Memorandum

To: Sophia White, Partner of C&W From: Jan Smithers, CGA Date: March 15, 20X2 Re: Analysis of Samila Soaps Limited, (SSL) Based on the documented meeting with Sabeena Joshi of SSL and the financial statements provided, this memo is to address the issues concerning the acceptance and planning of the proposed audit client, and corresponding recommendations are also provided. Acceptance of the audit

Analysis of significant variances in financial statements In reviewing the comparative financial statements, it was found that the numbers on the financial statements for the last month of 20X2 were projected; there are some key variances identified, the analysis and recommendations are listed below respectively. 1. Due to the 11.37% increase in cost of goods sold, the gross profit margin has fallen in 20x2, which could be the result of the new bonus plan. Since it was easy to increase sales volume by selling more discounted items, and then the discount given to customers were buried in COGS, it led to the increased COGS. Therefore the policy for recording discount should be reviewed, in order to reflect the actual profitability of SSL.

2. The salary expense was increased by 2%. This is another impact of the current bonus plan. In order to get better customer service rating and more bonus, store managers had to put more staff on the sales floor, which in turn increased the salary expense.

3. The occupancy costs, other selling expense, and merchandise losses all show an upward trend. A more detailed and in-depth investigation should be conducted to identify the reasons for the three expenses and decide the corresponding actions.

4. The A/R balance in 20x2 has increased around 700% compared to last year. Most likely it could be the consequence of the preferred customer sales program. Due to the uncertainty of the returned items and time difference between delivery and payments, the sales could be overstated, and more A/R accounts could be uncollectible. Therefore it is recommended that revenue recognition policy for this program may need to be reviewed, and the actual value of A/R balance may need to be adjusted.

5. The inventory balance has increased around 16% compared to 20x1. A full count and revaluation of inventory is recommended, meanwhile, the merchandise losses should be taken into account which may have not been reflected on the inventory account.

6. The balance of property, plant, and equipment in 20x2 was increased $1,460,000 compared with 20x1; however, the amortization expense in 20x2 was less than 20x1. So the amortization expense needs to be reviewed accordingly.

7. The total liabilities account needs to be separated as short-term and long-term liability, which is the requirement of financial statement presented from ASPE. In addition, the total liability was increased by $1,908,000 in 20x2 compared with 20x2, the reason and impact on debt covenant and liquidity should be examined. Preferred customer sales SSL is shipping goods to customers based on their purchasing profile, recognizing the sale at shipping point. This overstates sales, revenue and accounts receivable. Revenue should be recognized when:

Significant risks and rewards of ownership have been transferred customer has accepted the goods Collection of payment is reasonably assured Amount of revenue can be reasonably measured SSL no longer exercises the control of merchandise sold

Additional substantive tests around sales and revenue should be performed. Accounts receivable confirmation letters should be sent to preferred customers. Sales records should be vouched to

signed sales invoices, confirming unauthorized credit card purchases. Financial statements should be restated to reflect the correct sales driven balances. SSL should have a provision for returns account. Goods should only be shipped after approval from customers. Customer credit cards should be safeguarded by SSL such that only authorized personnel has access to them. The fact that customers are complaining about unauthorized charges raises concern over internal controls. According to PIPEDA, customers must consent to the collection and use of their purchasing preferences. Sales based on customer profiles, without their approval, is an invasion of privacy. Using customer credit cards for unapproved sales is unethical. SSL may lose business if customers are disgruntled over this. Factoring Sabeena is considering factoring preferred customers receivables as a source of funding for SSL. The company cannot satisfy the debt covenants for a bank loan. Factoring charges are around 1%-15% depending on company and accounts receivable risk profiles. Sabeena does not want responsibility for these receivables so is willing to pay a higher fee for non-recourse factoring. The issue is how to account for it. When receivables are sold to a factor, cash and factoring expense should be debited with a credit to accounts receivables. Non-recourse factoring confirms concerns raised above regarding the legitimacy of preferred customers accounts receivables. If Sabeena was reasonably assured of the collection of these receivables, she would opt for regular factoring with a low fee. The high fee for factoring will be significant to the company since preferred customers receivables are more than $2,000,000. This will reduce the profitability of the company and raise going concern issues. Factoring expense is tax deductable as soon as the receivables are sold. Bonus structure Sabeenas bonus plan is based on net profit. This gives her an incentive to overstate sales and understate expenses to maximize her bonus. There is motivation for recognition of revenue before goods are transferred to the customers to increase bonus in the current year. Transactions made before the fiscal year end must be verified for validity. The plan does not motivate managers to look at the long term profitability of the company. Managers bonus plan is based on the customer-service levels assessed by secret shoppers. This performance evaluation is not effective as evidenced by increased salary expenses. Store managers are hiring more sales floor employees to ensure great ratings. SSL needs to reconsider the current bonus plans for the management and managers to reflect not only the financial perspective but also non-financial perspectives such as customer retention, acquisition of new customers, net income, and customer service. Managers will control store costs because they affect net income. The balanced scored card will reflect SSLs needs and enable the company to meet its long term goals.

Sales associates are rewarded based on predetermined sales level targets. This will motivate employees to work harder if they think they can achieve the target. The moment they realize that they cannot achieve it, the employee may slack off since they will not be entitled to a bonus. Rewards should be based on the measurements that employees can control. Customer service ratings will be a good bonus measure for sales associates since they can control that and are not authorized to hire more personnel. SSLs bonus structure needs to be carefully evaluated. The company wants to pay all employees bonuses that it cannot afford. This seems like a push for sales, as evidenced above in preferred customer sales. Sales increased by 5% from 20X1 to 20X2 but cost of goods sold increased by 11.37% and net profit decreased by 45%. This is a major inconsistency since sales, COGS, and net profit should be directly proportional. This could be a result of employees consistently discounting items to meet the targeted sales volume without consideration of inventory costs. There should be documented procedures regarding giving discounts and only managers should be authorized to do this. Net profit is affected by the two stores which are not doing well as well as additional hiring of sales associates. Tax issues Timing of Bonus Payment The accrued bonuses to be awarded will affect taxes depending on when they are paid. Accrued bonuses paid within 180 days of the fiscal year end can be deducted in the current tax year by SSL, and will be included in income by the employees in the year received. This can generally have tax benefits for both parties, and should be done if cash flows and covenants allow. Golf membership According to CRA, golf memberships are never tax deductible to SSL. Since it is paid as a bonus, the membership fee will be taxable to the employee in the year it is received. Ethical issues The new preferred customer program revenue recognition, where the store would ship a variety of products to their preferred customer based on their profile, could signal some ethical concerns. First of all, the store managers and employees could be motivated to record higher sales as their bonuses are based on sales. So, it is possible that more items are send to preferred customers then they would buy in order to record higher sales, even though returns would be higher later (possibly in the other period after bonuses are paid). Second of all, the new preferred customer program wasnt explained very well to its customers, and the store is sending items to customers and record sales for them, when customers might actually think those are free samples. Finally, it was known that some of the stores keep their preferred customers credit cards on file in order to charge for items sent. This practice could be dangerous practice as no formal policies and

procedures exist at SSL on how to deal with personal customer information. This could lead to different types of frauds and lawsuits, if customers credit card leaks outside. I would be pleased to answer any questions you may have regarding my analysis or recommendations.