Presented by: Hei Cheng, Kieng Iv, May Leung, Tiffany Liu, Vikram Somasundaram

Planning Phase Circles Approach Outline Key Issues (Assurance and PMR) Other Issues (Pervasive, Finance and Tax) Our Comments BOE’s Comments Evaluation Guide

What is our responsibility in this engagement (required)?

The Claim:"the price it paid for GEL was excessive because it was misled as

to GEL's true financial status“ Specifically: CB's conduct was not in keeping with professional standards The contents of the information package were improperly

preparedThe emphasis of our search should be more on: Overstatement of assets Overstatement of earnings Overstatement of cash inflows

CB’s exposure to liability will depend on whether the following are true:

a) MIC relied on the information package, b) the information contained in the information package was

misleading and/or incorrect, and c) the misleading and/or incorrect information resulted in a loss

to MIC.

Our investigation should focus on Point B

Professional Conduct not to be associated with false or misleading information◦ Includes the cash flow forecast although only a notice to reader given

Rule 205: False or misleading documents and oral representation (ICAO)

A member, student or firm shall not (a) sign or associate with any letter, report, statement, representation or

financial statement which the member, student or firm knows, or should know, is false or misleading, whether or not the signing or association is subject to a disclaimer of responsibility, nor

(b) make or associate with any oral report, statement or representation which the member, student or firm knows, or should know, is false or misleading

Time Period Based on the facts known as at Audit Date (August 16, 2004)

CB should have read the package to ensure that: the financial statements and CB's audit report were accurately

reproduced in the package; the cash flow forecast and CB's Notice to Reader report were

accurately reproduced in the package; and any other information presented in the report contained no

misrepresentations or inconsistencies with the financial statements that CB should have known about as a result of its work.

Did you conclude that materiality was appropriate? If not, what do you think is appropriate?

CB’s assessment of materiality for 2004 $350,000 (1 % of GEL's net, assets of $34.9 million, and

consistent with PY) Inappropriate because:

◦ New user in 2004 that is more sensitive (the purchaser of GEL), the materiality should be reduced

◦ An income statement basis may have been more relevant.

Our assessment of materiality $228,000, calculated as 10% of $2.28 million (net income

before tax in 2004) This conservative approach is due to the use of GEL's 2004

financial statements in a sale/offering proposal (the information package)

In our opinion, the level of materiality used by CB of $350,000 was too high for the 2004 audit of GEL

Note: Alternative approach that is justified is acceptable

Identify two major accounting issues and provide a brief overview of the facts

Capitalized Cost

Construction Revenue

Recognition

Standard Panel

RevenueRecognition

Joint VentureInventory Valuation

Land Impairment

Non-monetary Transaction

Revenue Producing Properties

Made-To-Order Panel

RevenueRecognition

Game Over

Inclusion of investment tax credit received last year in taxable income for the current year

Income vs. Capital for the sale of land◦ Inclusion of the non-taxable portion◦ Land sale swap values at FMV◦ The immediate deduction of R&D expense as oppose to

capitalization◦ Treatment of holdbacks, capitalized interest and completed

contract

Quality of tax advice is poor If GEL is reassessed by Revenue Canada for 2004 and/or

previous taxation years:◦ tax liability may arise◦ GEL's new owners may turn to CB for compensation

CB's exposure to this liability may be lessened if GEL's previous owners agreed to pay any reassessed taxes under the purchase/sale agreement

CB had the following responsibilities: Evaluate whether assumptions were consistent with the

purpose of the forecast Ensure the forecast reflected the assumptions CB would have exercised its professional judgment and

considered whether the forecast was false or misleading Prohibited by the rules of professional conduct for Chartered

Accountants from associating itself with false or misleading information

CB was under a professional obligation to ensure that the forecast was based on reasonable assumptions.

Original solution:◦ Held to the standard of FOFI

Update to suggested solution: ◦ AcSB concluded that FOFI is no longer relevant to private

enterprises◦ CB should still perform with due care and understood that

they should not be associated with false or misleading information

There are several omissions from the forecast, which when included, result in negative cash flows (See Appendix IV of Suggested Approach)◦ Mortgage pay down/repayment◦ Capitalized cash expenditure (equipment, inducements)

Non-quantifiable but should be discussed:◦ Participation payments◦ Demand loan pay down/increase in interest rates◦ Cost to complete construction in progress◦ Joint Ventures

Some assumptions in the forecasted cash flow are illogical: The forecast assumes that the panel division sales would

increase ◦ Sales orders at lower levels than in previous years

The panel division was at 100% capacity◦ Expansion was planned (financing problems)◦ Therefore, sales volumes could not have risen

The assumption that divisional revenues would increase ◦ Inconsistent with the stated assumption that the economic

situation was expected to remain stable

Consider presentation of cash flow to include investing and financing activities sections

We conclude that the forecast was incorrect and materially misleading◦ CB should have recognized that the expected cash flows

were likely to be materially less than what was reported in the forecast

MIC's owners may have relied on the forecasted cash flow contained in the information package◦ If the items omitted had been included, MIC might have

been alerted to GEL's cash flow problems

Risk: CB assessed GEL’s risk to be high Appears to be appropriate due to financial statements being used

for investment decisions However procedures were not in line with risk assessment as seen

through the various audit procedures deficienciesApproach: CB concluded on approach to rely primarily on GEL’s internal control Appears to be inappropriate due to the following:

◦ errors CB found in its interim tests of GEL's internal control systems

Therefore, on the engagement, more substantive testing should have been used (Combined or Substantive Only Approach)

Real Estate Division Failure to aggregate all errors in Summary of Unadjusted

Differences/ Misstatements (SUDs/ SUMs)◦ CB failed to include the $250,000 - $500,000 overstatement

of net income otherwise they would not have concluded that aggregate errors were below their stated materiality of $350,000

Real Estate Division - continued Net income overstated and should have been adjusted for

SUMS per CB - overstatement of 2004 income $216,000

Add: panel error $250,000 or 500,000

Recalculated overstatement $466,000

CB's materiality $350,000

Our assessment of materiality $228,000

Real Estate Division Construction Division Panel Division

Revenue Producing Prop.•Appraisals (valuation) of revenue producing properties may not be appropriate• More work on valuation required

Accounts Receivable: •Existence assessed but not collectability

Deferred Development costs: •Since the costs seem to be "ongoing," CB should have questioned whether the costs were for new products and hence eligible to be treated as development costs

Tenant payments: •Vouch or verify payments made by GEL to tenants for improvements

Work in Progress: •No evidence that CB investigated WIP additions made during the fiscal year other than those made in June 2004

Inventory/ WIP: •CB found errors and did not quantify the error or post it to SUMS•Also, CB should have tested the overhead component of panel WIP given the known over application of costs at year end.

Capitalization•Cease date should have been reviewed

Was there a going concern problem? ◦Support your answer

The CICA Handbook requires an auditor to assess whether a company is a going concern ◦ ASPE 1400 and CAS 570◦ Considering facts such as the history of reported losses, cash

flows, etc.◦ If the conclusion was that GEL may not be a going concern:

a note to the 2004 financial statements provided by GEL management, explaining the going concern issue; or

in the absence of such a note, the issuance by CB of a qualified audit opinion on GEL's 2004 financial statements.

Profitability GEL's 2004 net income under GAAP was negative (after our

adjustments), indicating profitability problems The aggressive accounting policies selected by GEL may have

"hidden" GEL's profitability problems.Liquidity 2004 and expected future cash flows were negative (after

adjustments) due to debt servicing Ratio analysis and cash balance Shortfall in financing

CB should have assessed the profitability and liquidity of GEL and considered whether a going concern problem existed at GEL's 2004 year end◦ Note disclosure or qualified audit opinion◦ Balance sheet should have been restated to liquidation

values If it is determined that CB should have known, and should

have revealed that GEL was not a going concern at year end, failure to do so will constitute CB's most significant breach of professional responsibility

Should have qualified its audit report on GEL's 2004 financial statements for the following reasons:◦ Material ASPE deviations evident in GEL's 2004 financial

statements◦ CB's acceptance of these material misstatements is a major

deficiency

Ensuring that 2004 financial statements are fairly stated, free of any material misstatement

Free of any material misstatement on the basis of ASPE Generally, CB was required under, CAS to:

◦ team collectively have appropriate competence and capabilities to perform the audit engagement in accordance with professional standards and applicable legal and regulatory requirements (CAS 220)

◦ The auditor shall design and perform audit procedures that are appropriate in the circumstances for the purpose of obtaining sufficient appropriate audit evidence (CAS 500- audit evidence)

◦ The auditor shall obtain an understanding of the control environment including internal controls (CAS 315)

◦ Adequate planning (CAS 300)

Analysis of audited financial statements (compliance with CAS)CB was responsible for conducting the audit of GEL in

accordance with CAS to ensure that GEL's financial statements were free of material misstatement. We have found serious deficiencies in CB's planning and execution of its audit of GEL, including: a) assessment of the level of materiality b) audit approach c) audit procedures - did not assess going concern /not in

line with risk assessmentd) issuance of an unqualified audit opinion - material

misstatements in F/S

What was your overall conclusion on the case?◦Did you believe that CB did not meet its

professional standards?◦Did you believe the information package

were improperly prepared?

Required 1: CB's conduct was not in keeping with professional standards

Breach of professional conduct and GAAS as financial statements were materially misstated, yet an unqualified opinion was issued. CB has associated itself with false/misleading information. Misstatements due to inadequate procedures:

Failure to assess entity as a going concern (most significant breach) Failed to aggregate known/likely errors to assess material

misstatement Failure to design procedures consistent with risk assessment

Required 2: the contents of the information package were improperly prepared◦ Based on previous adjustments, amounts were materially

misstated◦ Assumptions under cash flow statements were

unreasonable◦ Assessed that the entity will not be a going concern, BS

should be liquidation method

Many candidates identified the role of an expert at the beginning of the report but failed to perform the function of the role

Majority of candidates did not define GAAS and GAAP for the lawyer

Candidates did not define the concept of materiality for CB's lawyer nor did they adequately conclude on the appropriateness of the level of materiality established by CB

Candidates provided one-sided arguments (in defense of CB)

Candidates did not rank issues when the candidates were directed by the case to “highlight the areas of greatest significance to CB's lawyers”

Candidates did not address general accounting concepts such as revenue recognition and capitalization concepts adequately, nor did candidates tie the accounting concepts into the case facts

Many candidates did not aggregate misstatements in order to determine the overall impact of the GAAP departures on GEL's 2004 financial statements

Candidates identified few of the many GAAS (CAS) deficiencies of audit procedures performed by CB. Many candidates did not focus on the critical deficiencies (e.g., cost to complete contracts and audit of billing for extra work).

Most candidates did not conclude on the magnitude of the misstatement of GEL's net income or net equity

Most candidates did not adequately conclude as to the pervasiveness of the GAAS (CAS) deficiencies with respect to CB's audit of GEL

Many candidates incorrectly concluded that CB had little or no professional responsibility for the cash flow forecast because CB had issued a Notice to Reader report on it

Less than half of the candidates presented evidence supporting the going concern or liquidity problem

Few candidates identified that MIC should have realized the limitation of the historical cost-based financial statements in making the purchase decision

Go To•ACC 610

Facts: As at June 30, 2004, FMV of Property 2 and 4 are less than carrying

amountRelevant Standards: ASPE Section 3063 Impairment of Long-Lived Assets Test for recoverability whenever events or changes in circumstances

indicate that asset’s carrying amount may not be recoverable Two step test for impairment:

1. Compare carrying amount to recoverable amount (= sum of undiscounted future cash flows less disposition costs). If carrying amount > recoverable amount:

2. Write down asset to FMV

Issues: Write down per income statement is $1,795K. Is this write

down sufficient?

Conclusions: Indications of impairment: FMV of Property #2 and #4 are less

than carrying amount Assuming carrying amount > recoverable amount for both

properties, write down Property #2 and #4 to FMV

Property No.

Carrying amount

FMV Write-down

2 12,610 11,500 1,110

4 18,015 16,600 1,415

Total Write-down 2,525

Write-down per Income Statement 1,795

Additional Write-down required 730

(in thousands)

Recalculate undiscounted future cash flows through examining tenant agreements (rental income, maintenance expenses etc.)

Determine the disposition costs if any (Does the company plan to dispose of the property upon the end of the tenant agreements? If so, should consider costs to sell)

Compare the carrying value to calculated recoverable amount If CV > recoverable amount, write down to FMV FMV can be determined through secondary markets (real

estate markets) or through asking expert in real estate market CB recognized that there was a write-down but failed to

perform all steps above to derive the correct amount

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Facts:◦ 40% partner withdrew from JV in July 2004◦ $9.5M in financing is still required

Relevant Standards:◦ ASPE Section 3820 Subsequent Events◦ Two types of subsequent events:

1. Conditions that existed at the financial statement date2. Conditions that arose subsequent to the financial

statement date

Issues: Whether the subsequent event should have been disclosed in

the notes to the financial statements or adjusted?

Conclusions: No indication that there were conflicts or disputes between

parties to joint venture prior to financial statement date Classify this subsequent event as #2. Thus, disclose in notes to

2004 financial statements. Future write-down may be necessary

CB was aware that 40% partner withdrew (in general, prior to audit date, there should be procedure to enquire management about subsequent events)

Subsequent events should have been disclosed in the notes. Procedures would have been for partner to review financial statements for appropriate disclosures.

Should obtain copy of environmental regulations & copy of assessment to ensure that it was properly adhered to

Did not assess recovery of investment after 40% partners withdrew funds

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Facts: May 2004: Traded a commercial rental building for a similar

commercial building and received $100K cash Gain on sale of building of $890K was recognized in the

income statement

Relevant Standards: ASPE Section 3831 Non-Monetary Transactions

Issue: Was it appropriate for GEL to record a gain on this transaction?

Conclusions: Since the properties exchanged were similar in nature (lack

commercial substance), the transaction should have been accounted for as a non-monetary transaction

Therefore, the gain of $890K should not have been recognized in the financial statements

However, a portion of the gain resulting from the ratio of cash received to total proceeds may recognized. This can be calculated as follows:$890,000 (gain) * $100,000 (cash consideration)/$18,870,000 (FMV of property given up) = $5,000 (approx.)

Therefore, $885,000 of the gain should be removed from the income statement.

Should determine FMV through the use of appraisals or experts

Should verify the receipt of cash exchanged through tracing to bank statements

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Facts: GEL changed its construction revenue recognition policy from

completed contract method to percentage completion method and applied it prospectively. (Page 12)

Relevant standards: ASPE 1506 – Accounting Changes ASPE 3400 – RevenueIssues: Was applying the accounting policy change prospectively

compliant with ASPE?

Issue 1: Was applying the accounting policy change prospectively compliant with ASPE?

Relevant Standards: “a change in accounting policy shall be applied retrospectively

except to the extent that it is impracticable to determine either the period-specific effects or the cumulative effect of the change.” (ASPE 1506.14)

Facts: Auditors inquired and claimed that accounting policy was

changed because of increasing length of contracts and change in facts for not applying it prospectively

Average 2004 contract lengths (2.5 years) is almost equal to the average of 2002 and 2003 contracts (2.25 years)

Contract information, such as expected revenue and costs, are available for pre-2004 and 2004 contracts

Contract information, such as expected revenue and costs, are available for pre-2004 and 2004 contracts

Conclusion: It is practical to apply the accounting policy retrospectively

Project Expected Margin% complete at year end

Total (in thousands)

02A 1860 13840/17990=77% 1431

03C 905 5115/8315=62% 557

1988

02B (note 1) (110)

03D (note 2) (150)

Retained Earnings 1728

Retained Earnings Not Quantifiable (RENQ):Contracts that started before 2004 and completed in 2004. Retained Earnings Under(Over) statement= $1728-$RENQConclusion: Retained Earnings is understated if RENQ<$1728 and overstated if

RENQ>$1728

Note 1: Total expected costs exceed total expected revenue by $110 (12990-13100). Expensed this amount. Note 2: Total expected costs exceed total expected revenue by $150 (11100-11250). Expensed this amount.

CB recognized that there was a change in accounting policy. There should be retrospective adjustments made. The following procedures would have been necessary:

Obtain contracts with periods relating to periods ending in 2002, 2003 and 2004.

Determine the percentage of completion of these contracts as at year end date based on the amount of work completed or percentage of total costs

Restate revenues based on relevant period that revenue is stated in

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Facts: The division records revenue on receipt of an order for

standard panels whenever the inventory is "in stock" and "can be delivered within 30 days." (Page 8)

$500,000 worth of gross profit was recognized for orders in the last two days of the fiscal year. Half of these orders were not shipped until August. (Page 15)

Relevant standards: ASPE 3400 – RevenueIssues: Is recognizing revenue on receipt of an order appropriate? Was recognizing the $500,000 worth of GP in 2004 correct?

Issue 1: Is recognizing revenue on receipt of an order appropriate?

Relevant Standards: “transferred to the buyer the significant risks and rewards of

ownership, in that all significant acts have been completed” (ASPE 1506.05) and performance is met when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered; and the sellers' price to the buyer is fixed or determinable (ASPE 1506.07)

Facts: Revenue is recognized before delivery

Conclusion: Revenue should be recognized when all significant acts have

been completed, the last being delivery. Therefore, the current accounting policy is inappropriate.

Revenue and cost of goods sold are overstated.

Issue 2: Was recognizing the $500,000 worth of gross profit in fiscal 2004 correct?

Relevant Standards: “transferred to the buyer the significant risks and rewards of

ownership, in that all significant acts have been completed” (ASPE 1506.05) and performance is met when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered; and the sellers' price to the buyer is fixed or determinable (ASPE 1506.07)

Facts: Order was received two business days before year-end Half the orders were not shipped until August

Conclusion: Panels that did not reach customer location before year end

should not be recognized. At least $250,000 (half of the orders) should not be recognized. Revenue and cost of goods sold were overstated for 2004.

Obtain all orders close to year end and trace to shipping documents to ensure revenue recognition criteria met (performance complete)

Should recalculate amount relating to next period and take to SUMs

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Facts: Revenue for made-to-order panels is recognized upon

completion of production (Page 8) Revenue for the installation work is recognized on a

percentage-of-completion basis (Page 8) Divisions combine bids for installation and manufacturing.

Prices installation to breakeven and manufacturing to make a profit (Page 9)

Relevant standards: ASPE 3400 – RevenueIssues: Is splitting the revenue appropriate? Is the revenue allocation appropriate?

Issue 1: Is splitting the revenue appropriate?Relevant Standards: “in certain circumstances, it is necessary to apply the

recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction.” (ASPE 1506.11)

Facts: There is strong competition for installation Manufacturing and installation is priced in one contractConclusion: Current revenue recognition policy is appropriate as

installation and the made-to-order panel

Issue 2: Is the revenue allocation appropriate?Relevant Standards: “in certain circumstances, …recognition criteria to the

separately identifiable components of a single transaction …reflect the substance of the transaction.” (ASPE 1506.11)

Facts: There is strong competition for installationConclusion: It is unlikely that the substance of installation service would

result in a breakeven. Allocate more revenue to installation from manufacturing. This

means that equity is overstated by an unknown amount.

Obtain from management and through review of contracts an understanding of the nature of the two components

Determine allocation between manufacturing and installation revenue through methods such as relative fair market value etc.

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Facts: Panels are costed on a full costing basis using a budgeted

overhead application rate that is based on the plant being utilized at 50% of its capacity (Page 8)

During fiscal 2004, the manufacturing overhead that was charged to units produced exceeded the actual manufacturing overhead by $488,290 because the division was operating at 100% capacity (Page 9)

Relevant standards: ASPE 3031 – InventoriesIssues: Was ending inventory appropriately valuated?

Issue 1: Was ending inventory appropriately valuated?Relevant Standards: The cost of inventories shall comprise all costs of purchase,

costs of conversion and other costs incurred in bringing the inventories to their present location and condition (ASPE 3031.11)

Facts: Panels are costed on a full costing basis using a budgeted

overhead application rate that is based on the plant being utilized at 50% of its capacity (Page 8)

During fiscal 2004, the manufacturing overhead that was charged to units produced exceeded the actual manufacturing overhead by $488,290 because the division was operating at 100% capacity (Page 9)

Conclusion: Excess overhead should be removed from ending inventory

because it does not represent an actual cost

Ending Inventory $4,925 (Page 6)

Beginning Inventory $5,560 (Page 6)Cost of Goods Sold (COGS) $13,165 (Page 5)Total over-applied overhead $488,290X by: % of panel in Y/E INV (Note 1) 39.31%Total expense charged $191,926

Note 1: % of Panel Production in Y/E Inventory = Ending/(COGS +

Ending – Beginning)* *rearrange formula -> Ending = Beginning – COGS +

Manufactured Inventory Manufactured Inventory = Ending – Beginning + COGS % of Panel Production in Y/E Inventory = 4,925/(13,165+4,925-

5,560)=39.31%

Conclusion:• Inventory is overstated and cost of goods sold is understated

by $191,926.

Verify inputs required to calculate overcharged overhead through examining production records

Recalculate the excess overhead charge Perform addition work on raw materials since no other work

was performed regarding errors nor was it posted to SUDs Count of raw materials and verify costs with invoices

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Facts: All property taxes, interest, and similar costs are capitalized to

revenue-producing properties until the project generates sufficient cash flows to pay all expenses except interest and amortization. During fiscal 2004, the division capitalized $677,400 of these costs (Page 6)

During 2004, $490,000 of renovation costs and $317,200 of other costs were capitalized as tenant inducements.

Relevant standards: ASPE 3061 – Property, Plant and EquipmentIssues: Can you capitalized $317,200 soft cost?

Issue 1: Can you capitalized $317,200 soft cost?Relevant Standards: Capitalization of carrying costs ceases when an item of property,

plant and equipment is substantially complete and ready for productive use. (ASPE 3061.12)

Facts: Cost relate to a building already openedConclusion: Cannot capitalize soft costs after the building is substantially

complete and ready for productive use. The building has already been in use and therefore the cost cannot be capitalized.

Expenses are understated and the building is overstated

In general, capitalization of soft cost until “the project generates sufficient cash flows to pay all expenses except interest and amortization” is appropriate according to ASPE 3061.12 where “Capitalization of carrying costs ceases when an item of property, plant and equipment is substantially complete and ready for productive use”

Inspect contracts that measures the progress of the building Inspect when costs were posted and accrued and any costs

capitalized after the building has been ready for productive use should be expensed

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Facts: During 2004, $1.2 million of land inventory was reclassified

from land held for resale to land held for future development. At the date of transfer, the net realizable value of the land was $900,000. Management intends to hold the land for future development instead of continuing to offer it for sale. (Page 7)

Relevant standards: ASPE 3061 – Property, Plant and Equipment ASPE 3063 – Impairment of Long-live AssetsIssues: Is the land held for use impaired?

Issue 1: Is the land held for use impaired?Relevant Standards: An impairment loss shall be recognized when the carrying

amount of a long-lived asset is not recoverable and exceeds its fair value. (ASPE 3063.04)

The carrying amount of a long-lived asset is not recoverable if the carrying amount exceeds the sum of the undiscounted cash flows expected to result from its use and eventual disposition. (ASPE 3063.05)

Facts: Carrying value is $1.2 Million The market value is $0.9 Million GEL has financing problemsImpairment Test Compare carrying value to the sum of undiscounted cash flow If carrying value is greater than the sum of undiscounted cash

flow; write down asset to fair valueConclusion: It is likely that there is write down of $300,000. Land is

overstated and write down expense is understated.

Similar to testing of valuation assertion for revenue producing properties (impairment), there should have been procedures to determine the recoverable amount. Specifically for land:

Needed to enquire management on re-classifications and document plans to development

Determine the recoverable amount FMV can be determined through secondary markets (real estate

markets) or through land appraisals with the help of an expert Recoverable amount is based on current conditions of the land. If it

is not ready to generate revenue “revenue producing” then should the amount be 0 and then just write to FMV

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