To: Audit Partner

From: CPA
Re: Sweet Temptations – Audit Planning Memo and Accounting Issues under IFRS

Audit Planning Memo

Overall Financial Statement Level Risk

The first step in audit planning is to assess the risk of material misstatement at the overall
financial statement level (OSFL). This includes various factors that may increase or decrease
said risk:
 Sweet Temptations Ltd. (STL) has relatively minimal accounting experience on staff.
Meghan, the owner, has a business degree, but is focused on the business of creating
cakes. There is a bookkeeper on staff; however, they may have limited experience
dealing with complex business acquisitions. This factor may increase the RMM at the
OFSL depending on the complexity of transactions during the year.
 STL had a hectic year that included the company acquiring another company for the first
time ever. This increases the RMM at the OFSL as additional complexity has been added
to the company’s reporting, and management was faced with additional responsibility
during the year.
 The company required additional bank financing during the year which created a new
user for the financial statements. This increases the RMM at the OFSL, as STL may face
additional pressure to conform to the bank’s requirements.
 Sweet Temptations Ltd. (STL) has been audited by our firm for the previous two years.
This decreases the OFSL RMM as we can rely on previous years’ financial statements.
 STL has successfully reported under IFRS for the previous two years. This may decrease
the RMM of OFSL as previous years’ FS may be relied upon, and management has
experience reporting under a complex accounting framework.
 STL has had stable earnings for the previous three years. This factor decreases the OFSL
RMM as STL has been operating in a stable environment, and its primary business has
been successful.

Based on these factors, I assess the OFSL risk of material misstatement as moderate for the year.
Previous operations have not changed; however, the new line has introduced additional
complexities and users to the financial statements.

Audit Approach

As we have audited STL in the past, we previously obtained an understanding of existing

controls. This year we will inquire with management as to any changes that have occurred, and
once documented, we will determine whether controls can continue to be relied upon at this time.
Due to our conversations thus far, it appears as though STL has effective controls over its cake
business. Many of the areas that contain increased risk pertain to the business acquisition,
Grabba Java Inc. that occurred at year end.

Therefore, this should result in a combined audit approach for areas with identified effective
controls. However, at this time we may be unable to assess controls related to the new business
area. As a result. we may need to take a substantive approach to the audit of this business area
this year, with the hopes that controls are operating effectively in the next year.

Materiality

Materiality is set based on the users of the financial statements and their needs. There are two
disclosed users of the statements:
 Ownership will be reliant on the financial statements to evaluate the success of the
company.
 The bank will be reliant on the financial statements to determine if STL will be able to
repay its new loan.

Based on the needs of these users, both will be interested in the pre-tax income of STL.
Therefore, this should be used as the base for determining materiality. STL is currently reporting
net income before tax of $770,000 and this should be adjusted for non-recurring revenues and
expenses. It appears a gain on disposal of equipment was realized that was recorded at $15,000.
This should be normalized in the net income figure, and we may proceed with the calculations
using a normalized net income of $755,000. As the users are moderately sensitive, we should set
materiality at the middle end of the acceptable range at 5%. Therefore, materiality should be set
at $37,750.

In addition, performance materiality should be determined. We have established that the OFSL
risk is moderate this year, therefore the threshold should be established for performance
materiality that reflects this risk level. We will set the PM threshold at 70% of materiality, which
equals $26,425.

Accounting Issues

Meghan Reese is the owner, and is relied on for oversight of STL. She has a bookkeeper that is
responsible for accounting and general office duties; however, they are uncomfortable with
several complex accounting issues that occurred during 20X4.

Contingent Liability
During 20X4, a patron of GJI contracted food poisoning and is sueing the company for $3,500.
This amount has not been recorded on the financial statements as GJI’s management believed
that the lawsuit was frivolous. STL’s layer believes that this amount should be paid so that it
“goes away”. This appears to be a potential contingent liability that may require GJI to include
the liability on the FS. IAS 37 Provisions, Contingent Liabilities and Contingent Assets provides
guidance on whether or not it should be reported. A contingent liability is considered a provision
when:
• The entity has a present obligation arising as a result of a past event.
 This case was a past event that may have caused a present obligation.
• It is considered probable that the entity will have an outflow of economic
resources.
 IAS 37.23 defines an event as being probable "if the event is more likely
than not to occur, i.e. the probability that the event will occur is greater
than the probability that it will not." This can be assessed as being a
greater than 50% chance that the even will occur.
 STL’s lawyer believes that this amount should be paid, which means it is
probable that the entity will have an outflow.
• The entity is able to make a reliable estimate of the outflow of economic resources.
 An estimate is not required as the value can be ascertained from the
documents provided in the lawsuit.

Therefore, as this meets the criteria and the legal counsel believes that it should be paid, STL
should have this amount recorded in GJI’s books. The resulting journal entry will be:

Dr. Lawsuit Settlement Loss $3,500

Cr. Lawsuit Settlement Provision $3,500

This will impact the financial statements of GJI, which will ultimately affect STL. We whould
take additional steps to identify if there are additional outstanding contingent liabilities that have
not been disclosed. This will require us to send a letter to GJI and STL’s legal counsel in order to
confirm if any legal matters are ongoing. As well, we should examine any meeting minutes that
exist to see if any such matters have been discussed by either company.

Secret Proprietary Sandwich Sauce

GJI has a secret proprietary sandwich sauce that it has started to sell as a stand-alone product.
Previously, GJI have not recorded this sauce as an asset; however, Meghan believes that the
rights to the sauce are worth roughly $100,000. This appears to be an intangible asset, as it is a
non-monetary asset without physical substance. IAS 38 Intangible Assets provides guidance on
when intangible assets can be recognized and included on the financial statements. The
following criteria apply:

1. The asset is identifiable, which is illustrated as either:

a. being separable such that it can be transferred / sold to another entity
Met – The rights to the sauce are separable and can be transferred. It was a
specific consideration of STL when they purchased GJI.
 b. arising from contractual or other legal rights
2. The entity controls the future economic benefits of the asset.
Met – GJI has a proprietary right to the sauce, which means that its competitors
are unable to use it without express permission.
3. The asset will generate future economic benefits.
Met – The sauce is being used in a separate line of bottled sauces that are being
distributed.
Further, an intangible is recognized when both of the following criteria are met:
1. It is probable that the expected future economic benefit of the asset flows to the
entity.
Met – This is expected as an agreement has been reached with a local distributor,
and all sides are optimistic that the venture will be profitable.
2. Its cost can be measured reliably.
Met – Although it has not been recorded, the cost to innovate and protect the
recipe could be identified.

Therefore, the sauce should be recognized as an intangible asset on GJI’s balance sheet prior to
the acquisition. IFRS 3 Business Combinations provides guidance that the cost of an intangible
acquired as part of a business combination is its fair value at the acquisition date. The intangible
is recognized separately from goodwill whether or not the acquiree had previously recognized it.
Therefore, since it was not previously recorded, it should be valued at its FV of $100,000 at the
time of acquisition.

To test intangible assets, we must determine whether or not they exist. This can be done through
an analysis of the

Business Acquisition of Grabba Java Inc.

STL has acquired 100% of GJI’s outstanding shares for $750,000. Guidance for business
combinations is covered in IFRS 3 Business Combinations. As this was a purchase of shares, the
initial acquisition should have been recorded as follows:
Dr. Investment in GJI $750,000
Cr. Cash $750,000

STL should record its purchase of the shares of GJI, and GJI will continue to maintain its own
financial statements independent of STL. STL must report its investment on a consolidated basis
going forward as it is the acquiring company. We have been provided information that indicates
that the FVs of GJI’s assets are equal to their BV. Therefore, any difference between the
purchase price and the BV of GJI can be attributed to the secret sauce and the goodwill. As per
Exhibit A:

Dr. Cash 24,300

Dr. Accounts Receivable 17,500
Dr. Inventory 9,800
Dr. Prepaid Expenses 13,250
Dr. Equipment 48,750
Dr. Leasehold Improvements 31,000
Dr. Secret Sauce 100,000
Dr. Goodwill 537,700
Cr. AP 12,200
Cr. Lawsuit 3,500
Cr. LTD 5,100
Cr. DIT 30,000
Cr. Investment in GJI 750,000

The investment in GJI will need to be eliminated upon consolidation, and STL will recognize
$537,700 in goodwill.

Gain on Sale of Ovens

During the year, STL entered into a lease for commercial ovens.

Analysis:
Leases are covered under IFRS 16 Leases. This transaction is a lease because it provides STL the
right to control the use of the ovens for a period of at least four years in exchange for
consideration.

The first step in accounting for the lease is to determine the term of the lease. Per IFRS 16.18:
An entity shall determine the lease term as the non-cancellable period of a lease, together with
both:
(a) periods covered by an option to extend the lease if the lessee is reasonably certain to exercise
that option; and
(b) periods covered by an option to terminate the lease if the lessee is reasonably certain not to
exercise that option.

The non-cancellable period of the lease is four years. We need to determine if it is likely that
STL will extend the lease for the additional three-year renewal term. Meghan thinks the ovens
will meet her needs for the next 10 years; therefore, we can assume that STL will take the
renewal term. In addition, the renewal term would cost a total of $7,500 (ignoring time value of
money), resulting in ownership of the asset; if not taken, a fee of $5,000 is required to be paid,
which suggests it would be more favourable to STL to accept this renewal period.

Next we must determine the measurement of the lease liability and right-of-use asset. Per IFRS
16.26, the lease liability is measured at: … the present value of the lease payments that are not
paid at that date. The lease payments shall be discounted using the interest rate implicit in the
lease, if that rate can be readily determined. If that rate cannot be readily determined, the lessee
shall use the lessee’s incremental borrowing rate.

Lease liability = Present value of the remaining lease payments at September 1, 20X41 Lease
liability = $11,215
1 Present value (9%,6,2500,0,0) Note: Since the first payment in the lease was made at lease
inception, the remaining liability is calculated using the remaining period of six years, with the
next payment due on September 1, 20X5.
The right-of-use asset will be recorded at the amount of the lease liability recognized plus any
lease payments made at the commencement date.
Right-of-use asset = $11,215 + installation of $1,500 + initial lease payment of $2,500 Right-of-
use asset = $15,215

Procedure: Obtain the loan agreement and compare the accounting treatment to the facts in the
agreement.