By setting high detection risk an auditor will

Auditing Course Assignment

Read "Chapter 3" pdf. then Answer the following questions(a.b.c) based on the information presented for Cloud 9 in the appendix to this book and in the current chapter and previous chapters.（Attached file "Chapter 3" contains the reading material and the assignment detail.Attached file "data"is the appendix for question a. Attached files "Chapter 1"&"Chapter 2" is optional reading for this assignment. "）

a. Using the September 30, 2022, trial balance(in the appendix to this book), calculate planning materiality and include the justification for the basis that you have used for your calculation.

b. Discuss how the planning materiality would be used to determine performance materiality.

c. If the planning materiality amount is subsequently increased or decreased later in the audit, how would that impact the audit?

Cloud 9 Inc. Audit

W&S Partners is a U.S.-based accounting fi rm with offi ces 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 pro- cess, 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.

Appendix A

Cloud 9 Inc. Company Background Cloud 9 is a Sacramento-based manufacturer and retailer of athletic shoes. 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 Inc. has wholly owned subsidiaries in Canada, Vietnam, and Brazil, and has built a reputation around the fact that its shoes have comfort and durability. The company pro- motes 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 to its main custom- ers 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 equip- ment 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 inter- national 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 specifi c 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 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.

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A-2 APPENDIX A Cloud 9 Inc. Audit

To further establish the brand, the fi rst Cloud 9 retail store was opened in San Francisco on June 1, 2022. The store operates on a just-in-time inventory system linked with the main warehouse in Sacramento. 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 offi ce has 358 full-time employees. In the retail store, the company em- ploys 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 fi scal 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 in- troduced 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 fi ve years. The company’s other debt relates to loans issued more than fi ve 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 2% of total sales.

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 103,450,000 100,246,154 Interest expense 2,257,692 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

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Cloud 9 Inc. Company Background A-3

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 5,250,000 7,276,923 Total current assets 151,895,192 151,175,962 Property, plant and equipment, net 62,261,539 60,900,000 Identifi able 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 SHAREHOLDERS’ EQUITY Current liabilties: Current protion of long-term debt 207,692 1,926,923 Notes payable 32,896,154 35,546,154 Accounts payable 16,615,385 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 Shareholders’ 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 shareholders’ equity 134,403,846 120,615,384 Total liabilties and shareholders’ 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 fi nancing activities* (13,457,692) (9,696,154) Eff ect 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 2021 and $5,119,231 in 2020

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A-4 APPENDIX A Cloud 9 Inc. Audit

Transcript of Meeting with Carla Johnson Present: Carla Johnson, Chief Financial Offi cer, Cloud 9, Inc.

John Thomas, Audit Senior, W&S Partners JT: Thanks for seeing me, Carla. CJ: You’re welcome, Josh. What can I do for you? JT: I need to ask you some questions about Cloud 9’s process for recording wholesale

revenue transactions, including the trade receivables and cash receipts aspects. After I understand the process from you, I will be doing a system walkthrough and confi rming my understanding by talking to the individuals who are involved in each step of the process.

CJ: We’ve got a pretty complex inventory management software system called Swift. It was de- signed by some of our tech guys. It tracks inventory and it integrates with our sales system.

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 Identifi able 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 – 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 17,419,231 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

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Transcript of Meeting with Carla Johnson A-5

JT: How do customers decide the quantity and know the price? CJ: 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? CJ: Price changes really depend on the market. While they don’t change that often, our mar-

keting managements meets weekly to discuss prices 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? CJ: The system doesn’t allow a customer to place an order greater than our current inven-

tory levels. If a customer needs more inventory, the customer should fi ll out a separate request for inventory not on hand. That then 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?

CJ: The submitted purchase order goes through a credit check and then becomes a sales or- der. If a customer exceeds his or her credit limit, there are a few people in my offi ce 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! CJ: 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 fi lled?

CJ: Every day, the system assigns shipments to the warehouse location nearest to the custom- er’s location that can fulfi ll the entire order. The warehouse manager then downloads the outstanding sales orders to these little hand-held 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?

CJ: 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 fi lled. Once they match, the approval box is activated, and the shipping supervisor can enter his or her passcode. This offi cially 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?

CJ: We go into the billing system and pull up a draft invoice that was generated when the shipping document was approved. At this point, the 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

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A-6 APPENDIX A Cloud 9 Inc. Audit

ordered. Then, the sales invoice is processed. Processing the sales invoice enters the trans- action in a database from which we build the sales journal and accounts receivable sub- sidiary 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 are they cleared? CJ: 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 identifi ed, 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 fi lled.

JT: Does fi nance ever go back to the sales order? CJ: No. Since the shipping document can’t get 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 con-

trols around Swift, given that it seems to do everything. CJ: 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 fi nd that our IT manager understands the importance of strong IT general controls, and strong controls over clearing any discrepancies identifi ed in transaction streams.

JT: Let’s talk about accounts receivable. Who follows up on past-due receivables? CJ: 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 signifi cant 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 fi nd that our allowance for doubt- ful accounts is only about 1% of outstanding receivables. I think this is good as we do a good job of screening customer’s credit upfront.

JT: What is the cash receipts process? CJ: 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 account- ing system, which fi rst screens the data, matching customer numbers with the master customer fi le. 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 subsid- iary 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? CJ: Yes, someone in my offi ce does bank recs every month for the main operating account

and other bank accounts. Our standard is to complete this by the fi fth 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 operat- ing 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.

CJ: The door is always open. JT: Thanks for your time.

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