Audit Case Study, 1st

Solutions Manual for Cloud 9 Ltd II An Audit Case Study, 1st Canadian Edition, 1e Fiona Campbell, Amanda White, Valerie Warren (All Chapters) 1 / 4

Assignment 1: Understand the business

General and industry-specific economic trends and conditions The Canadian economy is expected to grow at an average of approximately 2 to 3 percent to 2016.• After a period of spending and debt accumulation, Canadians are now focusing on reducing debt levels while interest rates are at historic lows. Today, the overall trend is toward more prudent spending, resulting in modest growth. With interest rates at historic lows, it is inevitable that they will increase in the future.However, the timing of such increases are uncertain. Future interest rate increases may decrease the amount of disposable income available for expensive running shoes.• The movement of U.S. retail chains into Canada continues to put pressure on Canadian retailers. With increased competition, price wars are common, putting pressures on profit margins. There is an adequate supply of workers and there are no special or unique labour relations requirements.• However, sales of the product will depend on the target market. Who is most likely to buy—Gen Y? Baby Boomers? Gen X? Millennials? House prices and interest rates don’t affect Millennials, Gen Ys, and the Baby Boomers as greatly as Gen Xs, who are experiencing the prime years of home ownership. Therefore, the target market may not be significantly impacted by future interest rate increases.• Lower pricing levels and improved quality of Chinese imports have resulted in large volume increases. Cloud 9 has responded well to this shift by obtaining the majority of its goods from its China distribution plant.• Recent foreign currency fluctuations (the weakening Canadian dollar against the U.S. dollar) has put pressure on the import market and companies’ cost of goods sold. The recent change in exchange rate means that imports are up to 30% more expensive, which directly affects costs.• Seasonality is not a specific concern for running shoes in general; however, shoes targeted to a particular market segment, such as basketball, may have some seasonality in sales corresponding to basketball season.• Having a retail outlet/store increases the risk of theft (and has been proven) and the need for reliable labour.• Cloud 9’s growth expectations are slightly above the industry’s growth outlook.

Competitive environment/Product information/Customer information/Supplier information Competition is high and increasing, with price and quality the deciding factors.• The ability to supply footwear retailers with products in a timely manner is an important success factor against competitors. Footwear is subject to fashion trends.• Image and functionality are two of the most important characteristics consumers use to differentiate footwear. An aggressive marketing campaign, often using sports and fitness references.. 2 / 4

• The industry is relatively capital intensive. The need for warehousing, transportation, and stock is high and may create barriers to entry.• While entry from new wholesalers can be difficult based on agreements between existing wholesalers and retailers, the trend in the industry is for the customer to buy directly from the manufacturer. Cloud 9 has responded well to this trend by opening its own store, thereby eliminating the wholesaler.• Discount stores/outlets and online shopping also compete in this sector. This may impact Cloud 9’s current customer base and sales opportunities.• To boost repeat customer visits, retailers are developing loyalty programs. While Cloud 9 started a program this year, it remains to be seen if the benefits will be achieved given the low regularity of consumers purchasing athletic footwear.• The Lightning 7 shoe is not selling as expected, and as a result the company has inventory build-up at their warehouse. This is a concern as there is the possibility that Cloud 9 will not be able to sell the inventory or will have to discount it in order to sell it.

Technological advances and the effect of the Internet Technological advances in this industry have mainly been in the areas of replacing the need for skilled labour with computerized automation of inventory control.• Computers allow inventory to be stored on an international basis, allowing for more efficient transportation and distribution.• Distribution management software allows advanced order management, inventory management, and delivery systems to be combined into one seamless supply chain.• An online presence will provide a competitive advantage through increased marketing power and the ability to provide product information.• The Internet has made consumers very price sensitive as they can quickly check the prices of products (and purchase) from many different websites.

Laws and regulatory requirements • As Cloud 9 is a public company it must adhere to the stock exchange regulations.Things to consider include corporate governance guidelines and filing requirements.• As the majority of Cloud 9’s products are manufactured in China with the remainder made in the US, Cloud 9 should be aware and in compliance with the laws and regulations of these foreign jurisdictions. This includes the consideration of labour law requirements in these foreign countries.

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By considering these factors, the auditor would identify key business risks that could have a material effect on the financial statements. These risks are inherent to the business operations. Based on the research above, the Cloud 9 audit team has identified the

following audit risk areas:

NOTE TO THE LECTURER:

Additional discussion points

It is important to clearly distinguish between business risks and significant risks. Business risks are faced by management in its operation of the business. Significant risks are those that increase the risk of material misstatement and require attention by the auditor.

From a big picture perspective, you may want to highlight the key risks in respect of understanding the wholesale/retail industry. This does not directly affect the outcome of the case study for Cloud 9 given the limited company background provided.• How does the company control the suppliers/manufacturers? Are they local or international?• How does Cloud 9 determine the quantities and styles for its purchases from the manufacturer? Ultimately, the wholesaler inherits some of the risk when determining inventory balances to effectively service the retailers.• What are the terms and conditions with the retailers? What rebates or discounts are provided? As price is the key driver in retail, this will be the area of concern when dealing with retailers.

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