Part 1: Gain an Understanding of the Client 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 9s 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 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. 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 Factors That Influence Inherent Risk Higher Inherent Risk Assessments Satisfied customers who pay on time and are likely (1) Major customers Dissatisfied customers who may withhold to remain a customer in the future payment or decide to not purchase from the Client has many customers client in the future Client has only one or very few customers Reputable suppliers that supply goods on a timely (2) Major suppliers Suppliers may not supply goods on a timely basis basis Few goods are returned to supplier as faulty Significant amounts of goods are returned Client pays suppliers on a timely basis to the suppliers because they are faulty Client does not pay suppliers on a timely basis Trades with countries that are stable (3) Importer or exporter Trades with countries that are not stable Trades in stable foreign currencies Trades in unstable foreign currencies Minimal tariffs or barriers to trade Complex tariffs and other barriers to trade Client maintains effective risk management policies Client does not maintain effective risk regarding foreign trade management policies regarding foreign trade Client well-positioned to adjust to changes in (4) Changes in technology Client falls behind with changes in technology technology and has not "kept up with the times" Client does not offer warranties on its products (5) Warranties Client offers warranties on its products If client does offer warranties, product quality is high History of poor product quality and goods and the likelihood that goods will be returned is low being returned for the same problem Few discounts are given by the client to its (6) Discounts Client offers discounts to its customers, customers possibly because it does not have much Client takes advantage of discounts offered by bargaining power suppliers Client misses opportunities to take advantage of supplier discounts Client has good reputation with customers, (7) Client reputation Client does not have a good reputation with suppliers, employees, and the wider community in customers, employees, and/or the wider which it operates community in which it operates Client has few locations and primary operations are (8) Operations Client has larger number of locations and centralized operations are decentralized No international operations 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 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 (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 (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 (13) Ownership structure Complex capital structure Struggles to pay dividends from operating cash flow 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 4.3 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 taxes or 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 ILLUSTRATION 4.2 Entity factors that influence inherent risk Lower Inherent Risk Assessments Factors That Influence Inherent Risk Higher Inherent Risk Assessments Satisfied customers who pay on time and are likely (1) Major customers Dissatisfied customers who may withhold to remain a customer in the future payment or decide to not purchase from the Client has many customers client in the future Client has only one or very few customers Reputable suppliers that supply goods on a timely (2) Major suppliers Suppliers may not supply goods on a timely basis basis Few goods are returned to supplier as faulty Significant amounts of goods are returned Client pays suppliers on a timely basis to the suppliers because they are faulty Client does not pay suppliers on a timely basis Trades with countries that are stable (3) Importer or exporter Trades with countries that are not stable Trades in stable foreign currencies Trades in unstable foreign currencies Minimal tariffs or barriers to trade Complex tariffs and other barriers to trade Client maintains effective risk management policies Client does not maintain effective risk regarding foreign trade management policies regarding foreign trade Client well-positioned to adjust to changes in (4) Changes in technology Client falls behind with changes in technology technology and has not "kept up with the times" Client does not offer warranties on its products (5) Warranties Client offers warranties on its products If client does offer warranties, product quality is high History of poor product quality and goods and the likelihood that goods will be returned is low being returned for the same problem Few discounts are given by the client to its (6) Discounts Client offers discounts to its customers, customers possibly because it does not have much Client takes advantage of discounts offered by bargaining power suppliers Client misses opportunities to take advantage of supplier discounts Client has good reputation with customers, (7) Client reputation Client does not have a good reputation with suppliers, employees, and the wider community in customers, employees, and/or the wider which it operates community in which it operates Client has few locations and primary operations are (8) Operations Client has larger number of locations and centralized operations are decentralized No international operations 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 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 (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 (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 (13) Ownership structure Complex capital structure Struggles to pay dividends from operating cash flow 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 4.3 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 taxes or 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
