1) Review the brief description of Southwest Appliances, Inc. attached to the end of these instructions, their financial statement information attached to this assignment in an Excel file, and the explanation of selected financial statement information attached to the end of these instructions. Identify three patterns in the data that might be symptoms of fraud. I appreciate that the text provides limited technical details on what to look for, but this also is a test of what you have retained from your Financial Accounting class. This relatively realistic assignment provides basic information you would have to work with in practice. Keep in mind that this is a homework assignment and I will not be grading it harshly. I do understand that student's financial statement analysis skills may vary significantly and am trying to determine what you can reason out based on a basic understanding of financial statements. The explanations of the financial statement information I have include should help you with the task. For each of your possible fraud symptoms, be sure to explain why you believe it might be a fraud symptom. If appropriate, you should also support your selections with relevant data from the background description of the firm. Also, don't limit yourself to just individual account balance issues but also look for changes in normal relationships between accounts. Since ratios track relationships between accounts, they are a good place to look for these sorts of issues. a) Possible Fraud Symptom 1 - b) Possible Fraud Symptom 2 - c) Possible Fraud Symptom 3 - 2) The following are Benford analyses of the first digit of each of Southwest's accounts receivable balances at the end of 2013 and each of their sales invoices for 2013. a) Do the calculations needed to compare these distributions of first digits to the Benford distribution in the text. Show your work either in Word tables in your solution or in an Excel file as either a table or a graph. If you use an Excel file, name it with your first name and "Benford." Conclude on whether you believe these data represent a symptom of fraud or not and why. b) Combine the Benford analysis data with the financial statement analysis data to see if you can find additional support for a possible fraud and explain your position. If you don't believe that there is any correlation between the two analyses, state why. ?

Southwest Appliances, Inc. Balance Sheets (Amounts in Dollars) 2012 2013 2012 % of Assets 2013 % of Assets % Change Assets Current Assets Cash and cash equivalents Money market funds Accounts receivable Allowance for doubtful accounts Inventory Total Current Assets $22,045 31,510 301,713 (31,916) 307,701 631,053 $10,867 16,000 395,755 (33,779) 503,091 891,934 2.18 3.12 29.90 (3.16) 30.49 62.54 0.89 1.31 32.28 (2.76) 41.04 72.76 (50.71) (49.22) 31.17 (5.84) 63.50 41.34 Property and Equipment Plant 500,000 Accumulated depreciation - plant (220,000) Equipment 120,000 Accumulated depreciation - equipment (72,000) Land 50,000 Net Property and Equipment 378,000 Total Assets $1,009,053 500,000 (240,000) 120,000 (96,000) 50,000 334,000 $1,225,934 49.55 (21.80) 11.89 (7.14) 4.96 37.46 100.00 40.79 (19.58) 9.79 (7.83) 4.08 27.24 100.00 (33.33) (11.64) 21.49 (9.09) Liabilities and Stockholders' Equity Current Liabilities Accounts payable Payroll taxes payable Income taxes payable Dividends payable Total Current Liabilities Notes payable Total Long-term Liabilities Stockholders' Equity Capital stock Paid-in capital Retained earnings Total Stockholders' Equity Total Liabilities and Equity 145,031 8,524 30,235 14,197 197,987 387,757 17,436 4,125 3,203 412,521 14.37 0.84 3.00 1.41 19.62 31.63 1.42 0.34 0.26 33.65 167.36 104.55 (86.36) (77.44) 108.36 90,000 90,000 60,000 60,000 8.92 8.92 4.89 4.89 (33.33) (33.33) 300,000 100,000 321,066 721,066 $1,009,053 300,000 100,000 353,413 753,413 $1,225,934 29.73 9.91 31.82 71.46 100.00 24.47 8.16 28.83 61.46 100.00 10.07 4.49 21.49 Southwest Appliances, Inc. Income Statements (Amounts in Dollars) 2012 % of 2013 % of % Change Sales Sales 100.00 100.00 19.78 (0.31) (0.28) (9.99) (1.24) (1.57) (52.50) (1.01) (1.01) (20.00) 97.45 97.14 19.39 Sales Sales discounts Sales returns Bad debt expenses Net Sales 2012 $2,736,561 (8,371) (33,809) (27,565) 2,666,816 2013 $3,277,873 (9,207) (51,559) (33,078) 3,184,029 Cost of goods sold Gross margin 2,159,042 507,774 2,601,646 582,383 78.90 18.56 79.37 17.77 20.50 14.69 259,287 18,434 14,357 6,491 21,943 6,149 3,067 974 4,636 11,386 980 42,374 9,215 44,000 443,293 64,481 290,400 21,199 16,081 7,140 25,673 6,456 3,650 1,140 5,100 11,500 1,225 53,815 12,164 44,000 499,543 82,840 9.47 0.67 0.52 0.24 0.80 0.22 0.11 0.04 0.17 0.42 0.04 1.55 0.34 1.61 16.20 2.36 8.86 0.65 0.49 0.22 0.78 0.20 0.11 0.03 0.16 0.35 0.04 1.64 0.37 1.34 15.24 2.53 12.00 15.00 12.01 10.00 17.00 4.99 19.01 17.04 10.01 1.00 25.00 27.00 32.00 12.69 28.47 22,864 87,345 28,580 111,420 0.84 3.19 0.87 3.40 25.00 27.56 25,114 $62,231 37,508 $73,912 0.92 2.27 1.14 2.25 49.35 18.77 $271,728 62,231 12,893 $321,066 $321,066 73,912 41,565 $353,413 Salaries expense Payroll tax expense Fringe benefits Rent Utilities Insurance Supplies expense Postage expense Advertising expense Professional fees Miscellaneous Purchase discounts lost Interest expense Depreciation expense Total operating expenses Operating Income Interest revenue Income before income taxes Income taxes Net Income Beginning retained earnings Net income Dividends Ending retained earnings Southwest Appliances, Inc. Statement of Cash Flows (Amounts in Dollars) 2013 Operating cash flows Net income Depreciation Allowance for doubtful accounts 2013 % of Sales $73,912 44,000 1,863 2.25 1.34 0.06 (94,042) (195,390) 242,726 8,912 (26,110) (10,994) 44,877 (2.87) (5.96) 7.40 0.27 (0.80) (0.34) 1.37 15,510 15,510 0.47 0.47 Financing cash flows Repayment of notes payable Dividends Financing cash flows (30,000) (41,565) (71,565) (0.92) (1.27) (2.18) Net cash flow Beginning cash Ending cash (11,178) 22,045 $10,867 Changes in working capital (Increase) in accounts receivable (Increase) in inventory Increase in accounts payable Increase in payroll taxes payable (Decrease) in income taxes payable (Decrease) in dividends payable Cash flow from operations Investing cash flows Money market funds Investing cash flows Southwest Appliances, Inc. Ratios (Amounts in Dollars) 2012 2013 Operating Performance Overall Performance Return on Assets Return on Equity Asset Turnover 6.2% 8.6% 2.7 6.0% 9.8% 2.7 Cash Conversion Cycle Days cash in receivables Days cash in inventories Days needs Days cash in payables and accrued liabilities Net conversion cycle 40.2 52.0 92.3 23.0 69.3 44.1 70.6 114.6 50.8 63.9 3.19 1.79 2.16 1.02 92.6% 0.40 0.12 0.63 0.08 28.8% 33.7% Financial Position Short-term Current Ratio Quick Ratio Dividend payout Long-term Total debt to equity Long-term debt to equity Effective Tax Rate Wholesale Heating and AC Industry Comparative Common-sized Balance Sheet CASH AND EQUIVALENTS ACCOUNTS RECEIVABLE (NET) INVENTORY OTHER CURRENT TOTAL CURRENT ASSETS 2012 2013 % of Assets % of Assets 5.00 4.50 35.00 37.00 40.00 39.00 1.50 1.40 81.50 81.90 FIXED ASSETS (NET) INTANGIBLES (NET) TOTAL NON CURRENT ASSETS TOTAL ASSETS 17.50 1.00 18.50 100.00 17.00 1.10 18.10 100.00 ACCOUNTS PAYABLE SHORT TERM LOANS PAYABLE INCOME TAXES PAYABLE OTHER CURRENT TOTAL CURRENT LIABILITIES 28.50 13.50 2.00 1.40 45.40 30.50 14.00 2.20 1.30 48.00 LONG-TERM DEBT NET WORTH TOTAL LIAB. AND NET WORTH 8.90 45.70 100.00 8.50 43.50 100.00 Comparative Common-sized Income Statement NET SALES COST OF GOODS SOLD GROSS MARGIN 100.0 79.0 21.0 16.5 4.5 TOTAL EXPENSES INCOME BEFORE TAXES 100.0 79.5 20.5 17.0 3.5 1.4 6.2% 13.6% 1.8 0.9 1.2 0.2 1.7 5.9% 13.6% 1.7 0.9 1.3 0.2 Comparative Ratios ASSET TURNOVER RETURN ON ASSETS RETURN ON EQUITY CURRENT RATIO QUICK RATIO TOTAL DEBT TO EQUITY LONG-TERM DEBT TO EQUITY Week 4 Homework Questions Instructions Download a copy of this file. Type your answer into the file after the questions, rename the file with your own name and HW4 (e.g., Jim Peters HW4.docx), and reattached the completed file to the assignment. You will lose points if you don't rename your files Questions Chapter 1 Review the brief description of Southwest Appliances, Inc. attached to the end of these instructions, their financial statement information attached to this assignment in an Excel file, and the explanation of selected financial statement information attached to the end of these instructions. Identify three patterns in the data that might be symptoms of fraud. I appreciate that the text provides limited technical details on what to look for, but this also is a test of what you have retained from your Financial Accounting class. This relatively realistic assignment provides basic information you would have to work with in practice. Keep in mind that this is a homework assignment and I will not be grading it harshly. I do understand that student's financial statement analysis skills may vary significantly and am trying to determine what you can reason out based on a basic understanding of financial statements. The explanations of the financial statement information I have include should help you with the task. For each of your possible fraud symptoms, be sure to explain why you believe it might be a fraud symptom. If appropriate, you should also support your selections with relevant data from the background description of the firm. Also, don't limit yourself to just individual account balance issues but also look for changes in normal relationships between accounts. Since ratios track relationships between accounts, they are a good place to look for these sorts of issues. a) Possible Fraud Symptom 1 - b) Possible Fraud Symptom 2 - c) Possible Fraud Symptom 3 - Chapter 2 The following are Benford analyses of the first digit of each of Southwest's accounts receivable balances at the end of 2013 and each of their sales invoices for 2013. 1 A/R Balances First Digit Count 1 35 2 45 3 23 4 18 5 14 6 3 7 5 8 7 9 1 Sales Invoice Totals First Digit Count 1 873 2 609 3 293 4 155 5 208 6 109 7 85 8 91 9 71 a) d) 2 Do the calculations needed to compare these distributions of first digits to the Benford distribution in the text. Show your work either in Word tables in your solution or in an Excel file as either a table or a graph. If you use an Excel file, name it with your first name and "Benford." Conclude on whether you believe these data represent a symptom of fraud or not and why. Combine the Benford analysis data with the financial statement analysis data to see if you can find additional support for a possible fraud and explain your position. If you don't believe that there is any correlation between the two analyses, state why. Description of Southwest Appliance, Inc. Southwest Appliances, Inc. (Southwest) 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. The wholesale appliance industry has been slowly recovering from global recession for the last two years. Prior to the recession, the industry's gross sales were growing at a real rate of about 5% per year (with the usual wide variations from year to year due to fluctuations in the residential housing starts). During the recession, their sales have fallen by 10% over the last two years. However, real growth rates are expected to increase to 2% in the current year. 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. 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 slow recovery. 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 all whole took an active role in hiring the new auditor and relied on the leadership of Mr. Washington the 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. 3 Explanation of Selected Financial Statement Information Balance Sheet The balance sheet includes two types of additional information to help with horizontal and vertical analyses. The two columns labeled as % of assets "common size" the accounts by dividing them by total assets. This helps with vertical analysis over time because it allows you to see how account balances have changed relative to the size of the firm (i.e., total assets) each year. The last column on the right calculates the 2012/2013 change in each account balance as a percent of the 2012 balance, which should help with horizontal analyses (i.e., rate of change over time). Note that horizontal and vertical analyses are not independent of each other. Rates of change in one account (horizontal analysis) should be put in the context of rates of change in other accounts (vertical analysis). In addition, shifts in the proportion of total assets that an included in one account (vertical analysis) should be put in context of changes in the proportions of related accounts over time (horizontal analysis). Income Statement The income statement contains the same type of additional information as the balance sheet, which can be used to support your analysis in the same way. The only difference is that the income statement is common sized using Sales, which is gross of any discounts and allowances, instead of total assets. Cash Flow Statement Only on year is available. This is a data limitation of the case and not a fraud symptom. The Cash Flow Statement has been common-sized" using Sales just like the income statement. Ratios Return on Assets (ROA) Net income for each year divided by average total assets for the year. This ratio measure a firm's ability to produce income from its total assets. Return on Equity (ROE) Net income for each year divided by average total owners' equity for the year. This ratio measures a firm's ability to provide returns to its owners. It is affected by leverage or the proportion of total assets financed by debt versus equity. Increased debt drives up the ROE without having to increase net income. Asset Turnover Total sales for the year divided by average total assets. This ratio measures a firm's ability to generate sales volume from its total assets. 4 Cash Conversion cycle This group of ratios measures how fast a firm turns sales into cash. Days receivables Accounts receivable divided by average daily sales. This ratio is also known as a collection period and measures how long, on average, a firm takes to collect its accounts receivable. Days inventory Inventory divided by average daily cost of goods sold. This ratio measures how it takes a firm, on average, to sell an item of inventory. Days needs This is a subtotal that measures how many days of operating activity a firm needs to finance before it collects cash from sales. That is, firms have to buy or build something, place it in inventory, sell it, and then collect for it to get cash from sales. Days needs measure the time it takes a firm to walk through these steps. Days cash in payables and accrued liabilities Total accounts payable and accrued liability balances divided by average daily operating costs. This ratio measures how long it takes for a firm to pay its operating bills or the expenses used in the daily operations of the firm. Net conversion cycle Days needs less days payables and accrued liabilities. It measure the number of days of average operating activity that a firm needs to finance outside of accounts payable and accrued liabilities. Current Ratio Total current assets divided by total current liabilities. This ratio measures a firm's ability to draw on current assets to pay current liabilities as those liabilities accrue. A common benchmark for this ratio is 2.0. This includes for an excess of current assets over current liabilities to allow for the fact that the collection of assets is less certain than the need to pay liabilities. Quick Ratio Total monetary current assets (cash, short-term investments, accounts receivable) divided by total liabilities. This is a more conservative measure of a firm's ability to pay its current liabilities as they fall due because it eliminates inventory and prepaid expenses from current 5 assets. Inventory and prepaid expenses are considered to be less liquid than monetary assets and, therefore, take longer to convert to cash. Dividend Payout The percentage of operating cash flows paid out as dividends each year. This ratio measures the percentage of operating cash flows the firm returns to its owners each year. Note that operating cash that is returned to owners cannot be used to expand the firm or pay down on debt. Only 2013 is available due to data limitations of the case. The lack of these data is not a fraud symptom. Total debt to equity Total liabilities, current and long-term, divided by owners' equity. This ratio measures how deep a firm is in debt and also how extensively they are using leverage. A common benchmark for this ratio is 1.0 because most firms try to finance their operations with an equal balance of debt and equity. More debt increases leverage and the return to owners, but also increases the firm's indebtedness and likelihood of default. Long-term debt to equity Long-term liabilities divided by owners' equity. This ratio measures the extent to which a firm uses long-term debt to finance its operations. Effective Tax Rate Income tax expense on the income statement divided by pre-tax net income. Effective tax rates normally should be a little higher than the Federal statutory tax rate of 25% due to state and local income taxes that some firms have to pay. It can be lower than the Federal rate if the firm has overseas taxable income in low tax nations. Industrial Data This section presents industrial average, common-sized balance sheet and income statement to provide you with data on how Southwest compares to its competitors. It also contains some industrial average ratios for the same purpose. 6