAS Environment

Appendix I

EXCERPTS FROM 2009 AUDIT WORKING PAPER FILE


• Based on a review of the accounts receivable confirmation procedures in 2009 CA
discovered 10 key items selected for confirmation which totalled a dollar value of $600,000.
2010 is not expected to be any different.

• Based on a review of the Sales/Receivables/Receipts systems narratives, CA notes that


following significant points:

• when cash receipts are received by mail, the receptionist forwards these to the controller
who reviews them for the purpose of updating his collection "hit list" and then passes
them to one of the accounts receivable clerks.

• the accounts receivable clerk prepares a list for input into the computer, as well as the
daily deposit for the bank.

• the second accounts receivable clerk enters the information into the computer, while the
first clerk goes to the bank to make the daily deposit.

• while the controller reviews the monthly bank reconciliations prepared by the accounts
receivable clerk who prepares the deposit, there is apparently no evidence of this review.

• with respect to inventory, the client's premises have multiple entrances and exits to and
from the warehouse area. The salesmen are frequently picking up stock to take out as
consignment inventory.

• as the salesmen take this inventory they are required to sign for it. History has
suggested that these sign out lists are not very accurate. However, when questioned in
the past, the usual response is that the goods eventually get invoiced to the customers.

• the client maintains a perpetual inventory system, and the warehouse staff perform cycle
counts on the entire inventory. History suggests the book to physical adjustments are
sometimes large. No apparent follow-up or authorization of these inventory adjustments
is performed.

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Notes

SECTION 2-20