Background Information-Cloud 9 – Continuing Case
Josh Thomas (audit senior) and Suzie Pickering (audit staff) are discussing the audit of the purchasing process for Cloud 9. Cloud 9 products are developed through a collaboration between Cloud 9’s product development teams and third-party manufacturers. Purchases from manufacturers represent a material transaction stream, and accounts payable is one of the most significant current liabilities on Cloud 9’s balance sheet. As Josh and Suzie plan the audit of the purchasing process, they believe they have a basic understanding of Cloud 9’s business processes. However, they still need to address a few key issues before they settle on an audit plan. What are the most significant inherent risks for Cloud 9 in the purchasing process? Do significant fraud risks exist? Are there significant substantive tests that can be performed at an interim date?
Josh and Suzie review what they know about Cloud 9’s purchasing function. Cloud 9’s product development teams work closely with a variety of manufacturers around the globe. Cloud 9 has been particularly concerned about the quality of manufacturing when choosing manufacturers. Cloud 9’s CFO, David Collier, has also expressed concerns about risks inherent in the purchasing function globally. David has had several meetings with accounting staff to raise awareness about the risk of duplicate payment or fictitious vendors. Further, he has placed a top priority on regular screening of the master vendor file to ensure the file is kept current, old vendors are removed from the file, and the file represents an accurate list of current vendors and manufacturers that Cloud 9 does business with. However, Josh points out to Suzie that inherent risk is still high related to the occurrence assertion for purchases and that the quality of Cloud 9’s internal control will likely allow for a low control risk assessment. Further, Josh and Suzie are concerned about potential cutoff problems that may lead to unrecorded liabilities; therefore, inherent risk is also assessed as high for the completeness of purchases.
Josh and Suzie are pleased with the results of tests of controls related to the purchasing process. They found strong controls over the master vendor file, and vouchers are prepared based only on original invoices. Cloud 9 is very careful about entering the right invoice number, including any leading zeros, so an invoice is not paid twice. Further, individuals who are responsible for following up on exceptions understood the types of exceptions they were following up on, and exceptions tended to be rare. Finally, under David Collier’s direction, Cloud 9 developed clear procedures for accruing payables for goods received in the warehouse for which vendor invoices had not yet arrived.
As Josh and Suzie finalize their plans for substantive tests in the purchasing process, they recognize that a significant number of tests of transactions were accomplished with dual-purpose tests for testing controls. With cutoff controls being performed monthly, they decided to test cutoff at interim with a dual-purpose test, plus retesting Cloud 9’s internal control and simultaneously performing substantive cutoff procedures at year-end. Josh did not feel that confirmations of payables was an effective procedure. Josh felt the audit team could perform a search for unrecorded liabilities at year-end, rather than performing the procedure at an interim date and performing roll forward tests. Josh felt that performing the search for unrecorded liabilities at year-end would not be overly time-consuming, and it would be good to have evidence as of the balance sheet date.
Cloud 9- Appendix & Financial Statements
Appendix A
Cloud 9 Inc. Audit
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.)
Financial Statements
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.
Overview
In this assignment, you will prepare a 2-3 page professional document that addresses the requirements specified in the Cloud 9 case. Fully address each requirement and include at least two current references to scholarly and/or authoritative sources.
Instructions:
Specifically you will be required to:
1.Calculate the required ratios for all given years.
2.Identify and explain high inherent risk assertions.
3.Analyze and draw conclusions about the nature and extent of tests of controls.
4.Analyze and draw conclusions about the nature, timing, and extent of substantive procedures.
5.Use at least two current, quality academic or authoritative sources in this assignment.