You are the owner of a successful fanny-pack company. your fanny-packs are selling
well. So well that you are considering adding a premium fanny-pack to your line-up of goods. Your
marketing department estimates that you will be able to sell $5 million worth of the premium fanny-
packs annually. Unfortunately, the team informs you that the premium product will not attract new
fanny-pack customers. Rather, the sales of premium packs will cannibalize your existing sales in a 1-to-1
ratio. For every premium fanny-pack you sell for $50, you sell one fewer regular fanny-pack (which
retails for $20). Luckily, both styles of fanny-pack use the same raw materials in the same quantities, so
the costs of goods sold will remain unchanged, and your inventory requirements will be unaffected. You
plan on selling fanny-packs indefinitely, but don't expect sales to increases year-over-year. Your firm's
effective tax rate is 30%, and your cost of capital is 8.5%
(a) The premium nature of these fanny-packs derives from the intricate sewing techniques which
must be used. The only machines capable of such delicate work are produced only in Italy, and
cost an astounding $20 million. If purchased today, the machine will be working by tomorrow.
Moreover, these machines, while beautiful, are notoriously expensive to maintain. If you buy the
machine, you can expect your annual maintenance costs to increase by $250 thousand. Should
you buy the machine?
(b) Alternatively, you learn that a large purse manufacturer has a machine capable of sewing the
premium fanny-packs, and that manufacturer is willing to construct them for you. The purse
company offers the following deal: You supply them with the necessary inventory of raw goods,
and you pay them $30 for each premium fanny-pack made. The pure manufacturer is responsible
for all maintenance costs associated with their machines. Furthermore, the purse company is
willing to let you pay the $30 three months after the date of the sale. Should you take the deal?
You are the owner of a successful fanny-pack company. your fanny-packs are selling
well. So well that you are considering adding a premium fanny-pack to your line-up of goods. Your
marketing department estimates that you will be able to sell $5 million worth of the premium fanny-
packs annually. Unfortunately, the team informs you that the premium product will not attract new
fanny-pack customers. Rather, the sales of premium packs will cannibalize your existing sales in a 1-to-1
ratio. For every premium fanny-pack you sell for $50, you sell one fewer regular fanny-pack (which
retails for $20). Luckily, both styles of fanny-pack use the same raw materials in the same quantities, so
the costs of goods sold will remain unchanged, and your inventory requirements will be unaffected. You
plan on selling fanny-packs indefinitely, but don't expect sales to increases year-over-year. Your firm's
effective tax rate is 30%, and your cost of capital is 8.5%
(a) The premium nature of these fanny-packs derives from the intricate sewing techniques which
must be used. The only machines capable of such delicate work are produced only in Italy, and
cost an astounding $20 million. If purchased today, the machine will be working by tomorrow.
Moreover, these machines, while beautiful, are notoriously expensive to maintain. If you buy the
machine, you can expect your annual maintenance costs to increase by $250 thousand. Should
you buy the machine?
(b) Alternatively, you learn that a large purse manufacturer has a machine capable of sewing the
premium fanny-packs, and that manufacturer is willing to construct them for you. The purse
company offers the following deal: You supply them with the necessary inventory of raw goods,
and you pay them $30 for each premium fanny-pack made. The pure manufacturer is responsible
for all maintenance costs associated with their machines. Furthermore, the purse company is
willing to let you pay the $30 three months after the date of the sale. Should you take the deal?
Related questions
Accounting 467 â CASE â Fall 2016 (75 pointspossible)
Use the format provided on page 3 to word process yourmemo. The solution to this final case is the completed memo. Thelength is 2-3 pages single spaced, but concise and direct in yourmemo. The partner, Linda Smith, works with many clients so youshould avoid assuming she will fully recall all relevant facts, orthat she will immediately recognize all important implications ofthose facts. Be sure to describe the specific facts you considerrelevant and explain the implications for the Freja auditengagement.
Freja, Inc. is an international retailer and designer ofathletic apparel. The company, founded in 1998, makes a number ofdifferent types of athletic wear, including performance shirts,shorts, and pants, as well as lifestyle apparel and yogaaccessories. They sell their clothing internationally. In 2005, thecompany went public to support business expansion throughacquisition of other athletic apparel lines and designs. Theexpansion happened in two ways 1) a 2006 purchase of three patentsfrom the original designers of a technically designed compressionwear, marketed to biking enthusiasts and 2) the 2011 acquisition ofCrescent Moon, a company with a high quality line of yogaapparel.
To maximize the investment in the patents, Freja built a newproduction facility to increase production of biking compressionapparel in hopes of selling more and capturing at least 30% of themarket share. The production facility is located in Cambodia andbegan production in 2008.
The Crescent Moon yoga apparel is produced by a Guatemalasupplier. Freja has maintained the supply relationship.
A distribution facility was completed in January 2016. Thefacility is located in Memphis, Tennessee. The cost was $15,000,000and the building has an estimated 40 year life. Freja uses thestraight-line depreciation method.
You are the senior auditor on the team assigned to the Frejafinancial statement audit for the year end, December 31, 2016. Itis December 29, 2016 and the interim work for the December 31, 2016financial statement audit is completed. Your firm, RJN, acquiredFreja as a client in 2002. Freja anticipated going public in 2005and changed auditors to work with a firm that is PCAOB registeredand has more experience with SEC filings. Frejaâs board ofdirectors is independent of the executives of the company, exceptfor the CEO, Marcy Madden. All of the board members own shares ofFreja. The majority of the board was in place when Freja wentpublic. Frejaâs audit committee of the board is meeting in 2 weeksand has asked the RJN engagement partner, Linda Smith, to explainthe significant risks identified during RJNâs interim audit testsand the year-end audit planning.
Smith has asked you to prepare an audit planning memorandum thataddresses significant engagement issues, and specificallyidentifies matters relevant to the audit committee. To prepare therequested memo you have consulted last yearâs audit file -EXHIBITI, findings of interim audit procedures â EXHIBIT 2, a memoprepared by Smith following a December 15, 2016 client meeting âEXHIBIT 3 and the preliminary December 2016 unaudited balance sheetand income statement â EXHIBIT 4. Freja shut down operations forthe remainder of 2016 beginning December 24, 2016. The preliminarybalance sheet and income statement were prepared on December28.
REQUIREMENTS
Your task as the senior on the audit team is to prepare a memofor the engagement partner based on the Freja information providedin the case, including EXHIBITS 1, 2, 3 and 4. The planning memoshould address the following: 1) Client business risks, 2) Auditrisk factors, 3) Accounting issues, 4) the accounts with the mostsignificance to the audit. Prepare the audit planning memorandumusing the following format (Italicized text gives instructionsfor completion of the memo):
RJN, CPAâs W/P Reference
Date: 12/20/2016
Client: Freja,Inc.
Period End: 12-31-2016
Purpose of the memorandum
The purpose of this memo is to documentâ¦(finish thesentence(s))
Business Risks Facing Freja, Inc.
(Write an overview paragraph here)
(Bullet-point descriptions of each business riskhere)
Audit Risk Factors to be Considered by RJN
(Write an overview paragraph here)
(Bullet-point descriptions of each audit risk here)
Accounting Issues Identified
(Write an overview paragraph here)
(Bullet-point descriptions of each accounting issuehere)
For the bullet-point descriptions of each accounting issue,include sub-headings as follows:
Accounting Issue:
Significant Accounts due to identified client businessrisks, audit risks, and accounting issues:
Accounts:
Concluding Remarks
EXHIBIT 1
Observations Noted in RJNâs Last Yearâs 2015 AuditFile
2015 sales increased but the gross profit rate decreased2%. The sales growth indicates the goal of increasing market sharein the biker compression apparel is being realized. The grossprofit on the product line is lower than planned. Competition fromUnder Armour is stronger than expected.
In the last six weeks of 2015 it was discovered thereusable bags made of polypropylene Freja orders from a Chinasupplier had high levels of lead and concerns about possible leadpoisoning were being evaluated. Freja has used these bags topackage all products since 2009. At the time of the discovery,$340,000 of the bags were on hand. The company halted use of thebags and was investigating possible costs of recall, destruction ofinventory and any possible claims of injury as the year ended. Theprobability of loss and any estimate of dollar cost could not beassessed at the date of the 2015 audit report.
Accounts receivables are from the independent retailers.Business customers who market the company apparel and sportsorganizations or team that custom order for their athletes buy oncredit terms. Individual consumers buy at Frejaâs retail locationsor online. Those customers purchase with third party credit cards.The client is monitoring the collection of the receivables butagreed to increase the allowance for the 12/31/15 financialstatements.
Freja implemented a new sales incentive plan in 2015.The sales management team earns a bonus based on increase in bothsales volume and sales dollars and gross profit dollargrowth. The sales bonus pool is calculated on the yearend financials and paid by March 15 of the followingyear.
EXHIBIT 2
Findings from Interim Audit Procedures
Conducted in September and November 2016
Accounts receivable were confirmed as of November 30,2016. The accounts receivables are related to the apparel sold tobusiness customers and custom orders for sports organizations. Thetotal sales through November 30 for those products were$46,000,000. The number of days to collect sales has increased from43 days to 50 days for the accounts receivables due from thesecustomers. The allowance for doubtful accounts aging percentageshave not been increased to reflect the slower paying customers.Credit terms for the business and sports organizations customershave been revised to allow more days to pay and establish highercredit limits.
A sample of cash disbursements was tested. The controlssurrounding disbursements were operating effectively. It was notedFreja is paying vendors on the average of 40 days from vendorinvoice date, an increase from the average of 36 days to pay in the2015 audit.
Inventory of all product lines has increased. Thecompany estimates the various apparel products have market appealfor up to 10 months. Even though the products do not lose quality,the market expects changes in color and style. Freja attempts tosatisfy the market with updated colors and styles every eightmonths. The company typically sells outdated inventory to outletand liquidation retailers at 20% below cost. As of November 30,Freja estimates 40% of the inventory is made up of the outdatedcolor and style apparel. Freja has not made any valuationadjustments.
A building addition depreciation expense was notcalculated as of the November 30 interim date.
EXHIBIT 3
Audit Partner Memo to File
December 15, 2016 Audit Planning Meeting withClient
On April 16, Freja declared a $2,000,000 dividend, paidon May15.
Freja issued new shares of stock on December 10 and usedthe cash to repay a portion of the debt incurred with the CrescentMoon acquisition.
The recall of the bags in the previous year continues tobe investigated. Freja has been named a defendant in three lawsuitsclaiming persons have health issues related to the lead content inthe polypropylene bags. Freja has not assessed the likelihood ofloss or estimated a dollar amount of a possible loss.
The goodwill asset was recorded with the Crescent Moonacquisition. At the time of the acquisition Crescent Moon had 55%of the yoga apparel market. As yoga has become more popular morecompetitors have entered the yoga apparel business. Crescent Moonhas experienced a 3% sales decline in each of the last 4 years andnow has 40% of the market share. The value of the overall businesshas decreased. The valuation of goodwill needs to beassessed.
Two of the three patents purchased in 2006 provedvaluable and are the designs for two apparel lines that areprofitable. The design for the third patent proved too costly toproduce. Freja allocated $3,600,000 to that patent, with a life of12 years. The client has abandoned hope of using the patent, buthas not written it off as of December 2016.
The production facility in Cambodia was established totake advantage of lower cost labor. A production plant in Ohio wasclosed when the Cambodia plant opened. Management has concerns howthat arrangement may be altered when Donald Trump assumes the U.S.presidency in January 2017. The facility has a carrying value of$13,000,000 as of 2016 year end.
EXHIBIT 4
Freja, Inc. â Balance Sheet (in thousands) | 2016 unaudited | 2015 | 2014 |
Assets | |||
Current Assets | |||
Cash | 200 | 456 | 1,300 |
Accounts Receivable | 7,589 | 4,784 | 3,788 |
Allowance for Doubtful Accounts | (1,000) | (889) | (500) |
Inventories | 21,800 | 8,600 | 7,000 |
Prepaid Expenses | 2,480 | 1,654 | 1,138 |
Plant and Equipment | 43,000 | 28,000 | 28,000 |
Accumulated Depreciation | (6,450) | (5,500) | (4,700) |
Patents, net of amortization | 13,000 | 13,500 | 11,000 |
Goodwill | 8,000 | 8,000 | 8,000 |
Other Assets | 4,976 | 2,696 | 423 |
Total Assets | 93,595 | 61,301 | 55,449 |
Liabilities | |||
Current Liabilities | |||
Line of Credit | 10,600 | 7,800 | 6,500 |
Accounts Payable | 14,500 | 3,420 | 3,300 |
Accrued Liabilities | 5,070 | 2,680 | 3,940 |
Noncurrent Liabilities | |||
Long Term Deferred Tax Liabilities | 8,134 | 4,600 | 3,250 |
Mortgage Payable | 25,000 | 10,000 | 10,000 |
Long Term Payable | 2,000 | 8,000 | 8,000 |
Shareholder's Equity | |||
Capital Stock | 18,000 | 12,000 | 12,000 |
Retained Earnings | 10,291 | 12,801 | 8,459 |
Total Shareholder's Equity | 28,291 | 32,801 | 28,459 |
Total Liabilities and Shareholder's Equity | 93,595 | 61,301 | 55,449 |
Freja, Inc. - Income Statement (inthousands) | |||
2016 unaudited | 2015 | 2014 | |
Net Sales | $ 118,000 | $ 102,000 | $ 85,000 |
Cost of Goods Sold | $ 86,140 | $ 70,360 | $ 56,950 |
Gross Profit | $ 31,860 | $ 31,640 | $ 28,050 |
Selling, general and | |||
administrative expenses | $ 24,780 | $ 19,380 | $ 15,300 |
Research & Development | $ 3,540 | $ 4,080 | $ 4,250 |
Depreciation | $ 950 | $ 800 | $ 800 |
Patent Amortization | $ 500 | $ 500 | $ 500 |
total expenses | $ 29,770 | $ 24,760 | $ 20,850 |
Operating Income (Loss) | $ 2,090 | $ 6,880 | $ 7,200 |
Interest Expense | $ 2,600 | $ 1,200 | $ 1,100 |
Income (Loss) Before Income Taxes | $ (510) | $ 5,680 | $ 6,100 |
Income Tax Expense | $ 1,988 | $ 2,135 | |
Net Income (Loss) | $ (510) | $ 3,692 | $ 3,965 |
