Multi- Subject - Simulation

It is September 15, 2019. The partner has called you, CA, into his office to discuss a special
engagement related to a purchase agreement. John Toffler, a successful entrepreneur with
several different businesses in the automotive sector, is finalizing the acquisition of Super
Sports Limited (SSL). The seller, Carl Thomas, founded SSL over 20 years ago, and has
decided to retire and sell his business. He has agreed to manage the business until the shares
are transferred.

SSL, a wholesale distributor of sports equipment and related products, is very profitable. The
company originally sold summer sports items, such as jet skis and canoes, and recently
acquired a wholesaler of winter sports items such as snowmobiles. SSL has loyal customers
and good relationships with its suppliers.

Excerpts from the purchase agreement provided in Exhibit I. The purchase price for the SSL
shares is the book value of net assets, according to the approved audited financial statements
as at August 10, 2019, plus any increase in the fair value of the land and building. See Exhibit II
for excerpts from the August 10, 2019, statements submitted to Toffler for his approval. SSL’s
auditor dated the audit report August 31, 2019.

Toffler asked Jill Savage, who works for one of his companies, to review SSL’s financial
statements and the audit working papers provided by SSL’s auditor. Jill raised several concerns
as part of her review (see Exhibit III). In the spirit of fairness, Thomas and Toffler have
requested your firm’s views on the issues noted by Jill before continuing with the approval of the
financial statements as per clause 29.1. The partner has asked you to draft a memo to his
attention, supporting your views.
SIMULATION 1 (continued)

EXHIBIT I

EXCERPTS FROM PURCHASE AGREEMENT (dated August 1, 2019)

2.1 The effective date of the sale of SSL is August 10, 2019.

10.2 The purchaser reviewed the inventory balance as at July 31, 2019, and noted a general
obsolescence provision of $75,000, which the seller will update at the effective date.

12.1 The seller will conduct a physical inventory count following the close of business on
August 10. The purchaser may have a representative attend the count.

13.1 Based on a review of the accounts receivable performed on July 31, both parties agree
that $90,000 is a reasonable allowance for doubtful accounts to be booked in the August
10 financial statements.

15.1 All amounts due to the shareholder will be paid before August 10.

29.1 As part of the final acceptance of this agreement, both the purchaser and the seller must
approve the August 10 audited financial statements.

35.1 Both parties accept that unforeseen circumstances related to the agreement might arise
that require an adjustment to the purchase price, and will work in good faith to arrive at a
fair settlement.

2
SIMULATION 1 (continued)

EXHIBIT II

SUPER SPORTS LIMITED

EXCERPTS FROM AUDITED BALANCE SHEET

As at (in thousands of dollars)

Aug. 10, 2019 Oct. 31, 2018

(Year-end)

Assets

Current assets
Accounts receivable $ 1,459 $ 996
Inventory 2,475 2,098
3,934 3,094

Property, plant and equipment, net 451 504

Goodwill and intangibles 60 80

$ 4,445 $ 3,678

Liabilities

Current liabilities
Bank overdraft $ 821 $ 9
Accounts payable 2,004 1,547
Salaries and bonuses payable 40 231
Income tax payable 63 17
2,928 1,804

Due to shareholder -- 750

2,928 2,554

Shareholders’ Equity

Common shares 100 100

Retained earnings 1,417 1,024
1,517 1,124

$ 4,445 $ 3,678

3
SIMULATION 1 (continued)

EXHIBIT III

LIST OF CONCERNS PREPARED BY JILL SAVAGE

(INCLUDING EXCERPTS FROM AUDIT WORKING PAPERS)

Inventory

The audit working papers include the following (in $000’s):

Summary of Writedowns
August 10, 2019 October 31, 2018
Net Net
Realizable Write- Realizable Write-
Cost Value down Cost Value down
Snowmobiles (stock
and customised) $876 $865 $11 $449 $404 $45

Winter parts and

accessories 387 450 -- 229 265 --

Subtotal 1,263 1,315 11 678 669 45

Jet skis 420 386 34 499 474 25

Motorboats 478 466 12 539 531 8

Canoes and kayaks 263 325 -- 280 345 --

Summer parts and

accessories 126 101 25 202 180 22

Subtotal 1,287 1,278 71 1,520 1,530 55

Total $2,550 $2,593 $82 $2,198 $2,199 $100

Days’ sales in
inventory 60 days 63 days

SSL applied the lower of cost and market using net realizable value as the definition of market
value, in accordance with its accounting policy. I do not agree with the method used. GAAP
requires conservatism, and using net realizable value less normal profit margin is more
conservative and would ensure historic profit margins are maintained. A further writedown of
the inventory and a reduction in purchase price are necessary.

4
SIMULATION 1 (continued)

EXHIBIT III (continued)

LIST OF CONCERNS PREPARED BY JILL SAVAGE

(INCLUDING EXCERPTS FROM AUDIT WORKING PAPERS)

The file noted that except for the custom snowmobile inventory, which SSL accounts for on an
item-by-item basis, SSL applies the lower of cost and market by product line using a weighted
average. As a result, increases in the value of some items offset declines in the value of others.
The last shipment of snowmobiles received had a lower unit price than the units still in inventory
purchased earlier in the season. I believe the snowmobile inventory, excluding the customized
items, should be valued at the lower price based on a first-in-first-out cost formula. Applying the
lower of cost or market in this way is in accordance with GAAP.

The auditor tested the valuation of inventory by referencing purchase invoices to subsequent
selling prices, reviewing sales margins after the cut-off date, and reviewing for obsolete or slow-
moving items while attending the physical count. The auditor also tested the inventory tracking
system and noted no errors or problems. I believe the auditor did not do enough work on
inventory, and did not realize that the amount booked should have been increased from
$75,000, as stated in Clause 10.2, to $82,000, as calculated by the auditor (see summary of
unadjusted misstatements), plus the normal margin on an item-by-item basis.

The audit working papers noted that a jet ski and accessories that were sitting in a separate
area of the warehouse were included in the count. SSL received a layaway payment for the
items from the customer on the day of the count and recorded a liability as of August 10. The
audit file noted that the repeat customer picked up the items, worth $30,000, two weeks later.
This is an obvious cut-off error. There should not be a liability. Since the items were sold the
day of the count, the inventory on the August 10 statements should have been reduced and a
receivable recorded.

5
SIMULATION 1 (continued)

EXHIBIT III (continued)

LIST OF CONCERNS PREPARED BY JILL SAVAGE

(INCLUDING EXCERPTS FROM AUDIT WORKING PAPERS)

Accounts Receivable and Bad Debt Expense

The following is the schedule prepared by the auditor to calculate the required allowance for
doubtful accounts (in $000’s):

Accounts
Receivable Aging August 10, 2019 October 31, 2018

$ $
Accounts $ Accounts $
Receivable % Allowance Receivable $ Allowance
Current 503 1.6 8 300 1.7 5
30-60 days 626 2.1 13 442 2.0 9
61-90 days 200 8.0 16 162 8.0 13
Over 90 days 200 15.0 33 140 15.0 21

Total 1,549 70 1,044 48

The audit files indicate that the aging was tested and large accounts were reviewed. Accounts
were confirmed on a test basis, and no significant errors were found. Subsequent payments
were also reviewed.

On September 4, 2019, I read in the newspaper that Fast and Furious (FF), a customer of SSL,
declared bankruptcy due to fire. The balance in FF’s account on August 10 was $145,000, of
which $50,000 remained unpaid when it declared bankruptcy. Since the account will probably
not be collected, SSL should increase the $90,000 allowance at the purchase date to include
the loss of $50,000 because the sale to FF was made before our purchase of SSL.

Accounts Payable

Accounts payable for previous periods included and accrual of $180,000 related to a disputed
payable to a supplier. The supplier initially sued SSL for payment, and SSL responded with a
countersuit. The audit file indicates that the dispute has been ongoing for about three years,
and SSL came close to going to court on a few occasions but the date was delayed by
procedural details. Carl Thomas had worked diligently to reach a settlement. On the August 10
statements, SSL reduced the accrual to $80,000, representing the settlement amount and the
related legal costs. The $100,000 difference was taken into income. The file includes
documents, signed by Carl Thomas on behalf of SSL, indicating that he finally settled the matter
out of court on August 25, 2019.

6
SIMULATION 1 (continued)

EXHIBIT III (continued)

LIST OF CONCERNS PREPARED BY JILL SAVAGE

(INCLUDING EXCERPTS FROM AUDIT WORKING PAPERS)

Carl did not tell you he had reached a settlement, nor did he get your approval before signing off
on it. Given that the settlement was a management decision, not the result of a court order, and
that it was reached after the purchase date, the full $180,000 accrual should have been left on
the August 10 balance sheet. The treatment is not in accordance with GAAP.

Audit Work

I gather that SSL has had the same auditor, David Wong, CA, since its inception. David is a
sole proprietor who employs one CA and several technicians. The audit working papers
indicate that the CA and two of the technicians completed the fieldwork and David reviewed the
file.

I question the auditor’s independence. David might be helping his long-time client get the
highest possible sales price, so we should be skeptical. Also, this appears to be a large audit
for a small firm, and that fact may cause a lack of independence. The audit fees almost doubled
over the previous year, so David may be dependent on SSL and not as stringent in the
application of GAAS and GAAP as he should be.

Management’s replies to the auditor’s analytical review inquiries were of interest to me.
Although there were positive comments indicating that the owner is very hands-on and
knowledgeable about the business, and that past representations by management have always
been reliable, there was also a comment that SSL would not pay any bonus this year due to the
sale. I question the motives of management based on another comment noted in the file: “SSL
has had a history of conservatism and a goal of tax minimization.”

A copy of a valuation report was in the audit file. The auditor assessed $80,000 of goodwill and
intangibles, and made a $20,000 writedown due to impairment, as SSL is no longer the
exclusive distributor of Polaris snowmobiles in the region. The auditor should have written off
the entire balance.

7
SIMULATION 1 (continued)

EXHIBIT III (continued)

LIST OF CONCERNS PREPARED BY JILL SAVAGE

(INCLUDING EXCERPTS FROM AUDIT WORKING PAPERS)

According to the report, the market value of the real property is $1.2 million. The auditor did not
do work on the land and building valuation, but appears to have relied on the valuator. The
auditor, under GAAS, must perform certain procedures before relying on the work of a
specialist, but this was not done.

Materiality and Summary of Misstatements

The audit file identified an increase in risk due to the sale and to other specific risk factors.
Materiality was established at $30,000 based on the book value of the net assets and on
professional judgment. This appears high given the reliance on the financial statements for
calculating the purchase price.

The summary of unadjusted misstatements related to estimates showed the following (in
$000’s):

Audit Estimate ($)

Account SSL’s Value Low High Best Difference
per Financial Estimate
Statements ($)
Allowance for doubtful
accounts 90 60 100 70 (20)

Inventory obsolescence
provision 75 75 90 82 7

Error in closing balance in

equity (August 10, 2019)