Nike is an American multinational organization which has worldwide presence and their principal business is design, development and worldwide marketing and selling of high quality of footwear, apparel, equipment, accessories and services. It is the largest provider of athletic shoes and sports equipments worldwide. It is headquartered in Washington County, Oregon in the USA. It was founded way back in 1964 as Blue Ribbon Sports by Phil Knight and Bill Bowerman. It eventually became NIKE Inc. in 1978. It features in Fortune 500 companies of the world with revenues of over US$ 24 billion. It is a public firm and it is listed on NYSE stock exchange as NIKE. They sell their products to retail accounts through NIKE owned retail outlets and Direct To Consumer, an internet channel, and through a mix of independent distributors and licensees in approximately 190 countries around the world.
Their products are manufactured by independent contractors. They manufacture all of their footwear and apparel products outside the United States while equipment products are also produced inside the United States apart from foreign countries. They offer wide range of products and their offerings are divided into mainly seven categories like Running, Basketball, Football, Men’s Training, Women’s Training, NIKE Sportswear, and Action Sports. Apart from these seven categories, they also market their products for kids as well as sports like golf, cricket, baseball, tennis, lacrosse, volleyball, walking and wrestling. They also sell their products through four wholly owned subsidiaries: * Cole Haan headquartered in New York, USA
* Converse Inc headquartered in Massachusetts, USA
* Hurley International LLC headquartered in California, USA * Umbro International Limited headquartered in Cheadle, UK As part of their long term plan, they continually evaluate their existing portfolio of business to ensure highest returns. Nike also sponsors many high profile sports personalities and teams in varied range of sports with the highly recognized trademarks of “Just Do It” and Swoosh logo. Taking the above information into consideration, one can understand how business model of Nike can quickly complicate an audit. Now let us proceed to analyze important portions of the Nike audit. Analyzing Nike’s 10-K
a. Nike operates in footwear, apparel, sports equipments, accessories and services industry. b. Primary Products as discussed above can be divided into seven main categories:
* Football (Soccer)
* Men’s training
* Women’s training
* Nike Sportswear
* Action Sports
Apart from these, they also market products designed for kids and other athletic and recreational uses in sports such as baseball, cricket, tennis, volleyball, lacrosse, outdoor activities, golf, American football, walking and wrestling. They also sell sports apparel and accessories for most of the above categories as well as athletic bags and accessory featuring same Nike logo. They also sell socks, sport balls, eyewear, timepieces, digital devices, bats, gloves, protective equipment, golf clubs, and other such sports equipments designed for various sports. Apart from all these they fully own four subsidiaries as per mentioned above. They sell dress and casual wear for men and women under Cole Haan brand, athletic and casual footwear, apparel under Converse brand, action sports and lifestyle apparels under Hurley brand and finally athletic and casual footwear and apparel especially for football under Umbro brand. c. The main raw materials used in footwear products are:
* Natural and synthetic rubber
* plastic compounds
* foam cushioning materials
* polyurethane films used to make Air Sole cushioning compounds The main materials used in apparels products are:
* Natural and synthetic fabric and threads
* plastic and metal hardware
* Specialized performance fabrics designed to repel rain, heat or efficiently transport body moisture. Nike’s independent suppliers and contractors buy these raw materials to manufacture footwear, apparel and other equipments in bulk. Most raw materials are purchased by suppliers and contractors from the country of manufacturing and hence Nike has limited control over it. This is a difficulty Nike faces managing its suppliers and contractors. d. Nike is the leading company within its industry ahead from Adidas, Reebok, Puma and few others of its competitors. Sales:
Total revenues for the year stood at US$ 24128 million with North America Region contributing highest at US$ 8839 million followed by Western Europe and emerging markets such as countries like Brazil, India and other Asian countries and central China contributing almost US$ 2539 million at third place. Footwear category was the highest contributor to overall sales at US$ 13426 million followed by apparel at US$ 6336 million and equipment business at US$ 1202 million. Assets:
Total assets rose by 3% during 2011-12 and stood at US$ 15465 million. Main contributors to total assets were Inventories of US$ 3350 million and accounts receivables at US$ 3280 million. Cash and Fixed assets followed these two in assets category and were the third and fourth contributors in total assets. The amount of account receivables is very high for a company to manage and hence Nike should deal with it carefully. Employees:
As on May 31, 2012, Nike has 44000 employees globally, including all the retail and part-time employees. Management’s relationship is very good with employees and very few numbers of employees are engaged in forming unions that too in emerging economies and the USA, certain amount of Cole Haan employees are represented by a trade union. Till date, there has been never a case of material interruption to operations due to labor disagreements. It is a very good sign for a company to keep its employees satisfied and motivated as it is the core strength of any organization apart from its expertise in product line. e. Nike has its headquarters in Washington County, Oregon in the USA. Apart from this Nike has its presence in many countries and sells its products almost everywhere. It has marketing and selling channels in 190 countries of the world which can be considered as a strong supply chain network in itself. f. Key stakeholders of Nike include its major shareholders in terms of its key executives, other top institutional holders and mutual fund holders. Top direct holders include Parker Mark G, Dununzio Ralph, and Denson Charles among few.
Vanguard Group and FMR LLC hold roughly 5-5% of shares of Nike Inc in institutional investors’ category. Growth Funds of America Inc and Fidelity Contrafund Inc are the major holders in mutual fund category with share of 4 and 3 per cent respectively. Nike manufactures all of its footwear from outside the US. It has contracted suppliers in China, US, Vietnam and Indonesia. They also have manufacturing capabilities built in India, Argentina, Brazil and Mexico to manufacture footwear for sale in these countries. The main reason for having manufacturing in such countries is to utilize cheap labor and raw materials cost. g. Item 1 gives general overview of the company and other such details like industry type, operations, location, and global presence of the company.
It also gives us details about its depth and width of product line, sales and marketing details and its position in the US and international markets. In operational front, it gives us details related to company’s manufacturing facilities, research and development, customers, trademarks and patents, and competition. It also gives us broad overview of their employees and management’s relationship with them. Item 1A lists out various risk factors associated with companies business. Few of the risks listed here include intense competition, failure to maintain their reputation and brand image, inability to anticipate consumer behavior and new product development as few. Outside information about company and the industry:
a. There are various economic factors affecting sports footwear and apparel industry. We have listed few of the major issues affecting this industry: Global Economic slowdown and high cost pressure: In last few years post 2008, the world is going through economic slowdown. Global Economies have not yet recovered from 2008 recession. Global demand is low and there are high cost pressures for companies to survive in such challenging times. The companies have to find out ways to produce cheaper products from emerging markets to keep their bottom lines unaffected. Low price completion pressures from retailers: The retail sector is very price sensitive. However, most of its income is derived from selling into retailers. Retailers tend to offer a very similar experience to the consumer. So margins tend to get squeezed as retailers try to pass some of the low price competition pressure onto Nike. Exchange Rate risks: Nike is exposed to the exchange rate risks as it manufactures most of its products from outside US and sells it in international markets. Fluctuations in currencies can severely harm profits of Nike.
b. Nike has its presence in 190 countries of the world and offers range of products in footwear, apparel and sports equipment categories. The industry is said to be in the maturity stage as it has to rely highly upon global economic turnaround and increase in income of the households by significant margins. Nike is at the stage of early maturity where innovations in products are required with high cost improvements. c. Brand Recognition: The sports apparel and footwear business is highly affected by brand recognition among consumers. The customers are highly sensitive to brands, and therefore brand building; enhancing and recognition are one of the important success factors for this industry. Quality of Products: The consumer purchases in this industry suggest that consumers highly value quality products as their purchases are not frequent. Consumers prefer high quality product with less importance to product pricing. Also quality of the product is indirectly related to brand equity and hence is the important success factor for this industry.
Marketing Channels: Effective marketing and advertising can lead to increased sales and increased goodwill for company’s brand in the minds of the consumers. Companies need to spend heavily in marketing and promotional activities for increased revenues and profits. Distribution channels: To develop and maintain efficient distribution channel can also be another success factor for sports footwear and apparel industry seeing its product types. Customer Relationships/Satisfaction: As brand image plays significant role for product purchase and repurchase in this segment, to have a strong relationships and high level of satisfaction among consumers is a critical factor. Entry Barriers: There are high entry barriers for new players as currents players have already established them in the global markets with major chunk of the market share enjoyed by few top players. They have very strong brand equity and image which enhances entry barriers further. d. For the Nike Inc,
Brand Recognition: Nike is the leading brand in its segment and enjoys highest levels of brand recognition. Quality of Products: Nike knows pretty well that to have the advantages of strong brand recognition, product quality is very necessary. They produce quality products and invest significant portion of their profits into new product development and R&D. Marketing: Effective advertising and promotional strategies are very important in this business and hence Nike has few of the biggest sports celebrities as their brand ambassadors. Distribution Channels: Nike manufactures its products in few low cost nations and supplies them into global markets in almost 190 countries. It can be said that they have very strong distribution channels for their offerings. Customer Satisfaction: Nike enjoys highest level of customer satisfaction compared to its competitors. Over the years, they have developed strong brand name for their products on account of high customer satisfaction and repeat buyers.
e. Five major business risks related to client business and industry: * Intense Competition: Nike is a consumer products company and the relative popularity of various sports and fitness activities play an import role in demand for their products. Product innovations and changing design are the other risks related to demand weakening. * Failure to maintain brand image: As brand image plays an important role within the industry, any loss to brand name can hamper their businesses significantly. * Global Capital and Credit Market conditions: Global economic condition is another factor which affects demand for these types of products. In the times of recession and slowdown, this industry is bound to show flat sales. * Business Model: The way they conduct their business i.e. manufacture at few places abroad and supply in multiple global markets is exposed to higher risks as they have no say in regulatory policies of individual countries. * Inability to anticipate consumer preferences and new product developments: In the times of global slowdown and fiercely competitive industry, continued customer satisfaction is of utmost importance.
They should anticipate changing customer preferences and develop new products to tap new customers and retain current. f. As the industry spends millions of dollars in advertising and promotional activities, these costs are included in the head Demand Creation Expenses. Advertising production costs are expensed when first time advertising is run on television or other media. Also, endorsement payments are expensed on a straight line basis over the term of contract and prepayments paid to contractors are included in prepaid expenses. Also, Inventory valuation is done in a way that it is stated at lower of cost or market and valued on average cost basis. Depreciation and amortization of assets used in manufacturing, warehousing and product distribution are recorded in cost of sales. Depreciation and amortization of other assets are recorded in selling and administrative expense. g. Loss of reputation: Adverse publicity about regulatory or legal action against Nike can harm their brand image and undermine customer’s confidence in them leading to demand fall for their products.
Government Regulations in Manufacturing Countries: Any changes in regulatory policies of countries where Nike’s manufacturing plants are located can seriously affect their supply side of the business. Nike should continuously study and assess business environment within these countries. h. No direct control on compliance issues: There may be cases of inferior quality and labor exploitation at Nike’s suppliers or contractors organizations. Nike does not have direct control over them and it may in turn affect reputation of Nike and their business. Nike should encourage their suppliers and contractors to follow their ethical code of conduct. Waste Management: There is large amount of waste generation in footwear manufacturing which affects environmental sustainability and loss of brand image in society due to improper environmental practices. Being leader of the industry, they should set example to have better practices and standards that do not deteriorate environment. Analyzing Financial Strength of Nike
a. Nike’s strategy is to achieve long term revenue growth by creating innovative and must have products with aim of building great brand image in the minds of consumers and giving them enhanced experience at their retail stores and outlets. Despite ongoing challenges of global economies, they have achieved their revenue targets during 2012. They have been able to achieve revenues of US$ 24 billion in 2012 which are highest figures till date. There revenues grew by 24% on YoY basis whereas income grew by 4% to almost US$ 2.2 billion. They have been able to achieve earnings per share of $4.73 which shows 8% increase on YoY basis. b. Company continuously assesses their portfolio of businesses and changes investment patterns based on future prospects and their long term business and corporate strategy. While there are concerns of increased input costs and greater foreign exchange volatility during fiscal 2013, but Nike foresees opportunities to drive future growth and expects moderate to high growth in the next fiscal to support their long term strategies. c. Sources of Capital: Till 2016, the company has entered into a contract with syndicate bank to finance their operations up to US$ 1 billion and which can be further increased to US$ 1.5 billion with lender approval.
They have managed to achieve credit ratings of A+ and A1 from S&P and Moody’s respectively. Company is considered to be good among financial institutions for lending. Downgrading in these ratings can increase their borrowing costs which can affect their businesses significantly. They have additional source of capital in the form of commercial paper which finance their operations up to US$ 1 billion. They have current assets of almost US$ 11.5 billion and accounts receivables form a large portion of it. The company is expecting to borrow from capital markets at similar rates and does not see any increase in interest rates costs in near term future. d. Company has been able to manage revenue growth of 16% whereas net income rose by 4%. These factors gave investors many reasons to hold the stock. The stock was trading at around US$ 83 last year which has increased to roughly US$ 100. The company has seen 8% rises in earnings per share. Investors still have high confidence in Nike and many analysts recommend Nike stocks to hold at current levels.
e. The Nike Inc. has been able achieve higher earnings on account higher sales which rose by 16% YoY basis. The growth of the net income was negatively affected by increase in tax rates. However, EPS grew by almost 8% during fiscal 2012 which was much higher than the growth in net income. The growth in earnings was on account of decrease in total number of outstanding shares of the company. f. The rivalry in the current sports footwear and apparel industry is very high. Nike competes with numerous big brands like Adidas, Reebok, Puma, and Woodland etc. on multiple product categories. However, Nike’s position in the industry is well established and the company leads in terms of revenues, market share and profits within this industry. Few points of concerns are recent takeover of Reebok by Adidas and pricing of Nike products which is higher than Adidas. Other point to be noted here is that company has lost its market share in its home country to its competitors. Broad Audit Plan:
a. Nike’s operations deal with all of the major transaction cycles. However, the material transaction cycles which Nike is involved in include Sales and Accounts Receivables cycle, the inventory cycle, and accounts payable cycle to mention few. By looking at Nike’s balance sheet one can understand that cash and equivalents and accounts receivables form a large portion of their current assets as well as total assets. It increase the importance that an auditor should place on the affected accounts within these cycles during his test of control, testing of transactions, and verification of yearly account balances of these accounts. Therefore, an auditor has to pay due preliminary judgments on the materiality of Sales and Collection cycles, inventories and payables cycles, capital acquisition and repayment of debt. Another account on the balance sheet that accounts for almost 20-22% of total available business assets is the inventories account. Due to such a high level of inventories in balance sheet, it is easier for the company to overstate or understate such items.
The auditor should pay careful attention to these accounts and verify inventory levels at random locations for the company and make judgments. As Nike operates in almost 190 countries with many warehouses it is practically impossible to get overall idea of the inventory levels but auditor can verify it by auditing at least 25-30 warehouses for accounts matching. Nike’s operations also involve risks associated with high revenue accounts and auditor should make sure that revenue accounts are not recorded until inventories are shipped, invoices are made in response to an order and amount, volume and timing of these entries are correct. The auditor should also ask for supporting documents for any unconventional recording of data into sales accounts.
The auditor should also pay attention to payables cycles and accrued liabilities which constitute large portion of current liabilities of the company. The auditor should look out for any understatement of amount in such data in last one year. Prepaid expenses of the company have increased significantly from last year by almost 50% and it forms roughly 7-8% of total business assets. The auditor should ask for all the necessary documents and supporting invoices of different accounts under this head. In the balance sheet of Nike, they have paid 50 million US$ debt in last one year and auditors should ask and verify for these details too. Additionally he should also review capital accounts, retained earnings account and overall shareholder’s equity. b. High Risk Areas:
* Sales Accounts
* Internal Controls
* Investments Accounts
c. Low Risk Areas:
* Collection and Payables cycles
* Cash and Prepaid Expenses
* Retained Earnings
* Long Terms debt account
d. If subjected to tremendous pressure, Nike’s management has the opportunities of overstating current and fixed assets, Revenues, Goodwill estimates. They may also understate cost of goods sold and other operating and overhead expenses, short term and long term liabilities, and deferred income taxes accounts. They may also exaggerate investing accounts and thus increasing overall business assets of the firm. Thus under extreme pressures the management may perform any of the activities mentioned above and misstate the amount of financial statements. The auditor has to keenly observe such entries and try to find out any irregularities. e. According to us, the extent to which assessed risks of Nike can be reduced is moderate to low. There are no significant changes in internal controls over last one year. One can see that, Nike has implemented COSO as their framework for evaluation with the help of CFO and CEO of the company and found internal controls to be satisfactory.
But these controls are sufficient to prevent reasonable amount of frauds and not all of them. It does not give assurance as these controls are susceptible to manipulation and frauds especially in the case of frauds done by the collusion of two or more people. f. Nike manufactures its products in low cost manufacturing countries outside the US and sells its products in international markets of 190 countries. It fully owns four subsidiaries out of which 3 operate from within US and one from UK. It is important to carry out audit procedures of Nike from US headquarters as many strategic decision, high level planning, and exchange of information take place through it.
All the necessary data needed to conduct audit procedures can be made available from US office in Oregon. But during the testing phase of audit, auditors should also plan to verify these details by visiting operations of all four subsidiaries in random location and other major retail outlets and warehouses over the world. A large number of locations is always better to have fair idea about validity and applicability of Nike data. g. According to us, the auditor would issue opinion as per below: * The current internal controls at Nike are adequate and are in line with COSO * The financial statements are in accordance with US GAAP accounting standards with increased transparency after new guidelines by FASB in April, 2011. * Management properly signed off on all the requirements
First step of the project was deciding the company on which the analysis is to be carried out. We had a meeting to discuss it and chose Nike Inc as the company for analysis of 10-k filings. Second step of the project was to study 10-k report of Nike Inc by all the group members and then decide on work allocation. We wanted to divide work equally among group members and hence first asked for the preferences of group members for individual sections and then accordingly distributed the work. We also decided on a deadline by which all the group members have to complete their work. After completion of individual parts we explained our understanding and analysis to other member and did few changes. We integrated the work, did necessary formatting and then did a final group review of the project.