A financial report on Viva Las Publishing

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Viva Las Publishing is a private publishing company. Recently, there is a major proposed change in transfer of Viva's ownership. The owners entered into a Purchase-and-Sale Agreement to transfer Greg's 80% ownership to Rowena upon Greg's retirement and the purchase price of the agreement is only based on revenue and net income for 2009. The primary users of Viva's financial statements are the owners Gregory and Rowena in particular as she will be taking over the business once the agreement is accepted. To stratify users' needs, we need to not only provide audited financial statements to justify the purchase price of the company, but also identify Viva's significant business risks and bring these risks to Rowena's attention. The main begins by addressing the engagement and audit risks, and the follow by an analysis of significant accounting and audit issues relating to the financial statement audit.

Business Risks Facing Client Organization

The business risks facing our client-Viva are considered to be high. First, one of the major advertiser- Dark Horse Designs has suffered from financial difficulties and there is a tendency for them to file for bankruptcy. This may threaten Viva's financial viability because a large portion of Account Receivable from our client's book is from this particular customer Blackhorse. In the worst scenario, it is very likely that Viva A/R will become uncollectible as they are the unsecured creditor. Then Viva would have to write off the entire balance of A/R. Also, the loss of major customer means loss in revenue, Viva would have to find a way to cover for the loss by either negotiating new advertiser or cutting costs which will create an impact on Viva's cash flows and increase its business risks. Second, there is some new change to Viva's business model. Historically, Viva's operations are focused almost entirely on their magazine Belle. Now, they are going to launch the new magazine Belle Dame, which may add in more complexity of their operations and increase their business risks. Lastly, it appears that Viva has been pursuing aggressive accounting policies. Due to Greg's intention to retire in 2010, he might be less committed to the business. Viva's revenue increased the fact that the economy went down. Given that the purchase price of his company is based on 2009 revenue, Greg's incentive will be to overstate these accounts. Thus, he may be pursuing aggressive accounting policies. Although this may affect the company's long term sustainability, Greg would want get a better selling price and he would not care about the company's long term success as he would be quitting the business. Hence, we should be skeptical whether the factors attributed to Viva's increase in revenue for 2009 was from Viva unique editorial content or Greg's incentive to overstate revenue.

Audit Risks Analysis

Overall, the Audit risk for this engagement is high given the purchase-and-sale agreement being proposed for the business. We will need to be very careful on detecting material misstatement in the financial statements especially on revenue and net income. In addition, we are given a tight reporting deadline as the purchase-and-sale agreement will be expired by February 21, 2010. Our clients will expect us to finish the audit by this particular date. On the other hand, we may as well need to be aware of any independence threats that may exist because Viva has been our client for 10 years, we might have familiarity threats with Viva. Also, Rowena's group of companies is a client of our firm. Thus, we should disclose all these information in the Notice of Readers. Other significant issues contributing to high audit risks for engagement include client's aggressive policy of revenue recognition, allowance for doubtful account, and going concern of one of its major advertiser.

Inherent risk- Inherent risks is assessed at maximum due to changing circumstances as the owner is retiring in 2010 and the selling price will be based on the "Revenue" and "Net income" of 2009. This is incentive for Greg to be biased to inflate these accounts. There is evidence of Greg acting on his incentive as revenue is being recognized when the contract is signed where criteria for revenue recognition is not met. Also, the fact that there's a new sister line launching will increase the inherent risks of Viva. Besides, there are potential management overrides of financial information as Greg appears to be the only person in control, which could lead to limitation of scope if financial information being provided is not reliable. Also it should be noted that Viva has been consistent with the revenue recognition policy of recognizing revenue when contract has been signed seems should have been countered and discussed with Greg by our audit firm in the past. This might mean that previous financial statements might be materially misstated as well.

Control Risk- Control risk is high as there is no clear policy of how to recognize allowance for doubtful accounts for readers/subscribers. And, there is no provision for allowance for doubtful account for advertisers even though one of their big customers might go bankrupt and can default on their payments. The credit policy is weak because of the "pay later option" for readers gives an option to readers to actually not pay after an year and still can get magazines each month, instead the policy could have been either pay at the end of the month or when the contract is signed.

Audit Strategy

It is very likely that we will be using a substantive approach given the fact that Greg can easily override accounting information and controls may not be as effective. Also, the fact that no allowance for doubtful account being set up for advertising revenue indicates that a poor control over accounting policies exists. The significant areas that we will need to focus on are revenue and accounts receivable. We will need to examine the source documents and other detail information to see if revenue recognition is in accordance with IFRS. We will also need to learn how credit and collection terms are set up for Viva's advertiser, subscribers and retailers. We could also compare Viva's revenue recognition, credit and collection terms policies with its competitors to confirm appropriateness.

Materiality­- As Rowena is the main user of the audited financial statement and is going to base her decision on the audited financial statements, it is important to set materiality level to very low. The base of materiality will be 2009 total operating revenue. We will prefer revenue than net income because the increase in net income before tax from 2008 to 2009 is 1794% ((12,067-637)/637), while revenue increased by 37.32% ((58,300-42,454)/42,454). We can tell that the increase in net income before taxes is somehow unrealistic and unreliable. Also, we will have to pick the lowest range of materiality level because of the high risks of the engagement which will be 0.5% of total revenue. Thus, our calculated materiality level will be $2,915,000

Significant Accounting and Audit Issues

1) Revenue Recognition re: Advertising

In 2009, Viva's has a $2 million one-year contract with one of its advertiser for the one-page ads in each month's magazine. Viva's current policy for advertising revenues is to fully recognize the $2 million contract when it is signed. However, the ad have only been published for November and December 2009 edition, which means the rest 10 months of the ad will be published in 2010. According to IAS 18.20, "Revenue associated with the transaction shall be recognized by reference to the stage of completion of the transaction at the end of the reporting period." Viva is only allowed to recognize part of the $2 million contract for the 2 months edition published, which will be $333,333 (2 million x 2/12) and remaining revenue of $1,666,667 should be deferred and to be recognized monthly as the magazine is published. In order to be able to quantify the errors, we will need to examine the advertising periods stated in the contracts. For any contract that consists of an advertising period for more than one month, we will examine whether they will involve year-end cut-off issues which will impact this year-end financial statements. The audit assertions being affected here are occurrence and valuation.

2) Advertising rebates

Viva currently use selling and marketing expense accounts to report for its advertising rebates. To date, Viva has accrued $657,000 for this account. However, the appropriate way to account for advertising rebates given to its advertiser should be netted in advertising revenue accounts. By categorizing the rebate under selling and marketing expense, revenue for advertising is overstated by $657,000. Also, since the revenue for advertising for of its advertiser has already been incorrectly recognized as mentioned above, based on matching principle, we will also need to defer the accrued rebate that is associated with that particular advertiser as expense must be matched in the same period with revenue recognized. Thus, accrued rebates, which will be netted in revenue for adverting will be overstated by $607, 000(657,000-1,666,667 *0.03) .Again, we will need to examine more details by looking at advertising contracts to see whether other rebates being accrued would also involve a year end cut-off issues and quantify the errors we founds.

3) Allowance for Doubtful Account

There is no allowance for doubtful account setup for advertisers even though one of their big customers (Dark Horse Designs) is on the verge of bankruptcy and might default on their payments. Not having Allowance for doubtful account for advertisers in place just because they are big companies is not reasonable. As the collection of receivables is not reasonably assured as predicted by Viva, the allowance for doubtful accounts should be setup for advertisers. So, allowance for doubtful accounts provision for advertisers should be made for accuracy and completeness. Also, as Viva has been consistent with this policy, all the account receivables from advertisers in the past should be checked to see if there were any uncollectible those were written off. Also the number of days the accounts have been outstanding should be reviewed by checking the invoices. For subscribers/ readers, 2008 audited financial statement shows that allowance for doubtful accounts was $300,000, but the estimated amount for 2009 is only $22,000 even though 2009 economic conditions are worse than 2008 and have more chances of customers defaulting on their payments. Hence professional skepticism is required in this case and also allowance for doubtful account policy should be in place to show how it is being calculated/ estimated based on various factors i.e. past data. It should also be reviewed by analytical procedures and by checking the billing documents for the time period after which Viva actually classify uncollectible account receivables as allowance for doubtful accounts. Even though competitors have less revenue as compare to previous years in the current economic downturn, but Viva still increased the number of subscribers to their publishing's. Viva might have created fictitious employees to increase current year revenues to manipulate the revenue account as purchase-sale agreement is based on that. Confirmation from customers if their accounts are still outstanding will be required for existence and accuracy.

4) Going concern of Dark Horse Designs

Dark Horse Designs, one of Viva's major advertisers has suffered form severe financial troubles and chances are they may file for bankruptcy. we must disclose this information in the financial statements because the outstanding balance of Account Receivable with Dark Horse Design is measurable and significant ($4.755 million). We will need to ask our clients to obtain more assurance over the collection of the outstanding balance of the receivable with Dark Horse. For example, since Dark Horse is in the process of renegotiating its financing, Viva should ask Dark Horse to provide the statues of updates of its process to ensure collectability. Viva should also obtain a copy of Dark Horse reorganization or business plan to determine whether they should offer shorter credit terms for Dark horse or no credit terms at all.

5) Revenue Recognition re: Subscription

Viva currently recognizes subscription revenue when the issue is mailed to the customer which looks appropriate. However, that was only based on its old situation where 75% of customers choose the "bill me now" option. The situation has changed since 2008 as the economy went down. Approximately 90% of Viva's customers now chose the "pay later" option. This will brings up the issue of collectability because customers not billed until the end of the subscription. Viva should only recognize the subscription revenue when they are collectible. We will need to examine Viva's credit granting policies for their subscribers. For example, did they obtain a credit check authorization from their customers when they sign up for subscription and if the credit check is done before the subscriptions are mailed out to the customer? If certain assurances over collectability are obtained for all their subscribers, then recognition is appropriate.

6) Capitalization of Launch cost of Belle Dame

Capitalization of the launch cost for Belle Dame would only be appropriate when the definition of assets can be met, which means that the future economic benefits are expected to flow to the entity. The assertions affected are accuracy and valuation. In this case we will need to examine whether there is actually a demand for Belle Dame by looking at the marketing plans and Viva's business strategy for promoting Belle Dame. If evidences of future economic benefits are presented, then capitalization of the launch cost is allowed.

7) Off- Balance Sheet Arrangement re: slotting fees

There is a private arrangement between Greg and his friend with regard to lowering Viva's slotting fees in exchange for use of Greg's condo in Hawaii. This is an off-Balance Sheet arrangement. It will not be shown on the face of Viva's Balance Sheet. However, Viva should disclose the details of the arrangement in notes. Also, because that Greg is retiring in the upcoming year and it is very likely that the private arrangement would be discontinued once Greg sold his business to Rowena. We should bring this to Rowena's attention that slotting fees will be increased in the upcoming year once the arrangement stopped and it will typically range between 20% - 30% of the magazine cover price.

Conclusion:

Based on our analysis above, we would recommend Viva to set up allowance account for advertising revenue immediately to address the needs of changing business environment as the economy in generally is in a downturn position. Also, we will need to communicate to Rowena that the $94,500,000 purchase priced that Greg has calculated is incorrect. Based on what we have found in issue1) & 2), revenue is being overstated by at $2,273,667 (1,666,667+ 607,000). Net income would also be affected as well. However we will need to obtain further information relating to as Account Receivable provision, capitalization of the launch cost, and revenue recognition for subscriptions in orders to recalculate the purchase price. Overall, we will expect purchase price to be lower as a results of errors and misstatements of the financial statements.

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