BACKGROUND INFORMATION

Wallace & Davey Partners, Chartered Accountants is a medium size accounting firm located in Auckland with 4 audit partners, 7 business advisor partners and 4 tax partners. The firm has been appointed to audit Cool and Cute Children Fashion Ltd for the year ended 31 December 2016. The former auditors have been rotated off the client. The engagement partner is Patrick Wallace, and you are the audit manager assigned to this client. Your firm does not have experience in children fashion industry, but Wallace thinks it is a good opportunity to learn about the industry. The fee for the financial audit of Cool and Cute is $150,000, which is about 16% of total audit fees your firm generate. The company would also require advice on taxation and treasury. Since this is a first time audit, you accompanied Wallace to meet the senior management of the client. The following is a summary of your notes from the interviews with senior management of Cool and Cute Children Fashion.

NOTES FROM CLIENT INTERVIEW: T

he company profile

Cool and Cute Children Fashion is an Auckland company incorporated in 1990. It was founded by Sally Hall, a former childrenswear buyer, and a mum. Hall spotted a gap in the market for quality and fashionable childrenswear and started the brand with a mail order catalogue. Halls mail order catalogue was very popular and soon after she opened the first Cool and Cute retail store. By 1994, Cool and Cute headed into Australia as a mail order catalogue, opening its first Australian store three years later. Cool and Cute adapted to ecommerce in 2001, launching a transactional website to service its Australasian markets. Cool and Cutes rise seemed unstoppable in the early 2000s. It secured its first US wholesale partner Nordstrom in 2002, and in 2003 added Australian department store David Jones as a distribution channel. In 2004 it listed on the NZ stock exchange and opened franchise partner stores across the Middle East. Retail stores in the US, franchises in Singapore, Malaysia, Indonesia, South Africa and Pakistan followed, along with the companys first ecommerce website in 2006. Around that time, the founder Hall stepped down from the Board, leaving the directors to find a new managing director. Since then, the company has changed three Managing Directors. The fast expansion of Cool and Cute was heavily financed through debts, which contributed to a highly geared financial position. It created pressure for the company in serving the high level of debts. The companys expansion ceased in 2007 and its shares price peaked in January 2007 at $4.95 per share. By November 2016, the share price dropped by 60% to $1.98. As of 2015, the company closed its stores in nearly all international markets, with just 92 stores remaining across Australia, New Zealand and Ireland. Market commentators believe that the deterioration of Cool and Cute financial performance were largely because its inability to sustain the rapid global expansion. 4 Despite the highly competitive retail market, the core retail businesses in New Zealand and Australia have performed well in the current financial period and progress has been made to improve stock efficiency. Despite the difficulties in performance, the new Managing Director Neil Jenkins, who was appointed in June 2015, is confident that the company can be turned around because the brand is still strong and well recognised. The company also has reduced net banking debt by $20 million, and its banking facilities are secured until the end of 2017. Before he was appointed as the managing director, Jenkins was an experienced director and was the CFO of a large retailing chain in NZ. At the meeting, you discovered that Jenkins daughter works for your firm as an audit graduate. The new Managing Director Neil Jenkins is changing its business strategy, which aimed at repositioning itself in the market. The new MD has a turnaround plan. He says that Cool and Cutes must redirect its focus to customers, the style of clothes parents desire to buy for their kids and enhance customers experience in the stores. To achieve this, investment will be required in new design of products, marketing channels and on various customer communication mediums.

Competition in the market

In recent years, clothing retailers in Australia and New Zealand have struggled. Although Cool and Cute is the biggest player in the market, it claims to have only 4.2% of the kids fashion market. It competes with brands carried by department stores as well as small boutiques such as Seed, H&M and Cotton On Kids etc.

Financial situation

Cool and Cute delivered a $9,079,000 after-tax loss for the year ended 31 December 2016, an improvement compared to the prior year loss of $11,495,000. Jenkins said "the financial position of the company has improved significantly over the last year in particular and we have formed a very strong working relationship with the bank. Over the last 12 months, we have made significant progress in reducing inventory level. Our debts (interest bearing liabilities) also have dropped from over $60 million last year to around $40 million this year. In our view, this is material and has created the platform for us to move forward."

The structure of the Board of Directors

The board of directors consists of five members: the Managing Director and four independent directors at end of 2016 financial year. Three of the four independent directors are also members of the Audit Committee. The Company has a formal Code of Conduct and Ethics Policy. This policy provides guidance to all Directors, managers, employees and contractors of Cool and Cute Limited expected conduct when undertaking business on behalf of the company.

Communication with the prior auditor

With the clients approval, the predecessor auditor shared their audit file for the last financial year. You noted in the audit file, a concern regarding the valuation of inventory. The predecessor auditor believed that the one of the inventory range called Comfort maternity 5 wear had a long turnover time and should be written off. The value of this particular label was 10% the total inventory. However management believed that it can still be sold at cost. Eventually no write-off was made for this inventory range in the last financial statements. The previous auditor also noted that they questioned about the companys risk of breaching its bank covenant because the turnover was disappointing. The management argued that the company is in a transition period and the poor performance was partially contributed by the failure of two suppliers because of a major flooding in a key supply region in China.

Required:

A. Referring to the case facts, identify and explain potential threats to professional independence. Discuss possible safeguard to address each threat?