Suzie Pickering has experience in the clothing and retail industry, which is why she was assigned to the Cloud 9 audit. Suzie is mentoring Ian Harper, a first-year staff on the audit team, and they are working together on the detailed substantive test program. Ian remembers that Suzie used analytical procedures in the risk assessment phase and she explained to Ian how useful they could also be in the risk response phase. Ian suggests that they plan to rely extensively on analytical procedures for Cloud 9s substantive tests. He is very enthusiastic and wants to put analytical procedures in the plan for all transaction processes and major balances because he believes analytical procedures are very efficient for the audit team to perform. Suzie is more cautious. Although she will definitely plan to use some analytical procedures, she knows they will also need other types of tests. Why? asks Ian. How do I know when to only use analytical procedures? What other tests do we need? Ian is starting to realize that the standards and professional practice would not allow him to rely exclusively on analytical procedures. Cloud 9 has significant inventory balances (around 25% of total assets) and receivables (around 28% of total assets), so the auditors will need to gather persuasive evidence about the existence, valuation and allocation, and rights and obligations assertions for these accounts. Procedures such as confirming receivables balances and observing inventory counts are definitely going to be included in the detailed audit program. Suzie warns Ian that it is not always the size of the account that determines the use of analytical procedures or other procedures. For example, in Cloud 9s trial balance there is a derivatives investment account that is around 5% of total assets. It is a smaller portion of total assets, but since accounting for derivative investments is complex, they probably cannot rely solely on analytical procedures, particularly regarding the valuation and allocation assertion. an and Suzie continue their discussion about using analytical procedures. Ian is starting to feel more confident and suggests that there are some factors to consider about the Cloud 9 audit that would affect the use of the various procedures. We could use all of the usual techniques in the Cloud 9 audit, although we have to be careful in making comparisons across years for a couple of reasons. We have only just taken over the audit, so although prior-year data was audited, we are still building up our level of familiarity with the data and dont really understand all the conditions that applied to the previous years. Also, the changes at Cloud 9, in particular the opening of the retail store and the additional borrowing to finance the purchase of the delivery trucks that we discovered during our preliminary work, will impact the data. Ian and Suzie have decided that analytical procedures will not be sufficient for all accounts. For each major transaction process and account balance they will also conduct tests of details of transactions. For vouching tests, the auditors will sample transactions and balances in the accounting records and go to the underlying documentation (or physical assets) to confirm the recorded details. For example, for sales recorded as being made prior to the fiscal year-end, they will examine the invoices and shipping documents to gather evidence on the date, amount, and other details of the transactions. If they find a sales invoice with a February date has been included in the sales for the year ended January 31, they have evidence of a misstatement in the occurrence and cutoff assertions for sales. They will also trace the details in a sample of documents through to Cloud 9s accounting records. This means that they will start with the documents and then test how that transaction (or asset or liability) is recorded in the clients accounts. For example, if they find a sales invoice with a January date that is not included in the sales for the year, they will have evidence of a misstatement in the completeness and cutoff assertions for sales. Suzie advises Ian that the sample sizes and approach to sampling are determined by the results of the controls testing and the resulting expectations for errors. Suzie also asks Ian to include tests of details of accounts, such as accounts receivables and property, plant, and equipment (PPE), in the detailed audit program. Where the risk is low, such as PPE, they will perform these tests at an interim date. Finally, Suzie informs Ian that the IT audit manager, Mark Batten, is writing the ADA program. Suzie asks Ian to consider Cloud 9s estimated warranty liability. The estimated warranty liability is included in accrued liabilities on the balance sheet and trial balance. Included in accrued liabilities on the October 31, 2022 trial balance is an estimated warranty liability of $832,015, which is slightly higher than the liability on the prior years October 31, 2021 trial balance of $808,326. Suzie asks, What is the likelihood that the liability is understated? Are there any reasons to believe there are unidentified claims, and how would auditors detect such claims? Ian does not know of any change in manufacturing conditions that would affect the quality of Cloud 9s product, and thus the obligation under the warranty program. However, a new product was introduced at the start of the previous year. Because sales of the new Heavenly 456 walking shoe are now 20% of total sales, we should consider any possible effects on the warranty liability. I recommend specific work be done to assess the claims from this new product. However, if we remove this product from the analysis, the relationship between the warranty liability and sales is likely to be similar to past years. Because warranties apply to products, the amount of the warranty liability is determined by sales volume and product quality. Therefore, if conditions affecting product quality have not changed, and there is no change to the warranty program, substantive analytical procedures are a useful way of testing the reasonableness of the warranty liability. Finally, Ian concludes, relying on substantive analytical procedures to test the warranty liability is more justified if control testing suggests that Cloud 9 has effective controls over warranty claim estimation and identification of pending claims. During their conversation about Cloud 9s warranty liability, Suzie asks Ian about how they would use other substantive procedures to obtain evidence about the completeness assertion for the liability balance. For example, Suzie asks, would inspecting documents using vouching and tracing be useful and, if so, how would you use them? Ian is still keen on using substantive analytical procedures but considers the question carefully. I think we would use vouching to get evidence about transactions or balances that are recorded as warranty claims by Cloud 9. We could do this by selecting transactions or items in the account balance and obtaining the documentary evidence to support each one. However, it might be more useful to consider tracing because this would allow us to start with the documents and get evidence about how and whether the transactions are recorded in the accounts. If we find a document relevant to a warranty claim has not been recorded in the accounting system, we would be concerned that the liability is understated, or not complete. Additionally, we would like to examine transactions around the balance sheet date and make sure they are recorded in the correct accounting period. This evidence relates to the cutoff assertion and is part of considering completeness. Suzie asks Ian to set up the working papers for the tests they will perform. W&S Partners uses electronic working papers and there are examples available for Ian to use as a base for the Cloud 9 working papers. The priorities for Ian are to ensure that each test is described in sufficient detail in the audit program so the audit staff can perform the test correctly and identify any misstatements. The working papers also have to provide for comments to be included as the work is completed and reviewed by senior staff.

a) Based on your conclusions from the case study questions in previous chapters (particularly Chapters 3, 4, and 8), complete the following worksheet to determine the risk of material misstatement (RMM) and the acceptable detection risk (DR).

Assertion	Inherent Risk	Control Risk	RMM	Detection Risk
Sales - Occurrence
Sales - Completeness
Receivables - Existence
Receivables - Completeness
Cash - Existence
Cash - Completeness

b) Scan the line items on the prior-year financial statements and the current-year trial balance for Cloud 9. Using your knowledge of financial accounting, identify line items that require estimates or fair value measurements. For each item, state whether estimation uncertainty is low or high and briefly explain why.

Cloud 9 Case Study

Chapter 3, 4, 8 Response:

Calculation of PM based on 5% of annualized Income before tax: $1,800,513

Appendix A Cloud 9 Inc. Audit W&S Partners is a U.S.-based accounting firm with offices located in most major cities. W&S Partners will be conducting the January 31, 2023, audit for Cloud 9 Inc., a publicly traded company. The audit team assigned to the client is: Partner: Jo Wadley Audit manager: Sharon Gallagher Audit senior: Josh Thomas IT audit manager: Mark Batten Experienced staff: Suzie Pickering First-year staff: Ian Harper Prior-year audits were conducted by Ellis & Associates. As part of the transfer of records process, Jo Wadley met with RJ Ellis (managing partner, Ellis & Associates) to discuss acceptance of Cloud 9 as a client and to inquire about access to Ellis & Associates' working papers. In the discussion, RJ Ellis stated that there were no issues that W&S Partners should be aware of before accepting the client or beginning the work. . Cloud 9 Inc. Company Background a Cloud 9 Inc. is a manufacturer and retailer of athletic shoes and apparel, based in Sacramento, California. In 2021, Cloud 9 purchased McLellan's Shoes from Ron McLellan. As part of the sale agreement, Ron McLellan was appointed to the Cloud 9 board of directors. Cloud 9 has wholly owned subsidiaries in Canada and Vietnam, and has built a reputation for its comfortable and durable shoes. The company promotes itself using its now well-known tagline, Our shoes are so comfortable, it's like walking on Cloud 9. Currently, Cloud 9 is primarily a wholesaler of athletic shoes and apparel to its main customers All Day Sports, Mayer, Bob's, and Varsity Sports. Cloud 9 receives about 25% of its inventory from the Vietnam production plant with the remainder coming from the United States. Also, about 20% of its property, plant, and equipment is located at the Vietnam production plant. All inventory is purchased on free on board (FOB) shipping terms, which means Cloud 9 takes ownership of the products once the international courier accepts the goods for delivery. The inventory is sent to the main warehouse in Sacramento, which is linked to retailers via an electronic inventory system. When retail inventory gets low, the company ensures deliveries are made using its own transport trucks, thus ensuring control throughout the entire process. In February 2021, Cloud 9 launched its new product line that included the Heavenly 456 walking shoe. Advertising 9 campaigns and media coverage have been very successful, and sales for this style of shoe have steadily increased. For Cloud 9, the Heavenly 456 now makes up 20% of total sales. A specific marketing campaign was initiated in 2022 to promote and build the Cloud 9 brand in the United States. Cloud 9 decided to sponsor a professional soccer team, Georgia Thunder, for the 2022 season. Under this sponsorship agreement, Cloud 9 is to provide all the athletic footwear and apparel for the team as well as have sole merchandising rights. The agreement also includes general advertising rights at the stadium. In a separate contractual arrangement, Cloud 9 has signed Miguel Fernandez, the captain of Georgia Thunder, as spokesperson for the brand. This arrangement allows Cloud 9 to use Miguel's image to promote and build the brand. To further establish the brand, the first Cloud 9 retail store was opened in San Francisco, California, on June 1, 2022. The 9 store operates on a just-in-time inventory system linked with a series of warehouses and distribution centers throughout the United States and Canada. However, the management team reports that there have been a few hiccups in determining ideal stock quantities for the store to allow optimum availability of merchandise to its customers. Because some thefts of merchandise from the store have also occurred, the company has installed closed-circuit television cameras. Personnel The Cloud 9 corporate office has 358 full-time employees. In the retail store, the company employs two full-time managers and some part-time staff, with seasonal employees enhancing staff levels in the busier retail period. Some key positions in the accounting and IT area are as follows: CFO: David Collier Financial controller: Carla Johnson IT manager: Will Burton These three employees are entitled to participate in the employee stock-purchase plan and receive stock options in Cloud 9 if revenue targets are met. Financial Information Cloud 9 set a goal to increase revenue by 3% for the 2022 fiscal year. One of the critical success factors for the company to achieve this 3% increase is to grow its share of the U.S. 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 decline in earnings for the year. In addition, to build customer loyalty and promote sales in the retail store, Cloud 9 introduced a loyalty program whereby customers earn one point for every $10 that they spend. Customers can then redeem points by going online to receive coupons that can be exchanged for merchandise in the store. On August 1, 2022, the company took out an additional loan of $7 million with Windsor 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 issued more than five years ago from various lending institutions. All inventory is purchased in U.S. dollars, which the company acquires under forward exchange contracts. The company provides a 12-month warranty on all footwear. Historical claims have been 0.2% of total sales. The most recent financial statements for Cloud 9 are as follows. (Note that these financial statements are also available in Excel format in WileyPLUS.) Cloud 9 Condensed Cash Flow Statement For the year ended January 31, 2022 January 31, 2021 Cash provided by operations $ 25,250,000 $ 26,907,692 Cash used by investing activities (13,165,385) (16,923,077) Cash used by financing activities (13,457,692) (9,696,154) Effect of exchange rate changes on cash 3,284,616 1,873,077 Net increase in cash and cash equivalents 1,911,539 2,161,538 Cash and cash equivalents, beginning of year 9,780,769 7,619,231 Cash and cash equivalents, end of year $ 11,692,308 $ 9,780,769 * Includes dividends paid of $4,988,462 in 2022 and $5,119,231 in 2021. $ October 31, 2021 Debit Credit 6,123,884 64,867,910 $ 648,679 57,900,000 13,805,769 3,584,615 6,446,154 97,576,923 35,207,692 3,851,923 8,410,849 Cloud 9 Trial Balance October 31, 2022 Debit Credit Cash and cash equivalents $ 13,446,154 Accounts receivable 70,485,625 Allowance for doubtful accounts $ 704,856 Inventory 55,100,000 Investments (derivatives) 13,419,231 Deferred income taxes (current) 2,857,692 Prepaid expenses and other current assets 9,265,385 Property, plant, and equipment 103,803,846 Accumulated depreciation 39,761,538 Identifiable intangible assets and goodwill 3,723,007 Accumulated amortization Deferred income taxes and other assets (noncurrent) 9,557,692 Current portion of long-term debt 2,115,385 Notes payable 21,376,923 Accounts payable 14,986,457 Accured liabilities 25,803,846 Income taxes payable 2,211,539 Long-term debt 23,661,538 Deferred income taxes and other liabilities (noncurrent) 4,915,384 Common stock at par value 111,538 Capital stock in excess of par value 19,415,385 Unearned stock compensation 253,846 Accumulated other comprehensive income 5,011,538 Beginning retained earnings 122,857,692 Dividends 3,866,838 Repurchases of common stock 4,627,381 Revenue 277,338,461 Cost of sales 169,346,154 Selling and administrative 79,092,308 Interest expense 1,438,461 Other expense 453,846 Income tax expense 9,511,538 Totals $555,260,542 $555,260,542 300,125 34,823,077 22,561,538 24,150,000 3,726,923 17,119,106 4,330,769 107,692 16,484,615 480,769 4,746,154 98,150,473 3,299,423 2,939,393 269,442,308 163,003,846 78,246,154 1,773,077 757,692 9,238,462 $527,052,997 $527,052,997 Transcript of Meeting with David Collier Present: David Collier, chief financial officer, Cloud 9 Inc. Josh Thomas, audit senior, W&S Partners JT: Thanks for seeing me, David. DC: You're welcome, Josh. What can I do for you? JT: I need to ask you some questions about Cloud 9's process for recording wholesale revenue transactions, including the trade receivables and cash receipts aspects. After I understand the process, I will be doing a system walkthrough and confirming my understanding by talking to the individuals who are involved in each step of the process. DC: We've got a pretty complex inventory management software system called Swift. It was designed by some of our tech guys. It tracks inventory and it integrates with our sales system. JT: How do customers decide the quantity and know the price? DC: The customers complete a purchase order online through a site that is linked to Swift. The site will tell customers the price for each item in inventory, as well as the quantity we have in stock. JT: How often are prices changed? Price changes really depend on the market. While they don't change that often, our marketing management meets weekly to discuss price changes. Price changes are initiated after that meeting. Only the marketing manager and a few of her staff members have access to update the master price list. JT: What if a customer logs on and you don't have the products? DC: The system doesn't allow a customer to place an order greater than our current inventory levels. If a customer needs more inventory, the customer should fill out a separate request for inventory not on hand. The request gets e-mailed to our production manager and our marketing manager, who determine if we need to manufacture more goods. The decision about manufacturing more goods is complex as it integrates with our production decisions, or whether we can purchase additional inventory from a subcontractor that manufactures for us. JT: OK. This is helpful. Let's stay focused on the sales process. Once a customer's purchase order is complete, then what? DC: The submitted purchase order goes through a credit check and then becomes a sales order. If a customer exceeds his or her credit limit, there are a few people in my office that can approve a credit override, on a case-by-case basis. We tend to allow this only for good customers with good payment history. Then, the purchase order becomes our sales order. JT: I guess this electronic process saves a lot of time and trees! DC: Yes, there's so much that we rely on the system to do for us, it's scary. I worry about things like what happens if we are hit by a storm or lose power. We do have the whole system backed up off-site. DC: JT: That is nice to know, and probably gives you some comfort. What happens to the sales order how does it get filled? DC: Every day, the system assigns shipments to the warehouse location nearest to the customer's location that can fulfill the entire order. The warehouse manager then downloads the outstanding sales orders to these little handheld computer/scanners. It's very Star Trek. Warehouse personnel use these to identify inventory in the warehouse, then the warehouse personnel put boxes of ordered shoes onto pallets. The pallets are taken to a staging area where each product is then scanned. 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? DC: Swift matches the quantities and products on the packing slip to the sales order. If they don't match, the order is set aside for follow-up to ensure that the order is accurately filled. Once they match, the approval box is activated, and the shipping supervisor can enter his or her passcode. This officially approves the packing slip and bill of lading, and each gets printed JT: OK, so once the goods are shipped to the customer, how do you bill for this shipment? DC: We go into the billing system and pull up a draft invoice that was generated when the shipping document was approved. At this point, Swift performs a number of checks. The system matches the quantities in the invoice against the packing slip and sales order. Prices are also matched to the sales order. The customer number should also match on the sales order, shipping documents, and draft invoice. A report is run daily of any shipments that have not resulted in invoices. The reverse is also true. A report is run of any invoices that are not supported by shipping documents. At month-end, we run a report to compare dates on shipping documents with the month that transactions are recorded in the sales journal. If there are any discrepancies, the transaction is reported for manual follow-up. I believe discrepancies are rare as the system is very tight, and we ship only what was ordered. Then, the sales invoice is processed. Processing the sales invoice enters the transaction in a database from which we build the sales journal and accounts receivable subsidiary ledger. Also, at the end of each day, we compare the totals for accounts receivable with the total of each customer's balance in the accounts receivable subsidiary ledger. JT: When you do have discrepancies, who follows up on them and how are they cleared? DC: We have a data control group that follows up on discrepancies in a variety of systems. Discrepancies have to be cleared daily. Once the reason for the discrepancy is identified, changes to the underlying data must be approved by a manager in the data control group. The data is then corrected, and the invoice is processed. As I noted, discrepancies are very rare. We don't ship goods unless the order is completely filled. JT: Does finance ever go back to the sales order? DC: No. Since the shipping document can't be generated unless it agrees to the sales order, Swift only looks at the sales order for prices. Do you think we should do otherwise? 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. DC: Yes, good IT general controls over the Swift program, and other programs, are extremely important. I meet with the IT manager monthly, to talk about the few discrepancies found, reasons for discrepancies, and the importance of controls. I think you will find that our IT manager understands the importance of strong IT general controls, and strong controls over clearing any discrepancies identified in transaction streams. JT: Let's talk about accounts receivable. Who follows up on past-due receivables? DC: That is the sales manager's responsibility. In my opinion, we do a good job of screening credit upfront so we don't have a significant problem with past-due receivables. We send statements to customers with their receivable balances monthly. The sales manager and I discuss past-due accounts on a regular basis. The sales manager, controller, and I review the allowance for doubtful accounts monthly. A monthly adjusting journal entry is made by the controller, which I review and approve. You will find that our allowance for doubtful accounts is only about 1% of outstanding receivables as we do a good job of screening customer's credit upfront. JT: DC: JT: What is the cash receipts process? We get most payments via EFT. If a customer pays by check, it goes to a lockbox where it also is directly received by our bank. Our AR clerk is able to download the previous day's cash receipts from online banking. She then merges this information with our accounting system, which first screens the data, matching customer numbers with the master customer file. On occasion, the bank has made errors in entering customer numbers, and we have to follow up on these transactions before they are processed in our accounting system. This is done the same day. Once the transaction is processed, it is posted to the database from which we build our cash receipts journal and accounts receivable subsidiary ledger. Finally, every morning someone reconciles what was posted to cash receipts with what has been deposited in various bank accounts. I believe it is critical that all cash receipts are posted timely and accurately. Are bank reconciliations done in a timely manner? Yes, someone in my office does bank recs every month for the main operating account and other bank accounts. Our standard is to complete this by the fifth business day of each month. My assistant reviews and approves the bank reconciliations. Keep in mind that what I explained is for the wholesale transactions. We have separate procedures for the retail store regarding daily cash balance reconciliations to the deposits in the operating bank account. Yes, we have another auditor who will be handling the retail store side of the sales-to-cash-receipts process. She or he will probably come and 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 the revenue process. The door is always open. Thanks for your time. DC: JT: a DC: JT: Appendix A Cloud 9 Inc. Audit W&S Partners is a U.S.-based accounting firm with offices located in most major cities. W&S Partners will be conducting the January 31, 2023, audit for Cloud 9 Inc., a publicly traded company. The audit team assigned to the client is: Partner: Jo Wadley Audit manager: Sharon Gallagher Audit senior: Josh Thomas IT audit manager: Mark Batten Experienced staff: Suzie Pickering First-year staff: Ian Harper Prior-year audits were conducted by Ellis & Associates. As part of the transfer of records process, Jo Wadley met with RJ Ellis (managing partner, Ellis & Associates) to discuss acceptance of Cloud 9 as a client and to inquire about access to Ellis & Associates' working papers. In the discussion, RJ Ellis stated that there were no issues that W&S Partners should be aware of before accepting the client or beginning the work. . Cloud 9 Inc. Company Background a Cloud 9 Inc. is a manufacturer and retailer of athletic shoes and apparel, based in Sacramento, California. In 2021, Cloud 9 purchased McLellan's Shoes from Ron McLellan. As part of the sale agreement, Ron McLellan was appointed to the Cloud 9 board of directors. Cloud 9 has wholly owned subsidiaries in Canada and Vietnam, and has built a reputation for its comfortable and durable shoes. The company promotes itself using its now well-known tagline, Our shoes are so comfortable, it's like walking on Cloud 9. Currently, Cloud 9 is primarily a wholesaler of athletic shoes and apparel to its main customers All Day Sports, Mayer, Bob's, and Varsity Sports. Cloud 9 receives about 25% of its inventory from the Vietnam production plant with the remainder coming from the United States. Also, about 20% of its property, plant, and equipment is located at the Vietnam production plant. All inventory is purchased on free on board (FOB) shipping terms, which means Cloud 9 takes ownership of the products once the international courier accepts the goods for delivery. The inventory is sent to the main warehouse in Sacramento, which is linked to retailers via an electronic inventory system. When retail inventory gets low, the company ensures deliveries are made using its own transport trucks, thus ensuring control throughout the entire process. In February 2021, Cloud 9 launched its new product line that included the Heavenly 456 walking shoe. Advertising 9 campaigns and media coverage have been very successful, and sales for this style of shoe have steadily increased. For Cloud 9, the Heavenly 456 now makes up 20% of total sales. A specific marketing campaign was initiated in 2022 to promote and build the Cloud 9 brand in the United States. Cloud 9 decided to sponsor a professional soccer team, Georgia Thunder, for the 2022 season. Under this sponsorship agreement, Cloud 9 is to provide all the athletic footwear and apparel for the team as well as have sole merchandising rights. The agreement also includes general advertising rights at the stadium. In a separate contractual arrangement, Cloud 9 has signed Miguel Fernandez, the captain of Georgia Thunder, as spokesperson for the brand. This arrangement allows Cloud 9 to use Miguel's image to promote and build the brand. To further establish the brand, the first Cloud 9 retail store was opened in San Francisco, California, on June 1, 2022. The 9 store operates on a just-in-time inventory system linked with a series of warehouses and distribution centers throughout the United States and Canada. However, the management team reports that there have been a few hiccups in determining ideal stock quantities for the store to allow optimum availability of merchandise to its customers. Because some thefts of merchandise from the store have also occurred, the company has installed closed-circuit television cameras. Personnel The Cloud 9 corporate office has 358 full-time employees. In the retail store, the company employs two full-time managers and some part-time staff, with seasonal employees enhancing staff levels in the busier retail period. Some key positions in the accounting and IT area are as follows: CFO: David Collier Financial controller: Carla Johnson IT manager: Will Burton These three employees are entitled to participate in the employee stock-purchase plan and receive stock options in Cloud 9 if revenue targets are met. Financial Information Cloud 9 set a goal to increase revenue by 3% for the 2022 fiscal year. One of the critical success factors for the company to achieve this 3% increase is to grow its share of the U.S. 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 decline in earnings for the year. In addition, to build customer loyalty and promote sales in the retail store, Cloud 9 introduced a loyalty program whereby customers earn one point for every $10 that they spend. Customers can then redeem points by going online to receive coupons that can be exchanged for merchandise in the store. On August 1, 2022, the company took out an additional loan of $7 million with Windsor 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 issued more than five years ago from various lending institutions. All inventory is purchased in U.S. dollars, which the company acquires under forward exchange contracts. The company provides a 12-month warranty on all footwear. Historical claims have been 0.2% of total sales. The most recent financial statements for Cloud 9 are as follows. (Note that these financial statements are also available in Excel format in WileyPLUS.) Cloud 9 Condensed Cash Flow Statement For the year ended January 31, 2022 January 31, 2021 Cash provided by operations $ 25,250,000 $ 26,907,692 Cash used by investing activities (13,165,385) (16,923,077) Cash used by financing activities (13,457,692) (9,696,154) Effect of exchange rate changes on cash 3,284,616 1,873,077 Net increase in cash and cash equivalents 1,911,539 2,161,538 Cash and cash equivalents, beginning of year 9,780,769 7,619,231 Cash and cash equivalents, end of year $ 11,692,308 $ 9,780,769 * Includes dividends paid of $4,988,462 in 2022 and $5,119,231 in 2021. $ October 31, 2021 Debit Credit 6,123,884 64,867,910 $ 648,679 57,900,000 13,805,769 3,584,615 6,446,154 97,576,923 35,207,692 3,851,923 8,410,849 Cloud 9 Trial Balance October 31, 2022 Debit Credit Cash and cash equivalents $ 13,446,154 Accounts receivable 70,485,625 Allowance for doubtful accounts $ 704,856 Inventory 55,100,000 Investments (derivatives) 13,419,231 Deferred income taxes (current) 2,857,692 Prepaid expenses and other current assets 9,265,385 Property, plant, and equipment 103,803,846 Accumulated depreciation 39,761,538 Identifiable intangible assets and goodwill 3,723,007 Accumulated amortization Deferred income taxes and other assets (noncurrent) 9,557,692 Current portion of long-term debt 2,115,385 Notes payable 21,376,923 Accounts payable 14,986,457 Accured liabilities 25,803,846 Income taxes payable 2,211,539 Long-term debt 23,661,538 Deferred income taxes and other liabilities (noncurrent) 4,915,384 Common stock at par value 111,538 Capital stock in excess of par value 19,415,385 Unearned stock compensation 253,846 Accumulated other comprehensive income 5,011,538 Beginning retained earnings 122,857,692 Dividends 3,866,838 Repurchases of common stock 4,627,381 Revenue 277,338,461 Cost of sales 169,346,154 Selling and administrative 79,092,308 Interest expense 1,438,461 Other expense 453,846 Income tax expense 9,511,538 Totals $555,260,542 $555,260,542 300,125 34,823,077 22,561,538 24,150,000 3,726,923 17,119,106 4,330,769 107,692 16,484,615 480,769 4,746,154 98,150,473 3,299,423 2,939,393 269,442,308 163,003,846 78,246,154 1,773,077 757,692 9,238,462 $527,052,997 $527,052,997 Transcript of Meeting with David Collier Present: David Collier, chief financial officer, Cloud 9 Inc. Josh Thomas, audit senior, W&S Partners JT: Thanks for seeing me, David. DC: You're welcome, Josh. What can I do for you? JT: I need to ask you some questions about Cloud 9's process for recording wholesale revenue transactions, including the trade receivables and cash receipts aspects. After I understand the process, I will be doing a system walkthrough and confirming my understanding by talking to the individuals who are involved in each step of the process. DC: We've got a pretty complex inventory management software system called Swift. It was designed by some of our tech guys. It tracks inventory and it integrates with our sales system. JT: How do customers decide the quantity and know the price? DC: The customers complete a purchase order online through a site that is linked to Swift. The site will tell customers the price for each item in inventory, as well as the quantity we have in stock. JT: How often are prices changed? Price changes really depend on the market. While they don't change that often, our marketing management meets weekly to discuss price changes. Price changes are initiated after that meeting. Only the marketing manager and a few of her staff members have access to update the master price list. JT: What if a customer logs on and you don't have the products? DC: The system doesn't allow a customer to place an order greater than our current inventory levels. If a customer needs more inventory, the customer should fill out a separate request for inventory not on hand. The request gets e-mailed to our production manager and our marketing manager, who determine if we need to manufacture more goods. The decision about manufacturing more goods is complex as it integrates with our production decisions, or whether we can purchase additional inventory from a subcontractor that manufactures for us. JT: OK. This is helpful. Let's stay focused on the sales process. Once a customer's purchase order is complete, then what? DC: The submitted purchase order goes through a credit check and then becomes a sales order. If a customer exceeds his or her credit limit, there are a few people in my office that can approve a credit override, on a case-by-case basis. We tend to allow this only for good customers with good payment history. Then, the purchase order becomes our sales order. JT: I guess this electronic process saves a lot of time and trees! DC: Yes, there's so much that we rely on the system to do for us, it's scary. I worry about things like what happens if we are hit by a storm or lose power. We do have the whole system backed up off-site. DC: JT: That is nice to know, and probably gives you some comfort. What happens to the sales order how does it get filled? DC: Every day, the system assigns shipments to the warehouse location nearest to the customer's location that can fulfill the entire order. The warehouse manager then downloads the outstanding sales orders to these little handheld computer/scanners. It's very Star Trek. Warehouse personnel use these to identify inventory in the warehouse, then the warehouse personnel put boxes of ordered shoes onto pallets. The pallets are taken to a staging area where each product is then scanned. 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? DC: Swift matches the quantities and products on the packing slip to the sales order. If they don't match, the order is set aside for follow-up to ensure that the order is accurately filled. Once they match, the approval box is activated, and the shipping supervisor can enter his or her passcode. This officially approves the packing slip and bill of lading, and each gets printed JT: OK, so once the goods are shipped to the customer, how do you bill for this shipment? DC: We go into the billing system and pull up a draft invoice that was generated when the shipping document was approved. At this point, Swift performs a number of checks. The system matches the quantities in the invoice against the packing slip and sales order. Prices are also matched to the sales order. The customer number should also match on the sales order, shipping documents, and draft invoice. A report is run daily of any shipments that have not resulted in invoices. The reverse is also true. A report is run of any invoices that are not supported by shipping documents. At month-end, we run a report to compare dates on shipping documents with the month that transactions are recorded in the sales journal. If there are any discrepancies, the transaction is reported for manual follow-up. I believe discrepancies are rare as the system is very tight, and we ship only what was ordered. Then, the sales invoice is processed. Processing the sales invoice enters the transaction in a database from which we build the sales journal and accounts receivable subsidiary ledger. Also, at the end of each day, we compare the totals for accounts receivable with the total of each customer's balance in the accounts receivable subsidiary ledger. JT: When you do have discrepancies, who follows up on them and how are they cleared? DC: We have a data control group that follows up on discrepancies in a variety of systems. Discrepancies have to be cleared daily. Once the reason for the discrepancy is identified, changes to the underlying data must be approved by a manager in the data control group. The data is then corrected, and the invoice is processed. As I noted, discrepancies are very rare. We don't ship goods unless the order is completely filled. JT: Does finance ever go back to the sales order? DC: No. Since the shipping document can't be generated unless it agrees to the sales order, Swift only looks at the sales order for prices. Do you think we should do otherwise? 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. DC: Yes, good IT general controls over the Swift program, and other programs, are extremely important. I meet with the IT manager monthly, to talk about the few discrepancies found, reasons for discrepancies, and the importance of controls. I think you will find that our IT manager understands the importance of strong IT general controls, and strong controls over clearing any discrepancies identified in transaction streams. JT: Let's talk about accounts receivable. Who follows up on past-due receivables? DC: That is the sales manager's responsibility. In my opinion, we do a good job of screening credit upfront so we don't have a significant problem with past-due receivables. We send statements to customers with their receivable balances monthly. The sales manager and I discuss past-due accounts on a regular basis. The sales manager, controller, and I review the allowance for doubtful accounts monthly. A monthly adjusting journal entry is made by the controller, which I review and approve. You will find that our allowance for doubtful accounts is only about 1% of outstanding receivables as we do a good job of screening customer's credit upfront. JT: DC: JT: What is the cash receipts process? We get most payments via EFT. If a customer pays by check, it goes to a lockbox where it also is directly received by our bank. Our AR clerk is able to download the previous day's cash receipts from online banking. She then merges this information with our accounting system, which first screens the data, matching customer numbers with the master customer file. On occasion, the bank has made errors in entering customer numbers, and we have to follow up on these transactions before they are processed in our accounting system. This is done the same day. Once the transaction is processed, it is posted to the database from which we build our cash receipts journal and accounts receivable subsidiary ledger. Finally, every morning someone reconciles what was posted to cash receipts with what has been deposited in various bank accounts. I believe it is critical that all cash receipts are posted timely and accurately. Are bank reconciliations done in a timely manner? Yes, someone in my office does bank recs every month for the main operating account and other bank accounts. Our standard is to complete this by the fifth business day of each month. My assistant reviews and approves the bank reconciliations. Keep in mind that what I explained is for the wholesale transactions. We have separate procedures for the retail store regarding daily cash balance reconciliations to the deposits in the operating bank account. Yes, we have another auditor who will be handling the retail store side of the sales-to-cash-receipts process. She or he will probably come and 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 the revenue process. The door is always open. Thanks for your time. DC: JT: a DC: JT