Accounting Practice – Pa1 Essay
Accounting Practice – Pa1
a. Potential tax issues related to the payment Erin received in August:
1) For Erin:
➢ Based on the information provided, Erin’s employment with CCC was terminated in July 2009 and Erin was informed on July 31, 2009. Thus the payment Erin received in August is considered as pay in lieu of termination notice. Therefore, it is taxable income and should be reported as employment income in her tax return. But it seems that the amount of $9500 she received is net of tax amount (her total before tax salary for two moths is $12,000). She should contact CCC to get a T4 slip so that she will not be double taxed on $9500.
2) For CCC:
➢ Since the payment is related to pay in lieu of termination notice, the correct way that CCC should have done was to deduct income tax, CPP, EI and provided a T4 to Erin. And CCC should pay EHT on that payment too. But Worldwide actually paid the termination pay, CCC failed the responsibility of withholding the income tax, CPP and EI and paying EHT for that payment. No deductible expenses should be charged on CCC’s book.
3) For Worldwide:
➢ It seems that Worldwide withheld $2500 from Erin’s termination pay (total before tax salary $12000-net paid amount $9500), which might be charged under income tax payable and others deductions per USA tax act. From Worldwide’s perspective, the payment is deductible expenses. But in fact, since Erin is the employee of CCC, the payroll should be paid through CCC instead of Worldwide. In other word, income tax should be paid to Canada instead of USA.
Erin mentioned that the payment was meant to be non taxable since it was somehow related to RRSP, which can not be applied to pay in lieu of termination notice. If the severance pay or retiring allowance were paid to Erin, the portion of payments may be transferred to an RRSP under certain conditions and the amount transferred to RRSP is tax free. But in this case, Erin has done maximum contribution on her RRSP. Beside, if Erin worked for CCC more than 5 years and CCC’s payroll is at least 2.5 million, or severed the employment of 50 or more employees in six months period, CCC is also responsible to pay severance pay to Erin, which is taxable and should be added to salary income. But CCC does not have to pay EHT for severance payment.
Date: xxxx, 2010
To: EHS audit manager
From: Ryan O’ Leary, EHS Kitchener office
Subject: New issues for audit plan at CCC
Contacted by a colleague from our Vancouver office, I am surprisingly aware of that several CCC’s employees have been terminated and termination payments have been paid from CCC’s parent company, Worldwide Connections Inc, which is a US company. The employees have been told that their termination was due to cash flow problems of CCC. Based on the above information and the fact that we didn’t notice any unusual things during our review of 20×9 T4s for CCC, I would like to draw your attention to how the information received might affect the audit plan and other concerns related to ethical issues.
a) First of all, the control risk should be planned higher based on the following facts:
➢ CCC should be the one who pays the termination fee and issue T4s to terminated employees but they failed to do so. Instead, their USA parent company paid. It might because the management has no knowledge of this, which they supposed to have or because they intended to do so. Therefore, the integrity of the management seems to be a problem.
➢ Cash flow problems: several employees have been terminated due to cash flow problems and their USA parent company helped CCC to pay the termination payment. It seems that it is the truth that CCC does have problems of cash flow. Beside these factors, examining the following financial ratios would help us to detect the cash flow concerns:
i. Quick ratio: (current assets-inventory)/current liabilities: it gives a more rigorous assessment of CCC’s ability to pay its current liabilities. If a quick ratio is greater than 1.0, then CCC has sufficient cash to meet their short-term liabilities. But low or decreasing quick ratio would be a good sign of cash flow concern. ii. OCF ratio: cash flow from operation / current liabilities, this ratio would measure how well current liabilities are covered by the cash flow generated from CCC’s operations. If the ratio is less than 1, it is an indication of cash flow concern and the smaller the ratio is, the bigger the concern.
iii. Short-term debt coverage ratio: operating cash flow/ short-term debt, this ratio would measure how well the short-term debts are covered by the operating cash flow.
iv. The capital expenditure coverage ratio: operating cash flow/capital expenditure, this ratio compares a company’s outlays for its property, plant and equipment to operating cash flow. A positive difference between operating cash flow and capital expenditures defines free cash flow. Therefore, the smaller this ratio is, the less cash assets CCC has to work with.
v. OCF/Sales ratio: this ratio, which is expressed as a percentage, compares a company’s operating cash flow to its net sales or revenues, which tells CCC’s ability to turn sales into cash. The greater the amount of operating cash flow, the better. There is no standard guideline for the operating cash flow/sales ratio, but obviously, the ability to generate consistent and/or improving percentage comparisons are positive qualities. It would be a concern to see CCC’s sales grow without a parallel growth in operating cash flow. Positive and negative changes in CCC’s terms of sale and/or the collection experience of its accounts receivable will show up in this indicator.
b) The audit risk needs to be planned to a lower level based on the higher control risk. Therefore, the detection risk has to be lower to reach the acceptable level of audit risk, which means more samples and substantive procedures need to be performed especially on payroll cycle and balances and transactions related to cash flow.
c) Potential ethical issues that might affect our audit plan:
➢ Integrity of CCC’s management: like I mentioned previously, it is reasonable doubt for CCC’s management’s integrity due to the fact that they failed to collect income tax and other deductions for the employees worked in Canada and had their USA parent company paid. The management either intended to do so to try to hide the cash flow problem or lack the knowledge of knowing their responsibility of collecting income tax and pay EHT when they make termination payment. Besides, when the time we did review of T4s, we were not told by the management the termination and payment from USA Company. Therefore, I would like to recommend to interview with the management first to understand what their intention was and interact with the higher level of management if necessary. If no correction can be agreed upon or no cooperation from the company, then involve CRA and audit committee.
➢ Due care /competence of our audit team: based on the fact that several employees have been terminated and nothing has been found unusual during our T4s review, it seems that due professional care and competence of our audit team is also questionable. I would like to recommend that not only use more experienced auditors, but also remind the team that perform the job with due dare to avoid unnecessary undetected misstatements.
I look forward to discuss the details with you!
a. A Memo to Albert Desrosiers:
Date: Feb 18, 2007
To: Albert Desrosiers, Audit Manager, Morrison and Associates
From: Wei Liu, CGA, Audit Manager, Morrison and Associates
Subject: Assessment for financial position and audit at Prime Restaurant Suppliers Ltd (Prime)
Upon your request, I have analyzed Prime’s financial ratios and the balance sheet and reviewed the audit work done by Paul. I would like to discuss the following issues with you:
i. After analyzed and evaluated Prime’s financial ratios and the balance sheet, the following are the problem areas that could impact the nature of the audit work required thus need our special attention:
➢ Inventory: it has increased significantly over the past two years, 27% in 20×6 and 35% in 20×5. And inventory turnover has dropped 0.6 from 3 in 20×5 to 2.4 in 20×6. It is an indication of either excessive inventories or ineffective buying or misstatements of valuation in inventory. Substantive procedures would be required to make sure the assertions of existence, valuation, ownership are fairly presented. Performing test counts of inventory should be done more cautiously.
➢ Accounts receivable: It increased 8.7% in 20×6 and 43% in 20×5. And receivables turnover has dropped 0.4 in 20×6 and dropped 0.6 comparing to industry average. Meanwhile, the average collection period has increased 16.8 days, which increased 21%. However, sales only increased 1.3% in 20×6. All of these indicated that the collection of accounts receivable is questionable and Prime’s credit policies might not be efficient or the allowance for bad debt is not adequate. Therefore, more positive confirmation of accounts receivable might be necessary to ensure the existence and valuation; review allowance for doubtful accounts to make sure whether it is adequate; review aged AR report; review credit and collection policies; perform cut-off procedures and so on.
➢ Sales: Even though sales have increased in 20×6 by 1.3% and 16% in 20×5, but net income dropped significantly by 47% in 20×6 and 0.3% in 20×5. And gross margin has dropped 4.5% in 20×6 and 8.9% lower than industry average. Net margin has dropped by 2% in 20×6. When interest expenses are lower than prior’s years due to lower bank loans and mortgage and term loans and other operating expenses has no signs of increase, the reason for higher sales but much lower net income (before tax) are focused to costs of goods sold. Again, we need to take extreme cautions to make sure that existences, valuation, ownership of inventory are fairly presented. On the other hand, more procedures need to be done to make sure the revenue recognition is reasonable.
➢ Cash flow/accounts payable-inventory: it has no balance recorded on the balance sheet for cash. Even though Prime’s current ratio is 1.19, but quick ratio is only 0.65. Even worse is that accounts receivable is not dependable due to potential collection problem or overstatement. Accounts payable-inventory has increased 37% in 20×6, plus other current liabilities, Prime is facing a serious cash flow problem. The significant increase in Accounts payable-inventory pointed out again the problem of inventory, either excessive inventory has been obtained or ineffective buying has been happening. Substantive procedures should be performed cautiously on accounts payable-inventory to make sure its valuation, existence. Positive bank confirmation should be obtained.
➢ Income tax payable/future income tax liabilities: income tax
payable has decreased 81% in 20×6 but future income tax liabilities increased 4.7%. In total, it decreased 40% while net income decreased 47%. Examining the computation is necessary to make sure fair presentation of these two figures.
ii. With respect to Paul’s recommendation regarding the audit report, I have the following different opinions:
➢ I don’t agree that Paul restricted subsequent evidence accumulation to Prime’s accounts receivable and inventory. From part I analysis of financial ratio and the balance sheet, we know that Prime has a high control risk in accounts receivable and inventory, therefore, we can not restrict subsequent evidence accumulation. Controversially, sufficient evidences need to be collected to allow the audit risk lower to an acceptable level.
➢ Paul concluded from what he could observe that internal control were present and appeared to be operating as intended. This is not correct. First of all, internal control has to be tested whether we rely on it or not. Secondly, Prime only did review engagement for prior years and never be audited. And an audited financial statement is needed for Prime’s loan approval process thus the management has the motive to manipulate the statements to get the loan. Plus concerns showed from their financial ratios and balance sheet, including high increased inventory, AR, AP, cash flow problems, all of these facts indicates that we are facing a client with high control risk and inherent risk. Internal controls have to be tested.
➢ Paul concluded that changing of LIFO accounting from FIFO has no big impact on income statement and balance sheet due to consistent inventory cost over the year. That is wrong. The inventory was increased significantly over two years, which means the cost of inventory in 20×5 could be very different comparing to 20×6. More importantly, if LIFO is allowed used in 20×6, a retroactive procedure need to be done for previous year’s financial statements.
➢ Paul instructed the other assistant to ensure that goods shipped in the last few days of the year were recorded in sales. The shipped goods to customers is not the only criteria that we can recognize the sales. We need to make sure other criteria also presented, such as the amount can be measured and collection is reasonable assured or an allowance of bad and doubtful accounts is properly set up.
➢ 10 confirmations for AR have been sent out. I am not quite sure what this number are based on. But if it is just a random number, no sample size and materiality was put into consideration, it is not appropriate number.
➢ Paul believed that testing was sufficient for him to issue unqualified audit opinion. Based on all above mentioned disagreement, this conclusion is certainly too early to make. More substantive procedures need to be done. Evidences collected so far is not enough to make conclusion.
iii. Other issues:
➢ Without permission from Mrs.Ruenstein, who is the owner of GoodFood Manufacturing, Paul showed Marvin a copy of GoodFood’s financial statements and advised him about Mrs.Ruenstein’s plan to retire. This is violation of confidentiality policy. I think we should advise Paul and inform GoodFood as soon as possible and explains the situation. Even though it might benefit the both parties, we still need to prepare for GoodFood’s complain/lawsuit.
I look forward to hear from you and discuss more in details.
b. Prime should consider the acquisition of GoodFood mainly based on the following facts: ➢ They are in the same industry but focus on different customers. By acquiring GoodFood, Prime can expand its business into larger restaurant market. ➢ Prime’s strong sales team has been successful in generating leads to attract new customers. Therefore, it meets Mrs.Ruenstein’s desire to invest additional effort to build up sales levels.
➢ GoodFood has plenty of excess capacity that can compensate Prime’s shortage of cash flow and other capacity.
The concerns about financing the purchase: Prime might have difficulty to obtain a long term loan to finance its purchase based on its current financial position. Even though Prime has increased sales in 20×5 and 20×6, but net income has dropped 47% in 20×6. It has large and increased current liabilities but has no reliable cash flow to depend on. Inventory is excessive, and AR’s average collection period is dropped. Return on total equity has dropped to 6.7% from 13.6% due to big drops in net income. All financial information is negative and can not support its financing request. However, if Prime can conquer the storage constraints and change back to FIFO accounting, it might be a big difference. Its cost of goods sold would dropped and net income would be increased!
A Letter to Board of Directors:
Wei Liu, CGA
Xxx Audit and consulting Firm
Board of Directors,
Townsville Recreation Centre (TRC)
Date: December xxx, 2009
Dear Board members,
It is my great pleasure to be in the position of providing my opinions regarding the creation of TRC and upcoming transfer of the recreational facilities from the municipality to TRC. The following you will find the discussions related to that and other issues requested by you, including the proposal for the social media site.
➢ Creation of TRC and transfer of the recreational facilities from the municipality:
o As what we all understand, the purpose of creating another independent legal entity, TRC, is to getting better information for decision making; to offer a wider range of lessons and activities on a cost-effective basis. It is agreed that Townsville would transfer not only all existing properties of the recreational centre operations and any related debt, but also all employees of the recreational centre. Therefore, from the financial perspective, TRC will record all transferred properties at fair value, record all related debt for remaining balance per bank’s confirmation, including unpaid accrued interests. A deferred capital contribution would be used to reflect the funding from Townsville.
As for all employees being assured that they would still be eligible for pensions as well as health and insurance coverage, the board need to make sure the details of the pension plans need to be discussed and prepared to accommodate old employees and new employees and make sure the pension policies and procedures as well as health and insurance coverage policies and procedures are in place. It is better off for TRC to consider only offering the defined contribution pension plans to employees instead of defined benefit plans since the first one is less cost and less burden on TRC. The cost to cover the pension plans and coverage should also be planned and budgeted.
➢ Accounting policies, format of the financial statements, and information necessary for decision making: o After transfer, TRC would be an independent non-for-profit legal entity. Therefore, all accounting policies need to be compliance with GAAP-general accepted accounting principles from CICA Handbook. PSA (Public sector accounting) Handbook will not be appropriate any more. TRC should determine and disclose which method is used for revenue recognition, either deferred method or the restricted fund method. The restricted fund method would be more suitable in TRC’s situation since TRC receives subsidies for low-income individuals as restricted funding. Separate reporting on this restricted funding would be benefit for users, including Townsville to better understand the statements. And other significant accounting policies, such as accounting for capital assets and donated materials and services, use of estimates etc should be determined and disclosed.
o As for the format of financial statements, according to the GAAP, normally it include: Statement of financial position; statement of operations; statement of changes in net assets; statement of cash flows.
o Information necessary for decision making: the board should obtain information not only from financial perspective, such as summary on TRC’s financial position, implication of current economic, government’s budget plan; but also non financial performance reports, such as whether TRC would be actually offering more lessons and activities on a cost effective basis.
➢ Requirements of the information technology system:
o Although it is costly to invest a new information system, but without it, it is much harder to produce useful and more reliable information to assist management operations effectively and efficiently. The new information system should not only record basic accounting information, but also produce information, like costs and revenues preparation between budgeted amount and actual amount; required funding reports; data for performance measurement etc. Also the board should ensure that policies and procedures for data integrity and security, IT supports, training for skilled personnel are all in place.
➢ Implications of the change in employment:
o As part of transferring agreement, all current employees of the recreational centre will become employees of the TRC and they will be still eligible for pensions and health and insurance coverage. Therefore, all income tax, CPP and EI have been contributed will be considered as contributed under TRC. For those employees who are nearly retiring, they can chose move their pension plan to TRC or leave it. And they can start to withdraw once their age reached to the defined age in the pension plan.
➢ Independent contractors and employees:
o From the tax’s point of view, making a distinction between independent contractors and employees is very important since for independent contractors, they are responsible for reporting business income for their tax return. TRC has no responsibility to withhold income tax, CPP and EI for them and do not have to provide same benefits to contractors as employees have. TRC also do not pay EHT for amount paid to independent contractors but need to pay EHT for remuneration paid to employees. o The factors to consider for distinctions between independent contractors and employees:
▪ Controls: Generally, in an employer-employee relationship, the employer controls, directly or indirectly, the way the work is to be done and the work methods used. But the contractors controls if he/she has the right to hire or fire, and decide where, when and how the work will be done.
▪ Ownership of tools: if it is employer-employee relationship, the employer generally supplies the equipment and tools required by the employee; also employer covers the cost of repairs, insurance etc for using of tools. ▪ Chance of profit/risk of loss: the employees are entitled to his or her full salary or wages regardless of the financial health of the business, the employer alone assumes the risk of loss. But for contractors, all risks are his/hers. ▪ Integration or organization test: the tasks performed by employees form an integral part of the business but tasks performed by the independent contractor merely being accessory to the business.
➢ Revenues: TRC’s revenues include subsidies provided by the Townsville, membership fees, registration fees and rental fees. To maximum the revenues, I would like to recommend:
o Subsidies from the Townsville: to be eligible to get the funding, TRC will have to provide complete listings of names, income levels, and subsidies provided. This information has previously been tracked through Townsville’s accounting system. Therefore, TRC could use the same system and maintain the same reporting to ensure maximum subsidies funding.
o For memberships are provided free of charge to families below a specific income level, the membership fees are actually covered by subsidies funding, revenue should be recognized even through the funding not yet received and fund receivable from Townsville could be set up.
o Registration fees: under the municipality’s management, often the lesson was run at a loss due to under enrollment or a higher than anticipated number of subsidized registrants. Therefore, the board should enforce the management in TRC to implement a better budget system to budget the registration fees and number of enrolment. The board and the management should work on strategies of getting more people to sign the lessons and activities. Meanwhile, TRC should consider setting up a policy that maintains the right of cancellation of lessons/activities in the case of enrollment not covering the cost.
o Rental fees: rental of the facilities is scheduled only around the times that the facilities are open to members and the general public, thus the rental income is limited due to time restraints. The board should consider a plan to expand available time for rental and fully use the facilities to maximum the rental income.
➢ Performance measures:
o I understood that TRC would evaluate employees’ performance partly based on measures that are reflective of the mission statement objectives. Therefore, the board should be provided with performance reports that can help you to define the mission statement objectives have been met. The list below should be considered for performance measures:
▪ The number of lessons/activities offered
▪ The type of lessons/activities offered
▪ The number of attendants for each type of lessons/activities ▪ newly developed lessons/activities offered ▪
Attendants for new lessons/activities
▪ Number of individuals received subsidies
▪ Type of lessons/activities offered to low-income families ▪ Cost and revenue for each type of lessons/activities.
➢ Internal controls for Cash:
o It seems that the internal controls for cash were not quite adequate due to the fact of theft of cash. To ensure this not continually happening in TRC, the board should make sure better internal control polices and procedures for cash management are in place, such as: segregation of duties for collecting and recording and bank reconciliations; more frequent cash deposit; proper authorizations, etc; the board should also make sure the implementation of the controls will be happening.
➢ Auditor for TRC:
o According to Canadian auditing standard, we can not accept audit engagement if we provide non-assurance services, such as accounting and bookkeeping services; valuation services; internal audit service; financial information systems design or implementation services. Based on the fact that we are now providing the consulting services not relating to those, we will be able to provide audit service to you. As for the fees schedule, we need to follow a standard fee schedule.
➢ Proposal of the social media site:
o The social media site provides many benefits for TRC to expand. While building up the site is necessary, many things need to be taken into consideration, especially when it is related to confidentiality and safety of information. It is not appropriate to publish the lists of all people being subsidized because it might violate the confidentiality policy; also to be able to keep the information collected safe, including client’s credit card number, the site has to be maintained under certain security to ensure data security. Besides, the board need to make sure whether there are skilled or enough personnel to maintain the site. More importantly, the board need to evaluate the overall costs to make sure that TRC does have the capacity to run this media site in a cost effective manner.
If you need more clarification, please feel free to contact me. I would be happy to discuss more details with you.
The end of assignment 8