Assignment 4: Inherent Risk, Tests of Controls, and Substantive Procedures In this assignment, you will prepare a two to three (2-3) page professional document that addresses the requirements specifie

Cloud 9 - Continuing Case Part 1: Gain an Understanding of the Client W&S Partners began the planning phase of the Cloud 9 audit. As part of the risk assessment phase for the new audit, the audit team needs to gain an understanding of Cloud 9's structure and its business environment, determine materiality, and assess inherent risk. This will assist the team in developing an audit strategy and designing the nature, extent, and timing of audit procedures. Required Answer the following questions based on the additional information about Cloud 9 presented in the appendix to this text and the current and earlier chapters. You should also consider your answer to the case study questions in earlier chapters where relevant. Your task is to research the retail and wholesale footwear industries and report back to the audit team. Your report will form part of the overall understanding of Cloud 9's structure and its environment. You should concentrate your research on providing findings from those areas that have a financial reporting impact and are considered probable given Cloud 9's operations. Use the factors listed in Illustrations 4.2 and 4.3 as a guide for your research.

Illustrations 4.2

Lower Inherent Risk Assessments Factors That Influence Inherent Risk Higher Inherent Risk Assessments Satisfied customers who pay on time and are likely to remain a customer in the future Client has many customers (1) Major customers Dissatisfied customers who may withhold payment or decide to not purchase from the client in the future Client has only one or very few customers Reputable suppliers that supply goods on a timely basis Few goods are returned to supplier as faulty Client pays suppliers on a timely basis (2) Major suppliers Suppliers may not supply goods on a timely basis Significant amounts of goods are returned to the suppliers because they are faulty Client does not pay suppliers on a timely basis Trades with countries that are stable Trades in stable foreign currencies Minimal tariffs or barriers to trade Client maintains effective risk management policies regarding foreign trade (3) Importer or exporter Trades with countries that are not stable Trades in unstable foreign currencies Complex tariffs and other barriers to trade Client does not maintain effective risk management policies regarding foreign trade Client well-positioned to adjust to changes in technology (4) Changes in technology Client falls behind with changes in technology and has not “kept up with the times” Client does not offer warranties on its products If client does offer warranties, product quality is high and the likelihood that goods will be returned is low (5) Warranties Client offers warranties on its products History of poor product quality and goods being returned for the same problem Few discounts are given by the client to its customers Client takes advantage of discounts offered by suppliers (6) Discounts Client offers discounts to its customers, possibly because it does not have much bargaining power Client misses opportunities to take advantage of supplier discounts Client has good reputation with customers, suppliers, employees, and the wider community in which it operates (7) Client reputation Client does not have a good reputation with customers, employees, and/or the wider community in which it operates Client has few locations and primary operations are centralized No international operations (8) Operations Client has larger number of locations and operations are decentralized Multiple locations operated internationally No recent implementation of new standards No change in the application of accounting standards Personnel involved in the selection and application of accounting standards are competent and experienced (9) Selection and application of accounting principles Recent implementation of new accounting standard Change in the application of an accounting standard Personnel involved in the selection and application of accounting standards lack competence and experience Determination of account balance is objective and supported by transactions with third parties Transactions are routine and relatively homogeneous Account has low volume of transactions (10) Significant accounts and classes of transactions Determination of account balance involves considerable subjectivity Transactions are complex and unique Account has high volume of transactions Less complex payroll system and benefit structures Defined-contribution pension plans (11) Relations with employees More complex payroll system and benefit structures Defined-benefit pension plans Less reliance on debt for financing Pays interest payments on time Less risk of violating terms of debt covenants (12) Sources of financing Heavy reliance on debt as a source of financing Struggles to pay interest payments on time Higher risk for violating terms of debt covenants which could indicate going concern issues Simple capital structure Pays dividends from operating cash flow (13) Ownership structure Complex capital structure Struggles to pay dividends from operating cash flow ILLUSTRATION 4.2 Entity factors that influence inherent risk (1) Major customers are identified so the auditor may consider whether those customers have a good reputation, are on good terms with the client (that is, likely to remain a customer in the future), and are likely to pay the client on a timely basis. Dissatisfied customers may withhold payment, which affects the allowance for doubtful accounts and the client's cash flow, or decide not to purchase from the client in the future, which can affect the client's operations. If a client has only one or a few customers, this risk is increased if losing a major customer would cause the client to significantly curtail operations. The auditor also considers the terms of any long-term contracts between the client and the client's customers. (2) Major suppliers are identified to determine whether they are reputable and supply quality goods on a timely basis. Consideration is given to whether significant levels of goods are returned to suppliers as faulty, the terms of any contracts with suppliers, and the terms of payment to suppliers. Auditors assess whether the client pays its suppliers on a timely basis. If the client is having trouble paying its suppliers, it may have trouble sourcing goods as suppliers may refuse transactions with a company that does not pay on time. Significant cash flow issues may be an indicator of going concern problems. Auditors identify whether the client is an (3) importer or exporter of goods. If the client trades internationally, auditors consider the stability of the country (or countries) the client trades with, the stability of the foreign currency (or currencies) the client trades in, tariffs or other barriers to trade, the effectiveness of any risk management policies the client uses to limit exposure to currency fluctuations (such as hedging policies), and the appropriateness of accounting for realized and unrealized gains and losses. Auditors consider the client's capacity to adapt to (4) changes in technology and other trends. If the client is not well-positioned to adjust to such changes, it risks falling behind competitors and losing market share, which in the longer term can affect the client's operations. If the client operates in an industry subject to frequent change, it risks significant losses if it does not keep abreast of such changes and “move with the times.” For example, if a client sells laser printers, auditors need to assess whether the client is up to date with changes in technology and customer demands for environmentally friendly printers. The financial statement consequences could include losses for obsolete inventory and accruals for loss contingencies associated with possible environmental cleanup. The nature of any (5) warranties provided to customers is assessed by the auditors. If the client provides warranties on products sold, auditors need to assess the likelihood that goods will be returned and the risk the client has underprovided for that rate of return (adequacy of the warranty liability). Auditors pay particular attention to goods being returned for the same problems, indicating there may be a systemic fault. For example, if the client sells quality pens and the auditors notice that a number of pens are being returned because the mechanism to twist the pen open is faulty, auditors will assess the likelihood that other pens will be returned for the same reason, the steps being taken by the client to rectify the problem, and whether the warranty liability is adequate in light of this issue. The financial statement impact would involve the adequacy of a warranty reserve and the adequacy of reserve for lower-of-cost-or-net-realizable-value issues with inventory. Auditors review the terms of (6) discounts given by the client to its customers and received by the client from its suppliers. An assessment is made of the client's bargaining power with its customers and suppliers to determine whether discounting policies are putting profit margins at risk, which may place the future viability of the client at risk. Auditors consider the (7) client's reputation with its customers, suppliers, employees, shareholders, and the wider community. A company with a poor reputation places future profits at risk and increases the risk of going concern issues. It is also not in the best interest of the auditor to be associated with a client that has a poor reputation, as we discussed in Chapter 3. Auditors gain an understanding of client (8) operations. Auditors note where the client operates, the number of locations in which it operates, and dispersion of these locations. The more spread out the client's operations are, the harder it is for the client to effectively control and coordinate its operations, which increases the risk of errors in the financial statements. Auditors visit locations where inherent risk is greatest to assess the processes and procedures at each site. If the client has operations interstate or overseas, auditors may plan a visit to those sites by audit staff from affiliated offices at those locations where risk is greatest. For example, an auditor is more likely to visit client operations if the client opens a new, large site or if the business is located in a country where there is a high rate of inflation or where there is a high risk of theft. Auditors must gain an understanding of the client's procedures for the (9) selection and application of accounting principles. They need to know who oversees the financial reporting process on a daily basis, an individual or a group, and consider the qualifications of those involved. Client personnel with more experience generally are more competent at applying complex accounting principles. Other considerations include whether the client has implemented a new accounting standard or changed how an accounting standard is applied. Financial reporting is already a complex process, but when implementing a new standard or making changes with a current standard, inherent risk increases because of the possibility of applying the accounting standard incorrectly. (10) Significant accounts and classes of transactions are identified during the risk assessment phase. Recall from Chapter 3 that a significant risk could be an account, transaction, or activity that has an increased risk of causing a material misstatement on the financial statements. For example, the inventory account would be a significant account for a large retail client for several reasons. It is probably the largest current asset for the client, it has a large volume of transactions, and some of the transactions may involve complex contractual arrangements with suppliers. Auditors devote more audit time to the inventory account since it poses a higher inherent risk. Another example would be a client's process of determining if goodwill has been impaired. Since there is subjectivity involved in the measurement of this financial statement item, auditors may plan audit procedures to ensure adequate time is spent testing the client's goodwill impairment procedures. Keep in mind, an account or class of transactions that is significant for one client may not be significant for other clients, even if they are in the same industry. For example, not every client is going to have a goodwill account. Auditors determine significant accounts and classes of transactions on a client-by-client basis. An understanding is gained of the client's (11) relations with its employees. Auditors consider how a client pays its employees, the mix of wages and bonuses, and the attitude of employees to their employer. The more complex a payroll system, the more likely it is that errors can occur. Auditors might also expect more complex control systems when payroll transactions are complex. When employees are unhappy, there is greater risk of industrial action, such as strikes, which disrupt client operations. Auditors assess a client's debt and equity sources, the reliability of future (12) sources of financing, the structure of debt, and the reliance on debt versus equity financing. Auditors determine whether the client is meeting interest payments on debt and repaying debt when it is due. If a client has a covenant with a lender, auditors need to understand the terms of that covenant and the nature of the restrictions it places on the client. Debt covenants vary. A company may, for example, agree to limit further borrowings, to freeze a line of credit for a period of time, or to maintain a certain debt-to-equity ratio. If the client does not meet the conditions of a debt covenant, the lender may recall the debt, placing the client's liquidity position at risk, and increasing the risk the client may not continue as a going concern. Auditors learn about the client's (13) ownership structure, such as the amount of debt financing relative to equity, the use of different forms of shares, and the differing rights of shareholder groups. The client's dividend policy and its ability to meet dividend payments out of operating cash flow are also of interest when evaluating whether an entity is a going concern. Also, complex ownership arrangements and differing rights of shareholder groups will require more complex disclosures by the client. Audit Reasoning Example Samsung Fire Fiasco Most likely you are familiar with Samsung and own at least one Samsung product, such as a TV, kitchen appliance, or laptop. Samsung has consistently been the top seller of smartphones worldwide, and in 2017 Samsung had 21% of the global smartphone market share.1 In the third and fourth quarters of 2016, Samsung experienced a public relations nightmare when some customers had problems with their Galaxy Note 7 smartphones catching fire. An investigation determined that the battery in the phone had the potential to catch fire when overheated. Samsung recalled all of the nearly three million Galaxy Note 7 devices that had been sold and permanently ended production of the device.2 Suppose you are on the audit team for the December 31, 2016, financial statement audit for Samsung. How does the Galaxy Note 7 situation impact the inherent risk factors listed in Illustration 4.2? Here are some examples: Customers may decide not to purchase Samsung mobile devices in the future, which impacts revenues and profits. Samsung may consider switching battery suppliers, which could affect costs and product quality. Samsung must honor the warranty on the phone and issue refunds and/or replacement products to customers, which impacts profits. Samsung's reputation was tarnished by the negative publicity, and the situation sparked multiple lawsuits that will drag on for years and cost Samsung millions of dollars. During the audit, you and the other audit team members would plan to give additional audit attention to accounts and note disclosures directly impacted by the Galaxy Note 7 situation, such as warranty-related accounts, inventory (lower-of-cost-or-net-realizable value), sales returns, and contingent liability accruals.

ILLUSTRATION 4.3

Lower Inherent Risk Assessments Industry Factors That Influence Inherent Risk Higher Inherent Risk Assessments Less competitive industry, which puts less stress on the client's ability to generate a profit (1) Level of competition Very competitive industry, which puts more stress on the client's ability to generate a profit Good reputation relative to others in the industry Customers and suppliers may be attracted to conduct business with the client versus a competitor (2) Reputation Poor reputation relative to others in the industry Customers and suppliers may shift business to a competitor A new industry with considerable government support and incentives New or established industry with intense international competition with considerable government support and incentives Industry with minimal government regulation and no special taxes or unique financial reporting requirements (3) Legal, political, and regulatory environment A new industry with little or no government support New or established industry with intense international competition with little or no government support Heavily regulated industry with special taxes and unique regulations and financial reporting requirements Demand is not seasonal, which provides steady revenue flow Industry minimally affected by trends/customer preferences Industry has low risk of technological obsolescence (4) Demand Seasonal demand for products, which leads to sporadic revenue flow Industry subject to changing trends/customer preferences Industry subject to technological obsolescence Economy as a whole experiences an upturn, which leads to easily sustainable profit levels (5) Economy Economy as a whole experiences a downturn, which leads to pressure to maintain expected profit levels ILLUSTRATION 4.3 Industry and business environment factors that influence inherent risk Auditors compare the client with its close competitors nationally and internationally. When auditors have a number of clients that operate in the same industry, and the audit firm has significant experience auditing clients in that industry, this stage of the audit is more straightforward than if the client operates in an industry the auditors are not already familiar with. The audit team assesses the (1) level of competition in the client's industry. The more competitive the client's industry, the more pressure is placed on the client's profits, which will assist auditors when developing expectations regarding the client's profitability. In an economic downturn, the weakest companies in highly competitive industries face financial hardship and possible going concern problems. A key issue for an auditor is the client's position among its competitors and its ability to withstand downturns in the economy. Auditors also consider the client's (2) reputation relative to other companies in the same industry. If the client has a poor reputation, customers and suppliers may shift their business to a competing firm, threatening the client's profits. In such circumstances, a client's management may resort to aggressive accounting choices to improve profits (or reduce losses). The audit team can assess the client's reputation by reading articles and industry publications. Auditors consider the (3) legal, political, and regulatory environment for the client's industry. This issue is important if the industry faces significant competition internationally or the industry is new and requires time to become established. Support is sometimes provided to industries that produce items in line with government policy, such as manufacturers of water tanks, solar heating, and reduced-flow taps in the context of environmental policies. Regulations can affect a client's ability to continue operating or affect continued profitability, for example, through different taxes and charges imposed on companies operating in the industry. Some industries have unique accounting and financial reporting requirements, such as the oil and gas industry. The audit team must be alert to how changes in the regulatory environment might affect the client's profitability and operations. The auditors should understand the level of (4) demand for the goods sold or services provided by companies in the client's industry. If a client's products or services are seasonal, this will affect revenue flow. As mentioned, if a client is an ice-cream producer, sales would be expected to increase in the summer; however, if the weather is unseasonal, profits may suffer. If a client sells swimsuits, sales will fall in a cool summer. If a client sells ski equipment, sales will fall if the winter brings little snow. If a client operates in an industry subject to changing trends, such as fashion, the client risks inventory obsolescence if it does not keep up and move quickly with changing styles. When a product or process is subject to technological change, there is the risk a client will quickly be left behind by its competitors. If products become obsolete, it will affect the lower-of-cost-or-net realizable value accounting for inventory, and it might affect the collectibility of receivables related to inventory sold to customers that has not yet been sold to end consumers. Finally, when gaining an understanding of a client, auditors assess how factors in the (5) economy affect the client. Economic upturns and downturns, changes in interest rates, and currency fluctuations affect most companies. The audit team is concerned with the client's susceptibility to these changes and its ability to withstand economic pressures. The auditors also determine if negative consequences have been appropriately reported in the financial statements.