Question

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. 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.

ILLUSTRATION 4.2 Entity factors that influence inherent risk Lower Inherent Risk Assessments Satisfied customers who pay on time and are likely to romain a customer in the future Client has many customers Reputable suppliers that supply goods on a timely a basis Fow goods are returned to supplier as faulty Client pays 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 Client well-positioned to adjust to changes in technology 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 Few discounts are given by the client to its customers Client takes advantage of discounts offered by suppliers 7 Client has good reputation with customers, suppliers, employees, and the wider community in which it operates Client has few locations and primary operations are centralized No international operations Factors That Influence Inherent Risk Higher Inherent Risk Assessments (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 (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 (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 (4) Changes in technology 4 Client falls behind with changes in technology and has not kept up with the times" (5) Warranties Client offers warranties on its products History of poor product quality and goods being returned for the same problem (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 (7) Client reputation Client does not have a good reputation with customers, employees, and/or the wider community in which it operates (8) Operations Client has large number of locations and operations are decentralized Multiple locations operated internationally (9) Selection and application of Recent implementation of new accounting accounting principles standard Change in the application of an accounting standard Personnel involved in the selection and application of accounting standards lack competence and experience (10) Significant accounts and Determination of account balance involves classes of transactions considerable subjectivity Transactions are complex and unique Account has high volume of transactions (11) Relations with employees More complex payroll system and benefit structures Defined-benefit pension plans 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 ( (13) Ownership structure Complex capital structure Struggles to pay dividends from operating cash flow 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 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 Less complex payroll system and benefit structures Defined contribution pension plans (12) Sources of financing Less reliance on debt for financing Pays interest payments on time Less risk of violating terms of debt covenants Simple capital structure Pays dividends from operating cash flow ILLUSTRATION La Industry and business environment factors that influence inherent risk Industry Factors That Influence Lower Inherent Risk Assessments Inherent Risk Higher Inherent Risk Assessments Less competitive industry, which puts less stress (1) Level of competition Very competitive industry, which puts more on the client's ability to generate a profit stress on the client's ability to generate a profit Good reputation relative to others in the industry (2) Reputation Poor reputation relative to others in the Customers and suppliers may be attracted industry to conduct business with the client versus a Customers and suppliers may shift business competitor to a competitor A new industry with considerable government (3) Legal, political, and regulatory A new industry with little or no government support and incentives environment support New or established industry with intense New or established industry with intense international competition with considerable international competition with little or no government support and incentives government support industry with minimal government regulation Heavily regulated industry with special and no special tresor unique financial reporting taxes and unique regulations and financial requirements reporting requirements Demand is not seasonal, which provides steady (4) Demand Seasonal demand for products, which leads revenue flow to sporadic revenue flow Industry minimally affected by trends.customer Industry subject to changing trends/ preferences customer preferences Industry has low risk of technological Industry subject to technological obsolescence obsolescence Economy as a whole experiences an upturn, (5) Economy Economy as a whole experiences a which leads to easily sustainable profit levels downturn, which leads to pressure to maintain expected profit levels

Answer 1

Answer:-

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 9s 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 9s operations. In conducting your research, you should consider the following key market forces, as they relate to Cloud 9s operations.

• General and industry-specific economic trends and conditions

• Competitive environment

• Product information

• Customer information

• Supplier information

• Technological advances and the effect of the internet

• Laws and regulatory requirements

They may have identified some of the following key market forces based on their research.

Economic characteristics/Supplier information/Regulatory

The Canadian footwear market is expected to grow at an average of approx 2% each year to 2012:

Household consumption expenditure has decreased over the last few years with gasoline and housing prices increasing. Expenditure is mostly going towards travel and leisure rather than clothing or footwear.

Tariff reductions have led to a decrease in prices for consumers.

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 their China distribution plant.

The strength of the Canadian dollar against the US dollar has improved the foreign currency exchange issues.

Having a retail outlet/store increases the risk of theft (and has been proven) and need for skilled or at least consistent labor.

Consider effect of recent events e.g., Global financial crisis.

Competitive environment/Product information/Customer 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 are key to establishing brand recognition.

The industry is relatively capital intensive need for warehousing, transportation, inventory/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 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 are surpassing department stores this may impact Cloud 9s 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.

Technology and Systems

Technological advances in this industry have mainly been in the areas of replacing the need for skilled labor 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 in one seamless supply chain.

An on-line presence will provide a competitive advantage through increased marketing power and the ability to provide product information.

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:

Growth of revenues given industry outlook and management incentive

Risk Description

Consumer discretionary spend is low and expected to grow by only 2% for the year. Management receives bonuses based on revenue targets, which was set at 3%. General economic conditions will also impact retail businesses with their recoverability of debt and valuation of assets.

Use of IT for inventory management system

Risk Description

Retail businesses are reliant on a smooth supply chain process. Where a business uses products 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.

Level of competition

Risk Description

Most sectors of retailing are relatively mature and continue to compete on the traditional basis of price, brand strength and level of market power. Price remains important in most mass market areas of retailing.

Merchandise cycle and fashion trends

Risk Description

Rapidly changing fashion trends and slow sales outlooks can result in obsolete inventory/stock.

Misappropriation of inventory and cash

Risk Description

Retail business selling highly desirable and moveable products (e.g., PC games, CDs, designer sunglasses) will be exposed to an increased risk of theft. In addition, employees handling cash at store locations increase the risk of fraud through theft also.

Rebates/Discounts to retailers

Risk Description

For the wholesale business, there is significant pressure from retailers to receive generous rebates or volume discounts. Retailers are heavily influenced by landlords and consumers; therefore they control their profits through the supply chain, thus impacting the wholesaler.