Question

As a senior in a professional services firm, you have been assigned to plan the financial statement audit of a private company named Toy Central Corporation (TCC). In addition, the partner on the engagement has asked you to identify business risks that could adversely affect TCC's sustained profitability, so that they can be brought to the attention of the company's board of directors. These tasks will require you to draw on your knowledge of supply chain management, marketing, internal controls, audit assertions, and financial accounting. Toy Central Corporation (TCC) designs, manufactures, and markets a variety of toys, which are sold primarily to large national retailers like Wal-Mart, Toys R Us, Kmart, and Target. TCC is a small company compared to competitors Mattel and Hasbro; nevertheless, TCC's managers believe its toys are among the best in the world. Unlike the larger toy makers, which bring thousands of toys to market each year but experience success with only a fraction of them, TCC has enjoyed success with a small portfolio of brands and products, representing three categories: (1) soft toys, consisting primarily of its Cuddle Monsters® stuffed animals; (2) hard toys, including metal-cast and plastic-cast toys like Fast Racers® cars and Acto® action figures; and (3) digital toys, consisting of video game software under development. Like most toy makers, 60 percent of TCC's sales revenues are generated in October and November, with the last two weeks of November driving half of those sales.

Your firm, KDOK, has been TCC's professional services firm since 2014, providing audit and tax services for the company. The primary external user of TCC's audited financial statements is its bank. Assume it is now October 28, 2018. You have taken over audit senior responsibilities for the company's October 31, 2018 year-end financial statement audit, because the original audit senior has left the firm. As a private company, TCC is not directly affected by the Sarbanes-Oxley Act (SOX). However, the partner in charge of the engagement has advised you that, ever since the financial scandals at the turn of the century, TCC has become interested in strengthening its corporate governance. Two years ago, following the release of the AICPA's Audit Committees Toolkit for public and private corporations, TCC has asked your firm to consider not only financial reporting issues, but also significant business risks that could affect the sustainability of TCC's success in the toy industry. Although TCC's board of directors believes it is aware of strategic issues facing the company, it has been considering spinning off its digital toy division into a separate company and, subsequently, merging it with an upstart software company. Before embarking on a change in organizational structure, the board wants a "second set of eyes" to ensure it has considered all significant business risks that currently exist and could adversely affect TCC in the foreseeable future. TCC's audit committee is meeting in two weeks and would like the partner to explain significant business risks identified during KDOK's interim audit tests and the year-end audit planning. The partner would like you to prepare an audit planning memorandum that addresses significant engagement issues, and specifically identifies matters relevant to the audit committee. To prepare the memo, you have consulted last year's audit file (Exhibit 1), findings of interim audit procedures (Exhibit 2), and a memo prepared by the engagement partner (Exhibit 3). (These Exhibits follow the template for your Memo). You should begin by reading and analyzing these exhibits!

REQUIREMENTS

(1) Business risks of TCC: Be sure to address risks affecting toy companies in general, including external risk factors (e.g. supply and demand for products, target customers, supplier issues, and retailer issues) and internal risk factors (e.g. inventory obsolescence, allowance for bad debts, earnings management pressures.) (2) Audit risk factors: Using the Audit Risk Model as a guide, be sure to address the inherent risk factors and internal control risk factors on the TCC engagement, as well as the fraud risk factors that are present. Be sure to provide a preliminary assessment of each type of risk as High, Moderate or Low. Note that some of Audit Risk factors may have been addressed as Business Risk factors above, but here they should be addressed in the context of the specific type of risk they represent for audit planning purposes. (3) Accounting issues and Audit Assertions: Identify the accounting issues being faced by TCC and discuss how these issues relate to the audit work you are likely to perform and the specific management assertions to which they relate. Be sure to identify the significant issues separately from the minor ones.

EXHIBIT 1 (Observations Noted in Last Year’s 2017 Audit File)

1) TCC’s management advised KDOK that retailers dramatically reduced the quantity of toys they were willing to carry in 2017 and were expected to continue this trend in 2018. This reduction in available retail shelf and warehouse space has intensified competition among all manufacturers of consumer products, particularly those in the toy industry. The change did not reduce the volume of toys sold through retailers. It did, however require that manufacturers be able to fill a retailer’s order within 1-2 days of advanced notice rather than the 2-3 weeks that they enjoyed in previous years. 2) By and large, 2017 was a successful year for TCC. Sales picked up from 2016-a result largely attributable to introducing the Cuddle Monsters® stuffed animals during the year. As compared to 2016, production costs in 2017 fell slightly because differences in foreign currency exchange rates allowed TCC to purchase toy parts from foreign suppliers at lower U.S.-dollar-equivalent prices. The only negatives for TCC in 2017 were substantial write-offs taken to increase reserves for receivables and inventories. Despite these charges, TCC exceeded its earnings target for fiscal 2017, reporting operating income of $1,008,700 and net income before tax of $857,600. 3) The Cuddle Monsters® stuffed animals were introduced on October 15, 2017, in time for the Christmas holiday selling season. By blending electronics-based facial gestures with the warm comfort of a teddy bear, the products instantly struck a chord with kids, selling out within only three weeks. Unfortunately, because TCC had not anticipated the wild popularity of the toys, the company had not placed sufficient orders with the supplier of the electronics components, whose manufacturing facilities are located in the Philippines and Taiwan. As soon as TCC realized the toy’s popularity, it place a large order for the electronics components. Unfortunately, the components were not delivered in time for TCC to make more Cuddle Monsters® for the 2017 holiday selling season.4) TCC’s October 31, 2017 allowance for doubtful accounts included a reserve to cover amounts owed by Kmart that TCC was concerned would not be collectible. According to TCC’s CFO, Kmart has struggled ever since it emerged from bankruptcy protection and merged with Sears in 2005, but was expected to receive a significant future infusion of cash from Sears Holdings Corporation. To be safe though, an extra $100,000 was added to the receivables reserve specifically for Kmart. 5) Ever since 2015, TCC’s executives have shared in a bonus pool that is created through TCC contributions of 10 percent of the first $250,000 of operating income, plus 20 percent on the next $250,000, and an additional 30 percent of the next $500,000. TCC’s total contributions to the bonus pool are capped at a yearly maximum of $225,000.

EXHIBIT 2 (Findings from Interim Audit Procedures Conducted in July and August 2018)

1) Based on a sample of 75 cash disbursements, KDOK concluded that controls over the purchase/payables/payments system were operating effectively. Most disbursements were made for purchases of raw materials from suppliers in Taiwan, and were properly converted to U.S. dollars and classified to appropriate accounts. Only one item seemed unusual in comparison to the sample: it involved a $10,000 payment to the International Workers Transport Union. The payment was requisitioned by TCC’s VP-Operations and was approved by the CFO. According to the VP, this payment was a “gesture of support for U.S. transport workers-a gesture we believe is important these days, as transport workers believe they are significantly underpaid and talking about organizing work stoppages and strikes in 2017 in the late fall or early winter. Our hope is that this payment will make it possible for the union executives to discuss and resolve this matter with their members before things get out of hand.” KDOK’s audit staff member noted that because the transaction was approved and was appropriately classified as an “other non-operating expense,” a control deficiency did not exist. 2)  One of the control tests for the receivables system involved determining whether bad debt write-offs and recoveries were properly authorized. KDOK’s staff member concluded, based on a sample of five transactions selected randomly from transactions during the first three quarters of fiscal 2018, that TCC’s authorization controls over bad debts and recoveries were effective. The staff member further noted that “even the CFO should be commended for his diligence of oversight, having approved the recording of a recovery on July 31, 2018 for $100,000 owed by Kmart that had been previously allowed for.” The staff member noted that the CFO not only approved the recording of the recovery, but that he also initiated the journal entry for the transaction. 3)  KDOK also performed interim substantive tests of inventory. The audit staff member noted that TCC counted its inventory of Acto® action figures on July 31, 2018. The staff member concluded that she was “satisfied that everything that TCC had produced was included in the inventory records.” Further, the staff member mentioned in passing that this was her first enjoyable inventory count because “there was something pleasing about seeing all those cute little stuffed animal faces everywhere throughout the warehouse.”

EXHIBIT 3 (Audit Partner Memo to File)

1)  Although TCC was unable to produce enough Cuddle Monsters® to satisfy the enormous demand for them during the 2017 holiday selling season, it was able to produce significant quantities during the second week of January 2018. Although not ideal, this timing allowed TCC to sell a fair quantity of this product for Valentine’s Day 2018. Soon after, at the insistence of the national retailers, all unsold Cuddle Monsters® were returned to TCC for a full refund. In addition to freeing-up shelf space in the short-term, the retailers claimed that this action would be beneficial in the long-run, as it would help TCC to build-up demand for Cuddle Monsters® over the summer-increasing the chances that a holiday season frenzy could again be created in November 2018. 2)  TCC’s executives have been working hard to boost sales in September-a month that traditionally 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-a movie company that has been created to produce and distribute its first animated movie called Delgo. The movie is scheduled for release in theatres on October 31, 2018. The partnering agreement states that, in exchange for a $300,000 licensing fee, TCC obtains the right to produce plastic-cast Delgo character toys, which are expected to be sold through TCC’s regular retail customers. TCC is contemplating deferring and amortizing this fee over the 7-year period of the agreement. This agreement further states that Fathom Studios will compensate TCC if sales of the Delgo toys fail to reach $500,000 during the first two months following the movie’s release. On the basis of this guarantee, TCC has accrued $500,000 of sales revenues in September 2018, when the contract was signed. The delay in reaching a final licensing agreement somewhat delayed final completion of the character toys, which are now expected to be ready for retailers on October 30, 2018. 3)  TCC’s executives claim they carefully reviewed their inventory pricing during October 2018 and determined that the inventory valuation reserve established in 2017 is no longer required. A journal entry was made on October 15, 2018, to reverse the entry that originally established the reserve. 4)  The company with which TCC’s digital toys division might be merged is named Open Game Inc. This company started its operations in 2017 by hiring a staff of programmers who were enticed to leave other software companies and join Open Game for its competitive salaries and attractive stock option program. Open Game’s staff is working solely on developing an innovative video game console. The operating system they are using will be an alternative to the more dominant operating systems such as Microsoft’s Windows and Apple. This system has a small but devoted following, which Open Game hopes to tap. Open Game believes that their console will attract high-end users of their operating system who dabble in video games. When Open Games’ work on its first-generation console is complete in Spring 20019, the console is expected to run videogames that TCC has begun developing. Open Game’s console is expected to be priced at 15 percent above other game consoles. Currently TCC has guaranteed one of Open Games operating loans, and has been asked by Open Game’s bank for a copy of TCC’s audited financial statements. The precise terms of the merger agreement are still being worked-out, but current plans are for TCC to contribute financing and video game rights to the merged entity and for Open Game to contribute manufacturing equipment and game console rights. 5)  To date, TCC’s digital division has hired a small staff of employees, invested nearly $150,000 in creating state-of–the–art software tools that are hoped to be useful in developing the video games, and made inquiries of the companies that hold the intellectual property rights to produce popular games, which currently are produced only for consoles and computers that run on Windows or Apple based software. 6)  On October 1, 2018, TCC’s compensation committee agreed to double the company’s contributions to 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 before tax of $275,000.

Answer questions 1 (business risks of TCC) and 2 (Audit risk factors to be considered by KDOK) with a small overview paragraph for each followed by bullet point descriptions for each risk.

Answer 1

There is always a risk involved in an audit, because the auditor is giving an opinion. An audit risk is when the opinion is inappropriate on the financial statements. There is a model to calculate this risk, it is the multiplication of inherent risk, control risk and detection risk.Business risk, on the other hand, includes factors that could hinder the goals and objectives of the company during the course of an audit. We will look at both types of risks in this last segment of the financial statement series.

business risks of tcc are

1. Inherent Risk - The risk of materially misstating in the financial statements caused by errors or omissions, from factors that are not a failure of controls. Inherent risk is usually higher when there is a higher degree of judgement and estimation involved or when the company’s transactions are very complex.
2. Control Risk - The risk of materially misstating in the financial statements caused by the lack of or failing of relevant controls in operations of the company. Internal controls and checks and balances must be in place to prevent and alert issues of error or fraud. Control risk tends to be higher when the internal controls are not adequate.
3. Detection Risk - the risk of failure to detect the occurrence of material misstatements in the financial statements. The auditor must use proper audit procedures to alert to misstatements whether due to error or fraud. If proper procedures are not followed or not applied correctly a misstatement could be undetected. There is always a certain amount of detection risk due to the inherent limits of an audit, for example, using sampling in selecting transactions. This risk can be lessened by sampling more transactions. audit risk factor to be considered by kdok is includes factors that can cause a misstatement, error or omission in the financial statements this is directly related to the auditor. Business risks relate to the company itself, including stakeholders. While these risks are very different, if there are large business risks they could lead to higher detection of audit risks. To ensure that business risks are considered in audit planning, a top down approach is encouraged. Ensuring that the auditor fully understands the environment of the company prior to auditing.