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Introduction:

As the senior in a professional services firm, you have been allotted to plan the financial statement audit of a private company named Toy Local Corporation (TLC). Additionally, the partner on the engagement has asked you to identify business risks which can adversely affect TLC’s sustained profitability, so that they could be brought to the attention of the company’s board of directors. These tasks would need you to draw on your knowledge of supply chain management, marketing, internal controls, audit assertions, and financial accounting.

Company Background:

Toy Local Corporation (TLC) designs, manufactures, and markets a number of toys, that are sold mainly to large national retailers like Wal-Mart, Toys R Us, Kmart, and Target. TLC is a small company compared to competitors Mattel and Hasbro; nevertheless, TLC’s managers believe its toys are among the best in the world. Unlike larger toy makers, that bring thousands of toys to market each year but experience success with only a fraction of them, TLC has enjoyed success with the small portfolio of brands and products, representing three categories: (1) soft toys, consisting primarily of its Cuddle Bears® 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 TLC’s sales revenues are generated in October and November, with last two weeks of November driving half of those sales.

Your firm, KWJM, has been TLC’s professional services firm since 2001, giving audit and tax services for the company. The main external user of TLC’s audited financial statements is its bank. Suppose it is now October 28, 2012. You have taken over audit senior responsibilities for the company’s October 31, 2012 year-end financial statement audit, since the original audit senior has left the firm. As the private company, TLC is not directly affected by Sarbanes-Oxley Act (SOX). Though, the partner in charge of the engagement has advised you that, ever since financial scandals at turn of the century, TLC 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, TLC has asked your firm to consider not only financial reporting issues, but also important business risks that can affect sustainability of TLC’s success in the toy industry. Though TLC’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 make sure it has considered all significant business risks which presently exist and can adversely affect TLC in the foreseeable future. TLC’s audit committee is meeting in two weeks and will like the partner to describe important business risks identified during KWJM’s interim audit tests and the year-end audit planning.

The partner will like you to prepare the audit planning memorandum which addresses important engagement issues, and specifically identifies matters appropriate 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 engagement partner (Exhibit 3).

Requirements:

Develop a planning memo for the TLC engagement based on the information provided in the case. The planning memo must address the following issues:

1. Business risks.

2. Audit risk factors.

Bear in mind that partner on this engagement is also responsible for many other client engagements. Thus, while you must try to be direct and succinct in your memo (limiting it to no more than two single-spaced pages), you must avoid supposing that the partner would fully recall all relevant facts, or that she would immediately recognize all significant implications of those facts. In short, ensure to describe the specific facts which you consider appropriate and describe the implications for the TLC engagement.

EXHIBIT 1: Observations Noted in Last Year’s 2011 Audit File

1. TLC’s management advised KWJM which retailers dramatically reduced quantity of toys they were willing to carry in 2011, and were expected to continue this trend in 2012. 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 alteration did not reduce volume of toys sold through retailers. It did, though, need that manufacturers be able to fill a retailer’s order with only 1–2 days of advanced notice rather than the 2–3 weeks that they enjoyed in previous years.

2. By and large, 2011 was a successful year for TLC. Sales picked up from 2010—a result largely attributable to introducing the Cuddle Bears® stuffed animals during the year. As compared to 2010, production costs in 2011 fell slightly as differences in foreign currency exchange rates allowed TLC to purchase toy parts from foreign suppliers at lower U.S.-dollar-equivalent prices. The only negatives for TLC in 2011 were substantial prepare-offs taken to increase reserves for receivables and inventories. In spite of these charges, TLC exceeded its earnings target for fiscal 2011, reporting operating income of $1,008,700 and net income before tax of $857,600.

3. The Cuddle Bears® stuffed animals were introduced on October 15, 2011, 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 TLC 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 TLC realized the toy’s popularity, it placed a large order for electronics components. Unfortunately, the components were not delivered in time for TLC to make more Cuddle Bears®  for the 2011 holiday selling season.

4. TLC’s October 31, 2011 allowance for doubtful accounts included a reserve to cover amounts owed by Kmart that TLC was concerned would not be collectible. According to TLC’s CFO, Kmart has struggled ever since it emerged from bankruptcy protection and merged with Sears in 2010, 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 2004, TLC’s executives have shared in a bonus pool that is created through TLC 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. TLC’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 2012

1. Based on a sample of 75 cash disbursements, KWJM 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 TLC’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 are talking about organizing work stoppages and strikes in 2012 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.’’ KWJM’s audit staff member noted that because the transaction was approved and was appropriately classified as an ‘‘other non-operating expense,’’ a control deviation did not exist.

2. One of the control tests for the receivables system involved determining whether bad debt prepare- ?offs and recoveries were properly authorized. KWJM’s staff member concluded, based on a sample of five transactions selected randomly from transactions during the first three quarters of fiscal 2012, that TLC’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 over- sight, having approved the recording of a recovery on July 31, 2012 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. KWJM also performed interim substantive tests of inventory. The audit staff member noted that TLC counted its inventory of Acto® action figures on July 31, 2012. The staff member concluded that she was ‘‘satisfied that everything that TLC 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 TLC was unable to produce enough Cuddle Bears® to satisfy the enormous demand for them during the 2011 holiday selling season, it was able to produce significant quantities during the second week of January 2012. Although not ideal, this timing allowed TLC to sell a fair quantity of this product for Valentine’s Day 2012. Soon after, at the insistence of the national retailers, all unsold Cuddle Bears® were returned to TLC 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 TLC to build-up demand for Cuddle Bears® over the summer—increasing the chances that a holiday season selling frenzy could again be created in November 2012.

2. TLC’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, TLC 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, 2012. The partnering agreement states that, in exchange for a $300,000 licensing fee, TLC obtains the right to produce plastic-cast Delgo character toys, which are expected to be sold through TLC’s regular retail customers. TLC is contemplating deferring and amortizing this fee over the 7-year period of the agreement. The agreement further states that Fathom Studios will compensate TLC if sales of Delgo toys fail to reach $500,000 during the first two months following the movie’s release. On the basis of this guarantee, TLC has accrued $500,000 of sales revenue in September 2012, 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, 2012.

3. TLC’s executives claim that they carefully reviewed their inventory pricing during October 2012 and determined that the inventory valuation reserve established in 2011 is no longer required. A journal entry was made on October 15, 2012, to reverse the entry that originally established the reserve.

4. The company with which TLC’s digital toys division may be merged is named Open Game Inc. This company started its operations in 2011 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 a Linux- based videogame console. Linux is an easily modifiable computer operating system that is at- tempting to provide an alternative to much more dominant operating systems such as Microsoft’s Windows. Linux has a small but devoted following, which Open Game hopes to tap. Open Game believes that its Linux-based console will attract high-end Linux users who dabble in videogames. When Open Game’s work on its first-generation console is complete in Spring 2013, the console is expected to run videogames that TLC has begun developing. Open Game’s console is expected to be priced at 15 percent above other game consoles. Currently, TLC has guaranteed one of Open Game’s operating loans, and has been asked by Open Game’s bank for a copy of TLC’s audited financial statements. The precise terms of the merger agreement are still being worked- out, but current plans are for TLC 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, TLC’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 Linux games, and inquired with companies which hold intellectual property rights to produce popular games, that presently are produced only for consoles and computers which run on Windows- based software.

6. On October 1, 2012, TLC’s compensation committee agreed to double the company’s contributions to the bonus pool, resulting in a yearly maximum contribution of $450,000, that would be effective for the 2012 year-end.

7. For the year ended October 31, 2012, TLC forecasts operating income of $979,980 and net income before tax of $275,000.

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