Review the description of Southwest Appliances, Inc. and identify four inherent risks based on the information provided. Inherent risks can flow from client's business risks, the nature of its governance structure, and its strategic plans. However, you need to be clear about how your risks create an increased risk of material misstatement in the financial statements and not just how they might create risks of lower performance for the firm.
Thus, for each inherent risk, describe the feature of the firm you believe affects inherent risk and explain how and why. By "how," I mean whether in increases or decreases inherent risk. Make sure your "why" addresses a specific risk to the accuracy of the financial statements and whether audit effort should be increased or decreased for specific accounts or related groups of accounts if possible.
Limit your inherent risk analysis to the verbal information in the case and not the financial statement data. Part b. covers risks identified using analytical procedures based on the financial data.
Management policy of maintaining large inventory to meet customer demand - The auditee maintains large inventories to facilitate sales. However, this increases the risk of obsolete inventory due to slow turnover. Assessing the value of obsolete inventory involves management judgment and increases the risk that inventory valuations will be overstated. Thus, I would recommend careful scrutiny of Southwest's inventory valuation allowance based on the lower of cost or market rule.
Preliminary Analytical Procedures - Review Southwest Appliance's financial statements, ratios, and industrial data presented after the verbal description of the case at the end of this assignment. I have included one example and you will need to add four more to the list.
Days Inventory Increase - Days inventory increased by 19 days in 19X1. This is a fairly large one-year increase and increases the risk of obsolete inventory. We should give some additional attention to valuing the inventory under the lower of cost of market rule.
History and Corporate Structure
Southwest Appliances, Inc. specializes in supplying a relatively small line of high quality household appliances to residential construction contractors in a large and growing metropolitan area. Southwest has a large list of customers, mostly custom builders of single family dwellings and some large builders of single and multiple family units. Southwest basic marketing strategy is to have inventory available at all times and to sell at competitive prices. At the end of every quarter, the President, Joe Navarro, reviews product costs and adjusts the authorized selling prices of products as necessary. These adjustments are based on Mr Navarro's assessment of what the competition will do as well as what is required to provide competitive profits to the owners.
The wholesale appliance industry has been affected by a global recession and by a slow economic recovery for the last three years, but is showing signs of recovery. Prior to the recession, the industry's gross sales were growing at a real rate of about 7% per year (with the usual wide variations from year to year due to fluctuations in the residential housing starts). During the recession, their sales fell by 15%. However, real growth rates for the industry are starting to increase to about 2% in the current year. Southwest management expects future growth in the industry to be around the same level for the next three to five years. Mr. Navarro's market strategy does not seem to be very effected because prior to year X1, Southwest's sales have not grown as fast as the industry in recent years and fell more than the industry during the recession.
Southwest's facilities are located in a single warehouse and office building adjacent to a railroad siding. Warehouse personnel simply unload rail deliveries with the forklifts and flat trucks that are used to handle inventory inside the warehouse. Because sales are made on a customer pickup basis, this location allows the company to avoid the expense of maintaining its own vehicles for transportation in and out. However, Southwest does have an arrangement with the trucking business next door to handle additional deliveries for customers on a freight collect basis (i.e., FOB shipping point). In the cases of customer pickup and the occasional delivery, sales are considered final when the appliances leave Southwest's loading dock.
Southwest is incorporated in the same state in which its home office is located. It does business in its home state and three surrounding states. The company's stock is held by almost 300 individuals and businesses, but is not yet publicly traded. Currently, Southwest's top management holds over 50% of the stock. The Board wants to expand their business and is anticipating going public with an initial public offering (IPO) within the next year. Executing an IPO will require that the Board make public their historic financial statements and have them auditing as part of the IPO prospectus to potential investors.
Southwest currently provides audited financial statements to banks when requesting loans and, therefore, has had audits for each of the last five years. Because Southwest is small, their local bank insisted that restrictive covenants be added to the firm's last loan agreement. These covenants require that the loan be repaid immediately in full if Southwest's current and debt to equity ratios fall below specified levels. The covenants also set limits on how much the firm can pay in dividends if they are violated.
To help stimulate sales Southwest recently instituted a profit sharing bonus agreement for its employees. This plan was negotiated because employees have gone without raises for the last two years due to the recession. The agreement specifies that employee bonuses will be based on unaudited net income for the past year because of the need to adjust employees' salaries at the beginning of each year. However, future bonuses are adjusted for any audit adjustments that are made after the bonuses are set based on unaudited data. No accrual has been made for the current year. Individual bonuses are to be based on an employee's position, length of service, and certain specific negotiated terms with individual officers. They will therefore vary in amount, but generally, the bonuses will average about 15% of the base net income.
Southwest's Board of Directors includes their current president, secretary/treasurer, and controller. It also includes two shareholders, who each hold about 5% interest in the firm, and one retired CPA, Jack Washington. While there is no audit committee, the board as a whole takes an active role in hiring and monitoring the firm's outside auditor. It also relies on the leadership of Mr. Washington to determine the scope of the audit engagement. Mr. Washington was recruited to the Board last year to help compensate for the fact that the prior president and controller retired during the new year and, therefore, the current president and controller have been in their positions for less than one year. The new controller was promoted from within, but the new president was recruited from outside the firm.
Southwest selected a new auditor for this year's audit engagement because their previous auditor had been with them for ten years and the Board felt it was time to get new insights into their operations. In addition, they wanted to hire a larger auditor with a more established reputation to support their anticipated IPO.