Sharon Star is the audit supervisor at Dung and Flag LLP. She has recently been assigned to the audit of Peak Track Inc. (PTI). PTI specializes in the retail of high-end fitness apparel for women. It operates approximately 75 retail stores across Canada and has recently begun selling its apparel over a newly launched e-commerce website. PTI's business goal is to be the leading North American retailer for women's athletic apparel. Over the first several years of operations PTI incurred significant losses as it established the credibility of its brand as a high quality athletic wear provider.
This investment in branding began paying off as PTI had its first annual profit in the year ended December 31, 2012 and ever since the company has seen increased revenue and income growth. PTI's management is currently working on developing plans to facilitate PTI's expansion into the United States market. Due to poor business performance, a former initiative to establish Peak Track fitness clubs was discontinued in the current year. The founder, Savina Kapur, and majority shareholder of PTI credits the company's success to the innovative design of its signature athletic woman's pant, the superior in-store service and to its commitment to high quality fabric and manufacturing.
Five years ago PTI issued 25,000 common shares to Jack Alderman, a private investor to meet the need for increased working capital. Savina owns the remaining 50,000 outstanding common shares. Savina makes all the final decisions on sales, marketing and accounting. Savina does not have an accounting background and in the prior year audits it was noted that she can be very aggressive in her decisions relating to revenue recognition polices.
As Jack is not active in the operations of PTI, he requires an annual financial statement audit. As such, PTI has been an audit client of Dung and Flag for the past 5 years. In order to fund the company's expansion into the United States, Savina is planning on obtaining another private investor and should she require additional funds she plans on obtaining an operating loan from the bank. In her initial discussions with the bank the bank has indicated that it would require that the loan be secured by PTI's inventory balance where the total operating loan cannot exceed 70% of the total loan balance.
It is now September 5th, 2015 and Sharon has started to plan for the upcoming December 31, 2015 year-end. She has prepared a summary of key business factors and key financial data:
Key business Factors
Sharon completed some preliminary research on PTI and has identified the following key business factors:
1. PTI operates in the highly competitive fitness apparel industry and directly completes with major industry players who all hold strong global brand recognition.
2. PTI relies on only two different third party suppliers for its fabrics and to three different manufactures to produce its product. All of these suppliers are located in Asia. Occasionally PTI's suppliers and manufacturers provide fabrics or manufacture products that do not comply with PTI's technical specifications and are not consistent with PTI's standards.
3. PTI is extremely dependent on its information systems for a variety of critical business functions including: managing inventory, purchasing goods, processing sales transactions and operating its e-commerce site.
4. PTI does not hold any patents related to the fabrics or manufacturing technologies used in the production of the apparel.
5. Several knock-offs of PTI's signature athletic pant have entered the market. The "Peak Track" name brand has been trademarked and PTI has incurred significant legal fees defending the trademark.
6. The costs associated with some of the raw materials used in the production of the fabrics are susceptible price fluctuations.
7. PTI leases all of its retail space and is subject to long-term non-cancelable leases (5 to 10 years) and are required to make substantial lease payments under these operating leases. The costs associated with these leases account for a significant portion of cost of sales.
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Balance
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December 31, 2015 (forecasted)
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December 31, 2014
(audited)
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Net earnings after taxes and losses from discontinued operations
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$200,207
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$255,366
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Loss from discontinued operations net of tax
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20,700
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Nil
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Net Income before taxes
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417,607
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472,566
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Revenue
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8,410,824
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6,601,255
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Current Assets
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2,254,106
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2,018,787
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Inventory balance
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1,124,149
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904,202
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Total Assets
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3,860,737
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3,129,842
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Current Liabilities
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1,214,893
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928,522
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Required:
a) Indicate four business risks associated with the factors that Sharon has identified and link each business risk to a specific risk(s) of material misstatement for PTI. State whether the risk of material misstatement (RMM) is at the financial statement level or at the account balance and assertion level. If the RMM is at the account balance level state the assertion with high risk.
b) What would you set audit risk (high, medium, or low) for the PTI audit engagement? Explain why.
c) Based upon your analysis in (a) what financial statement accounts would be high inherent risk? Explain why - include in this discussion the most relevant assertions and the potential misstatement for the account.
d) Make a preliminary assessment of (1) overall and (2) performance materiality for this year's audit engagement. Provide calculations and justify your response (explain why you chose the particular benchmark and the percentage).