Documenting an accounting process Learning objective In order to identify when, where, and how potential misstatements can occur, an auditor must obtain an understanding of the entity's internal control structure. This understanding covers the internal controls at the entity level, as well as at the transaction level. Entity-level controls include areas such as management integrity, policies and procedures, and monitoring of control activities. Transaction-level controls are those performed during the processing of accounting transactions. By documenting the flow of transactions in an accounting process, the auditor understands the stages where errors can occur. The entire process is reviewed, from the initiation of the transaction through to the recording in the general ledger (G/L). Often several accounting processes can be linked together into one seamless flow of transactions (see figure 4.1)

Required Audit Manager Sharon Gallagher and Audit Senior Josh Thomas previously met with the Cloud 9 Ltd. Finance Director, David Collier, to gain an understanding of the internal controls at the entity level. Based on their interview, they have assessed those controls as being effective. Therefore, at a high level, the company demonstrates an environment where potential misstatements are prevented or detected. You have been assigned the task of documenting the understanding of the process for recording sales, accounts receivable, and cash receipts for wholesale customers. In your absence, Josh met with the Cloud 9 Ltd. Financial Controller, Carla Johnson, and received permission to tape the interview, which is provided as a transcript (see Appendix 3)

Using this interview transcript, you are now asked to: flowchart or narrative documenting your understanding of the sales to cash receipts process for wholesale sales. Document your understanding in working paper A4-1 and A4-2 (if needed) on pages 14 and 15. Identify any follow-up questions you would like to ask the client if aspects of the process are not adequately explained. Also identify any weaknesses in the internal controls over the sales and cash receipts. Document these in working paper A4-3 on page 16. For the follow-up points and control weaknesses, describe any potential misstatements that could occur in the financial statements in A4-3. Note: The follow-up questions could be addressed to Carla Johnson or any other employee you deem appropriate.

Cloud 9 Ltd. December 31, 2020 Sales and cash receipts process?documenting understanding of internal controls Purpose: To document the sales to cash receipts process for wholesale sales

Cloud 9 Ltd. December 31, 2020 Sales and cash receipts process?documenting understanding of internal controls

JT: OK, so now the goods are delivered to the customer, how do you bill them? CJ: The drivers have the customers sign for the goods upon receipt and then give us the signed copy of the shipping document. We go in to the billing system and pull up the draft invoice that was generated when the shipping document was approved. We match the quantities in the invoice against the signed shipping document and confirm the customer sign-off. This way, we only bill for those goods that were actually received by the customer. At 4 p.m., we do a batch run of the day's invoices, which are printed in duplicate, and mailed out. The copy is stapled to the signed shipping document and put on file. The running of the batch posts the invoices to the sales journal and accounts receivable subledger. JT: Does finance ever go back to the sales order? CJ: No, since the shipping document can't get generated unless it agrees to the sales order, we don't go back that far into the process. Why, do you think we have to? JT: I wouldn't say so at this stage. But you'd have to be sure to have some tight controls around Swift given that it seems to do everything. CJ: Like I said, it does everything. JT: What is the cash receipts process? CJ: We get most payments via EFT, so my AR clerk downloads the previous day's receipts from on-line banking. She then goes into the subledger to post the receipts against the customer accounts. When she's finished posting each entry, she runs a batch report of all postings and reconciles it back to the bank statement. I review that reconciliation and signoff. JT: Are bank reconciliations done in a timely manner? CJ: I do bank recs each month for the operating and savings accounts. David reviews and approves them. Keep in mind, what I just explained is for the wholesale transactions. We have separate procedures for the store regarding daily cash balance reconciliations to the deposits in the operating bank account. JT: Yes, our graduate will be handling the store side of the sales to cash receipts process. They will probably come talk to you in a day or two. Well, I think that should do it for now. I may have some follow-up questions for you as I start getting my head around all of this. CJ: Door's always open. JT: Thanks for your time.TRANSCRIPT OF MEETING WITH CARLA JOHNSON Present: Carla Johnson, Financial Controller, Cloud 9 Lid. Josh Thomas, Audit Senior, W&S Partners JT: Thanks for seeing me, Carla. CJ: You're welcome, Josh. What can I do for you? JT: I need to ask you some questions around Cloud 9's process for recording wholesale revenue transactions, including the trade receivables and cash receipts aspects. After I understand the process, I'll need to select a sample transaction to confirm my understanding of the process as you have explained. CJ: Well, I can tell you what should be happening, but you may want to go and speak to the sales manager or warehouse managers to confirm they do what the company policy and procedures say. JT: Good point, I'll make appointments to see them. Thanks. So let's start at the beginning-how does a sale transaction get initiated? CJ: We've got a pretty complex inventory management software system called Swift. It was designed by some of our tech guys. It tracks and does everything! JT: Sounds impressive! CJ: Anyway, the customers-let's say the Myer store in Toronto-complete a purchase order on-line through a site that is linked to Swift. JT: How do the customers decide the quantity and know the price? CJ: Swift is linked (don't ask me how) to their store inventory records and sends them an alert when their inventory balance of our products gets below the predetermined limit they set with us. They can select the quantity based on their needs, but the prices are set in the system. They get sent price lists from the sales manager so they know the current prices. JT: How often are prices changed? CJ: Depends on the market, really. I don't think they change too frequently. JT: What if you don't have the products? CJ: The system doesn't allow them to place an order greater than our current inventory levels. If they need more, they need to fill out a separate request form that gets e-mailed to our warehouse manager so he can place the order with China. Appendix 3 47JT: OK, so they complete a purchase order, then what? CJ: The submitted purchase order goes through a credit check and then becomes a sales order. The sales order documents the quantity required, the selling price, and the shipping terms. That's all done behind the scenes in the system. We really don't see anything on our side until the sales order stage JT: Guess that saves a lot of time and trees! CJ: Yeah, there's so much that we rely on the system to do for us, it's scary. If we were hit by an electrical storm, we'd be in trouble. JT: What happens to the sales orders-how do they get filled? CJ: Every day, the warehouse manager downloads the outstanding sales orders to these little hand-held computer/scanner thingies. It's very Star Trek. Warehouse personnel use these to select the items off the shelves onto pallets. The pallets are taken to a staging area where each product is then scanned. This establishes the shipping in Swift, which then gets printed for the delivery. JT: Are the shipping documents approved before the goods go out the door? How do you know that what got sent is what was ordered? CJ: Swift matches the quantities and products on the shipping document to the sales order. Once they match, the approval box is activated and the shipping supervisor can enter his pass code. This officially approves the shipping document and it gets printed. JT: How many orders do you fill in a day? It sounds like a lot for one person to do. CJ: We probably complete about 50 orders a day. Shoes aren't perishable items, you know, so it's not like we are sending products to every store, every day. We're trying out the "pit crew" concept where there are two shipping supervisors with about four to five warehouse employees in their crew team. So they are in the staging area with them and do it right there with the hand-held devices. They like to have little contests on who can do it the fastest. You should go down there; it's quite a lively group. David encourages it and it's been great for productivity and morale. JT: Sounds like a great working environment. Better than being stuck in a broom closet sifting through invoices! CJ: Ah, the life of an auditor. I remember the good old days . . . JT: And the goods are sent out on your own trucks? CJ: That's right. We've bought our own trucks and vans rather than rely on couriers. The drivers pick up their loads in the morning and bring back anything undelivered. Because shoes are an easy product to off-load, we have to be careful about theft. So nothing can be left in the back of a truck at the end of the day. It comes back here and gets locked up in the shipping cage till it can be delivered again. JT: Why would goods be undelivered? CJ: Sometimes the drivers get behind or the store is closed unexpectedly. So there are occasions when all the goods won't get delivered in the day.ORDER PROCESSING RECEIVING INVOICING PAYMENTS Initiation: Purchase Purchase Reporting: Order order order Goods Goods requested approved sent arrive receipted Initiation: Invoice Reporting: Purchase Invoice invoice matched to order entered received in G/L Initiation: Processing: Reporting: Cash Disburse Cash payment Payment payment requested recordedINTRODUCTION This case study is designed to provide students with the opportunity to work through various audit procedures that are performed during the planning and interim phases of a financial statement audit. Typical client scenarios that are regularly observed in the profession are the basis for this case study, and the aim is to expose students to the tasks they would typically perform in their first year of auditing practice. In this case study, students play the role of a graduate working for W&S Partners, a Canadian accounting firm with offices located in each of the major Canadian cities. W&S Partners has just been awarded the December 31, 2020, statutory audit work for Cloud 9 Lid. The audit team assigned to the client is: Partner, J.M. Wadley; Audit Manager, Sharon Gallagher, Audit Senior, Josh Thomas; and IT Audit Manager, Mark Batten. Prior year audits were conducted by Ellis & Associates. As part of the change of auditors process, J.M. Wadley met with R.J. Ellis (Managing Partner, Ellis & Associates) to discuss the acceptance of Cloud 9 Lid. as a client and to inquire about access to Ellis & Associates' working papers. In the discussion, R.J. Ellis stated that there were no issues that W&S Partners should be aware of before accepting the client or commencing the work. Cloud 9 Lid. company background Founded in 1980 by Ron Mclellan, the Toronto-based company was a manufacturer and retailer of customized basketball shoes. In 1993, Cloud 9 Inc. (a publicly listed Canadian company) purchased the original company from Ron Mclellan and renamed it Cloud 9 Lid. As part of the sale agreement, Ron Mclellan was appointed to the Cloud 9 Lid. board of directors. The parent company, Cloud 9 Inc., has wholly owned subsidiaries in the United States, the United Kingdom (UK), Germany, China, and Brazil, and has built a reputation around the fact that its shoes are comfortable and durable. The company promotes itself using its well-known tagline "Our shoes are so comfortable, it's like walking on Cloud 9." Currently, Cloud 9 Lid. is primarily a wholesaler of athletic shoes to its main customers: David Jones, Myer, Foot Locker, and Rebel Sports. Cloud 9 Lid. receives the majority of its inventory from the production plant in China, with the remainder coming from the United States. All inventory is purchased on free on board (FOB) shipping point, which means Cloud 9 Lid. takes ownership of the products once the international courier accepts the goods for delivery. The inventory is sent to the main warehouse in Richmond, B.C., which is linked to retailers via an electronic inventory system. When retail inventory levels get low, the company ensures deliveries are made using its own transport trucks, thus ensuring control throughout the entire process. A specific marketing campaign was initiated in 2020 to promote and build the Cloud 9 brand in Canada. The Canadian company was granted permission from its parent entity to sponsor a new basketball team, the Thompson Thunders, for the 2020 season. Under this sponsorship agreement, Cloud 9 Lid. is to provide all the athletic footwear for the team as well as having sole merchandising rights. The agreement also includes general advertising rights at the stadium. In a separate contractual arrangement, Cloud 9 Lid. has signed Bodhi Parker, the captain of the Thompson Thunders, as spokesman for the brand. This arrangement allows Cloud 9 Lid. to use Bodhi's image to promote and build the brand in Canada. In February 2020, Cloud 9 Lid. launched its new product line, which included the "Heavenly 456" walking shoe and the "Lightning 7" basketball shoe. Advertising campaigns Introduction 1and media coverage have been very successful and sales of the Heavenly 456 walking shoe have steadily increased. For Cloud 9 Lid., the Heavenly 456 now makes up 25 percent of total sales. The Lightning 7 shoe was marketed in the basketball stadium during Thompson Thunders games as well as heavily advertised using Bodhi Parker's image. Due to a poor first season, sales of the Lightning 7 were unimpressive and, as a result, Cloud 9 still has a large amount of inventory in its warehouse. To further establish the brand, the first Cloud 9 retail store was opened in Toronto, Ontario, on June 1, 2020. The store operates on a just-in-time inventory system linked with the main warehouse in Richmond, B.C. However, the management team reports that there have been a few hiccups in determining ideal inventory quantities for the store to allow optimum availability of merchandise to the customers. There have also been some thefts of merchandise from the store and, in order to reduce inventory loss by theft, the company has installed closed-circuit television cameras. Personnel Cloud 9 Lid. has 52 full-time employees. In the retail store, the company employs part-time staff, with casual employees enhancing staffing levels in the busier retail period. To administer the company's finances, Cloud 9 Lid. employs Finance Director, David Collier, Financial Controller, Carla Johnson; and Business Systems Manager, Justin Reeves. These three employees are entitled to participate in the employee stock option plan and receive stock options in Cloud 9 Inc. if revenue targets are met. Financial information Responding to pressure from its parent company, Cloud 9 Lid. set a goal to increase its revenue by 4 percent for the 2020 fiscal year. One of the critical success factors for the company to achieve this 4-percent increase is to grow its share of the North American footwear market. However, with the new store opening and the subsequent increase in costs, as well as the costs related to the sponsorship deals, the management team is projecting a loss for the year. In addition, to build customer loyalty and promote sales in the retail store, Cloud 9 Lid. introduced a loyalty program whereby customers earn one point for every $10 that they spend. Customers can then redeem points on-line to receive coupons that can be exchanged for merchandise in the store. On October 1, 2019, the company took out an additional loan of $3 million with Ontario Bank to help fund the store costs, and to purchase additional delivery trucks and vans. This loan is repayable over five years. The company's other debt relates to loans from one of Ron Mclellan's other companies, which were issued between 1980 and 1993 when the original company was a sole proprietorship. R.A. Mclellan extended the repayment date as part of the consideration for the sale. All inventory is purchased in U.S. dollars. The company provides a 12-month warranty on all footwear. Historical claims have been 2 percent of total sales. Refer to Appendix I for the prior year's statement of income and statement of financial position. Required In the following section, there are 12 assignments that are designed to be completed as concepts are introduced throughout the auditing course. 2 Cloud 9 Ltd. - An Audit Case Study