Auditing an Acquisition - Case Study

INTRODUCTION

In June of 2019, Babysitter, Inc., a large publicly traded company, started negotiating the
acquisition of Toddlers Lane, Inc., a startup internet company. Toddlers Lane is a company that
provides care packages of baby products that are delivered to consumers on a recurring monthly
basis. These care packages include toys and other educational material that are age suitable for
children up to the age of five years old. Packages are delivered to consumers that subscribe to
their care package program. The company started in August of 2014, but as many startup
companies, it incurred significant operating losses. Nonetheless, its customers’ base increased
significantly during its four years of operation. This increase in the number of customers was
reflected in a remarkable increase in its sales revenue that showed a huge growth potential,
which made it an attractive acquisition for Babysitter that is also growing through the
acquisition of several successful smaller companies.
Since its inception, the company was highly leveraged with loans from close family
members to the founder of the company, Maria Forster, as well as a couple of virtual capital
funds (GNC Capital and Armlock Capital). The company needed additional funds to support
current operations, and the acquisition of the company by Babysitter created an attractive
opportunity for Forster to reap the benefits of her substantial effort in developing the company
and to pay back the debt she owed to her family and to the virtual capital funds.
McLawrence, LLP, a large national CPA firm, is hired by Babysitter to conduct an audit
that can provide the company with an independent audit opinion about the financial statements
of Toddlers Lane before it acquires it. McLawrence needs to complete the audit within a three-
month period so that the company’s attorney can initiate the legal requirements of the
acquisition. Toddlers Lane has never been audited before; however, the company’s founder is
somewhat prepared for an audit fieldwork, and the company’s Director of Finance is also ready
to provide the last three years financial statements, related disclosures, and all accounting
documentation.

THE COMPANY BACKGROUND

Maria Forster is the founder and CEO of Toddlers Lane. After earning her undergraduate
degree in computer science and a Master of Business Administration (MBA) degree in one of the
prestigious private universities in San Francisco, Maria began her e-commerce career as a
product manager during the early days of the internet. Throughout her fourteen years career, she
has held leadership positions and handled major product and social media initiatives at leading
technology companies all over the Silicon Valley. She also served on the board of a startup
communication company that was acquired by a large national internet service providing
company. In Fall of 2014, she left her employer to follow her entrepreneurial dream and start
her own company. Remembering how exhilarating and exhausting it was to be a first-time mom,
her vision was to create an e-commerce company that could make parents’ life easier and help
them make healthy product choices for their families. And that’s how Toddlers Lane came to be.
The company does not have a CFO. The highest-ranking finance employee is Lihan
Peng. Lihan has served as the company’s Director of Finance and Analytics since September
2016. She previously served as an analyst with one of the company’s venture capital funds.
Even though her entire professional experience is only limited to six years, she has adequate
knowledge about the company and good understanding of accounting and reporting.
 The company has three other employees who update the company’s website, advertise
the services through social media and other internet channels, send orders to third party
warehouses that send packages to customers, and handle customers’ questions. All three
employees are business graduates with experience ranging from two to four years.
The Board of Directors is comprised of Maria Forster (CEO), Jeffrey Johnson (of GNC
Capital), and Larry Brown (of Armlock Capital). Jeffrey and Larry have professional experience
appropriate to serve on the Company's board. Jeffrey has over 20 years of executive experience
and serves on the boards of other technology companies and is active in investments made by
the fund for which he is the Managing Partner. Larry was previously the CEO of a large internet
corporation, and currently he is a partner at Armlock Capital. Lihan, the company’s Director of
Finance and Analytics, previously worked as an analyst at one of the virtual capital funds
(Armlock) under one of the company's board members (Larry Brown). Due to the small size of
the board, the Company does not have an Audit Committee of the Board of Directors.

OPERATIONS OF TODDLERS LANE

The Company was founded in Fall of 2014, in Mountain View, California. The
Company’s primary product offering consists of compiling and selling surprise packages for new
mothers and mothers of children up to five years old. These surprise packages contain an
assortment of goods (i.e., toys, lotions, books, etc.), and are available for purchase on a one-time
basis, or on a multi-month subscription basis (i.e., three, six, or twelve months), whereby
customers receive a different box each month during the subscription period. At the end of each
subscription term, customers are automatically renewed for another term (i.e., same number of
months as original subscription), although customers also have the option to cancel the renewal.
In addition to box sales, the company also offers additional products on an individual
basis via its online shop; and in May 2017, the Company introduced the “add-to-box” concept,
whereby customers can purchase individual items to be included with their monthly boxes and
not incur additional shipping charges.

THE AUDIT BY MCLAWRENCE LLP

Toddlers Lane is in the late startup/early growth phase. The CEO has been focused on
growing operations in fiscal year 2018 and continuing in fiscal year 2019. She has also been
involved and is expected to close the sale of the company to a third-party company (Babysitter,
Inc.) in early July 2019. The audit firm, McLawrence, believes that there might be an incentive
for the CEO to make operations look better (i.e., increase revenues and assets, or decrease
expenses and liabilities) to make the company more attractive to the buyer and increase the
acquisition price. McLawrence audit team will test the completeness of expenses and liabilities
as well as the cutoff and existence of revenue and assets to ensure they are not overstated. The
audit firm will also perform testing of payroll and other operating expense accounts to determine
if there are any material understatement.
During the initial fieldwork, McLawrence audit team noted that there is a shortage of
accounting staff with only the Director of Finance, Lihan Peng, and her part-time assistant. Due
to this shortage, the company outsources most of its controller and accounting work to a third-
party accounting firm to perform the necessary accounting tasks. Lihan reviews all work
performed by the accounting assistance she receives each month. While she is not an
experienced controller and not completely competent in GAAP accounting, she does perform a
high level review of amounts entered into the system. The audit team also notes that cash is not
handled by the third-party accounting firm and generally all cash received is from third party
credit card companies. Lihan Peng and Maria Forster are the two check signers, and they both
review all payments prior to processing. Thus, there does not appear to be a high risk of
opportunity related to cash misappropriation.
The audit team also believes that there are enough controls in place to limit the
opportunities to commit fraud. Further, the CEO and top-level management are actively
involved via board meetings and in operations. All accounting and finance activities have a top-
level review process, and misappropriation of assets are unlikely with the processes and amount
of transactions for cash, inventory, and fixed assets. Most of the company's inventory is held at
third-party warehouses, which are managed by the third party with periodic counts by the
company to ensure that inventory levels are within reason.
Although management is made up of competent personnel, the company has limited
control efforts related to financial accounting and reporting. For example, all manual journal
entries appeared to be reviewed by Lihan Peng. The audit team believes that management has
the ability to increase earnings or lower expenses by booking improper cutoffs and fictitious
entries to revenues or expenses. Therefore, they will perform journal entries testing and
revenue/deferred revenue detailed testing to ensure that controls over the recording of journal
entries are proper.
CASE QUESTIONS

1. Identify significant factors that make Toddlers Lane an attractive investment for
Babysitter, Inc.
2. Based on your understanding of Toddlers Lane and its business environment, identify
risk factors unique to this industry that McLawrence audit team should consider
3. What additional information is needed by McLawrence audit team to be able to
conduct their audit?
4. Given the information provided, and the additional information you recommend the audit
team to collect, develop an audit plan to assist in completing the audit on time (