Assessing Audit and Business Risks at Toy Central Corporation

This case will provide example of how 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 marketing, as well as more traditional matters pertaining to accounting and auditing.

Case Background

As a senior in a professional services firm, you have been assigned to provide consulting service for a private company named Toy Central Corporation (TCC)1. Within this consulting task, you need to provide recommendation for the TCC internal audit team regarding 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. 1 This case study is fictitious. All the name of persons and organizations in this case study is just for the purpose of illustration. 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 statements is its bank. Assume it is now June 28, 2021 and you have taken over audit senior responsibilities because the original audit senior has left the firm. As a private company, initially 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. CC has asked your firm to perform a review based on COSO ERM framework 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 the meeting. The partner would like you to prepare recommendation for the internal 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).

Exhibit 1 - Observations Noted in Last Year's 2016 Audit File

1. TCC's management advised KDOK that retailers dramatically reduced the quantity of toys they were willing to carry in 2016 and were expected to continue this trend in 2017. 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.

2. By and large, 2016 was a successful year for TCC. Sales picked up from 2015a result largely attributable to introducing the Cuddle Monsters stuffed animals during the year. As compared to 2015, production costs in 2016 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 2016 were substantial write-offs taken to increase reserves for receivables and inventories. Despite these charges, TCC exceeded its earnings target for fiscal 2016, 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, 2016, 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 2016 holiday selling season.

4. TCC's October 31, 2016 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, 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 2014, 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 2017

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 workersa 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 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 nonoperating expense,'' a control deviation 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 2017, 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, 2017 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, 2017. 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 2016 holiday selling season, it was able to produce significant quantities during the second week of January 2017. Although not ideal, this timing allowed TCC to sell a fair quantity of this product for Valentine's Day 2017. 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 buildup demand for Cuddle Monsters over the summerincreasing the chances that a holiday season selling frenzy could again be created in November 2017.

2. TCC's executives have been working hard to boost sales in Septembera 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 Studiosa 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, 2017. 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 2017, 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, 2017.

3. TCC's executives claim that they carefully reviewed their inventory pricing during October 2017 and determined that the inventory valuation reserve established in 2016 is no longer required. A journal entry was made on October 15, 2017, 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 2016 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 attempting 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 2018, 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 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.

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 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.

6. On October 1, 2017, 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 2017 year-end.

7. For the year ended October 31, 2017, TCC forecasts operating income of $979,980 and net income before tax of $275,000.

Requirements: There are 3 main requirements for this case. In order to develop a planning memo for the TCC engagement based on the information provided in the case.

The planning memo should address the following issues: business risks, audit risk factors, and accounting issues.

Please follow the following case requirements:

Requirement 1. Identify and explain TCC business risks using PESTEL framework and porter's Five model