As a senior in a professional services firm, you have beenassigned to plan the financial statement audit of a private companynamed Toy Central Corporation (TCC). In addition, the partner onthe engagement has asked you to identify business risks that couldadversely affect TCC's sustained profitability, so that they can bebrought to the attention of the company's board of directors. Thesetasks will require you to draw on your knowledge of supply chainmanagement, marketing, internal controls, audit assertions, andfinancial accounting. Toy Central Corporation (TCC) designs,manufactures, and markets a variety of toys, which are soldprimarily to large national retailers like Wal-Mart, Toys R Us,Kmart, and Target. TCC is a small company compared to competitorsMattel and Hasbro; nevertheless, TCC's managers believe its toysare among the best in the world. Unlike the larger toy makers,which bring thousands of toys to market each year but experiencesuccess with only a fraction of them, TCC has enjoyed success witha small portfolio of brands and products, representing threecategories: (1) soft toys, consisting primarily of its CuddleMonsters® stuffed animals; (2) hard toys, including metal-cast andplastic-cast toys like Fast Racers® cars and Acto® action figures;and (3) digital toys, consisting of video game software underdevelopment. Like most toy makers, 60 percent of TCC's salesrevenues are generated in October and November, with the last twoweeks of November driving half of those sales.
Your firm, KDOK, has been TCC's professional services firm since2014, providing audit and tax services for the company. The primaryexternal user of TCC's audited financial statements is its bank.Assume it is now October 28, 2018. You have taken over audit seniorresponsibilities for the company's October 31, 2018 year-endfinancial statement audit, because the original audit senior hasleft the firm. As a private company, TCC is not directly affectedby the Sarbanes-Oxley Act (SOX). However, the partner in charge ofthe engagement has advised you that, ever since the financialscandals at the turn of the century, TCC has become interested instrengthening its corporate governance. Two years ago, followingthe release of the AICPA's Audit Committees Toolkit for public andprivate corporations, TCC has asked your firm to consider not onlyfinancial reporting issues, but also significant business risksthat could affect the sustainability of TCC's success in the toyindustry. Although TCC's board of directors believes it is aware ofstrategic issues facing the company, it has been consideringspinning off its digital toy division into a separate company and,subsequently, merging it with an upstart software company. Beforeembarking on a change in organizational structure, the board wantsa "second set of eyes" to ensure it has considered all significantbusiness risks that currently exist and could adversely affect TCCin the foreseeable future. TCC's audit committee is meeting in twoweeks and would like the partner to explain significant businessrisks identified during KDOK's interim audit tests and the year-endaudit planning. The partner would like you to prepare an auditplanning memorandum that addresses significant engagement issues,and specifically identifies matters relevant to the auditcommittee. To prepare the memo, you have consulted last year'saudit file (Exhibit 1), findings of interim auditprocedures (Exhibit 2), and a memo prepared by theengagement partner (Exhibit 3). (These Exhibits follow thetemplate for your Memo). You should begin by reading and analyzingthese exhibits!
REQUIREMENTS
(1) Business risks of TCC: Be sure toaddress risks affecting toy companies in general, includingexternal risk factors (e.g. supply and demand forproducts, target customers, supplier issues, and retailerissues) and internal riskfactors (e.g. inventory obsolescence, allowance for baddebts, earnings management pressures.) (2) Audit riskfactors: Using the Audit Risk Model as a guide, besure to address the inherent risk factors and internal control riskfactors on the TCC engagement, as well as the fraud risk factorsthat are present. Be sure to provide a preliminary assessment ofeach type of risk as High, Moderate or Low. Note that some of AuditRisk factors may have been addressed as Business Risk factorsabove, but here they should be addressed in the context of thespecific type of risk they represent for audit planningpurposes. (3) Accounting issues and AuditAssertions: Identify the accounting issues being facedby TCC and discuss how these issues relate to the audit work youare likely to perform and the specific management assertions towhich they relate. Be sure to identify the significant issuesseparately from the minor ones.
EXHIBIT 1 (Observations Noted in LastYear’s 2017 Audit File)
1) TCC’s management advised KDOK that retailersdramatically reduced the quantity of toys they were willing tocarry in 2017 and were expected to continue this trend in 2018.This reduction in available retail shelf and warehouse space hasintensified competition among all manufacturers of consumerproducts, particularly those in the toy industry. The change didnot reduce the volume of toys sold through retailers. It did,however require that manufacturers be able to fill a retailer’sorder within 1-2 days of advanced notice rather than the 2-3 weeksthat they enjoyed in previous years. 2) By andlarge, 2017 was a successful year for TCC. Sales picked up from2016-a result largely attributable to introducing the CuddleMonsters® stuffed animals during the year. As compared to 2016,production costs in 2017 fell slightly because differences inforeign currency exchange rates allowed TCC to purchase toy partsfrom foreign suppliers at lower U.S.-dollar-equivalent prices. Theonly negatives for TCC in 2017 were substantial write-offs taken toincrease reserves for receivables and inventories. Despite thesecharges, TCC exceeded its earnings target for fiscal 2017,reporting operating income of $1,008,700 and net income before taxof $857,600. 3) The Cuddle Monsters® stuffedanimals were introduced on October 15, 2017, in time for theChristmas holiday selling season. By blending electronics-basedfacial gestures with the warm comfort of a teddy bear, the productsinstantly struck a chord with kids, selling out within only threeweeks. Unfortunately, because TCC had not anticipated the wildpopularity of the toys, the company had not placed sufficientorders with the supplier of the electronics components, whosemanufacturing facilities are located in the Philippines and Taiwan.As soon as TCC realized the toy’s popularity, it place a largeorder for the electronics components. Unfortunately, the componentswere not delivered in time for TCC to make more Cuddle Monsters®for the 2017 holiday selling season.4) TCC’sOctober 31, 2017 allowance for doubtful accounts included a reserveto cover amounts owed by Kmart that TCC was concerned would not becollectible. According to TCC’s CFO, Kmart has struggled ever sinceit emerged from bankruptcy protection and merged with Sears in2005, but was expected to receive a significant future infusion ofcash from Sears Holdings Corporation. To be safe though, an extra$100,000 was added to the receivables reserve specifically forKmart. 5) Ever since 2015, TCC’s executives haveshared in a bonus pool that is created through TCC contributions of10 percent of the first $250,000 of operating income, plus 20percent on the next $250,000, and an additional 30 percent of thenext $500,000. TCC’s total contributions to the bonus pool arecapped at a yearly maximum of $225,000.
EXHIBIT 2 (Findings from Interim AuditProcedures Conducted in July and August 2018)
1) Based on a sample of 75 cash disbursements,KDOK concluded that controls over the purchase/payables/paymentssystem were operating effectively. Most disbursements were made forpurchases of raw materials from suppliers in Taiwan, and wereproperly converted to U.S. dollars and classified to appropriateaccounts. Only one item seemed unusual in comparison to the sample:it involved a $10,000 payment to the International WorkersTransport Union. The payment was requisitioned by TCC’sVP-Operations and was approved by the CFO. According to the VP,this payment was a “gesture of support for U.S. transport workers-agesture we believe is important these days, as transport workersbelieve they are significantly underpaid and talking aboutorganizing work stoppages and strikes in 2017 in the late fall orearly winter. Our hope is that this payment will make it possiblefor the union executives to discuss and resolve this matter withtheir members before things get out of hand.” KDOK’s audit staffmember noted that because the transaction was approved and wasappropriately classified as an “other non-operating expense,” acontrol deficiency did not exist.2) One of the control tests for thereceivables system involved determining whether bad debt write-offsand recoveries were properly authorized. KDOK’s staff memberconcluded, based on a sample of five transactions selected randomlyfrom transactions during the first three quarters of fiscal 2018,that TCC’s authorization controls over bad debts and recoverieswere effective. The staff member further noted that “even the CFOshould be commended for his diligence of oversight, having approvedthe recording of a recovery on July 31, 2018 for $100,000 owed byKmart that had been previously allowed for.” The staff member notedthat the CFO not only approved the recording of the recovery, butthat he also initiated the journal entry for the transaction.3) KDOK also performed interimsubstantive tests of inventory. The audit staff member noted thatTCC counted its inventory of Acto® action figures on July 31, 2018.The staff member concluded that she was “satisfied that everythingthat TCC had produced was included in the inventory records.”Further, the staff member mentioned in passing that this was herfirst enjoyable inventory count because “there was somethingpleasing about seeing all those cute little stuffed animal faceseverywhere throughout the warehouse.”
EXHIBIT 3 (Audit Partner Memo toFile)
1) Although TCC was unable toproduce enough Cuddle Monsters® to satisfy the enormous demand forthem during the 2017 holiday selling season, it was able to producesignificant quantities during the second week of January 2018.Although not ideal, this timing allowed TCC to sell a fair quantityof this product for Valentine’s Day 2018. Soon after, at theinsistence of the national retailers, all unsold Cuddle Monsters®were returned to TCC for a full refund. In addition to freeing-upshelf space in the short-term, the retailers claimed that thisaction would be beneficial in the long-run, as it would help TCC tobuild-up demand for Cuddle Monsters® over the summer-increasing thechances that a holiday season frenzy could again be created inNovember 2018. 2) TCC’s executives havebeen working hard to boost sales in September-a month thattraditionally has been the “quiet before the storm” of October,November, and December sales. After several months of negotiations,TCC has worked out a partnering agreement with Fathom Studios-amovie company that has been created to produce and distribute itsfirst animated movie called Delgo. The movie is scheduledfor release in theatres on October 31, 2018. The partneringagreement states that, in exchange for a $300,000 licensing fee,TCC obtains the right to produce plastic-cast Delgocharacter toys, which are expected to be sold through TCC’s regularretail customers. TCC is contemplating deferring and amortizingthis fee over the 7-year period of the agreement. This agreementfurther states that Fathom Studios will compensate TCC if sales ofthe Delgo toys fail to reach $500,000 during the first twomonths following the movie’s release. On the basis of thisguarantee, TCC has accrued $500,000 of sales revenues in September2018, when the contract was signed. The delay in reaching a finallicensing agreement somewhat delayed final completion of thecharacter toys, which are now expected to be ready for retailers onOctober 30, 2018. 3) TCC’s executivesclaim they carefully reviewed their inventory pricing duringOctober 2018 and determined that the inventory valuation reserveestablished in 2017 is no longer required. A journal entry was madeon October 15, 2018, to reverse the entry that originallyestablished the reserve. 4) The companywith which TCC’s digital toys division might be merged is namedOpen Game Inc. This company started its operations in 2017 byhiring a staff of programmers who were enticed to leave othersoftware companies and join Open Game for its competitive salariesand attractive stock option program. Open Game’s staff is workingsolely on developing an innovative video game console. Theoperating system they are using will be an alternative to the moredominant operating systems such as Microsoft’s Windows and Apple.This system has a small but devoted following, which Open Gamehopes to tap. Open Game believes that their console will attracthigh-end users of their operating system who dabble in video games.When Open Games’ work on its first-generation console is completein Spring 20019, the console is expected to run videogames that TCChas begun developing. Open Game’s console is expected to be pricedat 15 percent above other game consoles. Currently TCC hasguaranteed one of Open Games operating loans, and has been asked byOpen Game’s bank for a copy of TCC’s audited financial statements.The precise terms of the merger agreement are still beingworked-out, but current plans are for TCC to contribute financingand video game rights to the merged entity and for Open Game tocontribute manufacturing equipment and game console rights.5) To date, TCC’s digital division hashired a small staff of employees, invested nearly $150,000 increating state-of–the–art software tools that are hoped to beuseful in developing the video games, and made inquiries of thecompanies that hold the intellectual property rights to producepopular games, which currently are produced only for consoles andcomputers that run on Windows or Apple based software.6) On October 1, 2018, TCC’scompensation committee agreed to double the company’s contributionsto the bonus pool, resulting in a yearly maximum contribution of$450,000, which will be effective for the 2018 year-end.7) For the year ended October 31, 2018,TCC forecasts operating income of $979,980 and net income beforetax of $275,000.
Answer questions 1 (business risks of TCC) and 2 (Auditrisk factors to be considered by KDOK) with a small overviewparagraph for each followed by bullet point descriptions for eachrisk.
