Case Assignment II
The Assessment of Risk at the Crafty Trinkets Company
Introduction As a senior auditor in a public accounting firm, you have been assigned to plan the audit of the financial statements of a privately-held company called the Crafty Trinkets Company (“CTC” or “the Company”).
Company Background CTC designs, manufactures, and markets a variety of toys, which are sold primarily to large national retailers like Target and Wal-Mart. CTC is a small company compared to competitors like Mattel and Hasbro; nevertheless, CTC managers believe their company’s toys are among the best in the world. Unlike the larger toy makers, CTC has enjoyed success with a small portfolio of brands and products, representing three categories: (1) soft toys, consisting primarily of its Snuggle Pets stuffed animals; (2) sturdy toys, including metal-cast and plastic cast toys like Speedster cars and Lightning action figures; and (3) digital toys, consisting of video game software under development. Like most toy makers, 60 percent of CTC’s sales revenues are generated in October and November, with the last two weeks of November driving half of those sales.
Your firm, Smith and Company, LLP (“Smith” or “the Firm”), has been CTC’s public accounting firm since 2013, providing audit and tax services to the Company. The primary external user of CTC’s audited financial statements is its bank. Assume it is now 28 November 2018. You have taken over audit senior responsibilities for the Company’s 30 November 2018 year-end financial statement audit because the previous audit senior has unexpectedly left your Firm to accept a job in another city. (The Company’s year-end date is 30 November.)
Please review the following excerpts from relevant documents involving the planning and execution of the current year audit. Then review the academic and administrative requirements of this assignment at the end of the case materials.
Excerpts from the document…. “Observations Noted in My Review of the Previous Year (year-end 30 November 2017) Audit File” (written by you, the senior auditor…)
In fiscal 2017, CTC exceeded its earning targets, reporting operating income of $3,026,100 and net income before taxes of $2,572,800. The only large negatives for the year 2017 were the substantial additions to allowances for receivables and inventories, including an extra $300,000 in the allowance for doubtful accounts related to the struggling Toy-Mart chain in the United States. CTC’s management advised the Firm that retailers dramatically reduced the quantity of toys they were willing to stock on its shelves at any one time in fiscal 2017, and were expected to continue this trend into 2018. This change did not (at least in 2017) reduce the volume of the toys sold through retailers, but it has intensified competition among industry competitors for retail shelf space, and increased operating costs by increasing the frequency of shipments to stores. (In the competitive environment in which CTC operates, shipping costs are usually paid by the manufacturer, not the retailer.) It’s possible that the restrictions on shelf-space could result in lower sales in future periods.
Ever since 2014, CTC executives have shared in a bonus pool that is created through CTC contributions of 10% of the first $750,000 of operating income, plus 20% on the next $750,000, and an additional 30% of the next $1,500,000. CTC’s total contributions to the bonus pool are capped at a yearly maximum of $675,000.
Excerpts from the document…. “Findings from Visit to Client and Interim (before year-end) Audit Procedures Conducted in September 2018” (written by the audit senior that you replaced)
In January 2018, the long-time CEO and CFO of CTC retired, and replacements were hired and began work in March 2018. One senior manager told me that the pair are like “fire-breathing dragons,” and have indicated that their “sole number-one focus will be increasing sales and profitability, and those who do not contribute will be given the opportunity to continue their career elsewhere.”
In the tests of controls over purchases, payables, and disbursements (performed during the “interim” time period), only one item seemed unusual. It involved a payment of $30,000 to the International Toy Manufacturer Workers Union. The payment was initiated by the CTC VP-Operations and approved by the current CFO, and was properly classified as a non-operating expense. According to the VP-Operations, the payment was “a gesture of support for the toy factory workers – a gesture we believe is important since workers believe themselves to be underpaid and are discussing the possibility of work stoppages and strikes in the Fall of 2018. We hope this payment will assist in making it possible for union executives to encourage their members to resolve these issues before a work stoppage or strike.”
In the tests of controls over revenues and receivables, the staff auditor noted that controls were effective. In particular the staff member noted that one thing that was very impressive was that the CFO was active in oversight of the area of bad debts and inventory obsolescence. Indeed, as an example, the current CFO herself approved the reversal/recovery of the $300,000 amount allowed for with respect to Toy-Mart, and had even initiated and approved the journal entry for the transaction, reversing it into income without the involvement of the credit manager.
Excerpts from the document…. “Audit Partner Memo to Workpaper File”
CTC had been unable to produce enough Snuggle Pets for the December 2017 year-end holiday season, due to raw material shortages in an unstable stuffing supplier market. The Company was able, however, to increase production in January 2018, which allowed for increased sales for Valentine’s Day in February 2018. Soon after, at the insistence of the national retailers, all unsold Snuggle Pets were returned to CTC for a full refund. The retailers insisted that the absence of Snuggle Pets in stores after February 2018 would build demand for the Fall/Winter 2018-2019, as the retailers focused on the end-of-the-year holidays and gift-giving season.
CTC has deferred their purchase of new, hi-tech manufacturing equipment due to a shortage of cash and the inability to obtain favorable financing. This is the second year in a row that CTC has deferred this investment.
CTC executives entered into an agreement with Cartoon Studios, Inc., who had produced their very first animated movie, called “The Bronx Zoo – Escape to Manhattan!” for release on 30 November 2018. (The movie is billed as “Jumanji” meets “Babe: Pig in the City”!) For $900,000, CTC had won the rights to produce a line of soft and plastic toys based on characters from the movie. (CTC plans to amortize this fee over 9 years.) The toys would be sold through CTC’s regular retail customers. The toys were on schedule to be in stores on 30 November. The agreement between the Company and Cartoon Studios indicated that Cartoon Studios would compensate CTC for the cost of the unsold toys if sales of the toys failed to reach $1,500,000 during the first two months after the movie’s release. CTC plans to accrue $1,500,000 of sales revenue on 30 November relating to this provision of the agreement.
CTC executives have carefully reviewed the pricing and valuation of inventory during early November 2018, and determined that the inventory valuation reserve established in the previous year is no longer necessary; a journal entry was made by the CFO on 15 November 2018 to reverse the valuation allowance into operating income.
In October 2018, CTC announced that it was suspending it’s partnership with the charitable organization “Toys for Kids,” an organization that distributes toys to underprivileged children in less-developed countries around the world. In the past, CTC had donated a substantial number of toys to “Toys for Kids.”
On November 1, 2018, the Company’s Board of Directors Compensation Committee agreed to double the Company’s contribution to the bonus pool, to $1,350,000. This measure will be effective for the year-ending 30 November 2018.
Requirements: Using your textbook and material discussed in class as reference material, please address the following issues:
Identify at least one risk factor related to auditor business risk, and one related to client business risk.
Identify and briefly discuss significant risk factors for material misstatement (in other words, IR and CR) present at CTC. If any of these risk factors also increase the risk of fraud, identify them as such.
After identifying significant risk factors, use your judgment to assess the risk of material misstatement at the Company. You may assess RMM on a scale of 1 to 10, or using categories such as low, medium, high, and very high.
Then, identify one account in the financial statements of CTC that appears particularly risky, and then one management assertion relating to that account that appears to contribute significantly to the risk of material misstatement. In order to do this, you may need to assess the reasonableness of the accounting or proposed accounting for some of the issues cited above. If you don’t recall the particulars of how to account for certain issues, you may need to engage in a brief bit of accounting review/research to assess whether the accounting or proposed accounting is in conformity with GAAP. After you identify a risky account and a related risky assertion, discuss how you would approach the audit of that assertion. You may need to look in sections of the text that we did not cover in class, depending on your selection of account and assertion.
Please include a separate cover page that includes your name and student number. Please do not put your paper in a folder or binder. A stapled paper will be fine.
The body of the paper should be written in narrative form (not bullet point form, although you can make limited use of bullet points) and should be adequate in length to address the requirements, but in no case longer than 5 pages in length. Please use a single-spaced, block paragraph format (left and right justification), with one space between paragraphs or headings (similar to the presentation of the first page of the case above). Use a 12 point font and standard margins.
Be careful that you understand the timeline of the events in this case. Recognize that some of the information relates to the prior year audit, and some relates to the current year audit coming up.
Please do NOT spend significant portions of your write-up recounting the facts of the case, or presenting a summary of the case. Assume I have read the case information, am familiar with CTC, and most importantly, I am familiar with auditing terminology, theory, and practice. You need NOT define auditing terminology in your case write-up. Doing so is unnecessary, given your audience, and will detract from the quality of your paper.
Your paper should be well-written and professionally presented. I will evaluate both the content and the style of the document. Content will account for approximately 75% of the points relating to the paper, and style (grammar, punctuation, etc.) will account for approximately 25% of the points. Pervasively poor writing may cause you to lose all the points relating to style, so please invest the effort required to improve your paper before submission. PROOFREAD your paper and fix typos, misspellings, and grammar errors.