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6C-2 In the overall audit strategy for the audit of Keystone Computers \& Networks Inc. in Appendix 6C, there is a section on significant risks. For each of the risks, identify the implications and potential responses. (Estimated time: 20 minutes) Risk KNC has engaged in a strategy to sell to customers with higher credit risk. The officers of the company receive significant bonuses based on quarterly results. Implications and Response OBJECTIVES OF THE ENGAGEMENT Audit of the financial statements of Keystone Computers \& Networks Inc. (KCN) for the year ended December 31, 20X5. Alsa, the company's debt agreement with Western Financial Services requires the company to furnish the lender a report by our firm on KCN's compliance with various restrictive debt covenants. BUSINESS AND INDUSTRY CONDITIONS KCN sells and installs computers and networking hardware and software to business customers and provides other information technology consulting services. KCN also has begun developing its own computer networking software to be sold as a product to its customers. The company's primary competitive strategy is to maintain a high level of technical expertise and a broud range of services. KCN's long-term success is contingent on its ability to attract and retain qualified information technology personnel. The market for such individuals is very competitive. However, the company has a competitive advantage because of its desirable geographic location (Phoenix) which has a large number of colleges with technology programs. The market for computers and related products is extremely competitive. KCN competes with large retailers of computers, such as Dell. Hewlett-Packard, and Apple. The company also competes with other value-added resellers who provide computers aid softwire products and consulting services directly to customers. To effectively compete, the company must be able to obtain inventories of state-of theart equipment on a timely basis. Because the company does not have the buying power of some of its other competitors, it zenerally must charee a higher price for its products. Its customers are willing to pay the higher price because of the high level of expertine and service BUSINESS AND INDUSTRY CONDITIONS KCN sells and installs computers and networking hardware and software to business customers and provides other information technology consulting services. KCN also has begun developing its own computer networking software to be sold as a product to its customers. The company's primary competitive strategy is to maintain a high level of technical expertise and a broad nnge of services. KCN's long term suecess is contingent on its ability to attract and retain qualified information technolory personnel. The trarket for such individuals is very competitive. However, the company has a competitive advantage because of its desirable feographio locetion (Phoenix). which has a large number of colleges with technology programs. The market for computers and related products is extremely conpetitive. KCN competes with large retailens of conputors, sach as Det, Hewlett-Packard, and Apple. The company also competes with other value added resellers who provide computers and softwaite prodicts and consulting services directly to customers. To effectively compete, the company must be able to obsain imentories of statoof the art equipment on a timely basis. Because the company does not have the buying power of some of its other competitors, if generally nust charge a higher price for its products. Its customers are willing to pay the higher price because of the high level of expertike and service that the company provides. The market for compurer products and technology services is also very sensitive to economic conditioas. Recent reports indicate that the U.S. economy will be challenged for the next few years. The annual growth in spending for information technology products and services is expected to be 3 percent per year for the next three years. In the past year, the company has decided to increase salus by extending eredit to clients with slightly higher eredit risk PLANNING MEETINGS On July 20, Karen West and I met with Loren Steele, controller, and Sam Best, president, of KCN to discuss the planning of the audit for the current year. On August 2, a planning meeting was held in our office with all members of the engagement team assigned to the audit. OWNERSHIP AND MANAGEMENT KCN is a closely held company owned by five stockholders: Terry Keystone, Mark Keystone, John Keystone, Keith Young, and Rita Young. Terry and Mark Keystone are active members of the company's board of directors. None of the other owners take an active part in the management of the business. OBJECTIVES, STRATEGIES, AND BUSINESS RISKS KCN's primary business objectives are to increase revenues by 6 percent and increase net incorne by 8 percent each year for the next thrce years. Major strategies to achieve those objectives include - Aggressive marketing of products and services through increased advertising. - Sales to customers with a higher credit risk profile. - New software development. The primary business risks associated with the company's strategies include - The U.S. economy may suffer a significant downturn. The primary business risks associated with the company's strategies include - The U.S. economy may suffer a significant downturn. - Competitors may engage in predatory pricing to gain market share. - Increased advertising expenditures may not produce desired results. - Credit losses may exceed the benefits of increased sales. - Software development activities may not generate viable products. The company has developed the following responses to these risks - Careful monitoring of economy and industry conditions. - Careful monitoring of competitor actions. - Hiring of marketing consulting firm to evaluate the performance of advertising methods. - Daily review of aging of accounts receivable by Loren Steele, controller. - Use of carefully controlled software development budget. MEASUREMENT AND REVIEW OF FINANCIAL PERFORMANCE Management uses the following measures to monitor the company's performance: - Inventory and receivables turnover. - Aging of accounts receivable. MEASUREMENT AND REVIEW OF FINANCIAL PERFORMANCE Management uses the following measures to monitor the company's performance: - Inventory and receivables turnover. - Aging of accounts receivable. - Sales and gross margins by type of revenue. - Net income. - Total inventory balance. PROCEDURES TO OBTAIN AN UNDERSTANDING OF THE CLIENT AND ITS ENVIRONMENT The following procedures were performed to update our understanding of the client and its environment: - Roll forward of information from the prior year's audit. - Inquiries of management: Loren Steele 7/20,8/15 Sam Best 7/20,8/16 - Reading of quarterly board of directors meetings held on 4/05 and 7/12. - Review of monthly performance reports for January through July. PROCEDURES TO OBTAIN AN UNDERSTANDING OF THE CLIENT AND ITS ENVIRONMENT The following procedures were performed to update our understanding of the client and its environment: - Roll forward of information from the prior year's audit. - Inquiries of management: LorenSteeleSamBest7/20,8/157/20,8/16 - Reading of quarterly board of directors' meetings held on 4/05 and 7/12. - Review of monthly performance reports for January through July. - Industry reports- IT and consulting services. - Review of KCN's website. - Review of selected articles in The Wall Street Journal. SIGNIFICANT RISKS Several significant risks were noted as a result of obtaining information about KCN and its environment, including SIGNIFICANT RISKS Several significant risks were noted as a result of obtaining information about KCN and its environment, including Risk Implications and Response 1. KCN has engaged in a strategy to sell to customers with higher eredit risk: 2. The officers of the company receive significant bonuses based on quarterly results: SIGNIFICANT ACCOUNTING AND AUDITING MATTERS The company began offering for sale extended warranties on computers during the current year. We rieed to review the method of revenue recognition to determine whether it complies with the requirements of FASB ASC 606. In the prior year, KCN began developing networking software products for sale. This year the company has started capitalizing certain costs of development. We need to review the method of accounting for the cost of software development to dererminie whether it ecmplies with the requirements of FASB ASC 985-20-25. In 203,KCN acquired for $1,200,000 a small besiness accounting syuen (Pumbtree Systems) that it licenses to its customen. Recentyy. sales of the licenses for the software have begun to decline. In addition, a recent article in a trade journal ranked the ssstem poor in SIGNIFICANT ACCOUNTING AND AUDITING MATTERS The company began offering for sale extended warranties on computers during the current year. We need to review the method of rerenas recognition to determine whether it complies with the requirements of FASB ASC 606. In the prior year, KCN began developing networking software products for sale. This year the company has started capitalieing certain costs of development. We need to review the method of accounting for the cost of software dewelopment to determine whether if cornpities with the requirements of FASB ASC 985-20-25. In 20X3, KCN acquired for $1,200,000 a small business accounting system (Plumbtree Systems) that it licenses to its cuistoner. Recently. sales of the licenses for the software have begun to decline. In addition, a recent article in a trade journal ranked the system poor in relation to its competitors. This may indicate that an impairment in the value of the software may have occurred MATERIALITY FOR PLANNING Because the firm has experienced steady growth in sales and earnings over the last three years. we believe that operating results are the most appropriate basis for estimating materiality for planning as described below: MATERIALITY FOR PLANNING Because the firm has experienced steady growth in sales and earnings over the last three years, we believe that operating tesults are the most appropriate basis for estimating materiality for planning as described below: The range for materiality for planning is from $32,000 to $920,000. Based on the company's steady gromth in sales and earnings. and the fact that the company is not a public company, we have selected $300,000 as a reasonable materiality amcant for planaing purposes. Details on account and disclosure performance materiality and tolerable misstatement amounts are provided in the telated detailed documentation. Based on discussions with Staffing time requirements for the engagement are described below: 2. Consider results of inquiries of management about the risks of fraud and how they are addressed. G4 3. Consider the results of risk assessment analytical procedures. 4. Consider the existence of frand risk factors listed on G-30 through G-35. CA 5. Consider any other information that might be relevant to the risk of material misstatement due to fraud. Risks of Material Misstatement Due to Fraud Management may be motivated to misstate financial results due to impending sale of the company Responses Overall Responses Risks were considered in staffing the engogement and decermining the appropriate level of superwision Alterations of the Nature, Timing, and Extent of Further Audit Procedures Procedures were performed to address the risk of management onernde of internal controls, (Sese G23 G24)