Deluxe Chicken (DC) was established in 1989 by Sebastian Bony. It sells delicious rotisserie-cooked chicken with fresh vegetables and other side dishes through its own stores and franchisee stores, just like Kentucky Fried Chicken (KFC). According to Seb, DC’s strategy is to be “a home meal replacement” in the New England and Mid-Atlantic regions. DC went through an impressive expansion. At the end of 1991, the firm operated only 34 stores, with no franchisee stores. But by the end of 1994, the total of stores (company-owned stores and franchise stores) had increased to 534 (491 were franchise stores). It was estimated that DC’s franchise store can easily break even if its weekly average revenue per store is higher than $23,000. According to Reuters, its stock price had risen steadily from $8 in November 1993 to $23 in March 1997.

Deluxe Chicken (DC) was established in 1989 by Sebastian Bony. It sells delicious rotisserie-cooked chicken with fresh vegetables and other side dishes through its own stores and franchisee stores, just like Kentucky Fried Chicken (KFC). According to Seb, DC’s strategy is to be “a home meal replacement” in the New England and Mid-Atlantic regions. DC went through an impressive expansion. At the end of 1991, the firm operated only 34 stores, with no franchisee stores. But by the end of 1994, the total of stores (company-owned stores and franchise stores) had increased to 534 (491 were franchise stores). It was estimated that DC’s franchise store can easily break even if its weekly average revenue per store is higher than $23,000. According to Reuters, its stock price had risen steadily from $8 in November 1993 to $23 in March 1997.

DC’s auditor is a prestigious Big-8 accounting firm, Firehouse Young LLP. The 1994 and 1995 fiscal year financial statements below were all audited numbers, but the 1996 numbers were unaudited.

DC’s excellent performance also impressed the Street. Stock analyst Mike Foster of Silverman Sterling forecasted that DC’s EPS would grow at an annual rate of around 35% between 1997 and 2001 and gave a “strong buy” rating. It was rumored that the wealth management division of Mohan Stanley took a passive 3% stake in this firm. Many hedge funds followed the rumor and added DC’s shares to their portfolios.

Table 1. CONSOLIDATED INCOME STATEMENTS

Fiscal Years Ended

————————————————

December 25,      December 31,      December 29,

                                                   1994               1995              1996

(in thousands)  (in thousands)    (in thousands)

Revenue:

Royalties and franchise related fees………..   $43,603          $ 74,662           $115,510

Company stores sales…………………… ..    40,916            51,566             83,950

Interest income…………………………..    11,632            33,251             65,048

Total revenue………………………….    96,151           159,479            264,508

Costs and Expenses:

Cost of products sold……………………..    15,876            19,737             31,160

Salaries and benefits……………………..    22,637            31,137             42,172

General and administrative…………………    27,930            41,367             99,847

Relocation expense      …………………..     5,097                 –                  –

Total costs and expenses………………..    71,540            92,241            173,179

Income From Operations.…………………….     24,611            67,238            91,329

Other Income (Expense):

Interest expense, net…………………….    (4,235)          (13,179)           (14,446)

Gain on issuances of subsidiary’s stock……..         –                 –             38,163

Other income, net…………………………        74               314                137

Total other income (expense)…………….    (4,161)          (12,865)            23,854

Income Before Income Taxes

and Minority Interest…………………….    20,450            54,373            115,183

Income Taxes……………………………….     4,277            20,814             42,990

Minority Interest in (Earnings)

of Subsidiary…………………………..         –                 –             (5,235)

Net Income………………………………..   $16,173          $ 33,559           $ 66,958

=======          ========           ========

TABLE 1. CONSOLIDATED INCOME STATEMENTS (to continue)

Fiscal Years Ended

————————————————

December 25,      December 31,      December 29,

                                                   1994               1995              1996

(in thousands)  (in thousands)    (in thousands)

Net Income Per Common and Equivalent Share……                 $  0.38         $ 0.66           $ 1.01                                    ======      ========       ========Shares outstanding at year end(in thousands)……..                   44,700        59,129             64,246                                    ======      ========       ========

TABLE 2. CONSOLIDATED BALANCE SHEETS

December 31,     December 29,

                                                                        1995           1996

(in thousands)  (in thousands)

Current Assets:                                                                                    

Cash and cash equivalents………………………………..      $ 310,436      $  100,800

Accounts receivable, net…………………………………         13,445          22,438

Due from area developers, royalty and interest …………….          9,614          10,246

Notes receivable from area developers, due in 12 months………         5,462               –

Prepayment and other current assets…………………                 4,858          12,979

Total current assets.………………………………..          343,815        146,462

Property and Equipment, net……………………………….         258,550         334,748

Long-term Notes Receivable from area developers……………..         450,572         800,519

Goodwill, net……………………………………………               –         190,439

Other Assets, net………………………………………..          20,940          71,448

Total assets………………………………………..       $1,073,877     $1,543,616

Current Liabilities:                                                                               

Accounts payable……………………………………….      $   12,292      $   40,430

Accrued expenses……………………………………….           9,095          36,547

Deferred franchise revenue………………………………           8,945          10,656

Total current liabilities……………………………..         30,332          87,633

Deferred Franchise Revenue………………………………..           2,072           7,740

Convertible Subordinated Debt……………………………..         129,872         129,841

Zero coupon bond         …………………………………         177,306         182,613

Deferred Income Taxes…………………………………….          16,631          40,216

Other Noncurrent Liabilities………………………………             833           6,292

Minority Interest………………………………………..               –         153,441

Stockholders’ Equity:                                                                              

Common stock………………………………………..              591             642

Additional paid-in capital…………………………….         675,611         827,611

Retained earnings…………………………………….          40,629         107,587

  716,831         935,840

 Total liabilities and stockholders’ equity…………     $1,073,877      $1,543,616

Shares outstanding at year end(in thousands)……..        59,129       64,246

TABLE 3. CONSOLIDATED CASH FLOW STATEMENTS

December 25, 1994   December 31, 1995  December 29, 1996

(In thousands)     (In thousands)     (In thousands)

Cash Flows from Operating Activities:

Net income…………………………..    $  16,173          $  33,559          $    66,958

Adjustments:

Depreciation and amortization………..        6,074             11,442               22,887

Interest expense on zero coupon bond…             –              8,075               13,793

Gain on issuances of subsidiary’s stock             –                  –              (38,163)

Deferred income taxes……………….         4,277             12,133              14,059

Minority interest…………………..            –                  –                5,235

Provision for write-down of assets……            –                  –               14,550

Loss (gain) on disposal of assets…….         (368)               231                   68

Changes in assets and liabilities

A/R & due from area developers               (7,800)           (10,057)              (7,193)

Accounts payable and accrued expenses….     13,724              3,661               48,674

Deferred franchise revenue………….        5,926               (303)               3,174

Other assets and liabilities……… .       (2,088)            (3,265)                 868

Net cash provided by operating activities   35,918             55,476              144,910

Cash Flows from Investing Activities:

Purchase of PPE and other assets  ……      (168,797)          (149,231)           (137,432)

Proceeds from the sale of PPE assets.           62,342             80,910               86,320

Loans (notes receivable) to area developers   (225,282)          (661,033)         (1,467,065)

Repayment of notes receivable by area developers 68,498           407,499              993,151

Net cash used in investing activities..    (263,239)         (321,855)           (525,026)

Cash Flows from Financing Activities:

Proceeds from issuance of common stock          125,703           385,360              112,863

Proceeds from issuance of subsidiary’s stock         –                  –              135,422

Proceeds from issuance of convertible bond      130,000                 –                    –

Proceeds from issuance of zero coupon bond           –            172,464                    –

Increase in deferred financing cost…….      (7,615)            (6,313)             (3,799)

Proceeds from revolving bank credit line….    96,130            229,240               43,250

Repayments of revolving bank credit lin……  (96,130)          (229,240)           (117,256)

Net cash provided by financing activiti..  248,088            551,511              170,480

Net Increase (Decrease).                          20,767            285,132            (209,636)

in Cash and Cash Equivalents

Below is some info from footnotes for your reference:

1. Principles of Consolidation. The consolidated financial statements include the accounts of the Company and its subsidiaries.
2. Revenue Recognition. Revenue from Company stores is recognized when food is sold. Royalties are recognized when related franchise store revenue is generated. It is 5% of the franchise revenue. Initial franchise fees and area development fees are recognized as DC’s revenue when the franchised store opens. Franchisee store also pays 5.75% of its revenue for system-wide marketing use.
3. Franchise store performance is not included in the consolidated financial statements since DC has no equity investment larger than 50% in any store.
4. Area developers are large regional franchises which focus on major U.S. metropolitan markets. The initial investment consists of 25% equity (contributed by independent business people) and 75% loan made from Deluxe Chickens. Area developers have no other sources for investment. DC believes that it is difficult for small franchises to get bank loans, therefore, DC always loan the money to support those area developers. Loan is recorded at historical cost. The average interest rate is around 8.2% in 1996.

Below are some disclosed info about all area developers                1995              1996

Total number of area developers                                          15                 14

Total number of stores open by those developers                         627                841

Gross Revenue (in thousands)                                       $491,341           $865,082

Total gross assets aggregated for those developers (in thousands)  $513,926           $640,534

Debt to Deluxe Chicken Inc. (in thousands)                         $372,071           $555,105

Total stockholder’s equity (or deficit) (in thousands)              (9,891)          (102,754)

TABLE 4. NI vs. OCF

Fiscal Years Ended

————————————————

December 25,      December 31,      December 29,

                                                  1994               1995              1996

(in thousands)  (in thousands)    (in thousands)

Net Income………………………………..  $16,173          $ 33,559           $ 66,958

Net cash provided by operating activities          35,918            55,476            144,910

You are a senior auditor at Firehouse Young LLP, assigned to audit DC’s 1996 financial statements in early 1997. John is the manager in charge and Kelvin Collins, a straight-A graduate from CSU Southhill, is your junior. Below is some conversation between you (Y) and Kelvin (K).

Y: DC is not a difficult account, but audit fee is never fat. So watch out when filling time sheets. BTW, have you ever tried AP (analytical procedures) by now?

K: Got it, AP not done yet. But I had a quick scan of the numbers and compared net income and OCF in the last 3 years. Net income looks healthy as it is well-supported by operating cash flow.  Look at the numbers below, NI/OCF ratio varies between 0.45 and 0.60. No negative OCF and no “kiss of death” in 1995 and 1996. Not a tough audit this year.

Required: Turn your clock back to the February 1997. As a senior auditor, please perform the analytical procedures and then write a memo to your manager. In your memo, you must highlight those accounts that might be subject to material misstatements and support your conclusions with solid evidence/argument.