King Appliances Limited Case: Audit Planning Memo

King Appliances Limited Case: Audit Planning Memo

Date: February 23th 2016

To: Mr. Scollon, Partner at Scollon and Partners

From: King Appliances Ltd. Audit Team, Audit Senior

Re: Planning for the Year-End 2015 Audit of King Appliances Ltd.

Engagement Overview

This memo will outline the planning of the audit of King Appliances Ltd.’s financial statements. The main users of these financial statements are Ashley and Bradley King who are passive shareholders of King Appliances Limited “(KAL)” and siblings of the CEO Paul King. Ashley and Bradley are interested in selling their shares to Paul King and have agreed to a purchase price based on a multiple of Earnings. The audit opinion will be used to ensure that the earnings figure and therefore the price that Ashley and Bradley receive is accurate and fair. Since King Appliances Ltd is a private company they must comply with Accounting Standards for Private Enterprises (ASPE). Therefore, this audit will ensure that all accounting procedures used by KAL comply with the constraints of ASPE.

Risk analysis

Overall engagement risk is high.

Items increasing engagement risk

No audit committee at KAL, auditors reporting directly to owners (the King siblings)

Non-managing owners (Ashley & Bradley) have next to no financial competence and little interest in operations beyond revenue statistics and employment of family members — pervasive

Tension between owners is reason for audit

Multiple related-party transactions — pervasive

Potential preferential employment of Paul’s children over Bradley’s

Important supplier is owned by Paul’s son and was started with Paul’s money

“Free” advertising provided by GM’s brother

It may be necessary to audit Paul’s son’s company (CI) if it is determined to be a subsidiary — pervasive

KAL depends on sales of just one product, the Flash Freezer — pervasive

Evidence of questionable accounting (e.g. inventory write-ups) — pervasive

Audited financial statements will be used to set the price of Ashley’s & Bradley’s shares when sold to Paul — pervasive

Risk of non-payment if anything other than an unqualified audit opinion is given — pervasive

First time audit, no prior audit work to rely upon — pervasive

Items decreasing engagement risk

Financial health of KAL is generally good, gross sales increased 10% over 2014 — pervasive

Privately-held company. Known financial statement users are only Ashley, Bradley, & Paul. No long-term debt (at this time). — pervasive

Overall inherent business risk is high.

Items increasing business risk

Indications of poor management integrity — pervasive, and specific risk to earnings

Paul’s children paid out of petty cash

Fred’s indifference towards ethics training

Under-the-table arrangements to pay for advertising

Poor management attitudes to compliance with laws and regulations — pervasive

Related-party transactions with Paul’s son (CI) and Fred’s brother — specific

New, unusual transaction in government grant — specific

Innovative lines of business in maintenance contracts — specific

Highly competitive industry — pervasive

Items decreasing business risk

Business in operation for 40 years, established customer base, and good reputation — pervasive

Overall financial reporting risk is high.

Items increasing financial reporting risk

Managing shareholder and CEO (Paul) dominates operations of KAL — pervasive

Makes all strategic and management decisions (e.g. salesperson compensation)

Influences hiring decisions (e.g. new controller Michelle)

Works directly with controller on accounting issues, bypassing GM

Undue emphasis on revenues and earnings because of Ashley and Bradley — pervasive

Controller hadn’t worked as an accountant from 2005 to 2015. IFRS adopted in Canada in 2011. Controller’s familiarity with IFRS could be in question. — pervasive

Potential need for consolidated financial statements if CI is determined to be a subsidiary — pervasive

Decreased number of inventory counts, failure to perform a year-end inventory count, and usual requirement to make an inventory write-up — specific

Items decreasing financial reporting risk

Use of automated systems for tracking inventory and labor — specific

Audit strategy

The presence of many engagement and financial reporting risk factors, especially the evidence of a lack of management integrity, suggest a pervasive weakness of internal controls. Higher inherent and moderate control risk levels combined with a moderate audit risk associated with a new client indicate that a lower detection risk level is required. And while some specific internal controls present at KAL may be reliable for our purposes, due to the small size of KAL it will not be an effective use of resources to test them. We will therefore be using an entirely substantive approach for this audit, paying close attention to accounts and transactions that affect earnings.

Materiality

The main people relying on this audit are Ashley and Bradley King siblings of the CEO Paul King who own a passive investment

...