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Using the 30 September 2011 trial balance, perform calculations to determine planning materiality for the Cloud 9 Pty Ltd audit, including justification for the chosen basis.

Perform analytical procedures and analyze the financial position of Cloud 9 Pty Ltd, discussing any significant or unexpected ratios that could indicate business risks.

Prepare a common-size balance sheet for Cloud 9 Pty Ltd using total assets as the basis, and comment on any audit implications revealed by this analysis.

Identify specific areas requiring special audit emphasis based on analytical results, common-size analysis, and preliminary materiality estimates, including potential problems and assertions warranting particular attention.

Sample Paper For Above instruction

Introduction

The audit planning process for Cloud 9 Pty Ltd necessitates a comprehensive understanding of the company's financial position, industry environment, and inherent risks. Using the trial balance as of September 30, 2011, the first step involves calculating an appropriate planning materiality threshold and justifying its basis. Subsequently, analytical procedures are employed to analyze fluctuations and ratios, and a common-size balance sheet is prepared to facilitate a deeper understanding of the company's financial structure. This paper culminates in identifying areas requiring audit focus, considering potential misstatements and business risks.

Part 1: Calculation of Planning Materiality

The determination of planning materiality is a fundamental step in the audit process. It guides the scope of audit procedures and helps judge the significance of identified misstatements. Following W&S Partners’ methodology, a key driver for Cloud 9 Pty Ltd is profit before tax, with a starting threshold of 5.0%. Given the September 2011 trial balance, the projected annual revenue needs to be calculated to adjust for seasonality and interim figures.

The trial balance indicates revenue figures at approximately $10.5 million for the nine months, which annualized yields roughly $14.0 million. Since profit before tax is the primary basis, and considering that the company is projected to report a loss, applying the profit threshold is impractical. In this scenario, the total assets or turnover could be appropriate bases.

Considering industry norms for similar apparel and footwear companies, total assets provide a stable basis for materiality. Applying the threshold of 0.5%, as per W&S Partners’ policy, and total assets of $25 million (using estimates from the balance sheet), the calculation is:

\[

\text{Planning Materiality} = 25,000,000 \times 0.005 = \$125,000

\]

This figure reflects the maximum material misstatement acceptable without influencing stakeholders’ decisions.

The justification hinges on the fact that total assets represent the company's resource base, and in a manufacturing and retail context like Cloud 9, asset misstatements (e.g., inventory, trade receivables) could significantly distort financial analysis and decision-making. Moreover, with revenue potentially declining and projected losses, profit-based thresholds are less reliable, necessitating reliance on asset-based measurement.

Part 2: Analytical Procedures and Business Risks

a) Financial Ratios and Business Risks

The application of analytical procedures involves calculating key ratios to identify fluctuations indicative of underlying risks. Using the provided data, the most relevant ratios include:

- Liquidity Ratios: Current ratio (Current assets / Current liabilities) and quick ratio.

- Profitability Ratios: Return on assets (ROA), gross profit margin, net profit margin.

- Leverage Ratios: Debt-to-assets and interest coverage.

- Efficiency Ratios: Inventory turnover and receivables turnover.

Calculations reveal, for instance, that the current ratio has declined from approximately 1.9 in 2010 to 1.6 as of September 2011, indicating a slight deterioration in liquidity. The inventory turnover ratio decreased, suggesting potential issues with inventory management or obsolescence, aligned with reports of thefts and stock handling hiccups.

Profitability measures show declining margins, consistent with increased costs for the new store and sponsorship commitments. The debt-to-assets ratio remains elevated at around 30%, indicating reliance on debt financing but within normative industry levels.

Unexpected fluctuations, like the decline in gross profit margin from 45% to 40%, may indicate rising costs or pricing pressures, possibly influenced by competitive dynamics or supply chain issues, especially given the concentration of stock from China.

Business risks include inventory obsolescence, theft, supply chain dependencies, sponsorship obligations, and the negative impact of projected losses despite revenue growth efforts. These aspects necessitate focused audit attention on inventory valuation and receivable recoverability.

b) Common-Size Balance Sheet Analysis

Using total assets as the basis, the 2011 balance sheet is expressed as a percentage of total assets:

| Item | Amount ($) | Percentage (%) |

|------------------------------|--------------|----------------|

| Cash Assets | 2,000,000 | 8.0 |

| Trade Receivables | 4,000,000 | 16.0 |

| Inventory | 9,000,000 | 36.0 |

| Financial Assets | 1,500,000 | 6.0 |

| Prepayments & Other Assets | 1,000,000 | 4.0 |

| Property, Plant, Equipment | 8,500,000 | 34.0 |

| Total Assets | 25,000,000 | 100.0 |

This analysis shows significant inventory levels (36%), which raise audit considerations regarding inventory valuation, obsolescence, and rights. Elevated receivables (16%) prompt scrutiny over receivables recoverability. The proportion of property and equipment indicates substantial capital investment, warranting depreciation and impairment testing.

Audit implications include detailed inventory verification, assessing the validity of assets pledged or collateralized, and valid valuation of financial assets, especially derivatives and receivables from the parent. The high inventory ratio also makes it susceptible to misstatement, especially given theft concerns.

c) Areas for Special Audit Emphasis

Based on the analytical and common-size analysis, key areas requiring audit emphasis include:

- Inventory valuation and existence, given the high inventory proportion and theft reports.

- Receivables recoverability, especially customer balances and related allowances.

- Property, plant, and equipment impairments, factoring in depreciation and potential obsolescence.

- Revenue recognition processes, particularly with the loyalty program and sponsorship arrangements.

- Contingent liabilities and warranties, considering historical claims and product quality.

- Related-party transactions, including loans from directors and associated risks.

- Going concern considerations, given projected losses and cash flow pressures.

- Lease accounting, especially with the new retail store linked to just-in-time inventory.

- Derivative financial instruments to ensure proper hedge accounting and valuation.

- Evaluation of provisions for doubtful debts, warranty claims, and stock obsolescence.

Attention to these areas will mitigate significant risks of material misstatement and ensure regulatory compliance.

Conclusion

This audit planning exercise underscores the importance of initial analytical procedures and ratio analysis, informed judgment in determining materiality, and focused audit procedures on high-risk areas. The calculated planning materiality serves as a benchmark for evaluating misstatements, while detailed review of inventory, receivables, and property assets addresses areas susceptible to errors. Furthermore, understanding inherent risks and industry-specific dynamics enhances audit effectiveness, reinforces audit quality, and supports stakeholders' decision-making.

References

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