Assessing Audit and Business Risks at Toy Central
Corporation
INTRODUCTION
As 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 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.
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 Monstersstuffed 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 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 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. 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 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 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 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).
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.
You should avoid assuming that the partner will fully recall
all relevant facts, or that she will immediately recognize all
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.
2. 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 2006,
reporting operating income of $1,008,700 and net income before tax
of $857,600.
3. The Cuddle Monstersstuffed 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.
4. 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 specifically 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 $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 2007
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 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 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 non-operating expense,’’ a control
deviation did not exist.
2. One of the control tests for the receivables system
involved determining whether bad debt writeoffs 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 oversight, 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.
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, 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
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
Monstersto 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 Monsterswere 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 summer—increasing the chances that a
holiday season selling frenzy could again be created in November
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.
3. 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.
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 Linuxbased 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 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 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, 2007, 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 2007 year-end.
7. For the year ended October 31, 2007, TCC forecasts
operating income of $979,980 and net income before tax of
$275,000.
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