Requirement, Focusing on M-1 Part I Understanding the Entity and It.docx

Requirement, Focusing on M-1 Part I: Understanding the Entity
and Its Environment, Follow the Instructions for Preparation
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Appendix M-1: Young Fashions - Understanding of Entity and
Its Environment
(
Observations and Suggestions
You are required to obtain an understanding of your client and
its environment. Not only does this understanding allow you to
identify and assess risks of material misstatement, it also allows
you to exercise informed judgment about other audit matters
such as
materiality
and tolerable
misstatement.
whether
the client's selection and application of accounting policies
are appropriate and financial statement disclosures are
adequate.
areas
where special audit consideration may be necessary, for
example,
related party
transactions.

the
expectation of recorded amounts that you develop for
performing analytical procedures.
the
design and performance of further audit
procedures.
the
evaluation of audit
evidence.
Your understanding of the client encompasses the following
aspects of the clients business:
External
factors
The nature of the client, such as its operations and
organizational
structure
The clients objectives and strategies and resulting business
risks
How management measures and reviews the entity's financial
performance
The clients internal
control
This appendix illustrates an example form and the
documentation of your understanding of all of these elements,
except for
internal control.
Appendixes

M-2
,
M-2-1
,
M-3
,
and
M-4
illustrate the documentation of the understanding of internal
control
at
)
(
both
the entity and activity level, including an understanding of IT
controls.
This example assumes that the auditor will carry forward audit
evidence that was obtained in previous audits. When audit
evidence is carried forward in this manner, you should perform
procedures to determine that the audit evidence remains
relevant for the current audit. This example illustrates how you
might document the procedures performed to update audit
evidence from a prior period as well as the results of those
procedures.
Some of the procedures performed to update the understanding
of the entity involve inquiries of company management. As a
matter of audit efficiency, you may wish to make inquiries of
management about the risks of fraud (as required by AU section
316,
Consideration of Fraud in a Financial

Statement
Audit
[AICPA,
Professional Standards
, vol. 1]) when making inquiries to update your understanding
of the entity
and its
environment.
One of the primary objectives of obtaining an understanding of
the entity and its environment, including internal control, is to
identify risks of material misstatement. This example illustrates
how you might document identified risks of material
misstatement.
These risks of material misstatement have been cross-referenced
to
appendix M-5
, which illustrates how you might document your assessment of
the risk of material misstatement
All information that appears in this font style illustrates
information completed by the auditor.
)
Instructions for Preparation
This form documents the procedures performed and
understanding obtained about the following aspects of your
client's business:
· External factors
· The nature of the client

· The client's objectives and strategies and resulting business
risks
· How management measures and reviews the entity's financial
performance
Part I of this form is divided into four segments, which
correspond to these items. Within each segment are three parts:
· Understanding obtained in prior engagements. This part
presents your understanding of the client that has been carried
forward from previous engagements
· Procedures performed. This part documents the risk
assessment and other procedures you performed to determine
that your understanding from the prior period remains relevant
in the current period.
· Changes in the current period. This part documents changes at
the client or in its environment that you identified while
updating our understanding.
Part II of the form is the documentation of planning analytical
procedures. These procedures also provide audit evidence
supporting your understanding of the client and its environment.
Your understanding of the client and its environment may lead
you to identify risks of material misstatement. Part III of this
form summarizes the risks of material misstatement identified
in other parts of the form.
Part I: Understanding the Entity and Its Environment
Overview of the Client
As part of our client acceptance and continuance procedures, we
updated the general understanding of the client obtained in prior
years.

Understanding Obtained in Prior Engagements
Young Fashions is a privately held company that designs and
sells men's and women's apparel. The company has two distinct
brands: J Young Couture, which is a high-end, fashion forward
line, and JY Sport, which provides more casual wear. The
company sells it lines through department stores and clothing
stores and also operates a small chain of its own retail outlets.
The company does not manufacture its own garments, but
instead outsources the manufacturing to third-party suppliers
located in Asia and Europe. In most cases, Young owns the
goods at the manufacturer. See inventory system documentation
[not included in this illustration]. The company is owned by the
Young family and is run by the children of its founder.
In the prior year the Company recorded all adjustments
proposed by the auditor. In prior periods the auditor
communicated the lack of IT security and the need for an IT
director as material weaknesses. The company indicated these
issues would be addressed in the current period.
Written Understanding.
See Engagement Letter [not included]
Procedures Performed to Update our Understanding
We performed the following procedures to assess the continued
relevance of the audit evidence obtained in previous
engagements and to identify changes in the nature of the clients
overall business.
See Client Continuance Form (also includes procedures
performed) [not included]
Changes to Our Understanding in the Current Period
As a result of performing the procedures indicated, we noted the
following changes in the company's overall business that have

occurred since the prior engagement and that may affect the
current period audit.
The company hired an IT director during the year and security
controls have been strengthened over the year, although they
may not have been effective for the entire year. For further
detail, see the Internal Controls documentation (reference).
(
Observations and Suggestions
The remaining part of this appendix is divided into four
segments, each one relating to different aspects of the company
and its environment (for example, external factors, nature of the
client, and so on).
Each of these segments is further divided into the following
parts:
Understanding obtained in prior
engagements
Procedures performed to update the understanding obtained in
the prior engagement
Changes to the understanding of the client's business from the
prior
engagement
This organization scheme follows the process for updating your
understanding of the client's business from prior engagements,
which is discussed in more detail in paragraphs
3.128 -
.140
of this
guide.
)
External Factors

In obtaining our understanding of the apparel industry and other
external factors affecting the client, we considered the
following matters:
· Industry conditions
· Regulatory environment
· Government policies affecting the conduct of the client's
business
· Other external factors that affect the client's business
The men's and women's apparel industry is extremely
competitive, and no one brand dominates market share. J Young
Couture and JY Sport are smaller players in the industry and are
considered a niche brand. The competition for market share,
together with the constant availability of discounted garments
available over the Internet (for example, e-Bay and a variety
of discount retailers) create a consistent downward pressure on
prices.
The industry is quite seasonal, tracking with the four seasons.
Most designers release two collections per year, spring/summer
and fall/winter. The end of each season is marked by significant
markdowns by the company's customers in order to move
inventory and prepare for the new season. Within the retail
industry, these end-of-season markdowns are partially paid for
by the supplier (Young Fashions). Once the amount of the
markdown is determined, an allowance is calculated which is
used to offset the amounts due the supplier (Young Fashions).
The company's year end is December 31. By that date, all winter

merchandise has been shipped and most has been paid for,
although markdowns will still be coming in January, February,
and March (see working paper XXX for the audit of this
estimate). The December 31 year end means there will be low
inherent risk for the year-end shipping and sales cutoff, since
the winter line has been shipped and the spring line is not yet
ready to be shipped. There is some production of spring season
merchandise at December 31, and there might be shipments
between the vendor and the manufacturer or between the
manufacturer and the company warehouse. These are not
extensive since many of the vendors and manufacturers close
the last week of the year.
Since the early 19X0s, very few U.S. apparel companies have
manufactured their own garments, and Young Fashions is no
different. Suppliers generally are located in Europe
(predominately Italy) and Southeast Asia (Malaysia, Hong
Kong, and China).
Technology and IT systems play an important part in the
industry. Customers may stock out of items and need new
shipments; raw materials must be shipped to third-party
manufacturers; finished goods must be shipped to the company
warehouse or direct to customers; and customer orders must be
managed. To remain competitive, companies in this industry
have IT systems capable of managing all aspects of operations.
Larger retailers also require their suppliers (for example, Young
Fashions) to meet certain guidelines, which include supplier IT
systems that integrate with the retailer's inventory and
purchasing functions. Among other things, this integration
provides the supplier with information about inventory balances
and sales by product, which is important for estimating end-of-
season markdowns.
The use of off-shore suppliers is regulated and subjects the
company to certain laws and taxes. Changes in the regulations,

such as tariffs, can have a significant affect on company
business. Off-shore suppliers also subject the company to a
variety of federal and state taxes.
Some business practices that are standard in Europe or
Southeast Asia may be viewed as exploitive or unethical in the
United States. Issues such as employee working conditions may
cast the company in an unfavorable light and hurt its brand.
Procedures Performed
engagements and to identify changes in external factors
affecting the client:
· Discussion with Jane Young Ching (8/15), Josh Young (8/15),
and Bob Maguire, Operations Manager (8/22)
· Read memo dated February 10, X3 from Bob Maguire,
Operations Manager, and Barry Gregg, Sales Manager, to Young
Fashions' customers, "Current Weather Problems in Malaysia"
· Read article "Begnini Makes Good on Promises to Labor," The
Economist, April 8, X3
· Tracked monthly conversion rate of euro vs. U.S. dollar (see
working paper X-X) [not included in this guide]
· Reviewed the Young fashion Web site
· Searched on Internet for relevant articles in Apparel News
· Read report of CS Inc. (stockbroker) on apparel industry
· Read annual reports for key customers

following changes in external matters that have occurred since
the prior engagement and that may affect the current period
audit:
· Decline in the dollar versus the euro has resulted in increased
prices for finished goods and piecework performed in Europe.
Recent elections in Italy and changed political climate have
resulted in increases in wages paid to employees, increasing
prices for Italian goods.
· Amalgamated Federated acquired Bergman-Goodall luxury
department store during the year, continuing a general industry
trend toward consolidation.
· Unusually long and harsh monsoon season in Southeast Asia
severely disrupted shipping to and from Asian suppliers.
Nature of the Client
In obtaining our understanding of the client and other internal
factors, we considered the following matters:
· Business operations
· Investments
· Financing
· Financial reporting
The company has been in business for over 50 years and has
been a client of our Firm for 10 years. It was founded by Joseph
Young (who died 5 years ago) and is now owned and managed

by his children, Josh and Jane, who each own 30 percent of the
company. Mr. Young's widow owns 20 percent and is not active
in the business. Trusts for various grandchildren own the
remaining 20 percent.
The company's main wholesale customers for the J Young
Couture line are: Newman- MacLachlin, and Bernard's (a
wholly owned subsidiary of Amalgamated Department Stores).
The main wholesale customer for JY Sport is Amalgamated
Department Stores, which includes Ford & Mailer,
Mandelbaum's, Grosvernor's, and Daniel Fleisher's.
All the company's products are manufactured by independently
owned, foreign manufacturers under long-term contracts. The
company has two basic approaches to production:
· Purchase finished goods. Young Fashions buys finished
products from the supplier, who is responsible for the
purchasing and carrying of raw materials, in addition to the
manufacture of the product.
· Cut, make, and trim. Young Fashions buys raw materials and
piece goods and then moves these to finished product
assemblers who send the product to Young's warehouse or
directly to the customer. The ending inventory is expected to be
about 40 percent purchased finished goods, 40 percent finished
goods under the cut, make, and trim program, 10 percent raw
materials, and 10 percent work in progress at the assemblers.
The company has two warehouses, one in San Diego and another
in Philadelphia. As a way to prevent costly "stock outs," the
company maintains a high level of "basic" products, such as
shirts and blouses. Customers can order these products at any
time, and they will be shipped within five business days.
The company does not undertake any research and development

in the traditional sense of the term. However, they actively
search for new fabrics for their designs.
The company owns its own headquarters. It finances its
inventory and other operations primarily through cash and a
revolving line of credit, secured by receivables and inventory.
engagements and to identify changes in the nature of the client:
Lori Feldman, Finance Manager (8/16), and Bob Maguire,
Operations Manager (8/22)
following changes in the nature of the client that have occurred
since the prior engagement and that may affect the current
period audit:
· As a result of its acquisition by Amalgamated Federated,
Bergman-Goodall is now a major customer of Young Fashions.
This company has a strong balance sheet but is known in the
industry as being a tough negotiator on returns, disputes, and
markdowns. We will address this issue in our tests of
markdowns.
· In June, the company hired a full-time IT director, Robert
Haner. (Previously, the function was performed by Lori
Feldman, Finance Director, and one IT assistant. Most IT
functions were outsourced.)
· Company is considering changing suppliers for some goods
from Italian companies to those located in Romania or Poland.

Objectives, Strategies, and Business Risks
In obtaining our understanding of the client's objectives,
strategies, and related business risks, we considered the
following matters:
· How the entity addresses industry, regulator, and other
external factors that affect it
· Effects of implementing a strategy, including any effects that
will lead to new accounting requirements
The company's main objectives are
· continued growth.
· repositioning of the brand as a value-priced luxury brand,
competing against other luxury brands (for example, Giorgio
Pirandello, Bosch, L'Estrada) on the basis of price. This
positioning is different from its traditional position as a high
quality, bridge-line brand competing against other bridge-line
brands (Barry Ferris, Brutini, Amy Thomas).
The main strategies for achieving these objectives include
· expanding the line of women's and men's wear across the J
Young Couture line, which generally has higher margins than
the JY Sport line.
· expanding its retail outlet network.
· de-emphasizing sales to Amalgamated Federated to
concentrate more on the luxury retailers (although still selling
to Amalgamated Federated).

· maintaining a high quality IT system as a way to decrease the
long lead time between the design of new garments and their
sale. Decreased lead times allow the company to be more
responsive to customers, reducing end-of-the-season markdowns
and inventory carrying costs.
The main business risks associated with the company's
strategies include
· there are fewer customers for the J Young Couture line than
for the JY Sport line. Additionally, couture customers tend to be
more loyal to their long-time brands, creating a barrier for
expanding into this market.
· marketing costs for luxury brands are higher than the
marketing for bridge-line brands. Additionally, competing
successfully against other luxury brands will require significant
image marketing.
· amalgamated Federated is one of the company's main
customers, and there is the risk that increased income from sales
to luxury retailers will not offset any decrease in income from
sales to Amalgamated Federated.
· constant upgrading of IT systems carries the risk that the new
systems will not work as planned, will take longer than
expected to implement, or will cost more than anticipated.
Company Responses: The company has developed the following
strategies and controls or dealing with these risks:
· Hired a new IT director to attempt to reduce the IT systems
risks
· Changed the commission structure to offer higher commissions

for sales of the Couture line
· Significantly increased the advertising budget and the co-
CEOs review the results of advertising
· CEO meetings with key customers
engagements and to identify changes in the client's objectives
and strategies and related business risks:
Robert Haner, IT Director (8/24), and Bob Maguire, Operations
Manager (8/22)
· Read letter from Josh and Jane dated 5/17/03 announcing
launch of women's accessory line for spring/summer to its
customers
· Read minutes of quarterly Board of Directors Meeting, 1/20,
7/18 and 9/05
following changes in the client's objectives and strategies and
the related business risks that have occurred since the prior
engagement and which may affect the current period audit:
· Upgraded versions of order management application.
· Added a mid-range AS 400 computer to its configuration.
· Working to install a report-writing application that will
provide management with more and better reports to help plan
operations and manage the business.

· Expanded line of both men's and women's lines of J Young
Couture. Launched a new line of women's accessories in Q4 (J
Young Couture).
· Have not fully integrated new accessories line with the
inventory management system, which has prevented
management from monitoring inventory levels for accessories
sold through wholesale customers. This condition creates a risk
of material misstatement of the financial statements—see part
III, risk #3, for additional comments and follow-up.
· Did not actively pursue repositioning of brand or de-emphasis
of sales of JY Sport to Amalgamated Federated, due to higher
labor and materials costs for Italian goods.
Measurement and Review of Financial Performance
In obtaining our understanding how management measures and
reviews the entity's financial performance, we considered the
following matters:
· Key ratios and operating statistics
· Key performance indicators
· Employee performance measures and incentive compensation
policies
· Trends
· Use of forecasts, budgets, and variance analysis
· Analyst reports and credit rating reports
· Competitor analysis

· Period-on-period financial performance (revenue growth,
profitability, and leverage)
Company management uses the following measures to monitor
the company's financial performance:
· Cash on hand, receivables, and payables. This gives
management a quick assessment of liquidity.
· Total inventory balance. These balances will fluctuate
depending on the season. Total receivables plus inventory
compared with loan balance—these assets are pledged as
collateral for loan. Loan agreement requires receivables and
inventory to be at least twice the loan balance at end of each
month.
· Budget to actual comparisons for sales and gross margins by
product line and for the company as a whole, operating
expenses, net income, cash on hand, receivables and payables.
· Sales, gross margins, inventory turnover, and receivables by
product line. This is a primary measure of company
performance. It is used to determine whether Company is
meeting its financial goals. Markdowns and other credits are
monitored by product line, since this is a risk area.
· Sales by product line by customer. Report provides
information on sales channel inventory levels, which is
necessary to estimate end-of-season markdowns.
· Net income. Also used as the internal primary measure of
company performance.

Note: Data in most reports is summarized at a highly aggregated
level. See evaluation of entity- level controls (appendix M-2 )
for further consideration.
engagements and to identify changes in the way management
measures and reviews the entity's financial performance:
Barry Gregg, Sales Manager (8/16), and Lori Feldman, Finance
Director (8/16).
· Read minutes of quarterly Board of Directors meetings: 1/20,
5/05, 7/18 and 9/05.
Read the following reports: Quarterly financial statements for
quarters ended 6/30 and 9/30; quarterly budget to actual
worksheets for 6/30 and 9/30; Sales Analysis Report 6/30 and
9/30.
· E-mail thread from Barry Gregg, Sales Manager, to Bret
Jensen, Salesman, and Lori Feldman, Finance Director; subject:
"second quarter results." Thread was started 7/12 and asks for
explanation of variances between budget and actual for sales to
Newman- MacLachlin.
following changes in management's measurement and review of
the company's financial performance that have occurred since
the prior engagement and that may affect the current period
audit:
· Management is monitoring company-wide technology
expenditures and marketing costs by product line

Other reports that management will receive with new reporting
application include
· orders from customers, by customer and product line. This
helps develop expectations of sales for the next month and also
alerts management to possible stock outs.
· supplier reports. These reports show orders placed with
suppliers, the status of shipments, the amounts paid and owed.
· sales, gross margins, and receivables by customer.

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