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Cloud 9 Ltd. : An Audit Case Study, First Canadian Edition Solution Manual

Cloud 9 Ltd. : An Audit Case Study, First Canadian Edition Solution Manual is designed to reinforce textbook concepts through clear explanations.

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    2 Assignment 1: Understand the business General and industry-specific economic trends and conditions The Canadian economy is expected to grow at an average of approximately 2 to 3 percent each year to 2016. • After a period of spending and debt accumulation, Canadians are now focusing on reducing debt levels while interest rates are at historic lows. Today, the overall trend is toward more prudent spending, resulting in modest growth. As the Bank of Canada signals interest rates will increase in the future, the timing of such increases are uncertain. Future interest rate increases may decrease the amount of disposable income available for expensive running shoes. • Greater movement of U.S. retail chains into Canada continues to put pressure on the retail sector. With increased competition, price wars are common, putting pressures on profit margins. There is an adequate supply of workers and there are no special or unique labour relations requirements. • However, sales of the product will depend on the target market. Who is most likely to buy — Generation Y? Baby Boomers? Gen X? Mellennial ’ s? House prices and interest rates don’t affect Mellennial ’ s, Gen Yer ’ s, and the Baby Boomers as greatly as Gen Xers, who are experiencing the prime years of home ownership. Therefore, the target market may not be significantly impacted by future interest rate increases. • Lower pricing levels and improved quality of Chinese imports have resulted in large volume increases. Cloud 9 has responded well to this shift by obtaining the majority of its good from its China distribution plant. • The strength of the Canadian dollar against the U.S. dollar has improved the foreign currency exchange issues (dollar parity makes imports cheaper). • Seasonality is not a specific concern for running shoes. • Having a retail outlet/store increases the risk of theft (and has been proven) and need for skilled or at least consistent labour. • Cloud 9’ s growth expectations are in line with the industry. Competitive environment/Product information/Customer information/Supplier information Competition is high and increasing, with price and quality the deciding factors. • The ability to supply footwear retailers with products in a timely manner is an important success factor against competitors. Footwear is subject to fashion trends. • Image and functionality are two of the most important characteristics consumers use to differentiate footwear. An aggressive marketing campaign, often using sports and fitness preferences, riskey to establishing brand recognition. • The industry is relatively capital intensive. The need for warehousing, transportation, and stock is high and may create barriers to entry. • While entry from new wholesalers can be difficult based on agreements between existing wholesalers and retailers, the trend in the industry is for the customer to

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    3 buy directly from the manufacturer. Cloud 9 has responded well to this trend by opening its own store, thereby taking out the wholesaler. • Discount stores/outlets and online shopping also complete in this sector. This may impact Cloud 9’s current customer base and sales opportunities. • To boost repeat customer visits, retailers are developing loyalty programs. While Cloud 9 started a program this year, it remains to be seen if the benefits will be achieved given the low regularity of consumers purchasing athletic footwear. Technological advances and the effect of the Internet Technological advances in this industry have mainly been in the areas of replacing the need for skilled labour with computerized automation of inventory control. • Computers allow inventory to be stored on an international basis, allowing for more efficient transportation and distribution. • Distribution management software allows advanced order management, inventory management, and delivery systems to be combined into one seamless supply chain. • An online presence will provide a competitive advantage through increased marketing power and the ability to provide product information. Laws and regulatory requirements  As Cloud 9 is a public company it must adhere to the stock exchange regulations. Things to consider include corporate governance guidelines and filing requirements.  As the majority of Cloud 9’s products are manufactured in China with the remainder made in the US, Cloud 9 should be aware and in compliance with the laws and regulations of these foreign jurisdictions. This includes the consideration of labour law requirements in these foreign countries. By considering these factors, the auditor would identify key business risks that would have a material effect on the financial statements. These risks are inherent to the business operations. Based on the research above, the Cloud 9 audit team have identified the following audit risk areas: NOTE TO THE LECTURER: Additional discussion points It is important to clearly distinguish between business risks and significant risks. Business risks are faced by management in its operation of the business. Significant risks are those that increase the risk of material misstatement and require attention by the auditor. From a big picture perspective, you may want to highlight the key risks in respect of understanding the wholesale/retail industry. This does not directly affect the outcome of the case study for Cloud 9 given the limited company background provided. • How does the company control the suppliers/manufacturers? Are they local or international?

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    4 • How does Cloud 9 determine the quantities and styles for its purchases from the manufacturer? Ultimately, the wholesaler inherits some of the risk when determining inventory balances to effectively service the retailers. • What are the terms and conditions with the retailers? What rebates or discounts are provided? As price is the key driver in retail, this will be the area of concern when dealing with retailers.

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    5 Potential risk — description Account (s) Assertion (s) (assignment 3) Level of inherent r isk (assignment 3) Growth of revenues given industry outlook and management incentive Consumer discretionary spend is low and expected to grow by only 2 percent for the year. Management is to receive bonuses based on revenue targets, which is set at 3 per cent; therefore , there is a management bias to overstate assets and revenu e s and understate liabilities and expenses. General economic conditions will also impact retail businesses with their recoverability of accounts receivable and valuation of assets. R evenue Accounts Receivable Accrued Bonuses Payable Occurrence, Accuracy Existence, Valuation Existence, Valuation HIGH Use of IT for inventory management system Retail businesses are reliant on a smooth supply chain process. Where a business uses pro ducts with a long lead time, there is significant pressure to ensure that the correct type and quantity of inventory is ordered to meet the requirements of customers. Inventory Cost of Sales Completeness, Existence, Valuation Completeness, Occurrence, A ccuracy HIGH Where there is a high reliance on timing of supply or one supplier, this can affect the level of sales, making the assessment “High . ” The company’s early implementation issues of the JIT system and FOB s hipping p oint terms also contribute to t he higher assessment. Nature of the fashion industry and its trends Rapidly changing fashion trends and slow sales outlooks can result in obsolete inventory . Inventory Existence, Valuation LOW Based on the stability of the athletic footwear market, this i nherent risk is “Low” as the fashion trends are not as exaggerated as with other footwear producers or retailers.

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    6 Potential risk — description Account (s) Assertion (s) (assignment 3) Level of inherent r isk (assignment 3) Misappropriation of inventory and cash Retail business es selling highly desirable and moveable products ( such as PC games, CDs, and designer sunglasses) will be exposed to an increased risk of theft. In addition, employees handling cash at various store locations increases the risk of fraud through theft . Cash Inventory Cost of Goods Sold Existence, Valuation Existence, Valuation Existence , Accuracy HIGH Previous thefts, easy portability of cash and inventory. Rebates/ d iscounts to retailers For the wholesale business, there is significant pressure from retailers to receive generou s rebates or volume discounts. Retailers are heavily influen ced by landlords and consumers; therefore , they control their profits through the supply chain, thus impacting the wholesaler. Discounts G iven (Expenses) Revenues Cost of S ales Valuation and allocation Accuracy Accuracy HIGH Management incentives and p res sure from ownership for growth.

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    7 Assignment 2: Calculate materiality W/P ref: A2 – 1 Prepared by: _____ Date prepared: _____ Cloud 9 Ltd. December 31, 2014 Setting materiality Users Financial s tatement a rea of m ost c on cern to the u ser Cloud 9 Inc. This is the parent company of Cloud 9 Ltd. They are concerned with the company’s ability grow its market share of the North American footwear market. This would best be reflected by revenues. Bank Concerned with the ability of Cloud 9 to repay borrowed funds. As a result, it is mostly concerned with net income as this is the best predictor of an entity’s future ability to repay. Management Concerned primarily with revenues as this is the basis for their bonuses. Base selected for planning materiality (PM): _________________________________ Justification for selection: __________________________________________________________________________ Revenue is the most appropriate basis for calculating PM. This is the preferred method because: • Cloud 9 is currently in a loss for the year ended December 31, 2014; therefore, net income before tax is not an appropriate basis. • The parent entity (main users of the accounts) is concerned with increasing the market share of the Canadian market — essentially revenue. • Management has an incentive to manipulate revenue based on growth targets expected and compensation attached to meeting those targets. _______________________________________________________________________ __________________________________________________________________________ __________________________________________________________________________ __________________________________________________________________________ Calculation of PM Current Year Prior Year Trial balance amount: $ 37,194,932 $ 34,038,192 Normalizing adjustments (that is, non-recurring items) $ 0 $ 0 Annualized (if required): NA; full-year balances used NA; full-year balances used

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    8 Benchmark applied 0.5% of revenues Calculated materiality: $ 37,194,192 × 0.5% = $185,975 Conclusion: PM materiality is $185,000 (rounded). Performance materiality: 60% × $185,000 = $111,000. Conclusion: Performance materiality is $111,000 . Discussion points Consider how you will use the planning materiality in your audit. What factors might lead you to increase or decrease the planning materiality amount? NOTE TO THE LECTURER: Additional discussion points How would the planning materiality be used? • To compare fluctuations in (annualized) accounts between years, those with fluctuations greater than materiality may need greater attention. • In the allocation of resources within the audit, those accounts with greater levels of inherent risk and more material accounts may receive more audit hours. What would lead the auditor to increase or decrease materiality? • There could be uncertainty in the external environment. For example, during the global financial crisis, auditors may have been more conservative and decreased the level of materiality to ensure detection of material misstatements. • If this is a new audit client, the auditor may set materiality lower in the first year while gathering an understanding of the client. If no material misstatements are found in the first year, it may be increased on subsequent audits.

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    9 Assignment 3: Assertions See table provided in the solution for Assignment 1. Discussion points Significant risks not linked to any account or assertion • A significant risk increases the risk of material misstatement. Thus if a risk cannot be linked to an account or assertion, it probably does not increase the risk of error or fraud in the financial statements. Therefore, the auditor should consider it as part of their understanding of the business, but it will have limited impact on the execution of the audit. Overall analysis for the client • Overall, there is a HIGH risk. • There are a number of accounts where there is a high risk of misstatement due to potential management or employee manipulation. • Also, the general economic environment (with disappointing retail sales figures) coupled with significant (possibly unachievable) growth targets merits a HIGH overall rating.

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    10 Assignment 4: Documenting an accounting process The solution guide below is a detailed flowchart – a more simplified flow diagram as show in Figure 4.1 of the text can also be used

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    11 ACCOUNTS RECEIVABLE CLERK FINANCIAL CONTROLLER FINANCIAL DIRECTOR Download cash receipts Internet Bank report Post receipts A/R sub ledger Run batch report Batch report Conduct reconciliation Review reconcilia tion & sign off Monthly bank statements Journals Monthly reconciliation Reviewed & signed off 1 1

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    12 From the interview transcript, students should ask the following questions for further information or clarification: For the sales manager • How often are prices changed? What is the process for making a change to the master price list? Who has access to the master price lists? • What are the mechanics of the credit check that the system performs? Who set the limits? What happens if they are over their limits? How are the limits changed? For the shipping supervisor • How are the goods prepared for delivery; that is, how are they packaged? • Do the drivers check their loads against the shipping documents prior to departing the warehouse or during their deliveries? What is the evidence of this? For the warehouse manager • How do you ensure all sales orders are filled? • What happens if a product is returned? For Carla Johnson (to represent finance) • What happens if the batch posting report doesn’t reconcile to the bank repo rt? • How do you know to what invoice the payment relates? • Do you ever have cash that you can’t determine what customer or invoice again st which it should be applied? For an IT manager Overall, there is such a reliance on the IT systems that the audit team would want to get an IT specialist involved to help review the general controls (access, change management, backups) as well as help understand exactly what happens to the data that gets entered. Discussion points What would you do if you found a weakness that did have a mitigating control? Would it affect your assessment of the control systems’ ability to prevent or detect material misstatements? Weaknesses that have a mitigating control to detect whether an error may have occurred and as a result are rectified can mean that the weakness is lessened. It will depend on how frequently and diligently the mitigating control is performed.

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    13 Assignment 5: Identifying errors in the accounting process Significant p rocess Potential m isstatements Assertions Transac tion level internal control s (assignment 6) Sales/Accounts r eceivable Credit memos are not issued or recorded for returns on a timely basis or credit memos are not issued at all.  Sales — o ccurrence  Accounts Receivable — e xistence  Credit memos > $10,000 are approved by receiving manager and finance director.  All others are approved by receiving manager.  Bar code scanners are used to automatically record sales and returns. Duplicate/false sales transactions are recorded.  Sales — o ccurrence  Accounts Receiva ble — e xistence  Allowance for Doubtful Accounts — c ompleteness  Sales order is automatically matched to shipping document in Swift prior to shipment.  Shipping supervisor enters passcode in Swift authori z ing each shipment.  System generates draft invoice when sh ipping document authori z ed by shipping supervisor.  System automatically posts the invoice to the sales and A / R subledgers. Invoice misstates the quantity of goods shipped or incorrect pricing.  Sales — a llocation  Accounts Receivable — v aluation  Inventory — v aluation  Cost of Goods S old — a llocation  Draft sales invoices are agreed to shipping document s signed by customers.  Sale price s are taken from the master price file.  Sales orders are automatically matched to shipping document s in Swift prior to shipment.  Sy stem generates draft invoice when the shipping document is authorize d by the shipping supervisor.  System automatically posts the invoice to sales and A / R subledgers.

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