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Mugsy Brights Limited (MBL) is a private company in Winnipeg that sells mugs, jars and bottles in a variety of colours, sizes and materials. MBL is owned by four equal owners since inception. The owners have different skills - creative design, marketing, finance and information systems. The company attributes much of its success to the use of materials that can be easily shipped without breaking, and unique designs that appeal to a variety of buyers, particularly commercial buyers who purchase for restaurants, or for businesses who choose to advertise their business by giving away or selling regular or travel mugs.

The owners meet formally every month, and have informal meetings two or three times per week to discuss particular clients or new approaches. About a quarter of the sales are via the company's secure web site, while the remainder are by telephone or purchase order. MBL works with distributors of kitchenware, selling wholesale to hundreds of outlets in Canada. Most of these sales are done via the telephone, although a salesperson does spend some time in major cities across the country visiting some of the large customers, helping with shelf layout and marketing to the ultimate consumers for larger distributors. These efforts have resulted in gradually increasing market share for the company.

All sales are recorded in the accounting software package used by the company. The accounting manager reports directly to one of the owners, and there are two other employees in the accounting department. Password controls are used to limit functions that are accessible by employees. For example, only the controller can implement wage rate increases or product price increases (which are reviewed and approved by the owner responsible for marketing). Two owners are required to sign cheques, and do so with source documents attached. Similarly, two owners are required to approve new employees.

All manufacturing is outsourced to local producers who work with different materials. For example, a different supplier handles steel mugs versus plastics or glass. Ceramics is rarely used as it is quite breakable, whereas some forms of glass are very durable. MBL does not hold any inventory, as manufacturing is all done to order. However, as there have been some collection problems from customers, the company has had to go to the maximum of its line of credit, and has no additional borrowing capacity available. It is waiting for the results of the audited financial statements to approach the bank for an increase in its line of credit.

Internet sales are prepared (via credit card), while sales to distributors are net thirty. The company has an April year end.

Following are extracts from the annual financial statements:

    2012   2011   2010
Cash   $99,000   $110,000   $124,000
Accounts receivable   $320,000   $220,000   $150,000
Fixed assets (net)   $15,000   $20,000   $25,000
Accounts payable   $270,000   $180,000   $150,000
Bank indebtedness   $100,000   $25,000   $0
Share capital   $200,000   $200,000   $200,000
Revenue   $625,310   $538,120   $507,380
Cost of sales   $406,452   $333,634   $304,428
Administration expenses   $89,000   $57,000   $58,000
Sales expenses   $31,266   $21,525   $20,295
Amortization   $5,000   $5,000   $5,000

A) What audit risk would you assign to the company? Why? [Tip: Do some calculations and consider client business risk.]
B) Calculate preliminary materiality. Justify your decision of materiality base and choice of materiality.

Auditing: The Art and Science of Assurance Engagements, Canadian Edition

Edition: 12th
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Auditing: The Art and Science of Assurance Engagements, Twelfth Canadian Edition, 12/E (Arens, Elder, Beasley, Splettstoesser)
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4 years ago
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   2012   2011   2010
cost of sales percent   65   62   60
sales expenses percent   5   4   4
net income   $93,593   $120,961   $119,657

Client business risk should be set at high, because:
- Net income has declined substantially in the current year (supported by dollar calculations), which may indicate that the company is facing declining profitability
- Cost of sales seems to be steadily declining (see calculations), the company may not be able to pass cost increases on to its customers
- there has been a large increase in accounts receivable (so there may be a collection problem)
- a large accounts receivable write-off could substantially reduce or eliminate the net income for the year
- this would reduce the ability of the company to borrow money from the bank
- there has been a large increase in accounts payable (so they may be holding funds to conserve cash)
- the company is at the edge of its line of credit, and may not be able to borrow additional funds:
- if so, there could be a going concern problem if the owners cannot contribute additional capital

Client business risk is reduced by:
- the fact that manufacturing is outsourced and there is no inventory, reducing financial exposure for unsold items
Audit risk could be argued to be any of low/med/high depending upon the emphasis given to the points raised above.
- primary users are the owners and the bank, which is a limited number of owners, which increases audit risk
- however, as the company is intending to borrow additional funds, the bank may be paying closer attention to the financial statements, which reduces audit risk

B) Several potential methods for calculating materiality:
(1) five to ten percent of net income before taxes:
Net income: $93,593
low end of range: 5% = $4,680
high end of range: 10% = $9,359
(2) ½ to 5 percent of gross profit:
Gross profit: $218,859
low end of range: 1/2% = $1,094
high end of range: 5% = $10,943
(3) ½ to 1 percent of revenue:
Revenue: $625,310
low end of range: 1/2% = $3,127
high end of range: 1% = $6,253
Note: Base cannot be calculated using total assets or shareholders equity. If students state the assumption that they have all of the assets, or show the amounts that they have included in the calculation, then they could do a calculation based upon total assets, shown below, but they do not have retained earnings so could not do a base using shareholders equity.
(4) ½ to 1 percent of total assets:
Total assets: $434,000
low end of range: 1/2% = $ 2,170
high end of range: 1% = $ 4,340

- it is difficult to choose among bases, as revenue is increasing while net income is declining
- may be suitable to use an average of more than one base
- since revenue may be incorrect (due to potential problems with accounts receivable and accounts payable), it may be more suitable to do an average of one or more bases
This verified answer contains over 540 words.

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