As a senior in a professional services firm, you have been assigned to plan the financial statement audit of a private company named Toy Local Corporation (TLC). In addition, the partner on the engagement has asked you to identify business risks that could adversely affect TLC'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 Local Corporation (TLC) 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. TLC is a small company compared to competitors Mattel and Hasbro; nevertheless, TLC'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, TLC has enjoyed success with a small portfolio of brands and products, representing three categories: (1) soft toys, consisting primarily of its Cuddle Bears 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 TLC's sales revenues are generated in October and November, with the last two weeks of November driving half of those sales.
Your firm, KWJM, has been TLC's professional services firm since 2001, providing audit and tax services for the company. The primary external user of TLC's audited financial statements is its bank. Assume it is now October 28, 2012. You have taken over audit senior responsibilities for the company's October 31, 2012 year-end financial statement audit, because the original audit senior has left the firm. As a private company, TLC 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, TLC 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, TLC has asked your firm to consider not only financial reporting issues, but also significant business risks that could affect the sustainability of TLC's success in the toy industry. Although TLC'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 TLC in the foreseeable future. TLC's audit committee is meeting in two weeks and would like the partner to explain significant business risks identified during KWJM'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:
Prepare a planning memo for the TLC engagement based on the information provided in the case. The planning memo should address the subsequent issues:
1. Business risks.
2. Audit risk factors.
Bear in mind that the partner on this engagement is also responsible for several other client engagements. Consequently, while you could endeavor to be direct and succinct in your memo (limiting it to no more than two single-spaced pages), you should avoid considering 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 explain the specific facts that you consider relevant and describe the implicationsfor the TLC engagement.