Bill Travis owns two Just 4 Kids stores in Florence, SouthCarolina. He believes that the stores have been successful and hewants to open a new store in Sumter about 30 miles west ofFlorence. Bill has been in the retail line for over 20 years, andhe worked at his uncleâs hobby shop while in high school andcollege before starting his own store at the age of 25.

Two big secrets to a successful toy store operation are goodlocation and product selection. Billâs first store is located indowntown Florence. Since Bill had been born and raised in Florence,he attracted a good customer base that remained loyal to his storeafter some of the giant chain related toy stores began to move intothe area. About 10 years ago, Bill saw the change in customershopping habits and purchased a second store near an interchange toInterstate 95 in a rapidly growing retail area. Lots of newfamilies had moved into the area, and Bill could not totally relyon the âgood old boyâ market alone to sustain his market share.This second store catered to the younger more mobile generationthat shopped at or near malls.

Bill now was looking into other markets. Sumter was not locatedon the interstate, but the area was growing because of itsproximity to the state capital of Columbia, which was just 30 milesto its west. Bill believed that the people of Sumter who commutedto work in Columbia would prefer to limit their driving forshopping activities to the immediate Sumter area. Also, since Billwas a respected citizen of Florence, his reputation as an honestbusinessman had spread to Sumter. He believed he could quicklybuild up a new customer base in that location. The big chain typestores also did not seem as interested in the Sumter area,preferring instead to locate in the larger metropolitan areas ofColumbia and Florence.

The appropriate toy items to feature in his stores were veryimportant. Bill felt that his area of influence was strictlyregional, and he did not have to carry much of the standardinventory of the national chain type of toy stores. His toy lineswere more a reflection of local interest; thus NASCAR related itemswere hot sellers. Billâs clientele also seemed interested incomputer action games and a new line of Yaâll talking dolls.

Bill went to the Florence National Bank to inquire about fundingfor the new store location. He had found an abandoned furniturestore in downtown Sumter along Main Street that was up for sale for$280,000. The store seemed to be the right size and at a goodlocation. A grocery store was in the same block with ample offstreet parking. Bill brought his balance sheet for the last twoyears and an income statement for the last operating year to thebank to support his request for a retail loan of $250,000. (Copiesof the financial statements are listed at the end of the case.)

Nick Tightwad, the local bank loan vice president had been afriend of Billâs for many years. He was a customer at Billâs toystore on close out sales, and his bank had underwritten the fundingfor the second store. Nick was excited about Billâs expansion goalsand the prospect of another business loan with his friend. At thesame time, Nick had to live up to his reputation. He was not aboutto approve a loan unless he was almost 100 percent sure that theborrower would not default. Billâs past success had alleviated muchof Nickâs concern, but he still wanted to complete a detailedanalysis of the financial performance of Just 4 Kids during thelast calendar year. Upon reviewing the balance sheet, Nick noticeda drop in cash during the last year even though Bill showed astrong profitable performance. The current financial statements didnot seem to give enough information to answer Nickâs questions andhe asked Bill to prepare a statement of cash flows for the yearending December 31, 20x7.

Just 4 Kids

Balance Sheet

December 31, 20x6

ASSETS
Cash		$ 38,500
Accounts Receivable		43,000
Inventory		126,000
Other Current Assets		17,500
Total Current Assets			$225,000
Land		$100,000
Furnishings, Fixtures & Vehicles	$150,000
Less Accumulated Depreciation	-30,000
Furnishings, Fixtures & Vehicles (net)		120,000
Building	400,000
Less Accumulated Depreciation	175,000
Building (net)		225,000
Total Long-Term Assets			445,000
Total Assets			$670,000

LIABILITIES
Accounts Payable		$ 57,500
Short-Term Notes Payable		20,000
Other Current Liabilities		13,000
Total Current Liabilities			$ 90,500
Long-Term Notes Payable			400,000
Total Liabilities			$490,500
EQUITIES
Capital		$100,000
Retained Earnings		79,500
Total Equities			$179,500
Total Liabilities and Equity			$670,000

Just 4 Kids

Income Statement

For the Year Ended December 31, 20x7

Sales Revenue		$600,000
Less Cost of Goods Sold		310,000
Gross Margin		290,000
Less Operating Expenses
Selling and Administrative	$106,200
Depreciation	20,000
Total Operating Expenses		126,200
Operating Income		163,800
Interest Expense	$50,000
Loss on Vehicle Sale	2,500
Total Other Expenses		52,500
Net Income Before Taxes		111,300
Less Income Taxes		39,300
Net Income		$72,000

Just 4 Kids

Balance Sheet

December 31, 20x7

ASSETS
Cash		$2,600
Accounts Receivable		71,000
Inventory		193,000
Other Current Assets		18,900
Total Current Assets			$285,500
Land		$100,000
Furnishings, Fixtures & Vehicles	$166,000
Less Accumulated Depreciation	-28,500
Furnishings, Fixtures & Vehicles (net)		137,500
Building	400,000
Less Accumulated Depreciation	190,000
Building (net)		210,000
Total Long-Term Assets			447,500
Total Assets			$733,000

LIABILITIES
Accounts Payable		$ 91,500
Short-Term Notes Payable		35,000
Other Current Liabilities		7,000
Total Current Liabilities			$133,500
Long-Term Notes Payable			388,000
Total Liabilities			$521,500
EQUITIES
Capital		$100,000
Retained Earnings		111,500
Total Equities			$211,500
Total Liabilities and Equity			$733,000

Required:

1. Develop a Statement of Cash Flowsfor Just 4 Kids for the year ending December 31, 20x7.

2. Analyze the performance of Just 4Kids based on the financial statements.

3. If you were Bill, how would you explain the issues, whichcould be brought up from the analysis completed in parts 1 &2?

4. If you were Nick, would you approve the loan for Bill? Why orwhy not?

orchidgoat833

BACKGROUND INFORMATION

Wallace & Davey Partners, Chartered Accountants is a mediumsize accounting firm located in Auckland with 4 audit partners, 7business advisor partners and 4 tax partners. The firm has beenappointed to audit Cool and Cute Children Fashion Ltd for the yearended 31 December 2016. The former auditors have been rotated offthe client. The engagement partner is Patrick Wallace, and you arethe audit manager assigned to this client. Your firm does not haveexperience in children fashion industry, but Wallace thinks it is agood opportunity to learn about the industry. The fee for thefinancial audit of Cool and Cute is $150,000, which is about 16% oftotal audit fees your firm generate. The company would also requireadvice on taxation and treasury. Since this is a first time audit,you accompanied Wallace to meet the senior management of theclient. The following is a summary of your notes from theinterviews with senior management of Cool and Cute ChildrenFashion.

NOTES FROM CLIENT INTERVIEW: T

he company profile

Cool and Cute Children Fashion is an Auckland companyincorporated in 1990. It was founded by Sally Hall, a formerchildrenswear buyer, and a mum. Hall spotted a gap in the marketfor quality and fashionable childrenswear and started the brandwith a mail order catalogue. Hallâs mail order catalogue was verypopular and soon after she opened the first Cool and Cute retailstore. By 1994, Cool and Cute headed into Australia as a mail ordercatalogue, opening its first Australian store three years later.Cool and Cute adapted to ecommerce in 2001, launching atransactional website to service its Australasian markets. Cool andCuteâs rise seemed unstoppable in the early 2000s. It secured itsfirst US wholesale partner Nordstrom in 2002, and in 2003 addedAustralian department store David Jones as a distribution channel.In 2004 it listed on the NZ stock exchange and opened franchisepartner stores across the Middle East. Retail stores in the US,franchises in Singapore, Malaysia, Indonesia, South Africa andPakistan followed, along with the companyâs first ecommerce websitein 2006. Around that time, the founder Hall stepped down from theBoard, leaving the directors to find a new managing director. Sincethen, the company has changed three Managing Directors. The fastexpansion of Cool and Cute was heavily financed through debts,which contributed to a highly geared financial position. It createdpressure for the company in serving the high level of debts. Thecompanyâs expansion ceased in 2007 and its shares price peaked inJanuary 2007 at $4.95 per share. By November 2016, the share pricedropped by 60% to $1.98. As of 2015, the company closed its storesin nearly all international markets, with just 92 stores remainingacross Australia, New Zealand and Ireland. Market commentatorsbelieve that the deterioration of Cool and Cuteâ financialperformance were largely because its inability to sustain the rapidglobal expansion. 4 Despite the highly competitive retail market,the core retail businesses in New Zealand and Australia haveperformed well in the current financial period and progress hasbeen made to improve stock efficiency. Despite the difficulties inperformance, the new Managing Director Neil Jenkins, who wasappointed in June 2015, is confident that the company can be turnedaround because the brand is still strong and well recognised. Thecompany also has reduced net banking debt by $20 million, and itsbanking facilities are secured until the end of 2017. Before he wasappointed as the managing director, Jenkins was an experienceddirector and was the CFO of a large retailing chain in NZ. At themeeting, you discovered that Jenkinsâ daughter works for your firmas an audit graduate. The new Managing Director Neil Jenkins ischanging its business strategy, which aimed at repositioning itselfin the market. The new MD has a turnaround plan. He says that âCooland Cuteâs must redirect its focus to customers, the style ofclothes parents desire to buy for their kids and enhance customersâexperience in the stores. To achieve this, investment will berequired in new design of products, marketing channels and onvarious customer communication mediums.â

Competition in the market

In recent years, clothing retailers in Australia and New Zealandhave struggled. Although Cool and Cute is the biggest player in themarket, it claims to have only 4.2% of the kids fashion market. Itcompetes with brands carried by department stores as well as smallboutiques such as Seed, H&M and Cotton On Kids etc.

Financial situation

Cool and Cute delivered a $9,079,000 after-tax loss for the yearended 31 December 2016, an improvement compared to the prior yearloss of $11,495,000. Jenkins said "the financial position of thecompany has improved significantly over the last year in particularand we have formed a very strong working relationship with thebank. Over the last 12 months, we have made significant progress inreducing inventory level. Our debts (interest bearing liabilities)also have dropped from over $60 million last year to around $40million this year. In our view, this is material and has createdthe platform for us to move forward."

The structure of the Board of Directors

The board of directors consists of five members: the ManagingDirector and four independent directors at end of 2016 financialyear. Three of the four independent directors are also members ofthe Audit Committee. The Company has a formal Code of Conduct andEthics Policy. This policy provides guidance to all Directors,managers, employees and contractors of Cool and Cute Limitedexpected conduct when undertaking business on behalf of thecompany.

Communication with the prior auditor

With the clientâs approval, the predecessor auditor shared theiraudit file for the last financial year. You noted in the auditfile, a concern regarding the valuation of inventory. Thepredecessor auditor believed that the one of the inventory rangecalled âComfort maternity 5 wearâ had a long turnover time andshould be written off. The value of this particular label was 10%the total inventory. However management believed that it can stillbe sold at cost. Eventually no write-off was made for thisinventory range in the last financial statements. The previousauditor also noted that they questioned about the companyâs risk ofbreaching its bank covenant because the turnover was disappointing.The management argued that the company is in a transition periodand the poor performance was partially contributed by the failureof two suppliers because of a major flooding in a key supply regionin China.

Required:

A.Based on your audit planning, discuss which two Key AuditMatters should potentially be included in the Audit Report.

BACKGROUND INFORMATION

Wallace & Davey Partners, Chartered Accountants is a mediumsize accounting firm located in Auckland with 4 audit partners, 7business advisor partners and 4 tax partners. The firm has beenappointed to audit Cool and Cute Children Fashion Ltd for the yearended 31 December 2016. The former auditors have been rotated offthe client. The engagement partner is Patrick Wallace, and you arethe audit manager assigned to this client. Your firm does not haveexperience in children fashion industry, but Wallace thinks it is agood opportunity to learn about the industry. The fee for thefinancial audit of Cool and Cute is $150,000, which is about 16% oftotal audit fees your firm generate. The company would also requireadvice on taxation and treasury. Since this is a first time audit,you accompanied Wallace to meet the senior management of theclient. The following is a summary of your notes from theinterviews with senior management of Cool and Cute ChildrenFashion.

NOTES FROM CLIENT INTERVIEW: T

he company profile

Cool and Cute Children Fashion is an Auckland companyincorporated in 1990. It was founded by Sally Hall, a formerchildrenswear buyer, and a mum. Hall spotted a gap in the marketfor quality and fashionable childrenswear and started the brandwith a mail order catalogue. Hallâs mail order catalogue was verypopular and soon after she opened the first Cool and Cute retailstore. By 1994, Cool and Cute headed into Australia as a mail ordercatalogue, opening its first Australian store three years later.Cool and Cute adapted to ecommerce in 2001, launching atransactional website to service its Australasian markets. Cool andCuteâs rise seemed unstoppable in the early 2000s. It secured itsfirst US wholesale partner Nordstrom in 2002, and in 2003 addedAustralian department store David Jones as a distribution channel.In 2004 it listed on the NZ stock exchange and opened franchisepartner stores across the Middle East. Retail stores in the US,franchises in Singapore, Malaysia, Indonesia, South Africa andPakistan followed, along with the companyâs first ecommerce websitein 2006. Around that time, the founder Hall stepped down from theBoard, leaving the directors to find a new managing director. Sincethen, the company has changed three Managing Directors. The fastexpansion of Cool and Cute was heavily financed through debts,which contributed to a highly geared financial position. It createdpressure for the company in serving the high level of debts. Thecompanyâs expansion ceased in 2007 and its shares price peaked inJanuary 2007 at $4.95 per share. By November 2016, the share pricedropped by 60% to $1.98. As of 2015, the company closed its storesin nearly all international markets, with just 92 stores remainingacross Australia, New Zealand and Ireland. Market commentatorsbelieve that the deterioration of Cool and Cuteâ financialperformance were largely because its inability to sustain the rapidglobal expansion. 4 Despite the highly competitive retail market,the core retail businesses in New Zealand and Australia haveperformed well in the current financial period and progress hasbeen made to improve stock efficiency. Despite the difficulties inperformance, the new Managing Director Neil Jenkins, who wasappointed in June 2015, is confident that the company can be turnedaround because the brand is still strong and well recognised. Thecompany also has reduced net banking debt by $20 million, and itsbanking facilities are secured until the end of 2017. Before he wasappointed as the managing director, Jenkins was an experienceddirector and was the CFO of a large retailing chain in NZ. At themeeting, you discovered that Jenkinsâ daughter works for your firmas an audit graduate. The new Managing Director Neil Jenkins ischanging its business strategy, which aimed at repositioning itselfin the market. The new MD has a turnaround plan. He says that âCooland Cuteâs must redirect its focus to customers, the style ofclothes parents desire to buy for their kids and enhance customersâexperience in the stores. To achieve this, investment will berequired in new design of products, marketing channels and onvarious customer communication mediums.â

Competition in the market

In recent years, clothing retailers in Australia and New Zealandhave struggled. Although Cool and Cute is the biggest player in themarket, it claims to have only 4.2% of the kids fashion market. Itcompetes with brands carried by department stores as well as smallboutiques such as Seed, H&M and Cotton On Kids etc.

Financial situation

Cool and Cute delivered a $9,079,000 after-tax loss for the yearended 31 December 2016, an improvement compared to the prior yearloss of $11,495,000. Jenkins said "the financial position of thecompany has improved significantly over the last year in particularand we have formed a very strong working relationship with thebank. Over the last 12 months, we have made significant progress inreducing inventory level. Our debts (interest bearing liabilities)also have dropped from over $60 million last year to around $40million this year. In our view, this is material and has createdthe platform for us to move forward."

The structure of the Board of Directors

The board of directors consists of five members: the ManagingDirector and four independent directors at end of 2016 financialyear. Three of the four independent directors are also members ofthe Audit Committee. The Company has a formal Code of Conduct andEthics Policy. This policy provides guidance to all Directors,managers, employees and contractors of Cool and Cute Limitedexpected conduct when undertaking business on behalf of thecompany.

Communication with the prior auditor

With the clientâs approval, the predecessor auditor shared theiraudit file for the last financial year. You noted in the auditfile, a concern regarding the valuation of inventory. Thepredecessor auditor believed that the one of the inventory rangecalled âComfort maternity 5 wearâ had a long turnover time andshould be written off. The value of this particular label was 10%the total inventory. However management believed that it can stillbe sold at cost. Eventually no write-off was made for thisinventory range in the last financial statements. The previousauditor also noted that they questioned about the companyâs risk ofbreaching its bank covenant because the turnover was disappointing.The management argued that the company is in a transition periodand the poor performance was partially contributed by the failureof two suppliers because of a major flooding in a key supply regionin China.

Required:

A. Referring to the case facts, identify and explain potentialthreats to professional independence. Discuss possible safeguard toaddress each threat?

ACTG 2011 Lecture Notes - Lecture 7: Mcgraw-Hill Education, Financial Statement

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