On The Road Inc. (OTR) is a tour company owned by Joy Kerouak. OTR offers organized tours three weeks to six-months long, targeted to early retirees 55-years old and over. OTR is in its third year of operations. Joy is not actively involved in the business and has hired a team of skilled managers to run the business. OTR is a private Canadian corporation, with Joy owning 100% of its common shares. The managers receive a bonus of 30% of monthly pretax profits.
OTR’s tours are guided road trips across North America. Tour groups travel in brightly painted camper vans and visit sites of historic events of the 1950s and 1960s. The packages are sold online and through travel agents, under the following terms:
• A deposit of 40% is required upon booking, which is refundable until 14 days before the start of the tour and nonrefundable after that point.
• The remaining 60% is due 14 days before the start of the tour. This is nonrefundable.
• If for some reason OTR is unable to offer the tour, 100% is refunded to the customer.
Online sales are paid by credit card. Travel agent sales are the same as those terms previously listed, except the agents receive payments from customers and forward these to OTR within seven days. Travel agents receive a commission of 10% of the tour selling price, which they deduct prior to forwarding the payments to OTR. During OTR’s three years of operating, about half the tours have been sold through travel agents and the other half online, but the online portion has been increasing each year.
Economic conditions in the travel industry have been declining recently, and bankruptcies of travel agents are increasing. If travel agents that sell OTR tours go bankrupt, OTR would probably lose any customer payments the travel agents had not yet forwarded. Over its three-year history, the company’s bad debts from travel agents have been about 5% of sales. To date, only one tour has had to be cancelled by OTR due to Hurricane Katrina flooding New Orleans. This refund made up about 2% of the total 20X5 revenues of OTR.
The main assets of OTR are a fleet of 50 camper vans that were purchased when the business started up. Since these are high-quality VW vans in classic designs, and management chose to depreciate the cost of the camper vans over 9.4 years. However, this winter, management informed Joy that at least 35 of the vans are in poor condition and will need to be replaced at a cost of $40,000 each before the spring tour season begins. Joy has contacted her banker, Nik Beat, to arrange to borrow the cost of replacing the camper vans. Currently, OTR is debt free. Mr. Beat requested audited financial statements prepared in accordance with generally accepted accounting principles for the first three years of OTR’s operations.
Since, to date, OTR has mainly prepared its financial statements for the purpose of computing the managers’ monthly bonuses, Joy is not sure if these statements will meet Mr. Beat’s requirements. Joy has hired you to advise her on accounting issues and on how to obtain the audit that her banker is requesting.
Assume the role of an advisor to Joy and answer the following questions:
a. Identify the main users of OTR’s financial statements and the kinds of decisions/evaluations that each user will make based on these financial statements.
b. What are the main objectives of OTR’s management that may affect the accounting choices it makes in preparing OTR’s financial statements?
c. Describe four or more possible revenue and expense recognition points for OTR’s tour business, indicating the most appropriate method, in your judgment. Provide the reasons that support your judgment.
d. Outline the key issues that would need to be addressed by a prospective auditor in order to decide whether to accept the engagement.
e. Prepare a report to Joy describing in detail a preliminary audit plan for OTR. Include explanations for each component you include in the preliminary plan that will help Joy understands the audit objectives and procedures.