Module 7 Audit and Assurance-Charm Studios Inc. is a hair salon owned

Module 7Audit and AssuranceProject Chartered Professional Accountants of Canada, CPA Canada, CPAare trademarks and/or certification marks of the Chartered Professional Accountants of Canada.© 2016, Chartered Professional Accountants of Canada. All Rights Reserved. Module 7 — Audit and Assurance PROJECT (100 MARKS)Charm Studios Inc. is a hair salon owned and operated by Jennifer. Jennifer had worked as astylist in a high-traffic salon for over 10 years, and then on July 1, 20X5, she decided that thetime was right to open her own salon, so she took out a loan for the initial costs of setting upher salon.Over the last year, the salon’s business has grown so much that, in order to extend the salon’sbusiness hours to include evenings and all weekends, Jennifer has hired one full-time and twopart-time stylists, as well as a part-time receptionist who will help manage the front desk. Inaddition, an esthetician operates her own company, Nail Art — an entity separate from Charm— in a room within the salon.As the salon premises are being fully used and the salon’s clientele is continuing to grow,Jennifer is hoping to expand her storefront and is seeking an additional loan to do this. Thebank has requested audited statements for Charm in accordance with ASPE for its most recentfiscal year end (June 30, 20X6). Jennifer has provided the draft income statement for the yearended June 30, 20X6, in Appendix 1.In July 20X6, Jennifer approached Tracey, a CPA, to inquire whether her firm, Connolly, Drakeand Associates (CDA), could complete Charm’s financial statement audit. Tracey is one of fourpartners at CDA. Jennifer has been Tracey’s hair stylist for years. They have become closefriends and have often chatted about their mutual friends, and Jennifer has sought Tracey’sopinion on some accounting matters such as the correct accounting treatment for Charm’sexpenditures over the last year. Jennifer has implemented some of Tracey’srecommendations.Jennifer uses an off-the-shelf software package used by many salons. The software packageallows for easy input of sales transactions. As a sale is made, it is automatically recorded inboth the sales subledger and the general ledger. The software can quickly generate reports bycustomer, type of service, and total purchases for each period, although Jennifer has said shenever has time to do this. She uses a laptop to track everything, which she is hoping to replacesoon because it sometimes crashes.Jennifer is a skilled hair stylist and a natural leader, but she will be the first to admit that shehad a lot to learn about running her own business. She is usually prompt at paying bills andshe waits until invoices are paid before recording them. Once she records payments, they are 2 / 11 Module 7 — Audit and Assurance Project updated in the general ledger. Lately she has been so busy that sometimes bank depositsdon’t even get made for up to a few days at a time.Appendix 2 shows extracts from the monthly income statements for March to June 20X6;Jennifer would like you to review the impact of the changes to operations during these monthson revenues and costs. Appendix 3 contains the notes from Tracey’s meeting with Jennifer.Appendix 4 contains the memo that Jennifer has prepared to describe the sales process atCharm.Required:1. Identify any threats to independence that would prevent CDA from accepting CharmStudios Inc. as a client. Discuss how each threat could affect independence and how, ifpossible, CDA can mitigate each threat. (7 marks)2. Perform the planning analytical review for Charm’s revenues. In particular, use theinformation related to the number of services that Charm has provided, and distinguishbetween full-time and part-time staff revenues. Include any supporting calculations.Interpret the results from the analytical review. Which accounts and related assertions willbe most impacted by the results of your analytical review? (16 marks)3. Discuss whether there is any evidence to support the possibility of fraud occurring atCharm. Discuss the auditor’s responsibility with regards to detecting fraud at Charm. Iffraud did occur, discuss what steps CDA should take now. (10 marks)4. Complete the preliminary planning of the audit by determining the level of audit risk, andsupport your analysis by discussing seven risk factors associated with the engagement.Indicate what type of risk (inherent risk or control risk) is associated with each factor.(8 marks)5. Calculate overall planning materiality and performance materiality for the 20X6 fiscalyear-end audit. Provide both quantitative and qualitative analysis supporting yourassessment of preliminary materiality. (8 marks)6. Identify nine different risks at the financial statement level. For each risk, identify a relevantsubstantive audit procedure and the specific audit assertion that is being tested. Ensurethat these audit procedures you identify are specific to the case facts. Use a chart like theone below to structure your response. (27 marks)Financial statement risk 3 / 11 Substantive audit procedure Related assertion Module 7 — Audit and Assurance Project 7. Jennifer has asked you for some business advice related to controls. Describe at leasteight weaknesses in Charm’s business processes, explain the implications of eachweakness, and provide recommendations to reduce or eliminate the weaknesses. Use achart like the one below to structure your response. (24 marks)Weakness 4 / 11 Implication Recommendation Module 7 — Audit and Assurance Project APPENDIX 1: DRAFT INCOME STATEMENT FOR THE YEAR ENDED JUNE 30, 20X6Year ended June 30, 20X6UnauditedNotesRevenues — full-time staffRevenues — part-time staffProduct salesTotal revenues 212,15030,30013,825256,275 Cost of goods soldProducts used in servicesGeneral and administrativeWage expenseInterest expenseRent expenseTotal expenses 8,4854,8287,54779,7711,5549,000111,185 Total income before taxes 145,090 12345 Notes:1. This includes hair products purchased from Nova Scotia Beauty, which Charm normallysells to customers at a 50% markup.2. Products used in hair services are mostly made up of hair colour, shampoo and conditioner.Sometimes a client will need two colour treatments, depending on their hair length and typeof colour method.3. Jennifer has used $5,000 of her own money to purchase new lights, painting and custombuilt supply cupboards for the salon, which is included in general and administrativeexpense. Sometimes she uses her personal credit card to buy supplies for Charm, andthen takes money out of the cash register to reimburse herself for these purchases. Shehas kept all of the receipts for these items in a separate envelope.4. Interest expense relates to the $100,000 loan that Jennifer took out to finance the initialcosts of setting up the salon. The loan must be paid back over five years. There arecovenants on the loan that require Charm to maintain specific ratios, including a currentratio of 1.5 to 1 and a debt-to-equity ratio of 1.2 to 1.5. Charm is required to remit 5% of its gross sales to the lessor in addition to a monthly rentalamount of $1,000. No amount has been recorded for this yet; it will be done when thefinancial statements are finalized.6. Charm is being sued by a customer who had a severe allergic reaction after having her haircoloured at the salon — most of her hair fell out within 24 hours of the treatment. The 5 / 11 Module 7 — Audit and Assurance Project customer was supposed to get married three days after her hair service, but her fiancédecided not to proceed with the nuptials due to the incident.Jennifer always completes a profile on each new customer as required by TheCosmetology Association. In the profile, there is a section where the client must indicatewhether they have any allergies and the client signs to acknowledge that they understandthat there are risks involved with chemicals used in hair colouring. After the incidentoccurred, Jennifer couldn’t find a profile created for this customer. The CosmetologyAssociation has the ability to cease operations of any stylist or esthetician found to be inviolation of their guidelines. 6 / 11 Module 7 — Audit and Assurance Project APPENDIX 2: EXTRACTS FROM MONTHLY FINANCIAL STATEMENTSMonthly income statements for March to June 20X6 Revenues — full-time staffRevenues — part-time staffProduct salesTotal revenuesCost of goods soldProducts used in servicesGeneral and administrative expenseWage expenseInterest expenseRent expenseTotal expensesTotal income before taxes 7 / 11 March April May June 17,4507,2001,00025,6507003992479,2241251,00011,69513,955 17,7008,5001,30027,5009105573429,2241181,00012,15115,349 17,5007,60090026,0006303373789,2241451,00011,71414,286 17,3507,00080025,1505602854579,2241541,00011,68013,470 Module 7 — Audit and Assurance Project APPENDIX 3: NOTES FROM TRACEY’S JULY 20X6 MEETING WITH JENNIFERCharm staff consists of Jennifer, Meryna, who is another full-time stylist, and three part-timeemployees, Sherri, Marjan and Kaitlin. There is a full-time esthetician, Ayana, who operates aspa called Nail Art within Charm, but she is not on Charm’s payroll because her business is aseparate entity from Charm. Nail Art is owned 100% by Ayana.Nail Art shares Charm’s cash register. Ayana rings in services and products sold using acertain code to distinguish Nail Art’s sales from Charm’s sales. Jennifer and Ayana have averbal agreement that Charm will collect 20% of Nail Art’s revenue in lieu of charging rent.There appears to be some tension between Ayana and Jennifer in the salon.In March of this year, Sherri and Marjan had come to Jennifer looking for employment. Jenniferhired them both on the spot because they seemed to have the trendy appearance she thoughtwas important for stylists to have in her salon. Jennifer was so excited about not having tosearch for new stylists and was so eager to have Sherri and Marjan start right away that shedid not ask for their Cosmetology Association member numbers to verify that they werelicensed.Sherri and Marjan are best friends and they told Jennifer that they had just graduated fromChoice Hair Academy and were eager to work for Charm because they both have big studentloans. They always seem to have many friends in the store, and Jennifer is hoping this willlead to a new under-20 clientele base. They all want their hair to look just like Star Sims, apopular teen celebrity.Jennifer had always answered the phones and booked appointments herself until two monthsago, when she hired Kaitlin to take on this role. When clients book an appointment, it is enteredinto a master schedule, which is maintained electronically so that a historical record isavailable for each client. Jennifer has been so impressed with Kaitlin that she has also taskedher with doing the bank deposits and handling clients’ transactions when their services arecomplete.All Charm employees have access to process the salon’s payment transactions so they canhelp out when Kaitlin is busy, to ensure that customers are not kept waiting after their serviceis complete. Also, Ayana often processes payment transactions for Charm’s services andproducts sales, since her clientele is still growing and she often is not busy. Likewise, Kaitlinwill sometimes process Nail Art’s payment transactions when Ayana is busy.Jennifer is seeking a loan to expand Charm’s storefront location. Charm currently has a threeyear lease. Jennifer is not happy with the amount of rent Charm is being charged — a rate of5% of Charm’s monthly sales in addition to the $1,000 fixed rent amount per month. The lessorhad provided an upfront incentive of free rent for the first three months because there hadbeen some robberies in other stores at the strip mall.Charm has a loan with covenants tied to working capital ratios. The bank requires the auditedfinancial statements to be provided within two months of the year end. A breach of the 8 / 11 Module 7 — Audit and Assurance Project covenants means that the loan will become payable on demand. Jennifer does not havesufficient cash flows to repay the loan if the bank were to call it.Jennifer purchases 85% of her products from Nova Scotia Beauty, a local beauty supply shop.Charm sells these products in the salon and uses them during client services. Jennifer paysher employees a 10% commission on the sale of each product. On the employees’ pay stubs,the total commission amount is shown separately, recorded as part of wage. 9 / 11 Module 7 — Audit and Assurance Project APPENDIX 4: MEMO ON DESCRIPTION OF SALES PROCESS FROM JENNIFERMemoTo:From:Date:Re: TraceyJenniferJuly 15, 20X6Description of Sales Process at Charm I try to keep Charm product sales separate from Nail Art’s product sales, but lately, I’ve noticedthat the inventory records have reflected more product on hand than what is actually in stockwhen we are looking for items.The new customer loyalty card that Charm implemented a few months ago has been a hugesuccess. Customers earn one point for every $1 spent, and once they have earned 750 points,they can redeem their points for a free hair service or merchandise worth up to $50. The cashregister tracks points by customer. The only customers who have not signed up for the loyaltycard are walk-in customers, so I estimate that 90% of customers use the loyalty card.I’m thrilled that the amount of customer bookings has been increasing so quickly. I’m actuallykind of surprised that the bank deposits aren’t higher. Given the number of appointments we’vehad, and the amount of hair colour we’ve gone through since hiring the new part-time staff, Ihad expected sales to be even higher.A women’s haircut costs $50, and a colour service can range from $100 to $200 depending onthe hair length and type of service. The average charge for a colour service done by the parttime staff has been $125. Right now, the new part-time staff are charging $40 per haircut to tryto encourage business, which seems to be working — they are busy all the time!Charm is open from Tuesday to Sunday, and is closed on Mondays. Meryna and I havedecided to each work four days per week because the part-time staff work two full days on theweekends and three evenings. During the four days Meryna and I work per week, we arebooked 100% of the time. Normally we each do five haircuts and two colour treatment servicesper day. The two new part-time staff could do the same number of haircut and colour serviceson the weekends as Meryna and I do each day through the week, and sometimes more. In thethree evenings that they each work, the schedule that Kaitlin keeps shows them as being busy,each doing five haircuts and one colour treatment service on most evenings.I’m kind of surprised that we have constantly been running out of colour needed for hairdyeing. I used to know how much product I would go through each month, but for the last fewmonths I have been consistently running out of product, especially a particular brand that hasbecome popular after Star Sims started doing advertisements for the manufacturer. It’s a greatproduct but it’s really expensive compared to the other brands. I really should count inventorymore often; it seems like it’s the last thing I have time for after my salon bookings, running thestore and doing all the bookkeeping myself. 10 / 11 Module 7 — Audit and Assurance Project At the salon franchise where I worked previously, the payment system had product and servicecodes that employees could not change at the register. I don’t really want to get into thatbecause I trust my employees; they can override the standard price and input the price theyfeel is most appropriate to charge. I want my regular clients who followed me from my lastemployer to be happy, so I give some of them discounts on services. 11 / 11