Question 4 (14 marks)
My Chatr Inc. (MCI) is a medium sized private company in the business of developing, manufacturing and distributing wireless Internet devices. These devices permit users to browse the Internet and to send and receive e-mail while mobile. MCI’s niche is in commercial Internet devices, which are more durable than retail consumer versions. MCI’s special keyboard, the most advanced in the industry, is very small, easy to use and durable.
According to a leading market research firm, the market for this segment is growing at 70% per annum. Competition in this segment is fierce. MCI operates in an industry characterized by heavy expenditures in research and development and products that are regularly updated and revised. Recent innovations by one of MCI’s rivals suggest that the industry is in a period of intense competition. Most of MCI’s production is exported.
The company was founded by Linda Scott, CPA, CA and was incorporated in March 2004. MCI obtained a $5 million bank loan that was personally guaranteed by Scott. According to the loan agreement MCI must maintain a current ratio of 2:1 at all times otherwise the loan becomes payable. The company has a December 31 year end. Cotton & King LLP (C&K), a large public accounting firm, had been the auditors since 2003. In November 2013 MCI decided to hire your accounting firm, Lewis and Frydman LLP (L&F) to undertake its audit for the year ended December 31, 2014 based on the fact your firm’s audit fee was the lowest compared to all other firms who submitted a bid to do the audit.
MCI operates out of a single location in Canada and has 72 employees. The company has grown rapidly with annual revenue growth of approximately 40%. This was less than the forecasted 80% annual growth.
Shares of high technology companies have taken a major plunge over the last year. On the positive side, the tremendous shortage of high tech employees, which had hurt MCI, has eased due to widespread layoffs in the industry and the downturn in the economy.
Cash flow has been tight recently, but MCI in most cases has been able to pay suppliers on time. Management is looking at various options of obtaining additional financing over the next year. One of the considerations is to go public and to issue an initial public offering. Management is aware that if the company goes public that governance will be more important than it is now.
You are a recently qualified CPA,CA with L&F and have been assigned to the audit team for the audit of MCI’s financial statements for the year ending December 31, 2013. It is now January 30, 2015 and you have been assigned to start the planning for the year-end audit. In preparation for the audit planning you obtained the following information:
· MCI’s key financial information for the past two years was:
Revenues 19,061 14,044
Net loss before taxes 1,800 230
Total assets 15,631 8,908
· During March 2014, Scott authorized a change in credit policies. Previously, customers were granted credit based upon the credit ratings developed by MCI’s credit manager, which took into account the outstanding balance of the customer’s account and an analysis of its financial condition. Due to the recent downturn in the economy Scott decided that MCI must use a more lenient credit policy to keep sales flowing.
Accordingly, as a cost cutting measure, the credit manager was laid off in February 2014. Scott now evaluates each customer contract or purchase order
individually to determine whether credit should be granted. As a result of this
new policy, no customer orders were declined for poor credit since February
· Scott’s husband, Tim, was hired in early 2014 to replace the accountant who left due to family obligations. Prior to joining MCI, Tim was a bookkeeper for a not for profit organization for 5 years. Tim regularly consults with Scott on how to record any complex transactions.
· In February 2014 MCI purchased a small tract of commercial land near its present location for possible future expansion. It was purchased for $205,000 and has never been used. Management thinks it is now worth $150,000 less a 5% real estate commission.
· In August 2014, the company was sued by a supplier in California for breach of contract related to the cancellation by MCI of a firm order for software. MCI’s U.S. lawyers have said that they can probably drag out the case until at least February 2015. The order was for $1,280,000 and this is the amount of the claim. Scott believes the company should be able to settle for about half of that amount.
a) Describe four industry and environmental factors that increase MCI’s business risk. Explain why the factor increases business risk. Link the business risk factors you identified to specific risks of material misstatements (RMM). Use the following table to complete your answer. (8 marks)
b) Provide a recommendation for the appropriate materiality benchmark (base) and the related appropriate percentage to be applied to the base for the 2014 MCI financial statement audit. Justify your recommendation. (6 marks)