You have been assigned as the audit senior for the audit of Luxury Leathergoods Inc. (LLI), which is a new client. Based upon your audit firm s client acceptance procedures, it was determined that LLI s management team is highly experienced and has high integrity. LLI changed auditors because it wanted an audit firm with more experience with Initial Public Offerings (IPOs). Discussions with the previous auditor indicated they had encountered few problems in the past, although last year there was a dispute regarding the valuation of inventory.
LLI is a 55-year old Canadian public company that manufactures and retails quality leather goods including luggage, briefcases, and purses. LLI s philosophy is to offer its customers a variety of prices but to never compromise on quality. About half of its revenues are generated through credit sales to a variety of specialty luggage stores in North America and Europe. The other half comes through its own boutiques in Canada.
The Canadian retail industry is characterized by fierce competition. Retailers are serving customers without borders, and as such they face competition from US border cities and online. In addition, big-box retailers, such as Costco, and discount outlets put considerable pressure on retailers bottom-line. LLI is being pressured to offer more extensive discounts and more liberal return policies in order to remain competitive. Despite these challenges, the company continues to expand. It has ramped up store expansions, opening its first U.S. boutiques in New York City and San Francisco. It is also expanding beyond its luggage line to include a fashion collection of leather jackets for women.
In addition to the challenge of keeping luggage styles current and functional for the transport of rapidly changing technological devices, Canadian manufacturers face the additional challenge of producing their goods at costs that are comparable to those of Asian manufacturers. In fact, many Canadian manufacturers have moved their production offshore. However, LLI continues to manufacture its products at its Hamilton, Ontario facility.
In order to keep ahead of the competition, LLI invests heavily in research and development. Its state-of-the-art production facility includes an on-site tanning and dye house. This enables it to react quickly to the market with smaller production runs and by keeping core items in stock and ready to ship at a moment s notice. LLI also has a 5- member design team that travels worldwide to search out emerging styles and trends.Due to its heavy investment in research and development and the current shortage of additional capital (due to the worldwide recession), the company has been experiencing negative cash flows for the first time in 50 years. Management is negotiating with its bank for increased financing and may place an IPO in the next year (if the capital markets improve).
a) Based upon the above description, what are three industry and environmental factors that increase LLI s business risk? Explain why. Use the following format:
INDUSRTY / ENVIRONMENTAL FACTORS EXPLENATION
b) How effective is LLI at managing its business risk? Explain.
c) Based upon your analysis above, identify two financial statement accounts that would have high inherent risk? Explain why “ include in this discussion the most relevant assertions and the potential misstatement for the account.
d) Based upon the above description, what would you set audit risk (high, medium-high, medium, low-medium, or low) for the LLI audit engagement? Explain why.