Reference no: EM131786338

In your audit of Canyon Outdoor Provision Company's financial statements, the following transactions came to your attention.

1. Canyon Outdoor's operating lease for its main store is with York Properties, which is a real estate investment firm owned by Travis Smedes. Mr. Smedes is a member of Canyon Outdoor's board of directors.

2. One of Canyon Outdoor's main suppliers for kayaks is Hessel Boating Company.
Canyon Outdoor has purchased kayaks and canoes from Hessel for the last 25 years, under a long-term contract arrangement.

3. Short-term financing lines of credit are provided by Cameron Bank and Trust.
Suzanne Strayhorn is the lending officer assigned to the Canyon Outdoor account.
Suzanne is the wife of the largest investor of Canyon Outdoor.

4. Hillsborough Travel partners with Canyon Outdoor to provide hiking and rafting adventure vacations.  The owner of Hillsborough Travel lives in the same neighborhood as the CEO of Canyon Outdoor.  They are acquaintances, but not close friends.

5. The board of directors consists of several individuals who own stock in Canyon Outdoor.  As a recent board meeting, the board approved its annual dividend payable to shareholders effective June 1.

Required

a. Define what constitutes a "related party."

A related party transaction occurs when one party to a transaction has the ability to impose3 contract terms that would not have occurred if the parties had been unrelated.  Accounting standards conclude that related that related parties consist of all affiliates of an enterprise, including its management and their immediate families, its principal owners and their immediate families, investments accounted for by the equity method, beneficial employee trusts that are managed by the management of the enterprise, and any party that may, or does, deal with the enterprise and has ownership, control, or significant influence over the management or operating policies or another party to the extent that an arm's-length transaction may not be achieved.

b. Which of the preceding transactions would most likely be considered to be a related party transaction?

1. Related party transaction.  Canyon Outdoor has entered into an operating lease with a company owned by one of the directors on Canyon's board.  Because the board has control and significant influence over management of Canyon, the lease transaction may not be at arm's length.

2. Not a related party transaction.  The fact that Canyon Outdoor has purchased inventory items for many years from Hessel Boating Company is a normal business transaction between two independent parties.  Neither party has an ownership interest in the other party, and neither has an ability to exercise control or significance influence over the other.

3. Related party transaction.  The financing provided by Cameron Bank and Trust through the assistance of Suzanne may not be at arm's length given Suzanne's husband has control and significant influence over Canyon Outdoors and may have be able to influence the transaction through his wife's employment at the bank or through his influence over Canyon's management.

4. Not a related party transaction.  Just because the two owners are neighbors does not mean that either has significant influence or control over the other.  Mere acquaintance does not suggest the transactions would not be at arm's length.

5. Not a related party transaction.  The declaration and approval of dividends payable to shareholders is a normal board function.

c. What financial statement implications, if any, would each of the above transactions have for Canyon Outdoor?

When related party transactions or balances are material, the following disclosures are required:  the nature of the relationship or relationships, a description of the transaction for the period reported on, including amounts if any, and such other information deemed necessary to obtain an understanding of the effect on the financial statements, the dollar volume of transactions and the effects of any change in the method of establishing terms from those used in the preceding period, and amounts due from or to related parties, and if not otherwise apparent, the terms and manner of settlement.

d. What procedures might auditors consider to help them identify potential related party transactions for clients like Canyon Outdoor?

Obtain background information about the client, perform analytical procedures of nature, review and understand the client's legal obligations, review the information available in the audit files, discuss the possibility of fraudulent financial reporting with personnel assigned to the client their knowledge of management involvement in material transactions, discuss the possibility of fraudulent financial reporting, investigate whether material transactions occur close to year-end, and whenever there are material non-arm's-length transactions, each one should be evaluated to determine its nature and the possibility of its being recorded at the improper amount, inspect entries in public records concerning proper recording of real property transactions and personal property liens, and inspect the records of the related party to a material transaction.

You are auditing payroll for the Morehead Technologies company for the year ended October 31, 2013.  Included next are amounts from the client's trial balance, along with comparative audited information for the prior year.

	Audited Balance 10/31/2012	Preliminary Balance 10/30/2013
Sales	mce_markernbsp;         51,316,234	mce_markernbsp;                    57,474,182
Executive salaries	546,940	615,970
Factory hourly payroll	10,038,877	11,476,319
Factory supervisors' salaries	785,825	810,588
Office salaries	1,990,296	2,055,302
Sales commission	2,018,149	2,367,962

You have obtained the following information to help you perform preliminary analytical procedures for the payroll account balances.

1. There has been a significant increase in the demand for Morehead's products.  The increase in sales was due to both an increase in the average selling price of 4 percent and an increase in units sold that resulted from the increased demand and an increased marketing effort.

2. Even though sales volume increased there was no addition of executives, factory supervisors, or office personnel.

3. All employees including executives, but excluding commission salespeople, received a 3 percent salary increase starting November 1, 2012.  Commission salespeople receive their increased compensation through the increase in sales.

4. The increased number of factory hourly employees was accomplished by recalling employees that had been laid off.  They receive the same wage rate as existing employees, Morehead does not permit overtime.

5. Commission salespeople receive a 5 percent commission on all sales on which a commission is given.  Approximately 75 percent of sales earn sales commission.  The other 25 percent are "call-ins" for which no commission is given.  Commissions are paid in the month following the month they are earned.

a. Use the final balances for the prior year included above and the information in items 1 through 5 to develop an expected value for each account, except sales.

b. Calculate the difference between your expectation and the clients' recorded amount as a percentage using the formula (expected value - recorded amount)/expected value.