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Canadian Hydraulics Inc. (CHI) is a distributor of hydraulic fluid...

Canadian Hydraulics Inc. (CHI) is a distributor of hydraulic fluid used in heavy-duty commercial applications. The company was incorporated 20 years ago, beginning with one retail facility in Edmonton. CHI has expanded rapidly to include locations in Winnipeg, Regina, and Tulsa, Oklahoma, over the past four years. The Tulsa location filled the necessity of establishing a presence in the United States. A growing portion of the CHI's purchases are from U.S. wholesale suppliers and sales to U.S. customers are also increasing; all of these transactions are in U.S. dollars.


Many of CHI's customers are well-established companies in the transportation and automotive industries. As is typical for the industry, business tends to be steady during the year, with reduced activity in December and January due to weather considerations.


Given ongoing improvements in additives for the hydraulic fluid, it typically has a five-year product shelf life in this industry. The hydraulic fluid is stored in large tanks as well as smaller containers for transportation.


CHI is owned equally by Fred Draper and Martin Wong, both of whom are actively involved in the business. Fred is responsible for overseeing the sales, administrative, and finance areas. Martin is responsible for inventory management and marketing. Martin is currently planning to sell his shares to Alex Lee, an unrelated party. Fred has also expressed interest in selling some of his shares, should the "price be right."


It has been a challenging year for CHI. Autoworld Inc., a very successful multinational corporation, entered the marketplace recently and through its excellent array of products and large distribution network, has rapidly garnered a large share of the North American market for hydraulic fluids. It saw a well-established market with many financially healthy businesses that would make great customers.


The shareholders and the management team are all very proud of CHI's ability to succeed in the face of such stiff competition. In response to the challenge, CHI saw the need to change its policies and reduce costs. Commissions paid to sales staff were increased by approximately 3.5% of sales. Sales staff was given greater flexibility in negotiating contracts. The credit manager function was eliminated and credit granting responsibilities were reassigned to the sales manager.


Department managers now receive a bonus based on net income and are encouraged to "think outside the box" in order to maximize success. Recently, in order to increase sales, CHI reached an agreement with one of its suppliers, Quality State Inc., whereby CHI would also begin selling certain transmission fluids and brake fluids. As CHI does not have experience with these products and does not know the optimal product mix, Quality State agreed to provide $90,000 worth of transmission fluid and brake fluid product on consignment. CHI plans to begin selling this consignment product in 2020. Consignment inventory is new to the company; this inventory is stored separately from CHI's products.

CHI's loans with its bank are nearing renewal. Under its existing loan agreement with the bank, CHI must maintain a debt-to-equity ratio no greater than 1.3:1 and a minimum current ratio of 1.5:1. The bank requires audited annual financial statements, as the accounts receivable and inventory are used as collateral for the bank loan. The bank is especially concerned with the inventory balance at December 31 in light of the consignment inventory now being held at CHI. Audited financial statements must be provided to the bank by March 15.


CHI hired a new controller in September 2019. The previous controller, Adam Clarke, had been with CHI since day one. There was also turnover of clerical staff in the accounting department. The accounts receivable and accounts payable clerks left in December 2019. The turnover in staff was due to the stress of being understaffed and unable to keep up with the daily work load. As a result, staff were falling behind with many important duties, such as following up on accounts receivable.


The previous internal auditor resigned in September 2019 in order to enter the CPA program. His role has been taken over by the assistant controller, who now spends approximately 25% of his time on internal audit duties.


Severance costs incurred in the years amounted to $70,000. The shareholders have opted to receive dividends this year, in lieu of their normal annual salaries of $50,000 each.


It is now February 15, 2020. CHI's former auditors have recently resigned, and Fred Draper and Martin Wong have approached your firm to take over the audit engagement. 

Part A

Based on the narrative and the financial statements, Provide

at least eight factors that impact the risk of material misstatement at the overall financial statement level in the CHI engagement. Be sure to explain WHY each factor increases or decreases risk.


Document your response in the table below. The first row is completed as an example:


Risk Factor Explanation

1

2

3

4

5

6

7

8

Example: Previous auditor resigned Increases risk — Indicates there may be unresolvable issues with the financial statements or management

Part B

Based on the narrative and financial statements, Provide the most effective approach for the CHI audit. Consider both the inherent and control risks at CHI.

Part C

Based on the narrative and the financial statements, Provide a preliminary estimate for overall materiality and the related performance materiality. Consider specific materiality and specific performance materiality, and discuss the significant issues considered in your assessment. 

Answer & Explanation
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