Audit Planning Case Study On Cloud9: Materiality And Analytical Procedures

Overview of Cloud9

The formulation of the present report is done as an audit for checking the existing materiality in the accounts of a client of W&S Partners- Cloud9. This Sydney-based company was founded by Ron McLellan, originally in 1980, involved in manufacturing and retailing of customised basketball shoes. Discovering the inherent risks which are likely to affect the reliability of the financial report, is the main purpose of this materiality survey. The audit also aimed at gaining a thorough understanding of the Cloud 9’s financial structure and its business environment. For the purpose of assessing the materiality, the account balances are used as a basis for the review of material misstatement. A blended approach of all the benchmarks has been used to calculate material misstatement. An analysis of the financial position and business risk involved has also been reflected in the report through the presentation of common size balance sheet. This has made the comparison and analysis of accounts easier and effective.

Cloud9 is a Sydney-based company which was founded by Ron McLellan, in 1980. The company’s range of operations included manufacturing and retailing of customised basketball shoes. Cloud 9 Inc., is a parent company and has wholly-owned subsidiaries in various countries including UK, Canada, Germany, Brazil and China. A renowned image has been established by the company in manufacturing shoes which have excellent comfort and durability. The stocks of Cloud 9 Pty Ltd are acquired majorly from its China production plant, and the remaining shoes are developed in the manufacturing plant of United States. Cloud 9 Inc. launched its new product line in 2009, February which included the range of walking shoe ‘Heavenly 456’. In 2011, Cloud9 initiated a specific marketing campaign to promote and build the brand in Australia by signing Kevin McDonald as the spokesperson for the brand. A retail store was opened in the Sydney in 2011 to establish the brand further. [Appendix. Cloud9. 2010-2011. (PDF)].

According to Lin and et.al. 2015, the auditor applies the materiality concept is the planning as well as the performance stage of the audit, and also in the evaluation of the effect of misstatements that are identified in the former stages. During the audit planning stage, an assessment of risk was made in respect of material misstatement which represents significant error or fraud that could occur in the financial statement of the client. An auditor can plan their audit by understanding all the major areas which represent most significant risks. With this, the auditor can identify which areas need more attention. The risk thereon is assessed as per the IAS 315, “Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment.” Materiality judgments are made in the light of circumstances which surround the organisation. The judgements of materiality are also affected by the nature or size of misstatement, or an aggregation of both. According to this standard, there can be various reasons due to which the financial statements can be misstated-

• The client’s business nature.
• The industry of the client’s operation.
• The competition level in which an industry survives.
• The client’s customers and suppliers.
• The regulatory environment of the client’s operation.

On the basis of above discussions, it can be said that misstatements and omissions in accounts are considered material if they independently or as collective, might convincingly influence the decisions of the economic nature of users which they take based on the financial statements. It is required on the part of the client that any change in technology used for recording of financial statements must be fully ensured to minimize the risk of material statement which may occur due to changing from an old to a new system.

Part 1- Materiality

As per AAS 1031, the benchmarks that have been selected for materiality have been presented in the table below. All these standards reflect a stable measure for calculating planning materiality and misstatement in accounts (Eilifsen and Messier, 2014). According to the AAS 240, the auditor must also assess during the planning stage of audit any material misstatement present in the statements due to fraud. According to the views of Unerman and Zappettini (2014), “Tolerable misstatement” is established for individual accounts which reflect the amount which is different from its actual amount without affecting the reliability of the financial statements (Ruhnke and Schmidt, 2014). Any amount higher than the tolerable amount is said to be material.

According to AAS 315 there must be applications embedded in the Client’s IT system that detect the material misstatement at an early stage and thus requiring the company to oversee the accounts. On the basis of below benchmarks all the major accounts are found to be material. The auditor uses all the above benchmarks for assessing the materiality for individual accounts.

Base used	Details of the Account	Common Materiality percentage used	Planning materiality at the financial statement level
Profit before tax	1,217,170	5%	60858.5
Turnover	27896199	5%	1394809.95
Total Assets	18,589,328	0.5%	92946.64
Equity	7,190,083	1%	71900.83

Common size Balance Sheet of Cloud9 for the year ended 2010 and 2011
Amount in $
	30th    Sept. 2011		31st December2010
ASSETS
Current Asset
Cash and cash equivalents	245,965	1.32%	1753765	7.13%
Trade and other receivables	10,552,109	56.76%	10701064	43.52%
Inventory	6,341,924	34.12%	6263242	25.47%
Derivative Financial Assets	3,987,453	21.45%	4075205	16.57%
Prepayments	1,112,028	5.98%	666054	2.71%
Deferred Tax Asset	346,949	1.87%	277559	1.13%
Total financial assets	17,139,998	92.20%	23736889	96.53%
Non-Current Assets
Property Plant and Equipment	1,449,330	7.80%	852965	3.47%
Total non-financial assets	1,449,330	7.80%	852965	3.47%
Total Assets	18,589,328	100.00%	24589854	100.00%
Equity & Liabilities
EQUITY
Share Capital	5448026	29.31%	5448026	22.16%
Reserve & Surplus	1,742,057	9.37%	341160	1.39%
Total Equity	7,190,083	38.68%	5789186	23.54%
Non-Current Liabilities
Interest Bearing Liabilities	9,021,836	48.53%	9740091	39.61%
Deferred Tax Liabilities	–	–	170284	0.69%
Provisions	701,658	3.77%	79566	0.32%
Total	9,021,836	48.53%	189015	0.77%
Current Liabilities
Trade Creditors	1,857,543	9.99%	8413818	34.22%
Provisions for Tax	159,866	0.86%	207893	0.85%
Accounts Payable	360,000	1.94%	–	–
Total	2,377,409	12.79%
Total Liabilities	18,589,328	100.00%	24,589,853	100.00%

 

The major significance of creating a common size balance sheet is the ease of its comparability with a different company and over different years (Feng, and et.al.  2014). After analysing the common size balance sheet of Cloud9, it is indicated that the company’s obligations lie majorly in the payables in both the accounting years. The company is following a risky approach towards the management of its debts. The cash and its equivalents of the company are very low in both the years, being significantly lower in 2011; this indicated that the company’s liquidity is not in a good state. The plant, property and equipment from a comparatively low aggregate of the total asset in both the years. Low fixed assets may mean the company does not have enough fixed assets to meet its long-term liability. The common-size balance sheet gives one an insight into the structure of firm’s capital structure over the years and as compared to its rival.

According to the views of Robinson and et.al. 2015, an auditor can overview the structure and can take his decision wisely regarding the area which has to be assessed in detail. It can be studied from the common size balance sheet that the company had very low reserves in the year 2010 and this also affects the liquidity of the company. However, the company experienced no losses in the same year which is a positive sign. The company complies accounting policy of keeping its deferred tax liabilities to the minimum level, as there are no such liabilities in the year 2010 and even in 2011 such liabilities is significantly very low as compared to other liabilities.  The provisions created by the company for the discharge of its liabilities are also very low. There are no accounts payables in the financial year 2010, as observed from the balance sheet.

Financial Ratios	2011	2010
Current Ratio	3.01	2.69
Debt to Asset	0.49	0.39
Receivable Turnover	0.38	0.31
Profit Margin	0.04	0.03
Asset Turnover	0.21	0.34

The company’s current ratio reveals that attractive percentage which means the company has enough backups to discharge its liabilities, which may have a positive impact on the company’s long-term financial position. The debt to asset ratio is also less than 1 which indicates that the assets of the company are being financed through debt rather than equity. This poses a risk of financial stability to the business (Delen, Kuzey and Uyar, 2013). The company’s capability to issue credit and collect funds from customers is reflected from receivables turnover ratio which is presenting an opportunity to the company for the collection of the funds. The company’s profit margin has improved as compared to previous years; this means that the management is putting efforts in improving its efficiency. The asset turnover ratio that is the ability of the company’s asset to produce sales (Brigham and Ehrhardt, 2013) is also below the required level.  No major fluctuation has been observed in both the year. Thus the same represents that the accounts are viable and no specific transaction has impacted the financial position of the company.

Calculating materiality by taking different benchmarks as base from the balances of 2011

As per the views of Babalola and Abiola (2013), the financial ratios can be of great importance in planning the audit of the firm. Through these ratios, an auditor can judge significant risks involved in the financial stability of the business. If through assessing the ratios the auditor is a view that the company may fall short of its finances in the near future he may discharge a report clarifying that the financial stability is not as derided.

1. Respective Responsibilities: The CEO is responsible for maintaining and preparing proper accounting records; preparing annual Accounts and they should provide a  true and fair view of the state of affairs of the Board, and ensure that these Accounts have been properly prepared in such manner in accordance with standards.
2. Risk Assessment: By considering the evaluation of internal environment and control process of the Board, the overall inherent risk assessment will be determined of the account areas. Significant audit areas identified as per above materiality analysis and analytical procedure; the following accounts need to be assessed in detail

Debtors: A major amount has been provided for provision. Thus debtors are identified as a major risk area. Recoveries have their impact on current ratio, thus the same to investigate to ascertain whether efficient efforts have been made for the same or not.

Provisions for depreciation, bad and doubtful debts: There may be the risk of the Board for not depreciation in accordance with the standard, as a result leading to the misstatement of assets. In addition to this, if the Board members provide, provisions for bad and doubtful debts is to be examined by on the basis of viable aspects. Thus, the same is to be verified in an appropriate manner.

Interest on loans: Loan statements need to be assessed for verifying the balance of the loan and the terms of interest should be verified with the same.

Going Concern: This aspect is to be assessed that whether any transaction affects the going concern assumption. If any such transaction exists than the same should be assessed in detail. It is a fundamental assumption. Thus it is necessary to check whether the company assets will be able to meet its financial compulsions in next year.  

Audit Approach for each accounting area: the audit approach followed is based on risk supported by the understanding of the business of the Board. The audit is also informed by the accounting systems swell as the internal control methods used by the company. If these systems are strong tan assurance is sought from them. The assessment of risks is associated with the financial statements.

References

Books and Journal

Babalola, Y.A. and Abiola, F.R. (2013). Financial ratio analysis of firms: A tool for decision making. International journal of management sciences. 1(4). Pp.132-137.

Brigham, E.F. and Ehrhardt, M.C. (2013). Financial management: Theory & practice. Cengage Learning.

Cassell, C.A., Myers, L.A. and Seidel, T.A. (2015). Disclosure transparency about activity in valuation allowance and reserve accounts and accruals-based earnings management. Accounting, Organisations and Society. 46. Pp.23-38.

Christensen, B.E., Glover, S.M. and Wood, D.A. (2013). Extreme estimation uncertainty and audit assurance. Current Issues in Auditing. 7(1). Pp.P36-P42.

Delen, D., Kuzey, C. and Uyar, A. (2013). Measuring firm performance using financial ratios: A decision tree approach. Expert Systems with Applications. 40(10). Pp.3970-3983.

Eilifsen, A. and Messier Jr, W.F. (2014). Materiality guidance of the major public accounting firms. Auditing: A Journal of Practice & Theory. 34(2). Pp.3-26.

Feng, M., Li, and et.al.  (2014). Does ineffective internal control over financial reporting affect a firm’s operations? Evidence from firms’ inventory management. The Accounting Review. 90(2). Pp.529-557.

Knechel, W.R. and Salterio, S.E., (2016). Auditing: assurance and risk. Routledge.

Lin, C.C. and et.al. (2015).  Detecting the financial statement fraud: The analysis of the differences between data mining techniques and experts’ judgments. Knowledge-Based Systems. 89. Pp.459-470.

Robinson, T.R. and et.al. (2015). International financial statement analysis. John Wiley & Sons.

Ruhnke, K. and Schmidt, M. (2014).  Misstatements in financial statements: The relationship between inherent and control risk factors and audit adjustments. Auditing: A Journal of Practice & Theory. 33(4). Pp.247-269.

Unerman, J. and Zappettini, F. (2014). Incorporating materiality considerations into analyses of absence from sustainability reporting. Social and Environmental Accountability Journal. 34(3). Pp.172-186.

Online

Appendix. Cloud9. (2011). [PDF]. Available Through <Appendix-CloudNine-F%20(1).pdf>. [Accessed on 30^th March 2017.]