Yu Contracts Inc. (YCI)

Dr. Icey Yu is an optometrist and the sole shareholder of Yu Contracts Inc. (YCI), an optical company that sells prescription disposable contact lenses and eye glasses out of its location in Scarborough, a neighbourhood in Toronto. YCI is managed by Icey and has a May 31 year end.

You, CA, are a manager with Acorn LLP (Acorn). Yesterday, you and Anthony Green, the engagement partner, met with Icey at YCI. Icey asked for this meeting to discuss the future of YCI's operations. Acorn has performed review engagements for YCI for the past three years.

Icey began, "I have decided to live year round at my cottage in northern Ontario and have therefore been considering two options regarding the future of YCI. I believe I could sell YCI and live off the proceeds or I could oversee the operations of YCI from my cottage, as a web-based company selling contact lenses only. I would like your help in determining the best alternative for me.

"I will require an audit of YCI for 2016, as I believe a buyer would require audited statements. I need your assistance in determining a reasonable selling price for the shares of YCI. I have brought you a draft income statement for the 2016 year end. I believe the last three months of sales are the best indicator of future sales potential so I have included information for that period as well (Exhibit I). I have also included some background information on YCI which may be useful to you (Exhibit II).

"I have notes on how the web-based operations would work (Exhibit III) and would like to know how much cash I would be able to generate if I were to pursue this option. I am only concerned with my cash flows for the next four years, until I am eligible to access my pension income in 2020. I estimate I will need between $300,000 and $400,000 to cover my expenses until 2020.

"I met with a web consultant who provided me with information on a system that could be used if I were to operate YCI as a web-based company (Exhibit IV). I am concerned about the security with this kind of operation and would like you to identify the significant risks that the web-based company would be exposed to as well as any practical recommendations to mitigate these risks."

After the meeting you reviewed some of the accounting records and further discussed the business with Icey. A summary of some of the issues that you discovered while out at YCI are in Exhibit V. It is now June 4, 2016 and you are meeting with Anthony to discuss the YCI engagement. Anthony asks that you prepare memo to him addressing the issues raised by Icey in the meeting and asks that you discuss the accounting issues you discovered while at YCI and identify the related audit procedures that should be performed. For now, he would like you to ignore the personal income tax implications of the sale of YCI and any first time audit considerations.

Required:

Prepare report to the partner, Anthony Green,discussing:

1)Three accounting issues:

a)how you propose to account for each of them

b)The audit assertions and 1 to 2 audit procedures for each issue.

2)Comment on the current financial condition of YCI, including 3 important ratios and make recommendations.

3)Calculate the potential selling price of the YCI company including any adjustments

4)Prepare 4-year forecast ofthe web-based business including quantitative and qualitative analysis comparing (2) versus (3).

5)Three internal control issues, implications of the weaknesses and recommendations to improve the security and likelihood of success of the proposed web-based business.

Exhibit I

2015

2016

2016

** reviewed not audited

EXHIBIT II BACKGROUND INFORMATION PROVIDED BY ICEY

YCI has a regular customer base which I anticipate will make it an attractive acquisition for another business in the same industry.

I have been in communication with the owners of two other optical stores which operate in similar markets and learned that on average they made about a 10% after tax return on their investments.

I believe that any purchaser would have their existing staff place all orders. This would eliminate the salary currently being paid to YCI's order clerk of $50,000.

In recent years YCI has not invested much in advertising as its current customer base consists of mostly repeat customers. Other optical stores spend around $70,000 annually to attract new customers.

The current store location is leased at a rate of $3,000 per month. It is located within walking distance from several apartments and businesses making it convenient for customers to access.

YCI had a bank loan which they entered into in 2014 with a fixed interest rate of 5% that was secured by a personal guarantee I provided. This loan was repaid in full in January 2016.

EXHIBIT III NOTES ON OPERATING YCI AS A WEB-BASED COMPANY

Ordering

The store location is only necessary for the glasses portion of the business as customers typically want to try on frames before committing to a purchase. Since the sale of contact lenses could all be made via internet orders, I could oversee the operations from my cottage.

YCI would order the contact lenses from our suppliers as soon as the customer places their order. We would have the contact lenses delivered from our supplier directly to the customer within two days so there is no need to maintain an inventory of contact lenses on hand.

YCI would accept credit cards as the only form of payment from customers and would have a no return policy as the lenses are for each customer's specific prescription.

Customers

To retain existing customers, YCI would send a mass mailing explaining the changes to the business and providing the new contact information, etc. Such a campaign is estimated to cost around $12,000.

As a result of the mailing YCI should be able to retain approximately 75% of existing contact lens customers. There are currently approximately 1,000 existing customers who purchase an average of 30 pairs of disposable contact lenses each month. Although it varies by brand, the average retail price per pair of lenses is $2.

The remaining contact lens customers may leave either because they do not trust the security behind making online payments or because they would prefer to purchase both contacts and glasses from the same location.

I am not interested in spending a great deal of time and effort trying to grow the web-based business as the plan is to ease into semi-retirement. I estimate that sales will increase slowly so I would expect only a 2.5% increase in annual sales.

Operation Costs

The cost of contact lenses will remain around 38% of their selling price.

Selling expenses are expected to be around 9%. This will include payment to advertise on search engine websites.

General and administration expenses are expected to be $105,000 in the first year and then increase 2% annually. These costs will now include wages for only one part time staff member to assist me in the business.

Currently customers pick up their lenses at YCI's store. However under the web-based option, YCI will pay shipping charges to have the suppliers' ship the lenses directly to the customer. The additional shipping charges are expected to be approximately 10% of sales.

I anticipate the cost of setting up the web-based internet site will be around $30,000, with annual service and maintenance fees of $3,500.

Ordering

All customer orders will be placed via the website that will be developed and maintained by the web consultant.

As all orders will be placed online, customers must pay using a major credit card. Funds will then be deposited into YCI's bank account directly from the credit card companies.

When an order is placed, the customer will be asked to enter the following information onto the web page:

o brand and quantity of pairs of contact lenses

o prescription requirement for each eye

o personal information including shipping address

o credit card information

All information will be entered on one page, making the order process Yuck and easy for the customers. If the customer fails to enter the quantity of lenses, the system will not allow them to hit "Submit". The system will prompt them with an error message and require them to enter the quantity of lenses to proceed. This is the only field that when not completed will prevent customers from placing an order.

When the customer is done inputting information, they will click on "Submit" and the information will automatically transfer to YCI's sales tracking sheet and the general ledger will be updated concurrently.

Once the transaction is submitted the system will produce a sales receipt which indicates the total cost of the order with details of what was purchased.

Shipping

Once the orders are received by the system, YCI will take the information on the sales tracking sheet and contact the suppliers to place the orders and arrange for their shipment to the address input by the customer.

The part-time staff member will count the total number of orders on the sales tracking sheet and compare this to the total number of orders recorded in the general ledger for that day. Although counting the orders daily may be time consuming, this will ensure that the system is operating as it should.

Information System

The mainframe will be located in the cottage where YCI's operations will be run.

The system will be setup to make automatic weekly back-ups of the sales tracking information which will be stored on a separate drive on the mainframe.

There will be logins and password setup on the computer for each user.

The web consultant can use an internet connection to remotely access the system to install updates and make any necessary changes to the system. The web consultant can even fix a bug or perform an upgrade to the system while it is running so there will be no downtime.

EXHIBIT V ACCOUNTING AND OTHER ISSUES DISCOVERED WHILE AT YCI

In March 2016, as part of a special "pay now and get 5% off" promotion, sales orders were placed by 140 customers for 30 pairs of contact lenses for each of the remaining nine months of 2016. YCI recorded the full amount of these sales as revenue in March as these orders had been paid for in full. The contacts, however, are typically not ordered from the suppliers until closer to the month for which the orders relate, as customers pick up their orders on a monthly basis.

Icey indicated that a significant number of frame styles are out dated with a book value of $10,000. Icey is hopeful that the frames will come back in style however there has been no indication of this to date. The frames cannot be returned to the supplier. Icey is planning to sell these at 50% of cost in order to move them. It is typical in the industry to have to write down a portion of inventory annually as the styles change so frequently. YCI's inventory of frames is currently valued at $50,000.

YCI has 60 specialty sunglasses in inventory (separate from the frames) recorded at a cost of $200 per pair. In January 2016, Icey decided to reduce the selling price of the sunglasses from $250 to $150 as this is the price he believes will guarantee their sale. YCI has never had to lower the price of sunglasses before as they typically sell quickly and Icey does not expect to have to lower the price of any other specialty frames in the future.

YCI is planning to count the inventory on June 6, 2016.