Accounting-Huber Contracts Inc.(QCI)

| January 30, 2017

Question
Huber Contracts Inc.(QCI)

Dr. Mark Huber is an optometrist and the sole shareholder of Huber Contracts Inc.(HCI), an optical company that sells prescription disposable contact lenses and eye glasses out of its location in Scarborough, a neighbourhood in Toronto. HCI is managed by Mark and has a May 31 year end.

You, CA, are a manager with Acorn LLP(Acorn). Yesterday, you and Tony Bell, the engagement partner, met with Mark at HCI. Mark asked for this meeting to discuss the future of HCI’s operations. Acorn has performed review engagements for HCI for the past three years.

Mark began, “I have decided to live year round at my cottage in northern Ontario and have therefore been considering two options regarding the future of HCI. I believe I could sell HCI and live off the proceeds or I could oversee the operations of HCI from my cottage, as a web-based company selling contact lenses only. I would like your help in determining the best alternative for me.

“I will require an audit of HCI for 2010, as I believe a buyer would require audited statements. I need your assistance in determining a reasonable selling price for the shares of HCI. I have brought you a draft income statement for the 2010 year end. I believe the last three months of sales are the best indicator of future sales potential so I have included information for that period as well (Exhibit I). I have also included some background information on HCI which may be useful to you (Exhibit II).

“I have notes on how the web-based operations would work (Exhibit III) and would like to know how much cash I would be able to generate if I were to pursue this option. I am only concerned with my cash flows for the next four years, until I am eligible to access my pension income in 2014. I estimate I will need between $300,000 and $400,000 to cover my expenses until 2014.

“I met with a web consultant who provided me with information on a system that could be used if I were to operate HCI as a web-based company (Exhibit IV). I am concerned about the security with this kind of operation and would like you to identify the significant risks that the web-based company would be exposed to as well as any practical recommendations to mitigate these risks.”

After the meeting you reviewed some of the accounting records and further discussed the business with Mark. A summary of some of the issues that you discovered while out at HCI are in Exhibit V. It is now June 4, 2010 and you are meeting with Tony to discuss the HCI engagement. Tony asks that you prepare a memo to him addressing the issues raised by Mark in the meeting and asks that you discuss the accounting issues you discovered while at HCI and identify the related audit procedures that should be performed.For now, he would like you to ignore the personal income tax implications of the sale of HCI and any first time audit considerations.

Required:

In teams of up to 4 students, prepare a memo to the partner, Tony Bell, discussing the:
1) the accounting issues, and how you propose to audit the accounting issues,
2) valuation of selling HCI or a 4 year forecast of the web-based business including quantitative and qualitative analysis.
3) internal control issues, implications of the weaknesses and recommendation to improve the security and likelihood of success of the proposed web-based site design.

Include an introduction, problem statement, analysis of the three topics above and recommendations in your memo.

Exhibit I

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** the financial statements of HCI follow CICA HB – Accounting – Part V, XFI, without differential reporting options

EXHIBIT IIBACKGROUND INFORMATION PROVIDED BY MARK

 HCI has a regular customer base which I anticipate will make it an attractive acquisition for another business in the same industry.

 I have been in communication with the owners of two other optical stores which operate in similar markets and learned that on average they made about a 10% after tax return on their investments.

 I believe that any purchaser would have their existing staff place all orders. This would eliminate the salary currently being paid to HCI’s order clerk of $50,000.

 In recent years HCI has not invested much in advertising as its current customer base consists of mostly repeat customers. Other optical stores spend around $70,000 annually to attract new customers.

 The current store location is leased at a rate of $3,000 per month. It is located within walking distance from several apartments and businesses making it convenient for customers to access.

 HCI had a bank loan which they entered into in 2008 with a fixed interest rate of 5% that was secured by a personal guarantee I provided. This loan was repaid in full in January 2010.

EXHIBIT IIINOTES ON OPERATING HCI AS A WEB-BASED COMPANY

Ordering

 The store location is only necessary for the glasses portion of the business as customers typically want to try on frames before committing to a purchase. Since the sale of contact lenses could all be made via internet orders, I could oversee the operations from my cottage.

 HCI would order the contact lenses from our suppliers as soon as the customer places their order. We would have the contact lenses delivered from our supplier directly to the customer within two days so there is no need to maintain an inventory of contact lenses on hand.

 HCI would accept credit cards as the only form of payment from customers and would have a no return policy as the lenses are for each customer’s specific prescription.

Customers

 To retain existing customers, HCI would send a mass mailing explaining the changes to the business and providing the new contact information, etc. Such a campaign is estimated to cost around $12,000.

 As a result of the mailing HCI should be able to retain approximately 75% of existing contact lens customers. There are currently approximately 1,000 existing customers who purchase an average of 30 pairs of disposable contact lenses each month. Although it varies by brand, the average retail price per pair of lenses is $2.

 The remaining contact lens customers may leave either because they do not trust the security behind making online payments or because they would prefer to purchase both contacts and glasses from the same location.

 I am not interested in spending a great deal of time and effort trying to grow the web-based business as the plan is to ease into semi-retirement. I estimate that sales will increase slowly so I would expect only a 2.5% increase in annual sales.

Operation Costs

 The cost of contact lenses will remain around 38% of their selling price.

 Selling expenses are expected to be around 9%. This will include payment to advertise on search engine websites.

 General and administration expenses are expected to be $105,000 in the first year and then increase 2% annually. These costs will now include wages for only one part time staff member to assist me in the business.

 Currently customers pick up their lenses at HCI’s store. However under the web-based option, HCI will pay shipping charges to have the suppliers‟ ship the lenses directly to the customer. The additional shipping charges are expected to be approximately 10% of sales.

 I anticipate the cost of setting up the web-based internet site will be around $30,000, with annual service and maintenance fees of $3,500.

Ordering

 All customer orders will be placed via the website that will be developed and maintained by the web consultant.

 As all orders will be placed online, customers must pay using a major credit card. Funds will then be deposited into QCI‟s bank account directly from the credit card companies.

 When an order is placed, the customer will be asked to enter the following information onto the web page:

obrand and quantity of pairs of contact lenses

oprescription requirement for each eye

opersonal information including shipping address

ocredit card information

 All information will be entered on one page, making the order process quick and easy for the customers. If the customer fails to enter the quantity of lenses, the system will not allow them to hit “Submit”. The system will prompt them with an error message and require them to enter the quantity of lenses to proceed. This is the only field that when not completed will prevent customers from placing an order.

 When the customer is done inputting information, they will click on “Submit” and the information will automatically transfer to HCI’s sales tracking sheet and the general ledger will be updated concurrently.

 Once the transaction is submitted the system will produce a sales receipt which indicates the total cost of the order with details of what was purchased.

Shipping

 Once the orders are received by the system, HCI will take the information on the sales tracking sheet and contact the suppliers to place the orders and arrange for their shipment to the address input by the customer.

 The part-time staff member will count the total number of orders on the sales tracking sheet and compare this to the total number of orders recorded in the general ledger for that day. Although counting the orders daily may be time consuming, this will ensure that the system is operating as it should.

Information System

 The mainframe will be located in the cottage where HCI’s operations will be run.

 The system will be setup to make automatic weekly back-ups of the sales tracking information which will be stored on a separate drive on the mainframe.

 There will be logins and password setup on the computer for each user.

 The web consultant can use an internet connection to remotely access the system to install updates and make any necessary changes to the system. The web consultant can even fix a bug or perform an upgrade to the system while it is running so there will be no downtime.

EXHIBIT VACCOUNTING AND OTHER ISSUES DISCOVERED WHILE AT HCI

 In March 2010, as part of a special “pay now and get 5% off” promotion, sales orders were placed by 140 customers for 30 pairs of contact lenses for each of the remaining nine months of 2010. HCI recorded the full amount of these sales as revenue in March as these orders had been paid for in full. The contacts, however, are typically not ordered from the suppliers until closer to the month for which the orders relate, as customers pick up their orders on a monthly basis.

 Mark indicated that a significant number of frame styles are out dated with a book value of $10,000. Mark is hopeful that the frames will come back in style however there has been no indication of this to date. The frames cannot be returned to the supplier. Mark is planning to sell these at 50% of cost in order to move them. It is typical in the industry to have to write down a portion of inventory annually as the styles change so frequently. HCI’s inventory of frames is currently valued at $50,000.

 HCI has 60 specialty sunglasses in inventory (separate from the frames) recorded at a cost of $200 per pair. In January, 2010 Mark decided to reduce the selling price of the sunglasses from $250 to $150 as this is the price he believes will guarantee their sale. HCI has never had to lower the price of sunglasses before as they typically sell quickly and Mark does not expect to have to lower the price of any other specialty frames in the future.

 HCI is planning to count the inventory on June 6, 2010.

 The current store location is leased over a five year term which commenced on June 1, 2008. I requested a copy of the lease agreement and discovered that an obligation to pay for the cost to restore the building to its original condition was built into the lease. The contractors who performed the leasehold improvements at the time estimated that cost to restore the building to its original condition would be $20,000. This obligation has not been recorded in HCI’s financial statements.

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