Question 1

Intense Fitness Limited (IFL) operates a chain of 12 upscale fitness clubs located in and around the Greater Toronto Area. IFL offers some of Canada's most luxurious, modern and high-tech fitness facilities. IFL was founded in 1989 and was purchased from the original owner in December, 2012 by Ralph Gerret, a retired professional athlete. Ralph believed the fitness club business had strong growth potential and was a good fit with his athletic background. Ralph was very happy that a new fitness club opens every three months in Ontario.

In 2012, having exhausted his own savings to purchase the shares of IFL, Ralph approached a bank to obtain financing to open two additional clubs. The loan application required that IFL provide financial statements prepared in accordance with ASPE and include an unqualified audit report.  Last year your firm Body & Builder audited the financial statements as at December 31, 2012 and issued an unqualified opinion. 

You have been appointed as the audit senior for this year's audit of the December 31, 2013 financial statements. In preparation for the upcoming audit you have collected the following information:

1.      On May 31, 2013, the bank granted a 7.5%, 3 year term loan in the amount of $150,000.  Interest is payable every annum and principal is due at the end of the term. The loan agreement requires that IFL maintain a current ratio of 1.3 and net income before taxes and management bonus of greater than $500,000. Should IFL violate this covenant the loan becomes immediately callable and IFL will be required to pay the principal and interest immediately.

2.      Ralph is unsophisticated when it comes to financial matters. He relies entirely on the company's accounting clerk to prepare the financial statements.  Last year there were significant material adjustments required as the accounting clerk was not familiar with the complex revenue recognition policies required for the various types of memberships sold by the club. The various memberships offered were multiple deliverable arrangements over long-term periods.  Subsequent to last year's audit the accounting clerk has been re-trained on the appropriate revenue recognition policies and appropriate accounting entries for each of the membership types offered at the club. 

3.      In the current year IFL is now  running a brand new incentive program giving all new one year members 50% off the second year if they choose to renew their membership for an additional year. Since this is a new program the accounting clerk was unsure on how to recognize the revenue associated with the program.

4.      Ralph is very concerned about the possibility of losing his life savings if IFL's profitability declines.

5.      One of IFL's most significant assets is the fitness equipment in the club facilities. IFL is known for providing the most technologically advanced and widest range of equipment available. IFL leases most of its fitness equipment over a five year period and typically purchases the equipment at the end of the 5 year period by triggering the buyout option in the lease. The leases are treated as capital leases.  Equipment is normally kept for 8 to 10 years. 

6.      IFL is currently the defendant in a lawsuit in which it has been accused of offering Pilatercise, a specialty fitness class, without obtaining permission from the creators. IFL was not aware that the program was patented and expects to settle the $400,000 lawsuit out of court for a lesser amount. 

7.      One of the most critical factors in attracting and retaining new members is the quality of instructors and personal trainers at the club. Often members join or renew memberships primarily because they want to stay with a particular instructor or trainer.  In the current year, to reduce turnover, which is notoriously high in the fitness club industry, IFL offers signing bonuses to good trainers and instructors who commit to stay for two years. If the employee leaves before the end of the two-year period, the bonus is repayable by the instructor or trainer. The repayment amount is based on the amount of the bonus less a pro-rated amount calculated on the number of months worked. The bonuses are expensed when paid to the employee. 

8.      The majority of IFL's costs such as building and equipment leases, and utilities are fixed. The only variable cost is the wages for trainers as they are paid on commission basis depending on number of clients the trainer entertain. As a result the clubs will operate at a loss until they achieve a large enough membership base to cover the initial fixed costs for the building and equipment. Currently 6 of the 12 existing clubs are operating at below breakeven membership levels. 

9.      Obtaining prime locations in high growth areas with the right demographics is critical to achieving and maintaining the required membership base.  In the current year, Ralph has spent approximately $30,000 on research to identify potential locations for new clubs. He recently decided on two locations that he believes meet the necessary criteria and plans to proceed with signing leases once he receives the bank loan. The accounting clerk capitalized the $30,000 of site research costs and plans to amortize them over the first five years of the new clubs' operations.

10.  The main reason existing members have for not renewing their membership with IFL are   they prefer new methods of home fitness (purchase of own equipment or use Wii Fitness) or they can obtain very similar memberships at other new gyms for approximately 30% less than IFL's fees.   In the past three years, about 10 of IFL's clubs have recently seen a new competitor open in the same neighbourhood.

11.  Some key financial figures in the draft IFL financial statements for the period ended December 31, 2013 include:

Required:

1.      Describe three client business risks relevant to the IFL business and explain why they are important considerations for the auditor of the IFL financial statements.

2.      Assess audit risk (high, medium or low) for the IFL audit engagement. Support your assessment. 

3.      Assess four factors affecting inherent risk for the IFL audit engagement. For each risk, also identify the audit assertion impacted. 

4.      You have also completed an assessment of control risk for IFL and have appropriately assessed control risk at maximum for all cycles.  Describe the audit strategy that you recommend.  

5.      Calculate a preliminary assessment of materiality for this year's audit engagement. Justify your response. 

6.      Describe a substantive analytical procedure that could be used to test the interest expense recorded on the loan balance. 

Question # 2

For each of the audit procedures included below:

1.  State the relevant audit assertion(s)(specific audit objective being met) 
2. State the type of audit evidence being used 
3. State the quality of evidence and explanation 

Audit Procedure

Organise your answer as follows:

Question 3

Each year Sally Ripley, president of Big Construction Inc., takes a three week vacation to Hawaii and before she leave signs several cheques to pay major bills during the period she is absent.  Ripley's vacation often occurs near the end of Big's fiscal reporting period because it is a slack time for the construction business.  Jack Morgan, controller for the company uses this practice to his advantage.  He makes out a cheque to himself for the amount of a large vendor's invoice and records it as a payment to the vendor for the purchase of supplies.  He holds the cheque for several weeks to make sure the auditors will not examine the cancelled cheque.  Shortly after the first of the year Morgan resubmits the invoice to Ripley for payment approval and records the cheque in the cash disbursements journal.  At that point, he marks the invoice as paid and files it with all other paid invoices.  Morgan has been following this practice successfully for several years and feels confident that he has developed a foolproof fraud.

Required

1.      What is the auditor's responsibility for discovering this type of embezzlement? 

2.      Describe 3 (three) weaknesses in Big's internal controls and provide a recommendation for improvement for each weakness. 

Organise your answer as follows:

3.      Provide 2 (two) substantive audit procedures that could help to uncover the fraud.