II. Deluxe Chicken Inc. (INDIVIDUAL Report only, 50 points) Deluxe Chicken (DC) was established in 1989 by Sebastian Bony. It sells delicious rotisserie-cooked chicken with fresh vegetables and other side dishes through its own stores and franchisee stores, just like Kentucky Fried Chicken (KFC). According to Seb, DC's strategy is to be a home meal replacement" in the New England and Mid-Atlantic regions. DC went through an impressive expansion. At the end of 1991, the firm operated only 34 stores, with no franchisee stores. But by the end of 1994, the total of stores (company-owned stores and franchise stores) had increased to 534 (491 were franchise stores). It was estimated that DC's franchise store can easily break even if its weekly average revenue per store is higher than $23,000. According to Reuters, its stock price had risen steadily from $8 in November 1993 to $23 in March 1997. DC's auditor is a prestigious Big-8 accounting firm, Firehouse Young LLP. The 1994 and 1995 fiscal year financial statements below were all audited numbers, but the 1996 numbers were unaudited. DC's excellent performance also impressed the Street. Stock analyst Mike Foster of Silverman Sterling forecasted that DC's EPS would grow at an annual rate of around 35% between 1997 and 2001 and gave a strong buy rating. It was rumored that the wealth management division of Mohan Stanley took a passive 3% stake in this firm. Many hedge funds followed the rumor and added DC's shares to their portfolios. Table 1. CONSOLIDATED INCOME STATEMENTS Fiscal Years Ended ------------------------------------------------ December 25, December 31, December 29, 1994 1995 1996 (in thousands) (in thousands) (in thousands) Revenue: Royalties and franchise related fees........... $43, 603 $ 74, 662 $115, 510 Company stores sales.. 40,916 51, 566 83, 950 Interest income. ... 11,632 33, 251 65, 048 Total revenue. ....... 96, 151 159, 479 264, 508 Costs and Expenses: Cost of products sold. ..... 15, 876 19, 737 31, 160 Salaries and benefits....... 22, 637 31, 137 42, 172 General and administrative..... 27, 930 41, 367 99, 847 Relocation expense 5, 097 Total costs and expenses... 71,540 92, 241 173, 179 Income From Operations.... 24, 611 67, 238 91, 329 Other Income (Expense): Interest expense, net........ (4, 235) (13, 179) (14, 446) Gain on issuances of subsidiary's stock. ...... 38, 163 Other income, net....... 74 314 137 Total other income (expense)............ (4, 161) (12, 865) 23, 854 Income Before Income Taxes and Minority Interest. ........ 20, 450 54, 373 115, 183 Income Taxes...... 4, 277 20, 814 42, 990 Minority Interest in (Earnings) of Subsidiary.... (5, 235) Net Income... $16, 173 $ 33, 559 $ 66, 958 ======= ======== ======== 11 One T AA ........... ........... .......... ..... TABLE 1. CONSOLIDATED INCOME STATEMENTS (to continue) Fiscal Years Ended - - - - - - - - - - - - - - - - - - ----- ------------- -- -- ---- December 25, 1994 (in thousands) December 31, 1995 (in thousands) December 29, 1996 (in thousands) Net Income Per Common and Equivalent Share...... $ 0.38 ====== $ 0.66 $ 1.01 ======= = ======= = Shares outstanding at year end (in thousands) ........ 44,700 59,129 ======== 64,246 ======== = = = = = = December 29, 1996 (in thousands) $ TABLE 2. CONSOLIDATED BALANCE SHEETS December 31, 1995 (in thousands) Current Assets: Cash and cash equivalents...... $ 310, 436 Accounts receivable, net....... 13, 445 Due from area developers, royalty and interest ....... 9,614 Notes receivable from area developers, due in 12 month 5, 462 Prepayment and other current assets..... 4, 858 Total current assets......... 343, 815 Property and Equipment, net...... 258, 550 Long-term Notes Receivable from area developers.. 450, 572 Goodwill, net..... Other Assets, net..... 20, 940 Total assets........... $1,073, 877 100, 800 22, 438 10, 246 12, 979 146, 462 334, 748 800, 519 190, 439 71, 448 $1, 543, 616 $ $ Current Liabilities: Accounts payable......... Accrued expenses. ..... Deferred franchise revenue... Total current liabilities. .. Deferred Franchise Revenue... Convertible Subordinated Debt. Zero coupon bond Deferred Income Taxes.......... Other Noncurrent Liabilities... Minority Interest.. 12, 292 9,095 8, 945 30, 332 2,072 129, 872 177, 306 16, 631 40, 430 36, 547 10, 656 87, 633 7, 740 129, 841 182, 613 40,216 6, 292 153, 441 833 591 Stockholders' Equity: Common stock. ................ Additional paid-in capital... Retained earnings............................... 675, 611 40, 629 716, 831 $1, 073, 877 642 827, 611 107, 587 935, 840 Total liabilities and stockholders' equity........ $1, 543, 616 Shares outstanding at year end (in thousands) ........ 59,129 64, 246 TABLE 3. CONSOLIDATED CASH FLOW STATEMENTS December 25, 1994 December 31, 1995 December 29, 1996 (In thousands) (In thousands) (In thousands) Cash Flows from Operating Activities: Net income. ....... .............. $ 16, 173 $ 33, 559 $ 66, 958 Adjustments: Depreciation and amortization......... 6,074 11, 442 22, 887 Interest expense on zero coupon bond... 8,075 13, 793 Gain on issuances of subsidiary's stock (38, 163) Deferred income taxes................... 4,277 12, 133 14, 059 Minority interest... 5, 235 Provision for write-down of assets...... 14, 550 Loss (gain) on disposal of assets. ...... (368) 231 Changes in assets and liabilities A/R & due from area developers (7, 800) (10, 057) (7, 193) Accounts payable and accrued expenses.... 13, 724 3,661 48, 674 Deferred franchise revenue. .......... 5, 926 (303) 3, 174 Other assets and liabilities.......... (2,088) (3,265) 868 Net cash provided by operating activities 35,918 55, 476 144, 910 68 Cash Flows from Investing Activities: Purchase of PPE and other assets ...... (168, 797) Proceeds from the sale of PPE assets. 62, 342 Loans (notes receivable) to area developers (225, 282) Repayment of notes receivable by area developers 68, 498 Net cash used in investing activities.. (263, 239) (149, 231) 80, 910 (661, 033) 407, 499 (321, 855) (137, 432) 86, 320 (1,467, 065) 993, 151 (525, 026 125, 703 385, 360 112, 863 135, 422 130,000 Cash Flows from Financing Activities: Proceeds from issuance of common stock Proceeds from issuance of subsidiary's stock Proceeds from issuance of convertible bond Proceeds from issuance of zero coupon bond Increase in deferred financing cost....... Proceeds from revolving bank credit line.... Repayments of revolving bank credit lin. .....- Net cash provided by financing activiti.. Net Increase (Decrease). in Cash and Cash Equivalents (7,615) 96, 130 (96, 130 248, 088 20. 767 172, 464 (6, 313) 229, 240 (229, 240) 551, 511 285, 132 (3, 799) 43, 250 (117, 256 170, 480 (209,636 Below is some info from footnotes for your reference: 1. Principles of Consolidation. The consolidated financial statements include the accounts of the Company and its subsidiaries. 2. Revenue Recognition. Revenue from Company stores is recognized when food is sold. Royalties are recognized when related franchise store revenue is generated. It is 5% of the franchise revenue. Initial franchise fees and area development fees are recognized as DC's revenue when the franchised store opens. Franchisee store also pays 5.75% of its revenue for system-wide marketing use. 3. Franchise store performance is not included in the consolidated financial statements since DC has no equity investment larger than 50% in any store. 4. Area developers are large regional franchises which focus on major U.S. metropolitan markets. The initial investment consists of 25% equity (contributed by independent business people) and 75% loan made from Deluxe Chickens. Area developers have no other sources for investment. DC believes that it is difficult for small franchises to get bank loans, therefore, DC always loans the money to support those area developers. Loan is recorded at historical cost. The average interest rate is around 8.2% in 1996. 1995 15 Below are some disclosed info about all area developers Total number of area developers Total number of stores open by those developers Gross Revenue (in thousands) Total gross assets aggregated for those developers (in thousands) Debt to Deluxe Chicken Inc. (in thousands) Total stockholder's equity (or deficit) (in thousands) 627 $491, 341 $513, 926 $372, 071 (9, 891) 1996 14 841 $865, 082 $640, 534 $555, 105 (102, 754) TABLE 4. NI vs. OCF Fiscal Years Ended December 25, 1994 (in thousands) $ 16, 173 35, 918 December 31, 1995 (in thousands) $ 33, 559 55, 476 December 29, 1996 (in thousands) $ 66, 958 _144, 910 Net Income........ Net cash provided by operating activities You are a senior auditor at Firehouse Young LLP, assigned to audit DC's 1996 financial statements in early 1997. John is the manager in charge and Kelvin Collins, a straight-A graduate from CSU Southhill, is your junior. Below is some conversation between you (Y) and Kelvin (K). Y: DC is not a difficult account, but audit fee is never fat. So watch out when filling time sheets. BTW, have you ever tried AP (analytical procedures) by now? K: Got it, AP not done yet. But I had a quick scan of the numbers and compared net income and OCF in the last 3 years. Net income looks healthy as it is well-supported by operating cash flow. Look at the numbers below, NI/OCF ratio varies between 0.45 and 0.60. No negative OCF and no "kiss of death" in 1995 and 1996. Not a tough audit this year. Required: Turn your clock back to the February 1997. As a senior auditor, please perform the analytical procedures and then write a memo to your manager. In your memo, you must highlight those accounts that might be subject to material misstatements and support your conclusions with solid evidence/argument. II. Deluxe Chicken Inc. (INDIVIDUAL Report only, 50 points) Deluxe Chicken (DC) was established in 1989 by Sebastian Bony. It sells delicious rotisserie-cooked chicken with fresh vegetables and other side dishes through its own stores and franchisee stores, just like Kentucky Fried Chicken (KFC). According to Seb, DC's strategy is to be a home meal replacement" in the New England and Mid-Atlantic regions. DC went through an impressive expansion. At the end of 1991, the firm operated only 34 stores, with no franchisee stores. But by the end of 1994, the total of stores (company-owned stores and franchise stores) had increased to 534 (491 were franchise stores). It was estimated that DC's franchise store can easily break even if its weekly average revenue per store is higher than $23,000. According to Reuters, its stock price had risen steadily from $8 in November 1993 to $23 in March 1997. DC's auditor is a prestigious Big-8 accounting firm, Firehouse Young LLP. The 1994 and 1995 fiscal year financial statements below were all audited numbers, but the 1996 numbers were unaudited. DC's excellent performance also impressed the Street. Stock analyst Mike Foster of Silverman Sterling forecasted that DC's EPS would grow at an annual rate of around 35% between 1997 and 2001 and gave a strong buy rating. It was rumored that the wealth management division of Mohan Stanley took a passive 3% stake in this firm. Many hedge funds followed the rumor and added DC's shares to their portfolios. Table 1. CONSOLIDATED INCOME STATEMENTS Fiscal Years Ended ------------------------------------------------ December 25, December 31, December 29, 1994 1995 1996 (in thousands) (in thousands) (in thousands) Revenue: Royalties and franchise related fees........... $43, 603 $ 74, 662 $115, 510 Company stores sales.. 40,916 51, 566 83, 950 Interest income. ... 11,632 33, 251 65, 048 Total revenue. ....... 96, 151 159, 479 264, 508 Costs and Expenses: Cost of products sold. ..... 15, 876 19, 737 31, 160 Salaries and benefits....... 22, 637 31, 137 42, 172 General and administrative..... 27, 930 41, 367 99, 847 Relocation expense 5, 097 Total costs and expenses... 71,540 92, 241 173, 179 Income From Operations.... 24, 611 67, 238 91, 329 Other Income (Expense): Interest expense, net........ (4, 235) (13, 179) (14, 446) Gain on issuances of subsidiary's stock. ...... 38, 163 Other income, net....... 74 314 137 Total other income (expense)............ (4, 161) (12, 865) 23, 854 Income Before Income Taxes and Minority Interest. ........ 20, 450 54, 373 115, 183 Income Taxes...... 4, 277 20, 814 42, 990 Minority Interest in (Earnings) of Subsidiary.... (5, 235) Net Income... $16, 173 $ 33, 559 $ 66, 958 ======= ======== ======== 11 One T AA ........... ........... .......... ..... TABLE 1. CONSOLIDATED INCOME STATEMENTS (to continue) Fiscal Years Ended - - - - - - - - - - - - - - - - - - ----- ------------- -- -- ---- December 25, 1994 (in thousands) December 31, 1995 (in thousands) December 29, 1996 (in thousands) Net Income Per Common and Equivalent Share...... $ 0.38 ====== $ 0.66 $ 1.01 ======= = ======= = Shares outstanding at year end (in thousands) ........ 44,700 59,129 ======== 64,246 ======== = = = = = = December 29, 1996 (in thousands) $ TABLE 2. CONSOLIDATED BALANCE SHEETS December 31, 1995 (in thousands) Current Assets: Cash and cash equivalents...... $ 310, 436 Accounts receivable, net....... 13, 445 Due from area developers, royalty and interest ....... 9,614 Notes receivable from area developers, due in 12 month 5, 462 Prepayment and other current assets..... 4, 858 Total current assets......... 343, 815 Property and Equipment, net...... 258, 550 Long-term Notes Receivable from area developers.. 450, 572 Goodwill, net..... Other Assets, net..... 20, 940 Total assets........... $1,073, 877 100, 800 22, 438 10, 246 12, 979 146, 462 334, 748 800, 519 190, 439 71, 448 $1, 543, 616 $ $ Current Liabilities: Accounts payable......... Accrued expenses. ..... Deferred franchise revenue... Total current liabilities. .. Deferred Franchise Revenue... Convertible Subordinated Debt. Zero coupon bond Deferred Income Taxes.......... Other Noncurrent Liabilities... Minority Interest.. 12, 292 9,095 8, 945 30, 332 2,072 129, 872 177, 306 16, 631 40, 430 36, 547 10, 656 87, 633 7, 740 129, 841 182, 613 40,216 6, 292 153, 441 833 591 Stockholders' Equity: Common stock. ................ Additional paid-in capital... Retained earnings............................... 675, 611 40, 629 716, 831 $1, 073, 877 642 827, 611 107, 587 935, 840 Total liabilities and stockholders' equity........ $1, 543, 616 Shares outstanding at year end (in thousands) ........ 59,129 64, 246 TABLE 3. CONSOLIDATED CASH FLOW STATEMENTS December 25, 1994 December 31, 1995 December 29, 1996 (In thousands) (In thousands) (In thousands) Cash Flows from Operating Activities: Net income. ....... .............. $ 16, 173 $ 33, 559 $ 66, 958 Adjustments: Depreciation and amortization......... 6,074 11, 442 22, 887 Interest expense on zero coupon bond... 8,075 13, 793 Gain on issuances of subsidiary's stock (38, 163) Deferred income taxes................... 4,277 12, 133 14, 059 Minority interest... 5, 235 Provision for write-down of assets...... 14, 550 Loss (gain) on disposal of assets. ...... (368) 231 Changes in assets and liabilities A/R & due from area developers (7, 800) (10, 057) (7, 193) Accounts payable and accrued expenses.... 13, 724 3,661 48, 674 Deferred franchise revenue. .......... 5, 926 (303) 3, 174 Other assets and liabilities.......... (2,088) (3,265) 868 Net cash provided by operating activities 35,918 55, 476 144, 910 68 Cash Flows from Investing Activities: Purchase of PPE and other assets ...... (168, 797) Proceeds from the sale of PPE assets. 62, 342 Loans (notes receivable) to area developers (225, 282) Repayment of notes receivable by area developers 68, 498 Net cash used in investing activities.. (263, 239) (149, 231) 80, 910 (661, 033) 407, 499 (321, 855) (137, 432) 86, 320 (1,467, 065) 993, 151 (525, 026 125, 703 385, 360 112, 863 135, 422 130,000 Cash Flows from Financing Activities: Proceeds from issuance of common stock Proceeds from issuance of subsidiary's stock Proceeds from issuance of convertible bond Proceeds from issuance of zero coupon bond Increase in deferred financing cost....... Proceeds from revolving bank credit line.... Repayments of revolving bank credit lin. .....- Net cash provided by financing activiti.. Net Increase (Decrease). in Cash and Cash Equivalents (7,615) 96, 130 (96, 130 248, 088 20. 767 172, 464 (6, 313) 229, 240 (229, 240) 551, 511 285, 132 (3, 799) 43, 250 (117, 256 170, 480 (209,636 Below is some info from footnotes for your reference: 1. Principles of Consolidation. The consolidated financial statements include the accounts of the Company and its subsidiaries. 2. Revenue Recognition. Revenue from Company stores is recognized when food is sold. Royalties are recognized when related franchise store revenue is generated. It is 5% of the franchise revenue. Initial franchise fees and area development fees are recognized as DC's revenue when the franchised store opens. Franchisee store also pays 5.75% of its revenue for system-wide marketing use. 3. Franchise store performance is not included in the consolidated financial statements since DC has no equity investment larger than 50% in any store. 4. Area developers are large regional franchises which focus on major U.S. metropolitan markets. The initial investment consists of 25% equity (contributed by independent business people) and 75% loan made from Deluxe Chickens. Area developers have no other sources for investment. DC believes that it is difficult for small franchises to get bank loans, therefore, DC always loans the money to support those area developers. Loan is recorded at historical cost. The average interest rate is around 8.2% in 1996. 1995 15 Below are some disclosed info about all area developers Total number of area developers Total number of stores open by those developers Gross Revenue (in thousands) Total gross assets aggregated for those developers (in thousands) Debt to Deluxe Chicken Inc. (in thousands) Total stockholder's equity (or deficit) (in thousands) 627 $491, 341 $513, 926 $372, 071 (9, 891) 1996 14 841 $865, 082 $640, 534 $555, 105 (102, 754) TABLE 4. NI vs. OCF Fiscal Years Ended December 25, 1994 (in thousands) $ 16, 173 35, 918 December 31, 1995 (in thousands) $ 33, 559 55, 476 December 29, 1996 (in thousands) $ 66, 958 _144, 910 Net Income........ Net cash provided by operating activities You are a senior auditor at Firehouse Young LLP, assigned to audit DC's 1996 financial statements in early 1997. John is the manager in charge and Kelvin Collins, a straight-A graduate from CSU Southhill, is your junior. Below is some conversation between you (Y) and Kelvin (K). Y: DC is not a difficult account, but audit fee is never fat. So watch out when filling time sheets. BTW, have you ever tried AP (analytical procedures) by now? K: Got it, AP not done yet. But I had a quick scan of the numbers and compared net income and OCF in the last 3 years. Net income looks healthy as it is well-supported by operating cash flow. Look at the numbers below, NI/OCF ratio varies between 0.45 and 0.60. No negative OCF and no "kiss of death" in 1995 and 1996. Not a tough audit this year. Required: Turn your clock back to the February 1997. As a senior auditor, please perform the analytical procedures and then write a memo to your manager. In your memo, you must highlight those accounts that might be subject to material misstatements and support your conclusions with solid evidence/argument