Overlook Video Stores (60 minutes)

Overlook Video Stores Inc. (OVS) is a privately held chain of DVD rental stores headquartered in
Toronto. The company was incorporated in 1999 and has gone from a single store in Toronto to over 30
stores throughout Ontario.

Harford & Harford, LLP (H&H), a mid-sized professional services firm, have been the auditors for OVS
since its inception. You, CPA, are the audit senior on the OVS audit for the year ending December 31,
2024. On December 1, 2024, Alice Harford, the engagement partner, calls you into her office to explain
that the audit will need to begin in early January 2025, because OVS’s bank is eager to see the audited
financial statements.

“I would like you to prepare the audit planning memo for the OVS audit. OVS has experienced some
changes, and I want to make sure we consider those in our audit plan. The controller of OVS has faxed us
the interim financial statements for the 11 months ended November 30, 2024 (Exhibit I). These should
help you in your audit plan.

“I met with Victor Ziegler, the controlling shareholder of OVS, a few months ago and he told me about
OVS’s new directions. Here are my notes from that meeting (Exhibit II). In addition, there are some new
accounting issues that have arisen since last year end. I would like you to look at them and provide your
recommendations on the accounting treatments to adopt. Please also consider these issues when drafting
your audit planning memo and suggest ways to audit them.

“I also met with OVS’s Chief Information Officer, Nick Nightingale. He provided a description of OVS’s
expansion during 2024 into the Internet-based DVD rental market through a program called Movies By
Mail. Here are my notes from my meeting with Nick (Exhibit III). Please review them and assess the
impact on your audit plan.

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 EXHIBIT I
OVERLOOK VIDEO STORES INC.
EXCERPTS FROM THE BALANCE SHEET
(in thousands of dollars)

Nov. 30, 2024 Dec. 31, 2023

(unaudited) (audited)

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 EXHIBIT I (continued)
OVERLOOK VIDEO STORES INC.
EXCERPTS FROM THE INCOME AND RETAINED EARNINGS STATEMENT
(in thousands of dollars)

11 months ended Year ended

Nov. 30, 2024 Dec. 31, 2023
(unaudited) (audited)

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 EXHIBIT II
NOTES FROM MEETING WITH VICTOR ZIEGLER

After years of slow and steady growth, OVS began expanding in two directions. First, OVS opened ten
new video stores in 2024. In the past, OVS had only opened one store per year, but Victor felt more rapid
expansion was necessary to compete with pay-per-view TV and downloadable movies on the Internet.
Second, OVS moved into the Internet-based DVD rental business by launching a new website,
www.MoviesByMail.ca. The expansion was financed by a ten-year term loan from OVS’s bank. Victor
noted that the bank now seems concerned with the profitability of the company.

No Late Fees

OVS also introduced a new program called “No Late Fees” during 2024. Since people are often reluctant
to rent movies because they cannot return them on time, OVS eliminated late fees for its customers.
However, to prevent abuse of this program, after 30 days if the movie is not returned, the outstanding
movie is considered sold to the customer who rented it. The next time the customer comes to the store,
there will be a charge of $25, the price of purchasing a new DVD, on the customer’s account and they
have the right to keep the DVD.

The program has been “tremendously successful,” according to Victor. It has both increased rental
revenue and increased sales of DVDs, since many customers keep their DVDs beyond the 30 days.
However, Victor conceded that it has upset some customers who believed that OVS had truly eliminated
all forms of late fees. Most customers who were charged for an over-30-day DVD have refused to pay for
it and simply returned the DVD to an OVS store. Others have yet to pay for the DVD and have yet to
return it.

Movies By Mail

When customers first subscribe to the Movies By Mail service at the store, they supply their credit card
number and agree that it will be charged $30 at the end of each month until they cancel their subscription.
To rent a DVD, customers log on to the website using a user ID and password provided to them. Once
logged on, customers can browse the over 25,000 titles that OVS has in its DVD rental library. They can
choose up to 40 movies to have in their “wish list.” If customers really want a certain DVD, they can flag
it as urgent.

The customer is mailed his or her initial four DVDs from the OVS warehouse in Toronto. These are
selected automatically by the system based on availability of DVDs in the rental inventory, while giving
priority to those DVDs marked as urgent by the customer. Once the customer is finished watching a
particular DVD, he or she returns it by mail in a postage-paid envelope. OVS then sends the customer the
next DVD on the list.

During the introduction period of Movies By Mail, OVS offered new customers the option of paying
$500 up front for three years of DVD rentals by mail. Many customers took advantage of this option due
to its substantial savings.

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 EXHIBIT II (continued)
NOTES FROM MEETING WITH VICTOR ZIEGLER

RentPoints

In January of 2024, OVS introduced a customer reward program called RentPoints. For every dollar a
customer spends with OVS, they get one RentPoint added to their OVS account. The point-of-sale system
in OVS’s stores automatically tracks the points each time a customer rents or purchases DVDs.
Customers can then redeem RentPoints for selected rewards. For example, 100 RentPoints can be
redeemed for a new DVD, or 25,000 RentPoints can be redeemed for a trip for two to Hollywood.

Although Victor believes the program has been very popular, to date, only 92,000 RentPoints have been
redeemed. Victor has faith that more people will eventually redeem their points since the points do not
expire. However, he is now wondering if he should continue the program, since so few people have taken
advantage of it.

Previously viewed DVDs

In the past, a wholesaler purchased all of OVS’s previously viewed DVDs. Now, due to its expansion,
OVS first sells all the previously viewed DVDs it can to the wholesaler. OVS then offers the remaining
previously viewed DVDs for sale to its customers at discounted prices. Each of these remaining DVDs is
scanned and its cost is transferred from “Inventory–DVDs for Rent” to “Inventory–Previously Viewed
DVDs for Sale”.

When a new movie is released on DVD, OVS must order at least 20 copies of it for each store, at an
average cost of $20 per DVD. Within two months, demand for the movie has diminished so that only five
copies per store are necessary. As a result, OVS must sell off 15 copies per store for about $10 each.

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 EXHIBIT III
NOTES FROM MEETING WITH NICK NIGHTINGALE

Nick Nightingale is the Chief Information Officer for OVS and was responsible for the implementation of
the Movies By Mail system. He answers the OVS help desk phone, so he has been extremely busy lately
because Movies By Mail customers have been calling for assistance. He said the following:

“The Movies By Mail concept is great, but it has been difficult to get going. Moonwatcher Web
Designers (MWD) programmed both the front-end, which is the part the customer sees, and the back end,
which is the database that tracks the DVDs. MWD programmed the website very quickly but has not been
available very much since the website went live six months ago. We have had several crashes of the
website, and the only advice MWD has provided is to reboot the server. Considering all the money we
paid MWD to develop the site, which at last count was over $8.5 million, I hoped for better service.

“We were able to save money by hosting www.MoviesByMail.ca on an existing server. Because the
website needs to transfer credit card sales information daily to the accounting system, we used the same
server that runs our accounting system.