Part 1 Materiality Question 1(a)

Base amount Profit before tax Turnover Total assets Equity

$ 2,037,184 37,194,932 24,100,276 3,995,084

PM

5.0% 101,859.20 5.0% 1,859,746.60 0.5% 120,501.38 1.0% 39,950.84

Since our firms methodology dictates that only one planning materiality (PM) amount is to be used for the financial report as whole, only one base should be applied for calculating the PM. Among the various possible bases to be selected, we have to prioritise the base that is most indicative of the key driver of the business. In this case, our client is engaging in a retail and wholesale business of selling shoes. Although profit before tax has been typically used as a base for calculating planning materiality, our clients income statement for the year 2011 has revealed inconsistent profitability (as evident from its losses in financial year 2011). Hence, it would not be a suitable base for planning materiality in this audit work. The total assets and equity figure constitute a historical record of the company and would not be a good representation of its financial performance. Thus, sales turnover would be the next best alternative base that would be an appropriate key driver of business performance. Sales from the ordinary activities of the retail store and wholesale business operation clearly constitute key drivers of the business performance. As such, planning materiality would be obtained by calculating 5% of the clients total sales turnover in its annualised income statement for 2011. Its sales turnover comprises of 2 revenue components revenue from the newly-opened store in Sydney and from the wholesale business operation. Annualised sales turnover = ( Planning materiality (PM) = ( ) ) . .

Based on this threshold, any items in our clients financial statement that has an amount greater than this value would be considered material. Conversely, any items with a lower value than this materiality threshold would be immaterial for our audit planning and fieldwork.

Part 2 Analytical Procedures Question 2(a) Analytical procedures through analysis of key financial ratios would provide valuable insights into our clients financial condition and business risks. Comparisons can be made between current-year ratios with those in previous years or even industry benchmark. Any unexpected or significant fluctuations revealed from such comparisons would necessitate indepth investigation as to whether the deviation could be attributed to misstatement of one or more variables used in calculating these financial ratios. Solvency ratios 2011 0.892 2010 1.009

Quick ratio is also known as the acid-test ratio that reveals the companys ability to meet short term operating needs by using its cash or near-cash assets. It is generally considered a more reliable indicator of a companys short term financial strength as it subtracts inventory from current assets (as inventory is considered to be the least liquid of all the current asset items) and compares only the quick assets to the current liabilities. Generally, the larger the ratio the greater is the liquidity. Cloud 9 Pty Ltds quick ratio has declined by approximately 11.6%. This indicates a lower protection afforded by its liquid assets against its short-term obligations towards creditors. 1.214 1.276

Current ratio measures the degree to which current liabilities are covered by all current assets. It is used to evaluate the firms ability to pay its short term debt obligations such as accounts payable and accrued expenses. The higher the ratio, the greater the assurance that current liabilities can be paid in a timely manner. In this case, the current ratio for the client has decreased by 11.8%. Although there is a slight drop in this ratio, a ratio maintained at more than 1 would generally not signal too big a concern. However, when the inventory figure is omitted from calculation (quick ratio above), the ratio falls below 1 which could be signals of potential trouble. In this case, analysis of current ratio alone might understate the possibly precarious financial position of our client. This is especially since the nature of the company is such that inventory tends to be quite difficult to liquidate, and inventory build-up might obscure the companys true ability in meeting short-term debt obligation. 4.418 3.248

The debt to equity ratio measures the extent to which a company is using its debt financing capacity. This is a measure of a companys financial leverage that indicates what proportion of equity and debt the company is using to finance its operations. An acceptable debt-toequity ratio would depend on economic factors and the industry in which a company operates within. Since our client is engaging in the retail and wholesale business of selling shoes, the preferred debt to equity ratio should not be one that is too high. The debt to equity ratio for Cloud 9 Pty Ltd has increased by 36.0% for the last fiscal year. The drastic jump in this ratio

implies an adverse situation for our client, as it might jeopardise the companys ability to meet its debt commitment, which might be aggravated by any unexpected rise in interest rates or downturn in the economy -0.91 2.911

Times interest earned (TIE) is a debt ratio that measures the long-term solvency of a business, through its ability to meet its interest expense obligations. The higher the number denotes a higher ability for the company to pay its interest expense in its debt. Cloud 9 Pty Ltd has experienced a tremendous decline in its times interest earned by 131.3%. TIE has fallen below 1 which suggests that our client will not be able to meet its total interest payments. A failure in meeting these debt obligations could potentially force the company into bankruptcy. Conclusion: An aggregate analysis of these solvency ratios seems to suggest a negative going concern issue for Cloud 9 Pty Ltd, as reflected by the decrease in the quick and current ratio in the current year. The omission of inventory in the calculation of quick ratio resulting in a ratio below 1, also further reveal problems in its true ability to meet short-term obligations with its liquid assets efficiently. Coupled with the increase in gearing ratio and TIE, the company may encounter difficulties in meeting its debt obligations as they fall due, which reinforces the threat to its survival.

Efficiency ratios 3.559 3.205

Accounts receivable turnover ratio indicates how many times the accounts receivable has been collected during the financial year. It is used to determine the companys ability in collecting sales made on credit and may also reflect upon its credit policy. Thus, the higher the turnover, the faster the business is collecting its receivables. There has been a decrease (16.7%) in this ratio for our client. This could imply a lowered ability in the companys efficiency in processing credit, or it could also suggest a looser credit policy undertaken. A decrease in this ratio would generally have a negative impact on its cash flow. 2.16 2.617

The inventory turnover is used to determine how rapidly inventory turns over. This is commonly used to determine whether a business is maintaining adequate levels of inventory. A low turnover implies poor sales and is usually a bad sign because goods tend to deteriorate as they sit in a warehouse. Conversely, a high ratio may suggest that the company has strong sales or inadequate inventory levels which may lead to a loss in business. The inventory turnover for our client has decreased by 17.5%. This is a concern as a lowered value may indicate that there is overstocking, obsolescence, or deficiencies in the product line or marketing effort.

1.558

1.395

Conclusion: The efficiency ratios measure how effectively the company uses its assets. An improvement in the ratios generally translates to improved profitability. Cloud 9 Pty Ltd has experienced an increase in both accounts receivable turnover ratio and asset turnover ratio which hints that there may have been an improvement in their performance. However, a decrease in the inventory turnover may point to a negative aspect for the company as they are in the retail industry where the inventory turnover ratio is normally relatively higher. Nevertheless, assuming all else constant, an analysis of the efficiency ratios indicates that the company has been more efficient in utilizing their assets in the last financial year.

Profitability ratios

0.0417 0.07233

Return on sales measures the profit earned per dollar of sales. It indicates a companys ability to earn satisfactory profits for owners, and its ability to withstand adverse conditions such as falling prices, rising costs, declining sales. With just a slight marginal dip in this ratio from the year 2009 to 2010, there was unfortunately a sharp decline of about 273.45% in the return on sales ratio from the year 2010 to 2011. The negative return yielded 2011, has been attributed mainly to the huge loss evident in its income statement, coupled with its lower sales revenue in the year. ( ) -0.0845 0.0581 ( ) ROA measures the amount of profit earned relative to the firm's level of investment in total assets. The higher the ratio, the better is the management of assets in generating sales. There is a significant decrease in the ratio from 2010-2011, by approximately 245.44%. Similar to the return on sales, given comparable total assets figure over the years, the largely negative ROA ratio in 2011 is mainly due to its negative operating profit in 2011. This indicates the companys inefficiency in managing its investment in assets and using them to generate profit. -0.306 0.193 ( )

Being the most important financial ratios to shareholders and potential investors, ROE measures the return on the money the investors have put into the company. Generally, a minimum of 10% would be considered desirable to provide funds for dividends and growth. Cloud 9 Pty Ltd suffers a downward plunge of 259% in its ROE in 2011 compared to 2010. This significant drop in ROE to a negative 30.6% reflects managements failure to earn an adequate return on capital invested by shareholders. Given the constant equity figure over the 2-year period, the sudden tremendous loss figure in 2011 of almost $2 million has been the main culprit for the negative ROE. Conclusion:

Upon review of the common-size balance sheet in Figure 1.2, there is a significant decrease in the cash assets that is held on hand in 2011 (1.02%) as compared to 2010 (7.13%). Referring to the various expenses incurred by the company, a substantial amount of money has been invested for advertising and promotion in conjunction with the effort to boost the Cloud 9 brand as the Sydney retail store is opened. Hence, the sharp reduction in cash PPE increase: issue of existence assertion? Payables increase: `

Interest-bearing liabilities

SALES REVENUE The 2011 income statement reveals a huge decrease in sales revenue figure compared to the 2010 sales, and this fluctuation would require investigation. A close analysis of the components of the sales revenue shows that the overall sales decrease has been due to the decline in its regular wholesale revenue. The opening of the new Cloud 9 store in Sydney CBD may have resulted in greater focus shifted away from its regular wholesale business operation towards the operation of the new store. However, the increase in sales from the retail store has not been able to compensate for the decrease in sales in its wholesale operation. Coupled with its low profit margin, the retail store sales figure has not been forthcoming. The low sales from its retail store could also have been attributed to incidences of stock-out, as indicated by the management team reports that there have been difficulties in determining ideal stock quantities for the store to allow optimum availability of merchandise to the customers. Such loss of potential sales constitutes an opportunity cost that would be expensive to be borne by the company in the long run. We have to investigate into the efficiency of JIT system. As such, the occurrence and completeness of the sales figures would be pertinent. Sponsorship agreement was entered into by Cloud 9 Pty Ltd, in the bid to promote and build the Cloud 9 brand in Australia. A substantial amount of resources has been devoted for these advertising and promotion purposes to boost sales, especially for the newly-opened retail store. The percentage of sales pertaining to the retail store should be reviewed to assess the implication for the business if problems occur with the sponsorship deals. Cloud 9 Pty Ltd also suffers a tremendous loss in its 2011 financial year, as evident in the income statement (Appendix?). This has mainly caused the negative profitability ratios yielded from the analytical procedures conducted. The decrease in the quick and current ratio in the current year further seems to suggest a negative going concern issue for Cloud 9 Pty Ltd. The omission of inventory in the calculation of quick ratio resulting in a ratio below 1, also further reveal problems in its true ability to meet short-term obligations with its liquid assets efficiently. Coupled with the increase in gearing ratio and TIE, the company is likely to be experiencing difficulties in meeting its debt obligations as they fall due. The increase in payables figure by 8.61% with the simultaneous deterioration in accounts receivable turnover further reinforce the threat to Cloud 9 Pty Ltds going concern. It would thus be crucial to verify the existence, completeness and cut-off assertions of the receivables and payables account. Based on our planning materiality level, inventory figure would also be a material item that requires special emphasis in our audit in relation to the existence and completeness assertion. Due to the declining sales in the current year, it would also be crucial to verify the valuation and allocation assertion of inventory, which could have been impacted by the possibility of obsolescence etc. As mentioned in the analysis of the common-size balance sheet, the purchase of additional plant, property and equipment in the year also necessitates the verification of the existence, completeness, valuation and allocation assertion of these new. Due to the degree of difficulty in estimating useful lives and residual values, we have to

enquire management with regards to the policy and procedures used for their estimation and also the depreciation method selected. In addition to that, the presence of several factors that may lead to incentives for management to manipulate certain financial figures is a concern. This includes the incentive compensation offered by the company, where 3 of its top finance personnel are entitled to participate in the employee share-purchase plan and receive stock options in Cloud 9 Inc, if revenue targets are met. This is aggravated by the pressure exerted from its parent company in increasing revenue by 3% for the 2011 fiscal year. Clearly, it was a challenge and even unrealistic for the company to achieve that target in 2011 given the subsequent increase in costs from the newly opened retail store, and sponsorship deals. Such incentive-based compensation and undue pressure, in the absence of necessary controls, encourage the undertaking of aggressive accounting choices or even fraudulent financial reporting practices to achieve the sales target, e.g. overstatement of sales figure via fictitious sales, understatement of expenses etc.