Just Question (b)

ACCT 315: Intermediate Financial Accounting Level I OP52 Spring 2015 Term Project Due: June 22, 2015. As we are focusing on financial accounting concepts in this class, please ignore any requested information or inquiries included in the body of the case and only respond to the following questions. Overlook Video Stores Inc. (OVS) Please read the OVS case, focusing on the financial accounting issues only (ignore any audit or IT issues). Please keep in mind that OVS is a private corporation and therefore can follow Accounting Standards for Private Enterprises (ASPE). Prepare a memo to Alice Harford, the engagement partner, providing your recommendations on the accounting treatments that OVS should adopt for each of the following accounting issues: (a) No Late Fees Program - has OVS correctly recorded revenue for the new program or not? Please list the appropriate revenue recognition criteria and tie case facts to each criteria to determine if OVS has correctly recorded revenue from the new program. If not recorded correctly, provide a recommendation on when or how the revenue should be recorded. (b) Movies By Mail Program- has OVS correctly recorded revenue for the new program or not? Please list the appropriate revenue recognition criteria and tie case facts to each criteria to determine if OVS has correctly recorded revenue from the new program. If not recorded correctly, provide a recommendation on when or how the revenue should be recorded. (c) Previously viewed DVD's - discuss the appropriate treatment of inventory and how the previously viewed DVD's should be recorded on the Financial Statements. If an adjustment is required, provide the journal entry and amount for any adjustment. (d) Website - list and discuss the criteria for expensing vs. capitalizing internally developed intangible assets and apply case facts to determine if OVS has correctly recorded the website costs on the Financial Statements. If not recorded correctly, provide a recommendation for how the website should be recorded. 1 ACCT 315: Intermediate Financial Accounting Level I OP52 Spring 2015 As with all memos to the partner, be sure to use professional language, and provide thorough explanations of the accounting treatment recommendation. A thorough discussion of each issue would include the Accounting Handbook section (CICA Handbook-Accounting), accounting concept definition/criteria, supporting case facts and conclusion on treatment. 2 Uniform Evaluation Report - 2006 199 Paper III - SIMULATION 3 (60 minutes) Overlook Video Stores Inc. (OVS) is a privately-held chain of DVD rental stores headquartered in Toronto. The company was incorporated in 1992 and has gone from a single store in Toronto to over 30 stores throughout Ontario. Harford & Harford, LLP (H&H), a mid-sized professional services firm, have been the auditors for OVS since its inception. You, CA, are the audit senior on the OVS audit for the year ending December 31, 2005. On December 1, 2005, Alice Harford, the engagement partner, calls you into her office to explain that the audit will need to begin in early January 2006, because OVS's bank is eager to see the audited financial statements. \"I would like you to prepare the audit planning memo for the OVS audit. OVS has experienced some changes, and I want to make sure we consider those in our audit plan. The controller of OVS has faxed us the interim financial statements for the 11 months ended November 30, 2005 (Exhibit I). These should help you in your audit plan. \"I met with Victor Ziegler, the controlling shareholder of OVS, a few months ago and he told me about OVS's new directions. Here are my notes from that meeting (Exhibit II). In addition, there are some new accounting issues that have arisen since last year end. I would like you to look at them and provide your recommendations on the accounting treatments to adopt. Please also consider these issues when drafting your audit planning memo, and suggest ways to audit them. \"I also met with OVS's Chief Information Officer, Nick Nightingale. He provided a description of OVS's expansion during 2005 into the Internet-based DVD rental market through a program called Movies By Mail. Here are my notes from my meeting with Nick (Exhibit III). Please review them and provide your recommendations for improving the system. I will pass on your comments to our Information Technology (IT) partner so that she can include them in a report she is preparing for Victor. Victor has asked our IT partner to meet with him to discuss the information technology issues related to the Internet-based rental system.\" 200 Appendix C Paper III Paper III - SIMULATION 3 (continued) EXHIBIT I OVERLOOK VIDEO STORES INC. EXCERPTS FROM THE BALANCE SHEET (in thousands of dollars) Nov. 30, 2005 (unaudited) Assets Current assets Cash Accounts receivable Inventory - DVDs for rent Inventory - New DVDs for sale Inventory - Previously viewed DVDs for sale Other inventory Prepaid expenses $ Property, plant and equipment Website 21 4,210 7,935 2,315 3,526 598 1,251 19,856 Dec. 31, 2004 (audited) $ 35 - 6,545 2,119 - 412 1,105 10,216 40,780 8,512 31,105 - $ Liabilities Current liabilities Accounts payable Current portion of long-term debt 69,148 $ 41,321 $ 652 2,937 3,589 $ 3,569 Long-term debt Due to shareholders - 3,569 - 26,430 4,532 30,962 6,483 6,483 100 34,497 34,597 100 31,169 31,269 Shareholders' Equity Common Shares Retained earnings $ 69,148 $ 41,321 Uniform Evaluation Report - 2006 Paper III - SIMULATION 3 (continued) EXHIBIT I (continued) OVERLOOK VIDEO STORES INC. EXCERPTS FROM THE INCOME AND RETAINED EARNINGS STATEMENT (in thousands of dollars) 11 months ended Nov. 30, 2005 (unaudited) Revenues Rentals Sales Movies By Mail No Late Fees Other Year ended Dec. 31, 2004 (audited) $ $ Expenses Advertising Amortization Bank charges and interest Business and property tax Cost of movies sold Insurance Professional and consulting fees Rent and office Repairs and maintenance Utilities Wages and benefits 14,613 5,946 - - 419 20,978 3,124 659 1,325 151 8,797 125 691 1,286 569 1,542 10,540 28,809 $ 2,460 450 11 149 4,757 105 710 1,246 498 1,612 8,465 20,463 5,547 2,219 3,328 Income before taxes Income taxes Net income Retained earnings, beginning of period Retained earnings, end of period 15,477 6,321 7,432 4,539 587 34,356 515 206 309 31,169 34,497 $ 30,860 31,169 201 202 Appendix C Paper III Paper III - SIMULATION 3 (continued) EXHIBIT II NOTES FROM MEETING WITH VICTOR ZIEGLER After years of slow and steady growth, OVS began expanding in two directions. First, OVS opened ten new video stores in 2005. In the past, OVS had only opened one store per year, but Victor felt more rapid expansion was necessary to compete with pay-per-view TV and downloadable movies on the Internet. Second, OVS moved into the Internet-based DVD rental business by launching a new website, www.MoviesByMail.ca. The expansion was financed by a ten-year term loan from OVS's bank. Victor noted that the bank now seems concerned with the profitability of the company. No Late Fees OVS also introduced a new program called \"No Late Fees\" during 2005. Since people are often reluctant to rent movies because they cannot return them on time, OVS eliminated late fees for its customers. However, to prevent abuse of this program, after 30 days if the movie is not returned, the outstanding movie is considered sold to the customer who rented it. The next time the customer comes to the store, there will be a charge of $25, the price of purchasing a new DVD, on the customer's account and they have the right to keep the DVD. The program has been \"tremendously successful,\" according to Victor. It has both increased rental revenue and increased sales of DVDs, since many customers keep their DVDs beyond the 30 days. However, Victor conceded that it has upset some customers who believed that OVS had truly eliminated all forms of late fees. Most customers who were charged for an over-30-day DVD have refused to pay for it and simply returned the DVD to an OVS store. Others have yet to pay for the DVD and have yet to return it. Movies By Mail When customers first subscribe to the Movies By Mail service at the store, they supply their credit card number and agree that it will be charged $30 at the end of each month until they cancel their subscription. To rent a DVD, customers log on to the website using a user ID and password provided to them. Once logged on, customers can browse the over 25,000 titles that OVS has in its DVD rental library. They can choose up to 40 movies to have in their \"wish list.\" If customers really want a certain DVD, they can flag it as urgent. The customer is mailed his or her initial four DVDs from the OVS warehouse in Toronto. These are selected automatically by the system based on availability of DVDs in the rental inventory, while giving priority to those DVDs marked as urgent by the customer. Once the customer is finished watching a particular DVD, he or she returns it by mail in a postage-paid envelope. OVS then sends the customer the next DVD on the list. During the introduction period of Movies By Mail, OVS offered new customers the option of paying $500 up front for three years of DVD rentals by mail. Many customers took advantage of this option due to its substantial savings. (revenue unearned/ deferred revenue) Uniform Evaluation Report - 2006 203 Paper III - SIMULATION 3 (continued) EXHIBIT II (continued) NOTES FROM MEETING WITH VICTOR ZIEGLER RentPoints In January of 2005, OVS introduced a customer reward program called RentPoints. For every dollar a customer spends with OVS, they get one RentPoint added to their OVS account. The point-of-sale system in OVS's stores automatically tracks the points each time a customer rents or purchases DVDs. Customers can then redeem RentPoints for selected rewards. For example, 100 RentPoints can be redeemed for a new DVD, or 25,000 RentPoints can be redeemed for a trip for two to Hollywood. Although Victor believes the program has been very popular, to date, only 92,000 RentPoints have been redeemed. Victor has faith that more people will eventually redeem their points since the points do not expire. However, he is now wondering if he should continue the program, since so few people have taken advantage of it. Previously viewed DVDs In the past, a wholesaler purchased all of OVS's previously viewed DVDs. Now, due to its expansion, OVS first sells all the previously viewed DVDs it can to the wholesaler. OVS then offers the remaining previously viewed DVDs for sale to its customers at discounted prices. Each of these remaining DVDs is scanned and its cost is transferred from \"Inventory-DVDs for Rent\" to \"Inventory-Previously Viewed DVDs for Sale\". When a new movie is released on DVD, OVS must order at least 20 copies of it for each store, at an average cost of $20 per DVD. Within two months, demand for the movie has diminished so that only five copies per store are necessary. As a result, OVS must sell off 15 copies per store for about $10 each. 204 Appendix C Paper III Paper III - SIMULATION 3 (continued) EXHIBIT III NOTES FROM MEETING WITH NICK NIGHTINGALE Nick Nightingale is the Chief Information Officer for OVS, and was responsible for the implementation of the Movies By Mail system. He answers the OVS help desk phone, so he has been extremely busy lately because Movies By Mail customers have been calling for assistance. He said the following: \"The Movies By Mail concept is great, but it has been difficult to get going. Moonwatcher Web Designers (MWD) programmed both the front-end, which is the part the customer sees, and the back-end, which is the database that tracks the DVDs. MWD programmed the website very quickly, but has not been available very much since the website went live six months ago. We have had several crashes of the website, and the only advice MWD has provided is to reboot the server. Considering all the money we paid MWD to develop the site, which at last count was over $8.5 million, I hoped for better service. \"We were able to save money by hosting www.MoviesByMail.ca on an existing server. Because the website needs to transfer credit card sales information daily to the accounting system, we used the same server that runs our accounting system. \"Since MWD also programmed an antivirus component right into the website software, we did not have to purchase separate antivirus software for the server. I have been after MWD to provide us with updates to the antivirus software. MWD keeps promising us that updates will arrive shortly. Thank goodness we have a great firewall, so viruses cannot get access to the system in the first place. \"I am also not too worried because we have a backup that I store off-site, because I know how important that is for disaster recovery. The back up now does both the accounting data and the movie title database. I change the tape every week and whenever I do a backup, it finishes in about 10 seconds, and ejects the tape right away. It used to take much longer to do the back up, but the MWD people must have done more than just tweaking when they installed the website. \"One matter I am a little worried about, though, is the shipping report produced by the new system. Each day, the system generates and prints a shipping report and the addressed envelopes. The report indicates which DVD gets sent to which customer, and there is one envelope for each customer listed on the report. The idea is that the inventory picker can find the DVD, and immediately put it in the matching addressed envelope to be shipped. However, I have noticed that sometimes the customer names that the system prints on the shipping report are different from the names it prints on the envelopes. Usually, it is not a big deal because we can correct the information in the system and just reprint the envelope. However, it causes the shipping people to do additional manual work. \"We were also having a problem with the customer login screen. Customers would be denied access, even if they were using their correct username and password. After repeatedly calling MWD, they dialed in to the system last night and applied a service pack to the website to fix the problem. Today, the login screen seems to be working fine.\" ACCT 315: Intermediate Financial Accounting Level I OP52 Spring 2015 Answer Audit planning memo To: Alice Hartford From: CA Subject: OVS December 31, 2005 Audit risk Materiality Audit approach Accounting issues Certain GAAP deviations are noticed in the F/S prepared by OVS controller. The deviations appear to be significant due to the reason that bank wants to analyze the profitability of the company. THEREFORE, in order to reflect true and fair financial position we need to make sure that these GAAP deviations should not be the reason to reflect overstated profits. The transactions are analyzed here as follows:No Late Fees FACTS OF THE CASE According to the interim financial statements, OVS recognized $4,539K in revenues and $4,210K in A/R for the No Late Fees (NLF) program. This policy increases profitability by the average gross margin of $5 ($25 - $20) per DVD. This is done in accordance with the management intention to overstate profitability, Relevant SECTION According to CICA HB 3400, revenue should be recognized when 1) performance is achieved and 2) collection is reasonably assured Conclusion 1 ACCT 315: Intermediate Financial Accounting Level I OP52 Spring 2015 Revenue should be recognized only when performance is achieved or collection is assured. In this case some customers who have to pay or return are still pending therefore recognizing revenue at this stage is not correct Movies by Mail Program a) Company has collected $500 as upfront fees for three years of DVD rental by mail. The amount paid in advance for subscription services is not deferred and is not recognized as revenue over the subscription term. Therefore OVS has not recorded revenue correctly. b) CICA According to CICA HB 3400, revenue should be recognized when 1) performance is achieved and 2) collection is reasonably assured Further as per this standard, revenue should be recognized when it is earned and not when the amount has been received. If the amount is received as advance, it should be deferred over the period for which it is recognized and full amount should not be recognized in the year when it is received As per revenue recognition criteria, in the given case revenue from subscription should have been deferred over a period of three years whereas OVS has not done the treatment as per section CICA HB3400 c) Thus, it is recommended that management should defer the amount of upfront fees of $500 over a period of three years. The amount pertaining to current year should be recognized as revenue and balance amount should be shown as liability in the balance sheet. 2 ACCT 315: Intermediate Financial Accounting Level I OP52 Spring 2015 Previously viewed DVD's Company has shown inventory of previously viewed DVD for sale and for rent in spate columns. However due to diminishing trend in demand inventory in excess of what is required is also reflected in the assets section. Inventory is not recognized at $ 10 which is lower of cost or net realizable value CICA Section 3031 on inventories states that Inventories are assets: Held for sale in the ordinary course of business; In the process of production for such sale; or in the form of materials or supplies to be consumed in the production process or in the rendering of services. Further inventories must be recognized at Cost or net realizable value whichever is lower. Conclusion Inventory in excess of what is required must be sold off and revenue from rental of each class of DVD whether held for sale or for rent must be classified as classified in assets section in the balance sheet. Also valuation must be made at $10 (Cost or NRV whichever is lower) WEBSITE FACTS All the expenses incurred till date on development and maintenance of website are added up to the cost of website and recognized as asset of 8.5 million. CICA As per CICA section 3870, cost includes all direct expenses attributable to an asset for its intended use must be added to purchase price. 3 ACCT 315: Intermediate Financial Accounting Level I OP52 Spring 2015 Conclusion Cost includes cost of service packs and various antivirus programs for website which is routine expense and should not be added to the cost of website. Hope this will help you in understanding the facts. Regards. 4