The Company does not have an internal audit department.Cloud9 set a goal to increase revenue by 3% each 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 earings for the year. In addition, to build customer loyalty and promote sales in the retail store, Cloud9 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. The company recently 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

Samantha Young (SY), Chief Financial Officer, Cloud9 Inc. Ghalen Johnson (GJ), Audit Senior, W&S Partners

GJ: As part of our risk assessment, I need to ask you some questions about your company's major business operations and internal controls over financial reporting. I will break it out by process areas to keep the discussion organized. Let's start with a walkthrough of your inventory processes and systems.

Inven

SY: We've got a 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. Warehouse employees select inventory and put boxes of ordered shoes onto pallets. The pallets are taken to a staging area where each product is then scanned. The Swift inventory system 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 passcode. This officially approves the packing slip and bill of lading, and each gets printed.

GJ: How often are prices changed in the inventory system?

SY: 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 will be initiated after that meeting. Only the marketing manager and a few of her staff members have access to update the master price list.

GJ: That is nice to know and probably gives you some comfort. What happens to the sales orderhow does it get filled?

SY: Every day, the system assigns shipments to the warehouse location nearest to the customer's location so that they 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, and then the warehouse personnel put boxes of ordered shoes onto pallets. The pallets are taken to a staging area where each product is scanned.

GJ: Are the shipping documents approved before the goods go out the door? How do you know that what was sent is what was ordered?

SY: 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.

GJ: When you do have discrepancies, who follows up on them, and how are they cleared?

SY: We have a data control group that follows up on discrepancies in a variety of systems. Discrepancies must 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 entirely filled.

GJ: Does finance ever go back to the sales order?

SY: 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?

GJ: 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.

Acc Rec

GJ: How do customers decide the quantity and know the price when ordering?

SY: The customers complet 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.

GJ: What if a customer logs on and you don't have the products?

SY: 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 it for us.

GJ: OK. This is helpful. Let's stay focused on the sales process. Once a customer's purchase order is complete, then what?

SY: 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 a good payment history. Then the purchase order becomes our sales order.

GJ: I guess this electronic process saves a lot of time and trees!

SY: 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.

GJ: OK, so once the goods are shipped to the customer, how do you bill for this shipment?

SY: 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 several 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 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.

GJ: Let's talk about accounts receivable. Who follows up on past-due receivables?

SY: 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 the customer's credit upfront.

GJ: What is the cash receipts process? Let's start with some questions about Cloud9's process for recording wholesale revenue transactions, including the trade receivables and cash receipts aspects.

SY: 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 can 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 must 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.

GJ: How about collections and past dues?

SY: We send statements to customers with their receivable balances monthly. The sales manager and I discuss past due accounts on a regular basis. The balance in the allowance for doubtful accounts is reviewed monthly by the sales manager, controller, and me. Any adjusting journal entries are made monthly by the controller and approved by me.

GJ: Are bank reconciliations done in a timely manner?

SY: 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.

GJ: You mentioned earlier about your reliance on the Swift system and what would happen if the system was unavailable.

SY: 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.

GJ: How about your other accounting systems?

SY: We have various software programs designed within the accounting system to process transactions; whether there have been any changes to those programs during the year; how changes are authorized, reviewed, and tested; who has access to programs and data files; and how access to programs and data is protected.

All our systems are premise-based. Our accounting systems are old (10 years) and still use client-server architecture.

We also have other controls in place such as a report is run daily of any shipments that have not resulted in invoices. We also ran a report of any invoices that are not supported by shipping documents. At month end a report is run to compare dates on shipping documents with dates invoices are recorded in the sales journal

GJ: I have some questions about your accounts payable processes. How many vendors do you have and walk me through the AP payment cycle?

SY: Cloud9 has over 100 vendors with the same vendor having multiple locations. Each vendor can submit an invoice from any location. Vendors can email invoices or send hard copies to the company's accounting department. The company does not always submit purchase orders to its vendors.

Our estimated warranty liability is included in accrued liabilities on the balance sheet and trial balance. Included in accrued liabilities on Oct 31, 2025, trial balance is an estimated warranty liability of $832,015, which is slightly higher than the liability on the prior year's Oct 31, 2024, trial balance of $808,326.

The accounting AP team is small, so some personnel sometimes staff must perform multiple functions such as adding vendors, recording invoices and paying the vendors.

F Sments

GJ: I looked at your statements and have some questions. Let's look at them.

SY: Sure, let's look at the balance sheet and income statement for the last couple of years. Financial ratios are also included.

GJ: How will your acquisition of Stotez Shoes change your business environment?

SY: We already operate in international markets. Stotez is more U.S. based. However, they will bring in some more retail clients. Currently, we are a wholesaler to a few sporting goods chains for business.

GJ: That's it for now. We will follow up with questions once the audit testing begins. Thanks for your time.

1. Identify the potential risks within each Cloud9 process (e.g. What could go wrong?) 2. To help identify risk, refer to your work on financial statement assertions to help formulate the risk. For example: 1. How do I know all transactions are captured? 2. How do I know the transaction stated in the interview is valued correctly? 3. What secondary reviews are performed? 3. For each potential risk, define the level of uncertainty and estimate its impact on the financial statements based on materiality. To do this, review the company's financial statements. 4. Determine the controls or lack of controls that are currently in place based on the information on any further control measures that may be required. To do this, 1. Review internal control best practices for each area (e.g., accounts receivable, accounts payable, inventory, and IT controls). 5. See questions to consider in the supporting financial statements. 6. Lines of business Cloud9 deals with 7. Types of Cloud 9 customers 8. Types of Cloud9 suppliers 9. Associated general ledger accounts, including materiality 10. Analyze information technology controls to identify risk. Include the following: 1. IT general controls 2. Company-level and application controls 3. Cloud9's ability to adapt to changing technology 11. Analyze external and other factors to identify risk. Include the following: 1. Laws and regulations that may affect Cloud 9 2. Economy and its impact on Cloud9 3. Cloud9's industry 12. Analyze financial data gathered through data analytics to identify risk. Include the following: 1. Validated notes payable balances 2. Validated inventory balances 3. Timing of revenues to ensure proper period 4. Allowance for doubtful accounts 1. Is it reasonable? 2. How to confirm? 5. Liquidity risk based on ratios 6. Inventory moving based on ratios 7. Customers paying on time based on ratios 13. Create an audit program to address identified risks. Include the following: 1. Recommended audit tests for the audit team to perform