In the audit of Whirland Chemical Company, a large publicly traded company, you have been assigned the responsibility for obtaining background information for the audit. Your firm is auditing the client for the first time in the current year as a result of a dispute between Whirland and the previous auditor over the proper valuation of work in process inventory and the inclusion in sales of inventory that has not been delivered but has, for practical purposes, been completed and sold.
Whirland Chemical has been highly successful in its field in the past two decades, primarily because of many successful mergers negotiated by Bert Randolph, the president and chairman of the board. Even though the industry as a whole has suffered dramatic setbacks in recent years, Whirland continues to prosper, as evidenced by its constantly increasing earnings and growth. Only in the last two years have the company’s profits turned downward. Randolph has a reputation for having been able to hire an aggressive group of young executives by using relatively low salaries combined with an unusually generous profit-sharing plan.
A major difficulty you face in the new audit is that Whirland lacks the highly sophisticated accounting records expected of a company of its size. Randolph believes that profits come primarily from intelligent and aggressive action based on forecasts, not by relying on historical data that come after the fact. Most of the forecast data are generated by the sales and production department rather than by the accounting department. The personnel in the accounting department do seem competent but somewhat overworked and underpaid relative to other employees. One of the recent changes that will potentially improve the record-keeping is the installation of sophisticated information systems. Not all of the accounting records are fully integrated yet, but such major areas as inventory and sales are included in the new system.
The first six months’ financial statements for the current year include a profit of approximately only 10 percent less than that of the first six months of the preceding year, which is somewhat surprising, considering the reduced volume and the disposal of a segment of the business, Mercury Supply Co. The disposal of this segment was considered necessary because it had become increasingly unprofitable over the past four years. At the time of its acquisition from Roger Randolph, a brother of Bert Randolph, the company was highly profitable and was considered a highly desirable purchase. The major customer of Mercury Supply Co. was the Mercury Corporation, which is owned by Roger Randolph. Gradually, the market for its products declined as Mercury Corporation began diversifying and phasing out its primary products in favour of more profitable business. Even though Mercury Corporation is no longer buying from Mercury Supply Co., it compensates by buying a large volume of other products from Whirland Chemical.
The only major difficulty Whirland faces right now, according to financial analysts, is underfinancing. There is a high amount of current debt and long-term debt because of the depressed capital markets. Management is reluctant to obtain equity capital at this point because the increased number of shares would decrease the earnings per share even more than 10 percent. At the present time, Randolph is negotiating with several cash-rich companies in the hope of being able to merge with them as a means of overcoming the capital problems.
REQUIRED
a. List the major concerns you would have when assessing inherent risk and audit risk for the audit of Whirland Chemical Company. Explain why they are potential problems. Provide a conclusion (high, medium, or low) for inherent risk and audit risk.
b. State the appropriate approach to investigating the significance of each item you listed in (a).