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Requirement, Focusing on M-1 Part I: Understanding the Entity and Its Environment,

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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

Understanding Obtained in Prior Engagements

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

We performed the following procedures to assess the continued relevance of the audit evidence obtained in previous 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

Changes to Our Understanding in the Current Period

As a result of performing the procedures indicated, we noted the 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

Understanding Obtained in Prior Engagements

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.

Procedures Performed

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 client:

· Discussion with Jane Young Ching (8/15), Josh Young (8/15), Lori Feldman, Finance Manager (8/16), and Bob Maguire, Operations Manager (8/22)

Changes to Our Understanding in the Current Period

As a result of performing the procedures indicated, we noted the 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

Understanding Obtained in Prior Engagements

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

Procedures Performed

We performed the following procedures to assess the continued relevance of the audit evidence obtained in previous engagements and to identify changes in the client's objectives and strategies and related business risks:

· Discussion with Jane Young Ching (8/15), Josh Young (8/15), 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

Changes to Our Understanding in the Current Period

As a result of performing the procedures indicated, we noted the 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)

Understanding Obtained in Prior Engagements

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.

Procedures Performed

We performed the following procedures to assess the continued relevance of the audit evidence obtained in previous engagements and to identify changes in the way management measures and reviews the entity's financial performance:

· Discussion with Jane Young Ching (8/15), Josh Young (8/15), 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.

Changes to Our Understanding in the Current Period

As a result of performing the procedures indicated, we noted the 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.