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MGT 321 – MIDTERM TEST – FALL 2006 ( MGT 321 – AUDTING AND ASSURANCE – WINTER 2020 - MIDTERM – MAKE UP – TO BE WRITTEN AS AN ASSIGNMENT. Please note that this make up assignment must be written solely by the student and may not be discussed with any other parties. When submitting this as an assignment, please place the following statement on the front cover: “ I acknowledge that I have completed this assignment (make up) solely on my own and that I have not discussed it with any other individual or used any unauthorized aids. I further acknowledge that if I had any assistance that this would constitute an academic offense and that it would be subject to academic sanctions .” ) SIMULATION FACT PATTERN In early 2018, Debit & Credit, Chartered Professional Accountants (“D&C”) were appointed as the auditors of Cannabis Leading Growers Corp. (“CLGC”). John Flake, a partner at D&C accepted the audit engagement based on a handshake with Sally Lee, the head of the audit committee of CLGC. Sally and John had been discussing some of the issues that Sally said existed as between CLGC and their current auditors, KPMG LLP. Sally explained that KPMG was constantly raising measurement issues related to accounting estimates, which was a “drain” on profitability. GLGC wants to show a positive performance (income) as they seek to obtain either further debt or equity. When John told Sally, “as your auditors, we work for you. You will find us easy to work with. We understand that estimates are just that and we will never argue with management as they know best.” – That statement made Sally decide that D&C was a good fit. Because of successfully obtaining GLGC as an audit client, John was elected as the partner-in-charge of the firm, D&C. The year end of GLGC is December 31. GLGC is a medium size cannabis grower with primary operations located outside the city of Guelph. Hank Lee founded GLGC in 2010. GLGC is now a micro-cap public company that trades on the TSX. The 2018 financial statement audit went fine. D&C relied on KPMG for opening balances based solely on their reputation as a Big 4 firm as John did not want to “rock the boat” with them. John stayed true to his word to Sally that D&C would be easy to work with. No changes were made to the statements and an unmodified audit opinion was issued. Cannabis retailers or manufacturers cannot advertise their product. To increase GLGC’s public profile, D&C launched a series of advertisements promoting the accounting firm. These advertisements featured D&C’s clients in them, but primarily GLGC. The advertisements are humorous and had pictures of GLGC’s products with endorsements from D&C’s staff. The most recent advertisements featured pictures of cannabis plants and the line, “At D&C we are not dopers or drug dealers. We know quality and have quality clients like GLGC”. GLGC appeared to be a great client. Several children of D&C professional and administrative staff worked part time at GLGC while going to school. In an effort to help GLGC grow and to strengthen relationships with existing high new worth clients, John began promoting GLGC as an investment to his wealthy clients. John promoted GLGC as the next “Apple computers”. John created his own forecasts that projected high earnings, which he showed his wealthy clients along with the audited financial statements. Because of his efforts, D&C clients invested $5,000,000 of new financing (debt and equity). For the 2019 audit, certain matters were noted. Under IFRS, cannabis (marijuana) GLGC reports the unrealized, non-cash change in the fair value of their cannabis plants as they grow, relative to their theoretical selling price. This requires GLGC management to make several estimates, including growing, harvesting and selling costs; projected plant yields; and the price the cannabis will sell for. Given the number of plants that were planted in 2019 by GLGC, the company was showing large profits, even though they made no actual sales. The company had a very large negative cash flow from operations. Negative cash flows were even larger as GLGC purchased two corporate competitors at a very large share price premium. Significant goodwill balances were set up to reflect the purchase price. When members of the audit team wanted to count and see the growing cannabis (marijuana) plants, they were told that with the possible spread of disease that only employees in hazmat suits were allowed into the greenhouses. A member of the audit team did note that they thought they saw mold on some of the plants when they looked through the glass. When auditing the 2019 “development costs”, the D&C audit team staff member discovered certain amounts included in the opening balance of development costs that in fact should have been initially expensed when incurred. The ( 1 ) amounts were quite significant. GLGC management were not prepared to make any changes on this and John, the audit partner, did not want to “push” for a change, as he would be “embarrassed if users found out.” As part of performing the audit work, John met with the Board of Directors of GLGC. The GLGC board meets on the 20th day of each month. He explained that his audit team had concern about inventory impairment, difficulties measuring revenues and whether the goodwill had future benefit given a general industry decline in cannabis demand. The Board agreed that these were “interesting issues” that should be monitored in 2020, but for now, no financial reporting changes would be made to the 2019 statements. They reminded John that several accounting firms were interested in acquiring cannabis clients and that he should treat their engagement with utmost respect keeping in mind GLGC pays his firm a significant fee for the audit and various consulting services each year. Several members of the D&C audit team, most whom are chartered professional accountants and who were assigned to the GLGC audit, felt strongly that the statements needed to be changed and that in critical areas, not enough audit work was completed. John as partner, felt very overwhelmed by the decisions that he had to make on his own. In the end, he told the audit team, “I am the partner and I call the shots. Everything is fine. I believe the GLGC management when they tell me that the business will succeed. There is nothing further we can do as auditors.” John signed an unmodified audit report on February 12, 2020 and the board of GLGC, at their regular monthly meeting, approved the statements. In late March 2020, GLGC sought court protection from bankruptcy under the Companies' Creditor Arrangement Act ("CCAA"). The corporation is seeking to restructure in an effort to stay in business. It is uncertain if this will happen. One thing that is certain is that GLGC creditors and investors will be taking a loss on their investments. If GLGC does go bankrupt, they will likely lose their entire investment. Several creditors and shareholders have met with their lawyers and are contemplating a class action lawsuit against D&C, the auditors of GLGC. Professional Insurance Corporation (“PIC”), the insurance company that provides liability insurance coverage to D&C, has retained you, Bea Calm. PIC want to have a better understanding of what has taken place so they can assess their exposure and possible next steps. They have asked for a memorandum that covers the following matters commencing from when D&C commenced their relationship with GLCC. More specifically, they would like the memorandum to cover: · Instances where D&C may not have complied with CAS – specifically noting what they have done and what they should have done; · Instances where D&C as a firm, or CPA Ontario members may not have complied with the Code of Professional Conduct – specifically noting what they have done and what they should have done; · An analysis of how the audit report was prepared and what possible changes should have occurred to the audit report to be in compliance with CAS; · An analysis of whether D&C as a firm complied with CSQC-1, citing examples of possible breaches and what could be done to improve; · A preliminary assessment as to whether D&C could be liable under tort law; · Any other relevant matters. REQUIRED (make sure you allocate your time to complete all parts): Assume the role of Bea Calm and prepare the memorandum that was requested.