Assessing Audit and Business Risks at Toy Central Corporation Christine E. Earley and Fred Phillips ABSTRACT: This case requires you to evaluate business risks and accounting issues facing a toy manufacturer, and determine how these matters will translate into assertion-specific audit risks. When performing your analyses, you will need to draw on your general knowledge of toys and possibly research some of the issues facing the toy industry. Through these analyses, you should begin to see a need for auditors to consider broad management issues relating to supply chain management and mar keting, as well as more traditional matters pertaining to accounting and auditing INTRODUCTION s 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 busi- ness 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 COMPANY BACKGROUND 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 2001, providing audit and tax services for the company. The primary external user of TCC's audited financial Christine E. Earley is an Associate Professor at Bentley College and Fred Phillips is a Professor at the University of Saskatchewan. Professor Phillips is thankful for the financial support of the George C. Baxter Scholarship at the University of Saskatchewan. 299 300 Earley and Phillips statements is its bank. Assume it is now October 28, 2007. You have taken over audit senior responsibilities for the company's October 31, 2007 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 engage- ment 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 com pany, 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 com- mittee. To prepare the memo, you have consulted last year's audit file (Exhibi 1), findings of interim audit procedures (Exhibit 2), and a memo prepared by the engagement partner (Exhibit 3) REQUIREMENTS Develop a planning memo for the TCC engagement based on the information provided in the case. The planning memo should address the following issues (1) Business risks (2) Audit risk factors. (3) Accounting issues, related management assertions impacted by these issues, and planned audit approach to address these issues. Bear in mind that the partner on this engagement is also responsible for many other client engagements. Consequently, while you should endeavor to be direct and succinct in your memo (imiting it to no more than four single-spaced pages), you should avoid assuming that the partner will fully recall all relevant facts, or that she will immediately recognize al important implications of those facts. In short, be sure to describe the specific facts that you consider relevant and explain the implications for the TCC engagement. In addition, you are not expected to outline all audit procedures that would be performed on the engagement. Instead, just provide a general overview of how KDOK might approach the audit for each accounting issue identified EXHIBIT 1 Observations Noted in Last Year's 2006 Audit File 1. TCC's management advised KDOK that retailers dramatically reduced the quantity of toys they were willing to carry in 2006, and were expected to continue this trend in 2007. 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 with only 1-2 days of advanced notice rather than the 2-3 weeks that they enjoyed in previous years. By and large, 2006 was a successful year for TCC. Sales picked up from 2005-a result largely attributable to introducing the Cuddle Monsters stuffed animals during the year. As compared to 2005, production costs in 2006 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 2006 were substantial write-offs taken to increase reserves for receivables and inventories. Despite these charges, TCC exceeded its earnings target for fiscal 2. 006, reporting operating income of $1,008,700 and net income before tax of $857,600 3 The Cuddle Monster" stuffed animals were introduced on October 15, 2006, 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 placed a large order for electronics components. Unfortunately, the components were not delivered in time for TCC to make more Cuddle Monsters for the 2006 holiday selling season TCC's October 31, 2006 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 specif ically for Kmart. 5. Ever since 2004, TCC's executives have shared in a bonus pool that is created through TCC contributions of 10 percent of the first S250,000 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 2007 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 pur- chases 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; involved a S10,000 payment to the International Workers Transport Union. The pay ment 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 are talking about organizing work stoppages and strikes in 2007 in the late fall or early winter. Our hope is that this payment will make it possible for the union executives to discuss and resolv this matter with their members before things get out of hand." KDOK's audit staff member noted (continued on next page) EXHIBIT 2 (continued) that because the transaction was approved and was appropriately classified as an "other non- operating expense," a control deviation did not exist. 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 2007, 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 over- sight, having approved the recording of a recovery on July 31, 2007 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. 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, 2007. 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 inven- tory count, because "there was something pleasing about seeing all those cute little stuffed animal faces everywhere throughout the warehouse 2. 3. 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 2006 holiday selling season, it was able to produce significant quantities during the second week of January 2007. Although not ideal, this timing allowed TCC to sell a fair quantity of this product for Valentine's Day 2007. 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 sum- mer-increasing the chances that a holiday season selling frenzy could again be created in No- vember 2007 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, 2007. 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. The agreement further states that Fathom Studios will compensate TCC 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, TCC has accrued $500,000 of sales revenue in September 2007, 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, 2007 TCC's executives claim that they carefully reviewed their inventory pricing during October 2007 and determined that the inventory valuation reserve established in 2006 is no longer required.A journal entry was made on October 15, 2007, to reverse the entry that originally established the reserve. 3. (continued on next page) Assessing Audit and Business Risks at Toy Central Corporation 303 EXHIBIT 3 (continued) 4. The company with which TCC's digital toys division might be merged is named Open Game Inc. This company started its operations in 2006 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 2008, 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 Open Game's 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. guaranteed one of 5. To date, TCC's digital division has hired a smal 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 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- based software. On October 1, 2007, TCC's compensation committee agreed to double the company's contribu tions to the bonus pool, resulting in a yearly maximum contribution of $450,000, which will be effective for the 2007 year-end. 6. 7. For the year ended October 31, 2007, TCC forecasts operating income of $979,980 and net income before tax of $275,000