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
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 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 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 Consolidated Statement of Income
For the year ended January 31, 2022
For the year ended January 31, 2021
Revenues
$364,953,846
$345,965,385
Costs and expenses:
Cost of sales
$222,496,154
$207,838,462
Selling and administrative
104,450,000
100,246,154
Interest expense
1,257,692
1,730,769
Other (income)/expense, net
1,311,539
??796,154
Total costs and expenses
?329,515,385
?310,611,539
Income before income taxes
35,438,461
35,353,846
Income taxes
??12,757,692
??13,080,769
Net income
$ 22,680,769
$ 22,273,077
Cloud 9 Consolidated Balance Sheet
January 31, 2022
January 31, 2021
Assets
Current assets:
Cash and cash equivalents
$11,692,308
$9,780,769
Accounts receivable, less allowance for doubtful accounts of $2,773,077 and $2,515,385
62,361,538
60,361,539
Inventory
54,773,077
55,615,385
Investments (derivatives)
14,460,577
14,852,885
Deferred income taxes
3,357,692
3,288,461
Prepaid expenses and other current assets
Total current assets
$151,895,192
$151,175,962
Property, plant, and equipment, net
62,261,539
60,900,000
Identifiable intangible assets and goodwill, net
3,820,192
3,950,961
Deferred income taxes and other assets
5,853,846
9,238,462
Total assets
$223,830,769
$225,265,385
Liabilities and Stockholders’ Equity
Current liabilties:
Current portion of long-term debt
$207,692
$1,926,923
Notes payable
28,896,154
35,546,154
Accounts payable
20,615,385
20,915,385
Accrued liabilities
18,157,692
23,336,581
Income taxes payable
842,308
582,650
Total current liabilities
$ 68,719,231
$ 82,307,693
Long-term debt
16,765,384
18,088,462
Deferred income taxes and other liabilities
3,942,308
4,253,846
Stockholders’ equity:
Common stock at par value
107,692
107,692
Capital in excess of par value
17,669,231
14,192,308
Unearned stock compensation
(380,769)
(450,000)
Accumulated other comprehensive income
(5,850,000)
(4,273,077)
Retaining earnings
122,857,692
111,038,461
Total stockholders’ equity
134,403,846
120,615,384
Total liabilties and stockholders’ equity
$223,830,769
$225,265,385
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.
Cloud 9 Trial Balance
October 31, 2022
October 31, 2021
Debit
Credit
Debit
Credit
Cash and cash equivalents
$13,446,154
$6,123,884
Accounts receivable
70,485,625
64,867,910
Allowance for doubtful accounts
$704,856
$648,679
Inventory
55,100,000
57,900,000
Investments (derivatives)
13,419,231
13,805,769
Deferred income taxes (current)
2,857,692
3,584,615
Prepaid expenses and other current assets
9,265,385
6,446,154
Property, plant, and equipment
103,803,846
97,576,923
Accumulated depreciation
39,761,538
35,207,692
Identifiable intangible assets and goodwill
3,723,007
3,851,923
Accumulated amortization
Deferred income taxes and other assets (noncurrent)
9,557,692
8,410,849
Current portion of long-term debt
2,115,385
300,125
Notes payable
21,376,923
34,823,077
Accounts payable
14,986,457
22,561,538
Accured liabilities
25,803,846
24,150,000
Income taxes payable
2,211,539
3,726,923
Long-term debt
23,661,538
17,119,106
Deferred income taxes and other liabilities (noncurrent)
4,915,384
4,330,769
Common stock at par value
111,538
107,692
Capital stock in excess of par value
19,415,385
16,484,615
Unearned stock compensation
253,846
480,769
Accumulated other comprehensive income
5,011,538
4,746,154
Beginning retained earnings
122,857,692
98,150,473
Dividends
3,866,838
3,299,423
Repurchases of common stock
4,627,381
2,939,393
Revenue
277,338,461
269,442,308
Cost of sales
169,346,154
163,003,846
Selling and administrative
79,092,308
78,246,154
Interest expense
1,438,461
1,773,077
Other expense
453,846
757,692
Income tax expense
9,511,538
9,238,462
Totals
$555,260,542
$555,260,542
$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?
DC:
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.
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:
What is the cash receipts process?
DC:
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.
JT:
Are bank reconciliations done in a timely manner?
DC:
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.
JT:
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.
DC:
The door is always open.
JT:
Thanks for your time.
CHAPTER 1 Introduction and Overview of Audit and Assurance
Learning Objectives
· LO 1 Differentiate among assurance, attestation, and audit services.
· LO 2 Describe the different types of assurance services.
· LO 3 Explain the demand for audit and assurance services.
· LO 4 Discuss the different roles of the financial statement preparer and the auditor.
· LO 5 Identify the roles of different regulators and organizations that affect the audit profession.
· LO 6 Explain the concepts of reasonable assurance, materiality, and the nature of an unqualified/unmodified report on the audit of financial statements.
· LO 7 Explain the concept of reasonable assurance and the nature of an unqualified report on internal controls over financial reporting.
· LO 8 Discuss the audit expectation gap.
Auditing and Assurance Standards
PCAOB
AUDITING STANDARDS BOARD
Framework for Audits of Public Companies
Framework for Audits of Private Companies
AS 2201 An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements
AU-C 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Generally Accepted Auditing Standards
AS 3101 The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion
AU-C 700 Forming an Opinion and Reporting on Financial Statements
Cloud 9 – Continuing Case
This text is designed to provide you with the opportunity to learn about auditing by using a practical, problem-based approach. Each chapter begins with some information about an example audit clientCloud 9 Inc. (Cloud 9). The chapter then provides the underlying concepts and background information needed to deal with this client’s situation and the problems facing its auditor. As you work through the chapters, you will gradually build your knowledge of auditing by studying how the contents of each chapter are applied to Cloud 9. The end-of-chapter exercises and problems also provide you with the opportunity to study other aspects of Cloud 9’s audit, in addition to applying the knowledge gained in the chapter to other practical examples.
Cloud 9 Inc., a listed company (publicly traded) in the United States (U.S.), is looking to expand. McLellan’s Shoes was seen as a potential target.
In 1985, Ron McLellan started McLellan’s Shoes in Seattle, Washington, manufacturing and retailing customized basketball shoes. Ron borrowed from the bank to start the company, using his house as security, and over the years he worked very hard to establish a profitable niche in the highly competitive sport shoe market. Ron repaid the bank in 1999, and he vows to never borrow again.
As the business grew, Ron’s wife and three adult children started to work with him, with responsibility for administration, marketing and sales, production, and distribution. By the early 2000s, Ron’s business employed 20 people full-time, most of whom work in production. There are also several casual employees and part-time staff in the retail outlet in Seattle, particularly during busy periods.
In February 2020, Ron received a call from Chip Masters, the senior vice president of Cloud 9. Chip expressed an interest in buying McLellan’s Shoes. Ron wants to retire, and his children are starting to fight among themselves about who is going to take over their father’s business. Ron is looking for an exit strategy, but he does not want Chip to know that. He asks if Chip is ready to talk about the price. Chip says he is, but first he needs to see the audited financial statements for McLellan’s Shoes.
Ron asks for some time. He tells Chip that he first needs to talk to his family and will then get back to him. When Ron puts the phone down, he immediately calls his friend from the golf club, Ernie Black, who is a CPA. For years, Ernie has been suggesting to Ron that his business affairs need attention. Ron is good at making deals and working hard, but he has never bothered with sophisticated financial arrangements. He is still running his business as a sole proprietor (not a corporation), and his wife does all the tax returns. Ron is in a paniche wants to sell McLellan’s Shoes, but what is he going to do about Chip’s request for audited financial statements?
Chapter Preview: Audit Process in Focus
The purpose of this chapter is to provide an overview of assurance, attestation, and audit services. While the focus of this text is the audit of financial statements, in this chapter we define assurance and attest engagements and differentiate among the types of assurance engagements. The assurance engagements explained in this chapter include financial statement audits, compliance audits, operational (performance) audits, and internal audits. We also discuss why there is a demand for audit and assurance services and then discuss the separate roles of the financial statement preparer and the auditors.
Regulatory bodies and other organizations that impact the audit profession are introduced in this chapter. Also, the audit reports issued by auditors at the completion of the audit are discussed with the goal of explaining what is communicated in the auditor’s report. We discuss the audit expectation gap in the last section of this chapter.
Cloud 9 – Continuing Case
Chip Masters has asked Ron McLellan for audited financial statements of McLellan’s Shoes. Ron has never had an audit and is not sure what it involves. He has heard about tax audits, safety audits, efficiency audits, as well as financial statement audits. Are they all the same thing? Ernie explains to Ron that there are several services that people call audits that are different from financial statement audits. However, all these services, including financial statement audits, can be defined as assurance services.
Assurance, Attestation, and Audit Services
LEARNING OBJECTIVE 1
Differentiate among assurance, attestation, and audit services.
The terms assurance, attestation, and auditing are sometimes used interchangeably, but they actually represent different types of services. They are similar in that they all represent a common process of an independent accounting firm taking information prepared by someone else and comparing that information to an established set of criteria. At the end of the service, the independent accounting firm provides a written report about the results of the service performed. This process is important because it adds credibility, or integrity, to the information, which makes it more useful for decision making. An everyday example of this process would be needing a physical exam from a medical doctor before joining a sports team. The doctor would be the independent professional. The doctor would conduct the physical exam and compare your results to standards considered acceptable for someone of your age and height. At the completion of the physical exam, the doctor would provide you with written documentation stating that you were in good physical condition to play on the sports team. The service provided by the doctor improves the integrity of your claim that you are in good condition to participate on the team.
The relationship of assurance, attestation, and auditing services is shown in Illustration 1.1 and resembles overlapping umbrellas. We will refer to Illustration 1.1 as we discuss the three services in more detail.
ILLUSTRATION 1.1 Relationship of assurance, attestation, and auditing services
Audit services are the most specific and narrow of the three services; therefore, it is the smallest umbrella in Illustration 1.1. Two primary types of audit services are an audit of financial statements and an audit of internal controls over financial reporting (ICFR). The purpose of an audit of financial statements is to provide financial statement users with an opinion by the auditor on whether the financial statements are presented fairly in accordance with an applicable financial reporting framework. The purpose of an audit of ICFR is to provide financial statement users with an opinion by the auditor on the design and operating effectiveness of ICFR. These audit services enhance the degree of confidence that intended users can place in the financial statements (AU-C 200.04). Some key concepts in these descriptions require further explanation. The financial statements refer to historical financial statements of either a public or private company. The auditor refers to an independent certified public accountant, or CPA, who is qualified to perform the auditing service. The
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