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Overlook Video Stores Inc.

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The purpose of this memo is to document the planning of the financial statement audit st‚Ä謆engagement of our client Overlook Video Stores Inc. (OVS) for the year ended December 31‚Äč , 2009. OVS has been our client since its inception in 1998. This year‚Äôs audit will commence January, 2010, though certain procedures have already taken place to ensure our opinion can be given promptly, as requested by OVS‚Äôs bank.

OVS is a privately held company, headquartered in Toronto and operating in the DVD rental and retail industry. OVS has over thirty store locations and is rapidly expanding, including a recent foray into the online DVD­rental/retail space and potential entry into Western Canada markets.

The main users of OVS’s financial statements are the managing (majority) shareholder, Mr. Victor Ziegler, the three remaining private investors who exercise no active participation in managing business operations (and so will be using these financial statements to monitor the health of and management stewardship over their investment) and OVS’s bank which has extended financing for expansion of the business (and thus requires financial statements for monitoring OVS’s credit/default risk). To satisfy the aforementioned users’ needs, we must not only provide audited financial statements, but also identify OVS’s significant business risks and bring those risks to the attention of the financial statement users. The second purpose of this memo, as per your request, is to specifically address the control issues arising from OVS’s new Internet business.

Engagement Risk and Financial Reporting Risk Analysis (CAS 315) We have performed an analysis of the Engagement Risk (ER) and Financial Reporting Risk of st‚Ä謆the OVS financial statement audit for the year ended December 31‚Äč , 2009. The following is a ¬†list of concerns regarding the OVS engagement‚Äôs Control Risk (CR) and Inherent Risk (IR), together the Risk of Material Misstatement (RMM)Õĺ as well as OVS‚Äôs Business Risk (BR), which may exacerbate the affect of RMM on our potential liability in providing a clean opinion. Consideration of these factors will help us identify an appropriate figure within our range of materiality against which the audit will be performed and will dictate how much audit work will be required to provide a clean opinion without exposing H&H and the audit partner to excessive liability:

‚Üí Factors Increasing Business Risk (BR)
BR is increased due to OVS’s venturing into a new Internet­based DVD rental market space via the newly­implemented Movies By Mail program. Management has no prior experience in this retail space, the technology, and their expectations and ability to accurately project/budget is severely limited.
BR is increased due to fierce competition in the Canadian video industry from entities who are capable of highly competitive pricing as well as from other platforms such as pay­per­view and internet downloads. These factors have lead to OVS’s decreased market share and thus an increase in BR.
BR is increased by OVS‚Äôs aggressive and untested plan to expand at a much expedited rateÕĺ opening 10 locations in one year where, in prior years, one new location per year was the trend. This rapid expansion will strain OVS‚Äôs financial resources and raise a going concern issue that will need to be scrutinized throughout the audit.
BR is increased by OVS’s poor communication of policies to its customers and employees resulting in dubious revenues/receivables. Moreover, there are hidden costs associated with OVS charging its customers late fees. Poor customer relations/reputation can be a serious impediment to OVS long­term success.
BR is increased by the failure of the measures OVS has taken to remain competitive in their challenging industryÕĺ namely, the RentPoints (RP) and the Movies By Mail (MBM) Programs. The RP Program, a customer loyalty reward initiative, has had very few partic¬†ipating customers taking advantage of its incentives for repeat business (only 92,000 RentPoints redeemed, representing $92,000 spent in OVS). The MBM program has had serious complications in its implementation specifically relating to website integrity and numerous crashes. Frustration over the program has caused some customers to cancel their memberships or be offered some compensation (eg. 2¬≠month free memberships).

Overall BR Assessment:‚Äč
The highly competitive industry has decreased OVS’s market share thereby driving them to match competitor’s prohibitively low prices or venture into new markets and take measures to remain competitive. Management has no experience/expertise in this area and because these new initiatives have largely failed in this objective, we feel we must assess OVS’s BR as medium­high.

‚Üí Factors Increasing Inherent Risk (IR)
IR is increased by the unique store inventory accounting policies chosen by OVS and the resulting issues of obsolescence/valuation. This increases the RMM in the various Inventory accounts relating to valuation.
IR is (potentially) increased by any binding covenant (that may be) associated with the  ten­year loan OVS has been extended by their bank to help finance its rapid expansion. If such a covenant exists, there will likely be a pervasive incentive to meet the terms of the covenant at all costs (ie. misstate various accounts).
IR is increased due to Mr. Ziegler‚Äôs interest in selling his portion of shares to a Western Canadian company in the next couple of years. As such, there is a pervasive RMM due to management‚Äôs bias to overstate profit (overstate revenues and understate expenses) to garner a more favourable purchase price. This RMM is pervasive insofar as it potentially affects a number of profit¬≠related accounts at the financial statement level. Importantly, a heightened level of professional skepticism will be required throughout this engagementÕĺ especially when developing audit procedures.
IR is increased by the implementation of the new Movies By Mail (MBM) Program. Revenue recognition with respect to this program is more complex than traditional in­store sales and OVS’s management’s lack of familiarity with online sales and with their appropriate accounting treatment increases the RMM in the revenue and A/R accounts. Moreover, development and use of a web site further complicates the accounting, thereby further increasing the RMM.

IR is increased by the implementation of the new RentPoints (RP) Program. Management’s lack of experience accounting for such loyalty rewards programs introduces a RMM, particularly in the liabilities and expense accounts.

IR is increased by the failure of OVS’s new website software to accurately keep track of the customer database (membership info, purchase and payment information, etc.)

Factors Decreasing Inherent Risk (IR)
IR is decreased by the fact that the OVS audit is a repeat audit engagement and so we are familiar with many of the issues that will be relevant to providing an appropriate opinion.

Overall IR Assessment: ‚Äč
Due to the complexities of accounting for OVS‚Äôs ‚Äč new initiatives, management‚Äôs deficient accounting expertise and pervasive bias to overstate revenues and understate expenses, we assess IR for this engagement as high.

‚Üí Factors Increasing Control Risk (CR)
CR is increased by the new controls put in place in 2009 that have yet to be tested (ie. relating the MBM Program). These controls need to be tested before we can comfortably rely on them. Moreover, we are as of yet unaware of when longstanding controls were last tested. Controls need to be tested at least every third audit (CAS330.14(b)).

‚ÄčMWD designed both the back¬≠end and front¬≠end of the MBM Program. This customer ERP software will no longer be monitored or maintained by MWD in three years and it already has significant functional issues that have not been resolved. Furthermore, orders placed and are not being filled due to periodic system crashes causing unknown quantities of information loss. The CIO, Mr. Nick Nightingale, is forced to cross¬≠reference customer complaints with the separately maintained accounting system to ensure orders are filled, but how often that separate system is updated is unknown. To further complicate the issue, MWD has not been very helpful in servicing their technology.
Customer records (orders and sometimes whole accounts) are being lost which affords the possibility of customers lying to have their membership ‚Äėreinstated‚Äô when they have already ceased payment, or keeping DVD‚Äôs beyond the rental period and OVS having no certain way of knowing. This information is recorded redundantly in the separate accounting system but it may not be updated regularly. As such, RMM is increased in the Inventory accounts related to the valuation and existence assertions as well as in the revenue and A/R accounts related to valuation, existence and completion.
CR is increased by evidence of employees failing to follow or even know of certain company policies, for example, the No Late Fees Program and communicating these policies correctly to customers. This raises a RMM in the revenue account related to the occurrence assertion.

‚ÄčCR is increased because of its control environment. There is evidence OVS has a bias towards increasing net income and has selected its accounting policies to satisfy this imperative. For example, taking the $20 late fee charge into revenue automatically 30¬≠days after a rental has not been returned, improper capitalization of some website costs that should have been expensed and failure to recognize an allowance for doubtful accounts. Moreover, OVS does not have an audit committee or internal audit department to ensure controls are being implemented and maintained appropriately.

‚Üí Factors Decreasing Control Risk (CR)
CR is decreased by the fact that the Mr. Nightingale has implemented some measure of redundancy by maintaining a separate accounting system to record customer records, etc. to reduce risk of data loss due to website malfunction. ‚ąô‚Äč

‚ÄčCR is decreased by OVS‚Äôs policy to refrain from implementing online customer subscription to the website until issues regarding its functionality have been resolved.
Overall CR Assessment:‚Äč
Due to the moderately successful implementation of new systems and the myriad control issues resulting therefrom as well as the choice of accounting policies which seem to serve management’s ends (Mr. Ziegler’s bias) over those of other users, we have assessed CR as medium­high.

Assessment of Risk of Material Misstatement (RMM)‚Äč: As we have assessed IR as high
and CR as medium­high, the RMM (IR x CR) must also be high. We have highlighted the pervasive, financial statement­level RMM and the account/assertion­level RMM relevant to the OVS engagement below:
Pervasive, Financial Statement­Level RMM:
‚Üí There is a clear bias on behalf of Mr. Ziegler, who is contemplating selling his majority interest in OVS, to overstate net income (ie. inflate revenues and decrease expenses) as much as possible so as to portray OVS as a better investment and thereby garner a higher price for his shares.

‚Üí We are as yet unsure whether there is a binding covenant attached to the loan extended to OVS by its bank or whether the bank simply has a general interest in the health of the OVS given its lending relationship. If, however, there is a binding covenant in place (eg. D/E Ratio, Working Capital, etc.). we must acknowledge a (likely) pervasive RMM resulting from the interest to stay onside of that covenant, regardless of the economic realities of the company. ‚ąô‚Äč

Account/Assertion­Level RMM:
‚Üí RMM to overstate Revenues and Accounts ReceivablesÕĺ the relevant assertions being Existence, Valuation and Occurrence.
‚Üí RMM to understate Inventory (and thereby overstate revenues ‚Äď assuming no covenant)Õĺ the relevant assertion being Valuation.

Assessment of Detection Risk (DR):‚Äč
Where we wish to limit our risk of potential
liability for this engagement to a minimum, by setting our planned Audit Risk (AR) low, we must conclude that our acceptable DR must also be low. This DR informs our audit strategy, briefed below.

Assessment of Engagement Risk‚Äč
(‚ÄčER‚Äč): It would be prudent to note that the bank has requested audited financial statements as soon as possible and that we must be wary of this as a potential threat to our independence (via intimidation). The engagement is risky enough (as outlined above) without feeling forced to provide an opinion in a very tight time frame. If we are pressed for time via intimidation, we must be prepared to offer a Disclaimer of Opinion or leave the engagement.

Recommended Materiality
Based on the information provided and principal financial statement users’ needs (further developed in Appendix I), it is most appropriate to base materiality on net income as it is the common interest between all users of the financial statements (assuming no binding bank covenant).

The potential sale of Mr. Ziegler’s controlling interest in OVS and thus pervasive bias to inflate net income (as this would be the primary concern of a prospective buyer), the company’s rapid growth as well as silent shareholders’ reliance on the financial statements are the primary reasons for this selection. As noted, in light of our assessment of RMM as high and our risk/liability aversion forces us to set AR quite low, to overcome a low DR we have chosen to recommend a planning materiality at the lower end of the materiality range. It should be noted that the figures below are for the first 11­months of the period and are thus for planning only. We will perform a similar calculation when the year­end statements (12­month figures) are submitted for our opinion.

Where reported net income for OVS‚Äôs (first 11¬≠months of) fiscal 2009 is $3,328,000, our corresponding range of materiality (between 5% and 10% of net income) would be between $166,400 and $332,800. As there are potential new users of these audited financial statements, absentee owners and a series of potential issues introduced during the year (discussed above), we recommend a planning materiality of $166,400. Performance materiality would then be set to 75% of recommended planning materiality, ie. $124,800, to allow room for inevitably undetected/ undetectable errors‚Äč

Audit Strategy
Based on preliminary assessments, a pervasive approach will be needed as no reliance can be comfortably placed on internal controls. There is no mention in the audit file of interim tests of control during fiscal 2009, which under normal circumstances, would be required to rely on the fact that controls have been working properly throughout the period, not just at year-end. Had the control environment/business model not been changed throughout the period, we would be able to rely on controls tested as efficient and relied upon sometime within the last 2 audits of OVS (CAS330.14(b)). As there is no mention of the last time these longstanding controls were tested and in light of the rampant change to business processes and corollary changes to the control landscape, we simply cannot rely on controls in the requisite way for a combined approach.

Given our inability to perform an inventory count to test the existence assertion regarding inventory on hand at year-end, we must apply roll-forward procedures from the successful th‚Ä謆inventory count performed November 30‚Äč, 2009. Once the period is complete and¬†management supplies us with information encompassing the full period (including the month of December), we can calculate what inventory should be using the counted figure as a starting point and adding purchases made and subtracting sales made in December. This final figure can then be checked against the final inventory balance provided by management for reasonable assurance regarding the existence assertion

A high level of professional skepticism will need to be exercised during the audit because of the inherent risks associated with management to bias the net income figure (as noted in our risk assessment there is already evidence this is taking place) and the potential users who will rely on this information. Special attention should be placed on those accounts we have identified in our risk analysis including understatement of expenses, overstatement of revenues, inventory valuation (highly material based on recommended materiality) and the accounts receivable. An IT expert will likely be need to audit the system put in place by MWD using CAATs to provide you, Ms. Hartford, with the appropriate understanding and assessment of the existence and effectiveness of controls therein.

Any misstatements should be tallied and revised financial statements should be assembled. Carefully analyzing these revised statements will allow the us to assess the risk of misstatement at the financial statement-level and better identify going-concern risks as liquidity and the ability to repay outstanding debt have been identified as issues. Accounting Issues and Audit Procedures

Inventory Count – Performed Early
To facilitate the early financial statement preparation the count was performed on November 30th instead of December 31st. The count was attended by audit team members and no issues were noted at that time.

Inventory Audit Procedures – Assertion: Existence
‚óŹ To properly assess the year-end existence of inventory roll forward procedures will be required. A sample of items should be selected and a reconciliation should be performed to determine if the ending balance at December 31‚Ä謆is appropriate. As we have already¬†confirmed that there are no issues with the samples counted at the count November 30‚Äč,¬†these items should be used for the roll forward procedures as we are confident that the opening balance (November 30 balance) is reasonably correct. Inventory Balance Valuation

When new DVD‚Äôs are released OVS acquires 20 copies, each DVD costs $20. After 2 months only 5 copies are required to be available for renting. The remaining 15 copies are transferred to the ‚ÄúPreviously Viewed‚ÄĚ shelf making them available to customers for a sale price of $10. After the DVD has been available on the sale shelf for another month it is further reduced to $5. if the DVD does not sell at $5 after a month it is reduced to $1 and sold to a previously viewed distributor. Under GAAP, assets should appear on the financial statements at the lower of cost and net realizable value. The discounting OVS engages in as the inventory ages, indicates a decrease in value (future economic benefits) attributable to the inventory.

As such, when DVD’s are moved from the Inventory-DVD’s for Rent account to the Inventory-Previously Viewed DVD’s for Sale account after two-months, they should be written down from their historical cost ($20/DVD) to their new net realizable value ($10/DVD) and an impairment expense recognized to Cost of Goods Sold in the period. After two-months in this account (ie. not been sold) inventory should be written down a further $5/DVD to reflect their new net realizable value ($5/DVD) further increasing COGS. Inventory in this account for three-months should be written down a further $4/DVD to reflect its ultimate net realizable value before they are sold to the previously viewed distributor for $1/DVD, further increasing COGS.

As it stands, OVS has not recognized this impairment to its Inventory-Previously Viewed DVD’s account. Instead OVS simply transfers the historical cost of the transferred inventory ($20/DVD) to the Previously Viewed account. As such, (assuming, highly conservatively, that inventory in this account is simply two-months old), Inventory-Previously Viewed DVD’s is overstated and COGS is understated by $5,526,000/2 = $2,763,000. If the inventory is four- or more months old this variance would be increased.

Further, OVS should use its knowledge from operating the business for a number of years to estimated a useful life for the DVDs that remain in the Rental Inventory account and depreciate them over that period as they bring in economic benefits. The depreciation expense for any individual DVD will be non-material, but for the account (assuming, say, even a 20-year useful life ‚Äď highly improbable)¬†would be $7,935,000/20 = $396,750; a material amount. As depreciation is based on a number of estimates the exactness of the number is less important than conveying the economic realities of the situation to financial statement users by recognizing the consumption of a limited life asset as it is used to produce economic benefits for the company.

Inventory Audit Procedures – Assertion: Valuation
‚óŹ Obtain an aged listing of inventory. Based on the age of inventory recalculate the provision for each DVD. Inventory less than 2 months old should have no provision, 2 months to 3 months should have a 50% provision, 3 months to 4 months provision should be 75% and anything older than 4 months should have a 100% provision.

‚óŹ Total the provision and compare to managements estimated provision. Discuss any discrepancies with management.
‚óŹ Calculate depreciation and consult with management as to why they aren‚Äôt currently booking the expense/ask that they do before we provide an opinion on the final statements. No Late Fee Program

During 2009 OVS implemented a ‚ÄúNo Late Fee‚ÄĚ program in which the customer does not have to worry paying late fees if the DVD is not returned immediately. If the DVD is kept beyond 30 days, however, the customer is charged as if they had purchased the DVD outright (ie. once the DVD is outstanding for more than 30 days the system automatically generates the sale and offsetting receivable). According to management, this rule has not always been made clear to customers. As such, most customers have refused to pay and returned the DVD; some DVDs have not been returned and not paid for. When the DVD is returned the receivable is reversed and if there are greater than 5 copies in the store the DVD is put on the ‚ÄúPreviously Viewed‚ÄĚ listing. If there are less than 5 copies the DVD is added to the DVD for rent inventory listing. From an accounting perspective, GAAP has outlines basic criterion for revenues to be recognized, a main component of which is reasonable expectation of collectability of the economic benefits (IAS18, section 3400).

If OVS’s customers, and in some cases even employees, were unaware of the policy then it is hard to argue that OVS had a reasonable expectation of collectability of the price of amounts supposedly owed by those customers with DVD’s outstanding for greater than the allotted 30-day period. If this policy may not have been communicated appropriately at the time of rental but was, say, say stipulated in the membership contract or in a letter to existing members at time of implementation of the program, and it was the customers who failed to read the new policy carefully, one could argue OVS had a reasonable expectation of collection and could recognize the revenue after 30-days. These particulars need to be examined.

If recognition of revenue is appropriate, GAAP dictates that assets be held at the lower of their cost or net realizable value. It also stresses employing accrual accounting to satisfy the matching principle. In so far as this is the case, an accrual should be set up for an allowance for doubtful accounts for the proportion of the outstanding DVDs will not be returned and for which customers have no intention of paying the sale price. When customers specifically notify OVS of their intention not to pay the receivable amount, the allowance can be expensed as a bad debt, offsetting the revenues supposedly earned in the period through this policy.

By doing so, OVS would reduce the receivable to a more appropriate net realizable value amount (of future economic benefits they still expect to receive) and offset the expense of this effectively stolen inventory with the revenues claimed earned when the sale was booked after 30-days. As it stands right now, the profit (ie. 7¬† revenues ‚Äď expenses) and accounts receivable are largely overstated because no allowance is being accrued (against A/R) and no expense is being recognized (against revenues). Revenue Audit Procedures – Assertion: Occurrence, Accuracy
The process of this sale transaction should be compared to the revenue recognition criteria. Given that management asserts the rule is not always clear it would appear that the criteria of collections being reasonably assured is not met. If this is true, all sales and revenues should be reversed. If the revenue is deemed to have not existed, then the following inventory procedures should be performed:

Inventory – Assertion: Valuation
An aging list should be obtained and similar procedures to the ones performed for the inventory on hand should be completed.
Discuss with management the likelihood of actually receiving the movie back and whether a further provision should be recorded for theft.
If it is determined that the revenue does exist, then the following accounts receivable procedures should be performed: Accounts Receivable РAssertion: Valuation
Obtain an aging list of the outstanding receivables as at December 31, 2009. Obtain a second aging list as at fieldwork date. Compare the listing to determine which accounts have been paid subsequent to year end. For accounts still outstanding discuss with management the likelihood of collecting receivables that are over 30 days old (as this would mean the customer has had the movie for 60 days).

: If the result of the revenue recognition criteria are met, that test would help satisfy the existence assertion for the receivable.
Movies by Mail Program
In fiscal 2009, OCS expanded to the internet-based Movies by Mail program which allows customers to browse movie titles online and order them to be delivered and returned by mail. The customer is initially mailed their top four picks, then as they return movies the next movie on their list is mailed to them. The cost of this service is $30 per month paid at the end of the month by credit card. However, during the introductory period customers were offered the option to pay an upfront fee of $500 for a two-year term;

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