W&S Partners began the planning phase of the Cloud 9 audit. As part of the risk assessment phase for the new audit, the audit team needs to gain an understanding of Cloud 9’s structure and its business environment, determine materiality, and assess inherent risk. This will assist the team in developing an audit strategy and designing the nature, extent, and timing of audit procedures.
Required
Answer the following questions based on the additional information about Cloud 9 presented in the appendix to this text and the current and earlier chapters. You should also consider your answer to the case study questions in earlier chapters where relevant.
Your task is to research the retail and wholesale footwear industries and report back to the audit team. Your report will form part of the overall understanding of Cloud 9’s structure and its environment.
You should concentrate your research on providing findings from those areas that have a financial reporting impact and are considered probable given Cloud 9’s operations. Use the factors listed in Illustrations 4.2 and 4.3 as a guide for your research.
Part 2:
Required
Answer the following questions based on the information presented for Cloud 9 in the appendix to this text and the current and earlier chapters. You should also consider your answers to the case study questions in earlier chapters.
a. Using analytical procedures and the information provided in the appendix, perform an analysis of Cloud 9’s financial position and its business risks. Discuss the ratios indicating a significant or an unexpected fluctuation.
b. Which specific areas do you believe should receive special emphasis during your audit? Consider your discussion of the analytical procedures results as well as your preliminary estimate of materiality. Prepare a memorandum to Suzie Pickering outlining potential problem areas (that is, where possible material misstatements in the financial statements exist) and any other special concerns.
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Figure 4.2
| Lower Inherent Risk Assessments | Factors That Influence Inherent Risk | Higher Inherent Risk Assessments |
|
Satisfied customers who pay on time and are likely to remain a customer in the future Client has many customers |
(1) Major customers |
Dissatisfied customers who may withhold payment or decide to not purchase from the client in the future Client has only one or very few customers |
|
Reputable suppliers that supply goods on a timely basis Few goods are returned to supplier as faulty Client pays suppliers on a timely basis |
(2) Major suppliers |
Suppliers may not supply goods on a timely basis Significant amounts of goods are returned to the suppliers because they are faulty Client does not pay suppliers on a timely basis |
|
Trades with countries that are stable Trades in stable foreign currencies Minimal tariffs or barriers to trade Client maintains effective risk management policies regarding foreign trade |
(3) Importer or exporter |
Trades with countries that are not stable Trades in unstable foreign currencies Complex tariffs and other barriers to trade Client does not maintain effective risk management policies regarding foreign trade |
| Client well-positioned to adjust to changes in technology | (4) Changes in technology | Client falls behind with changes in technology and has not “kept up with the times” |
|
Client does not offer warranties on its products If client does offer warranties, product quality is high and the likelihood that goods will be returned is low |
(5) Warranties |
Client offers warranties on its products History of poor product quality and goods being returned for the same problem |
|
Few discounts are given by the client to its customers Client takes advantage of discounts offered by suppliers |
(6) Discounts |
Client offers discounts to its customers, possibly because it does not have much bargaining power Client misses opportunities to take advantage of supplier discounts |
| Client has good reputation with customers, suppliers, employees, and the wider community in which it operates | (7) Client reputation | Client does not have a good reputation with customers, employees, and/or the wider community in which it operates |
|
Client has few locations and primary operations are centralized No international operations |
(8) Operations |
Client has larger number of locations and operations are decentralized Multiple locations operated internationally |
|
No recent implementation of new standards No change in the application of accounting standards Personnel involved in the selection and application of accounting standards are competent and experienced |
(9) Selection and application of accounting principles |
Recent implementation of new accounting standard Change in the application of an accounting standard Personnel involved in the selection and application of accounting standards lack competence and experience |
|
Determination of account balance is objective and supported by transactions with third parties Transactions are routine and relatively homogeneous Account has low volume of transactions |
(10) Significant accounts and classes of transactions |
Determination of account balance involves considerable subjectivity Transactions are complex and unique Account has high volume of transactions |
|
Less complex payroll system and benefit structures Defined-contribution pension plans |
(11) Relations with employees |
More complex payroll system and benefit structures Defined-benefit pension plans |
|
Less reliance on debt for financing Pays interest payments on time Less risk of violating terms of debt covenants |
(12) Sources of financing |
Heavy reliance on debt as a source of financing Struggles to pay interest payments on time Higher risk for violating terms of debt covenants which could indicate going concern issues |
|
Simple capital structure Pays dividends from operating cash flow |
(13) Ownership structure |
Complex capital structure Struggles to pay dividends from operating cash flow |
Figure 4.3
| Lower Inherent Risk Assessments | Industry Factors That Influence | Inherent Risk Higher Inherent Risk Assessments |
| Less competitive industry, which puts less stress on the client’s ability to generate a profit | (1) Level of competition | Very competitive industry, which puts more stress on the client’s ability to generate a profit |
|
Good reputation relative to others in the industry Customers and suppliers may be attracted to conduct business with the client versus a competitor |
(2) Reputation |
Poor reputation relative to others in the industry Customers and suppliers may shift business to a competitor |
|
A new industry with considerable government support and incentives New or established industry with intense international competition with considerable government support and incentives Industry with minimal government regulation and no special taxes or unique financial reporting requirements |
(3) Legal, political, and regulatory environment |
A new industry with little or no government support New or established industry with intense international competition with little or no government support Heavily regulated industry with special taxes and unique regulations and financial reporting requirements |
|
Demand is not seasonal, which provides steady revenue flow Industry minimally affected by trends/customer preferences Industry has low risk of technological obsolescence |
(4) Demand |
Seasonal demand for products, which leads to sporadic revenue flow Industry subject to changing trends/customer preferences Industry subject to technological obsolescence |
| Economy as a whole experiences an upturn, which leads to easily sustainable profit levels | (5) Economy | Economy as a whole experiences a downturn, which leads to pressure to maintain expected profit levels |
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