CS4 – Gibson Envers Ltd.

1. CS4 – Gibson Envers Ltd. Presented by: Hei Cheng, Kieng Iv, May Leung, Tiffany Liu, Vikram Somasundaram

2. Agenda • Planning Phase • Circles Approach Outline • Key Issues (Assurance and PMR) • Other Issues (Pervasive, Finance and Tax) • Our Comments • BOE’s Comments • Evaluation Guide

3. Planning Phase

4. Blue Card Question #1 • What is our responsibility in this engagement (required)?

5. Planning Phase

6. Circles Approach Outline

7. What is considered “significant” in assessing CB’s liability?

8. MIC’s Claim Against CB The Claim: "the price it paid for GEL was excessive because it was misled as to GEL's true financial status“ Specifically: • CB's conduct was not in keeping with professional standards • The contents of the information package were improperly prepared The emphasis of our search should be more on: • Overstatement of assets • Overstatement of earnings • Overstatement of cash inflows

9. Focus of Investigation CB’s exposure to liability will depend on whether the following are true: a) MIC relied on the information package, b) the information contained in the information package was misleading and/or incorrect, and c) the misleading and/or incorrect information resulted in a loss to MIC. • Our investigation should focus on Point B

10. Professional Conduct Responsibility – Association • Professional Conduct not to be associated with false or misleading information • Includes the cash flow forecast although only a notice to reader given • Rule 205: False or misleading documents and oral representation (ICAO) • A member, student or firm shall not • (a) sign or associate with any letter, report, statement, representation or financial statement which the member, student or firm knows, or should know, is false or misleading, whether or not the signing or association is subject to a disclaimer of responsibility, nor • (b) make or associate with any oral report, statement or representation which the member, student or firm knows, or should know, is false or misleading

11. CB’s Responsibility Time Period • Based on the facts known as at Audit Date (August 16, 2004) CB should have read the package to ensure that: • the financial statements and CB's audit report were accurately reproduced in the package; • the cash flow forecast and CB's Notice to Reader report were accurately reproduced in the package; and • any other information presented in the report contained no misrepresentations or inconsistencies with the financial statements that CB should have known about as a result of its work.

12. What is considered “significant” in assessing CB’s liability? (Materiality)

13. Blue Card Question #2 • Did you conclude that materiality was appropriate? If not, what do you think is appropriate?

14. FS Audit – Materiality CB’s assessment of materiality for 2004 • $350,000 (1 % of GEL's net, assets of $34.9 million, and consistent with PY) • Inappropriate because: • New user in 2004 that is more sensitive (the purchaser of GEL), the materiality should be reduced • An income statement basis may have been more relevant.

15. FS Audit – Materiality Cont’d Our assessment of materiality • $228,000, calculated as 10% of $2.28 million (net income before tax in 2004) • This conservative approach is due to the use of GEL's 2004 financial statements in a sale/offering proposal (the information package) • In our opinion, the level of materiality used by CB of $350,000 was too high for the 2004 audit of GEL • Note: Alternative approach that is justified is acceptable

16. Were the audited financial statements materially misstated?

17. Blue Card Question #3 • Identify two major accounting issues and provide a brief overview of the facts

18. Choose your own Accounting Adventure Capitalized Cost Construction Revenue Recognition Standard Panel Revenue Recognition Joint Venture Inventory Valuation Land Impairment Non-monetary Transaction Revenue Producing Properties Made-To-Order Panel Revenue Recognition Game Over

20. Thank you Professor Kennedy

21. Was CB’s income tax advice to GEL deficient?

22. Tax Advice – Adjustments • Inclusion of investment tax credit received last year in taxable income for the current year • Income vs. Capital for the sale of land • Inclusion of the non-taxable portion • Land sale swap values  at FMV • The immediate deduction of R&D expense as oppose to capitalization • Treatment of holdbacks, capitalized interest and completed contract

23. Tax Advice – Conclusion • Quality of tax advice is poor • If GEL is reassessed by Revenue Canada for 2004 and/or previous taxation years: • tax liability may arise • GEL's new owners may turn to CB for compensation • CB's exposure to this liability may be lessened if GEL's previous owners agreed to pay any reassessed taxes under the purchase/sale agreement

24. Was the cash flow forecast misleading?

25. Forecasted Cash Flow Statement CB had the following responsibilities: • Evaluate whether assumptions were consistent with the purpose of the forecast • Ensure the forecast reflected the assumptions • CB would have exercised its professional judgment and considered whether the forecast was false or misleading • Prohibited by the rules of professional conduct for Chartered Accountants from associating itself with false or misleading information

26. Forecast – CB’s Responsibility • CB was under a professional obligation to ensure that the forecast was based on reasonable assumptions. • Original solution: • Held to the standard of FOFI • Update to suggested solution: • AcSB concluded that FOFI is no longer relevant to private enterprises • CB should still perform with due care and understood that they should not be associated with false or misleading information

27. Forecast - Omissions • There are several omissions from the forecast, which when included, result in negative cash flows (See Appendix IV of Suggested Approach) • Mortgage pay down/repayment • Capitalized cash expenditure (equipment, inducements) • Non-quantifiable but should be discussed: • Participation payments • Demand loan pay down/increase in interest rates • Cost to complete construction in progress • Joint Ventures

28. Forecast – Illogical Assumptions Some assumptions in the forecasted cash flow are illogical: • The forecast assumes that the panel division sales would increase • Sales orders at lower levels than in previous years • The panel division was at 100% capacity • Expansion was planned (financing problems) • Therefore, sales volumes could not have risen • The assumption that divisional revenues would increase • Inconsistent with the stated assumption that the economic situation was expected to remain stable

29. Forecast – Conclusion • Consider presentation of cash flow to include investing and financing activities sections • We conclude that the forecast was incorrect and materially misleading • CB should have recognized that the expected cash flows were likely to be materially less than what was reported in the forecast • MIC's owners may have relied on the forecasted cash flow contained in the information package • If the items omitted had been included, MIC might have been alerted to GEL's cash flow problems

30. Did CB’s work comply with GAAS? (including Going Concern assessment)

31. FS Audit - Risk Assessment and Audit Approach Risk: • CB assessed GEL’s risk to be high • Appears to be appropriate due to financial statements being used for investment decisions • However procedures were not in line with risk assessment as seen through the various audit procedures deficiencies Approach: • CB concluded on approach to rely primarily on GEL’s internal control • Appears to be inappropriate due to the following: • errors CB found in its interim tests of GEL's internal control systems Therefore, on the engagement, more substantive testing should have been used (Combined or Substantive Only Approach)

32. FS Audit - Analysis of specific auditing procedures Real Estate Division • Failure to aggregate all errors in Summary of Unadjusted Differences/ Misstatements (SUDs/ SUMs) • CB failed to include the $250,000 - $500,000 overstatement of net income otherwise they would not have concluded that aggregate errors were below their stated materiality of $350,000

33. Real Estate Division - continued • Net income overstated and should have been adjusted for

34. Other Audit Procedure Deficiencies

35. Assurance: Going Concern

36. Blue Card Question #4 • Was there a going concern problem? • Support your answer

37. Going Concern - Responsibility • The CICA Handbook requires an auditor to assess whether a company is a going concern • ASPE 1400 and CAS 570 • Considering facts such as the history of reported losses, cash flows, etc. • If the conclusion was that GEL may not be a going concern: • a note to the 2004 financial statements provided by GEL management, explaining the going concern issue; or • in the absence of such a note, the issuance by CB of a qualified audit opinion on GEL's 2004 financial statements.

38. Going Concern - Issues Profitability • GEL's 2004 net income under GAAP was negative (after our adjustments), indicating profitability problems • The aggressive accounting policies selected by GEL may have "hidden" GEL's profitability problems. Liquidity • 2004 and expected future cash flows were negative (after adjustments) due to debt servicing • Ratio analysis and cash balance • Shortfall in financing

39. Going Concern - Conclusion • CB should have assessed the profitability and liquidity of GEL and considered whether a going concern problem existed at GEL's 2004 year end • Note disclosure or qualified audit opinion • Balance sheet should have been restated to liquidation values • If it is determined that CB should have known, and should have revealed that GEL was not a going concern at year end, failure to do so will constitute CB's most significant breach of professional responsibility

40. FS Audit - Issuance of an unqualified opinion • Should have qualified its audit report on GEL's 2004 financial statements for the following reasons: • Material ASPE deviations evident in GEL's 2004 financial statements • CB's acceptance of these material misstatements is a major deficiency

41. Financial Statements Audit • Ensuring that 2004 financial statements are fairly stated, free of any material misstatement • Free of any material misstatement on the basis of ASPE • Generally, CB was required under, CAS to: • team collectively have appropriate competence and capabilities to perform the audit engagement in accordance with professional standards and applicable legal and regulatory requirements (CAS 220) • The auditor shall design and perform audit procedures that are appropriate in the circumstances for the purpose of obtaining sufficient appropriate audit evidence (CAS 500- audit evidence) • The auditor shall obtain an understanding of the control environment including internal controls (CAS 315) • Adequate planning (CAS 300)

42. Conclusion of GAAS deficiency Analysis of audited financial statements (compliance with CAS) CB was responsible for conducting the audit of GEL in accordance with CAS to ensure that GEL's financial statements were free of material misstatement. We have found serious deficiencies in CB's planning and execution of its audit of GEL, including: • assessment of the level of materiality • audit approach • audit procedures - did not assess going concern /not in line with risk assessment • issuance of an unqualified audit opinion - material misstatements in F/S

43. Is CB Liable?

44. Blue Card Question #5 • What was your overall conclusion on the case? • Did you believe that CB did not meet its professional standards? • Did you believe the information package were improperly prepared?

45. Conclusion Required 1: CB's conduct was not in keeping with professional standards Breach of professional conduct and GAAS as financial statements were materially misstated, yet an unqualified opinion was issued. CB has associated itself with false/misleading information. Misstatements due to inadequate procedures: • Failure to assess entity as a going concern (most significant breach) • Failed to aggregate known/likely errors to assess material misstatement • Failure to design procedures consistent with risk assessment

46. Conclusion • Required 2: the contents of the information package were improperly prepared • Based on previous adjustments, amounts were materially misstated • Assumptions under cash flow statements were unreasonable • Assessed that the entity will not be a going concern, BS should be liquidation method

47. BOE’s Comments

48. Board of Examiner’s Comments • Many candidates identified the role of an expert at the beginning of the report but failed to perform the function of the role • Majority of candidates did not define GAAS and GAAP for the lawyer • Candidates did not define the concept of materiality for CB's lawyer nor did they adequately conclude on the appropriateness of the level of materiality established by CB • Candidates provided one-sided arguments (in defense of CB)

49. Board of Examiner’s Comments • Candidates did not rank issues when the candidates were directed by the case to “highlight the areas of greatest significance to CB's lawyers” • Candidates did not address general accounting concepts such as revenue recognition and capitalization concepts adequately, nor did candidates tie the accounting concepts into the case facts • Many candidates did not aggregate misstatements in order to determine the overall impact of the GAAP departures on GEL's 2004 financial statements

50. Board of Examiner’s Comments • Candidates identified few of the many GAAS (CAS) deficiencies of audit procedures performed by CB. Many candidates did not focus on the critical deficiencies (e.g., cost to complete contracts and audit of billing for extra work). • Most candidates did not conclude on the magnitude of the misstatement of GEL's net income or net equity • Most candidates did not adequately conclude as to the pervasiveness of the GAAS (CAS) deficiencies with respect to CB's audit of GEL