Question

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. Hall’s 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 andCute’s 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 company’s 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. Thecompany’s 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 Cute’ 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 Jenkins’ 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 “Cooland Cute’s must redirect its focus to customers, the style ofclothes parents desire to buy for their kids and enhance customers’experience in the stores. To achieve this, investment will berequired in new design of products, marketing channels and onvarious customer communication mediums.”

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 client’s 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 “Comfort maternity 5 wear” 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 company’s 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.