Southwest Appliances Inc.			WP B.2.1
Inherent Risk and Materiality Memo		Initials	Date
	Prepared
	Reviewed

Preliminary Inherent Risk Assessment

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

Days Inventory Increase - Days inventory increased by 19 days in 2015Prelim. 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.

Preliminary Materiality

Balance Sheet -

Income statement -

Southwest Appliances Inc. Inherent Risk and Materiality Memo Initials WP B.2.1 Date Prepared Reviewed Preliminary Inherent Risk Assessment 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 Days Inventory Increase - Days inventory increased by 19 days in 2015Prelim. 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. Preliminary Materiality Balance Sheet - Income statement - 1 I. Title: Southwest Appliance Inherent Risk and Control Design Assessment Prepare Inherent Risks and Control Design Assessment. II. Introduction In this Learning Demonstration (LD) you will demonstrate your knowledge and skills of a portion of the audit process of a small appliance wholesaler. The firm, Southwest Appliance, Inc. (Southwest) is fictitious, thus all information in this case is simulated. The context for this case is that you are a member of an audit team led by a supervising senior auditor who will be making recommendations to the manager of the engagement, structuring the parts of audit, and presenting the results of those a preliminary review to the manager. Southwest has been audited in each of the last five years by a small, local CPA firm. However, your firm has been engaged to do an audit for 2015. Completing this LD is designed to help partially or completely achieve the following goals by demonstrating the following competencies: Goal 1: Communication: Learners demonstrate ability to communicate clearly both orally and in writing Competencies: o 1.1 Organize documents or presentation clearly in a manner that promotes understanding o 1.2 Develop coherent paragraphs or points so that each is internally unified and so that each functions as part of the whole document or presentation o 1.3 Provide sufficient, correctly cited support that substantiates the writer's ideas o 1.4 Tailor communications to the audience o 1.5 Use sentence structure appropriate to the task, message and audience o 1.6 Follow conventions of Standard Written English Goal 2: Critical Thinking: Learners demonstrate ability to apply logical, systematic decision-making processes to formulate clear, defensible ideas and to draw ethical conclusions. Competencies: o 2.1 Articulate and frame the issue o 2.2 Collect and evaluate information 1 o 2.3 Evaluate the underlying causes or conditions of elements contributing to an issue o 2.4 Use systems thinking to arrive at a decision in the context of an issue Goal 3: Quantitative Reasoning: Learners demonstrate the ability to use mathematical operations and analytical concepts and operations to address problems and to inform decision-making o Competencies: 3.3 Analyze data using mathematical/algebraic operations 3.4 Use calculated results to inform the problem or process Goal 4: Leadership, Facilitation, and Collaboration: Learners lead, facilitate, and collaborate with a variety of individuals and diverse teams to achieve organizational objectives. o Competency 4.1 Demonstrate an ability to plan a particular objective or goal Goal 9Technical Competencies in Risk assessment, Risk management, and Auditing: learners demonstrate an applied understanding of Generally Accepted Auditing Standards (GAAS), the requisite steps to execute a financial statement audit, and issue an audit report for a domestic public company. o Competencies: 9.2 Professional auditing standards: learners demonstrate an applied understanding of professional auditing standards for profit entities. 9.3 Planning the audit: learners demonstrate an applied understanding of planning an audit for domestic for-profit firms. III. Southwest Case Specifics Description of Firm and Market Conditions Southwest Appliances, Inc. (Southwest) is a small firm with about 50 total employees including corporate officers. It specializes in supplying a relatively small line of high quality household appliances to residential construction contractors in a large and 2 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's 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. He makes the selling prices adjustments based on his assessment of what his competitors will do with pricing and what is required to provide competitive profits to the owners of Southwest. Table 1: A summary of major personnel and their roles Actor Cecilia Cheng Frank Harris Jane Jones Joe Navarro Franklin Peters Bob Smith Jack Washington Role Secretary / Treasurer Bookkeeper Controller President Major shareholder, Chairman of the Board of Directors Accountant Retired CPA and Board member The global recession in 2008 affected the wholesale appliance industry, which has had a slow economic recovery since, but is showing signs of recovery. Before 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, Southwest sales fell 15%. However, real growth rates for the industry are starting to increase to about 3% 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 effective because 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 and a major highway. Warehouse personnel simply unload rail deliveries with the forklifts and flat trucks used to handle inventory inside the warehouse. Customers pickup all purchases in this location, thus the company avoids maintenance expenses on its own vehicles, which would be incurred if Southwest delivered to its customers. However, Southwest has an arrangement with a trucking business next door to deliver goods to some customers on a freight collect basis (i.e., FOB shipping point). Sales are final when appliances leave the Southwest loading dock for customer pickup orders and deliveries. Southwest is a privately held corporation incorporated in the same state in which its home office is located. It operates in its home state and three surrounding states. Stockholders include approximately 300 individuals and businesses. Currently, Southwest's top management holds over 50% of the stock. The Board of Directors wants to expand operations and is anticipating going public with an initial public offering 3 (IPO) within the next year. Executing an IPO will require the Board to disclose historical financial information. Southwest currently provides audited financial statements to banks when requesting loans and, therefore, has had audits for each of the last five years from the same accounting firm. Because Southwest is small, their local bank insisted on adding restrictive covenants to the firm's last loan agreement. These covenants include a provision that calls the loan immediately and in full, if Southwest's current and debt to equity ratios fall below specified levels. The covenants also set limits on the amount of dividends the firm can pay. To help stimulate sales and operating efficiency, Southwest recently instituted a profit sharing bonus agreement for its employees, to include top management. Management negotiated the plan because employees have gone without raises for several years. The agreement bases employee bonuses on unaudited net income for the past year because of the need to adjust employees' salaries at the beginning of each year. However, management will adjust future bonuses for any audit adjustments made after the bonuses are set based on unaudited data. The firm sets a bonus pool based on five percent of operating income, which limits the total available to pay bonuses. Management bases individual bonuses on an employee's position, length of service, and certain specific negotiated terms with individual officers. Southwest's Board of Directors includes its current president, secretary/treasurer, and controller. It also includes two shareholders, who each hold about a 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 because the prior president and controller retired during the year and, therefore, the current president and controller have been in their positions for less than one year. Management promoted the new controller from within, but they recruited the new president from outside the firm. Southwest selected a new auditor for this year's audit engagement because their previous auditor had been with the company for five years. The Board felt it was time to get new insights into their operations. In addition, they wanted to hire a larger auditing firm with a more established reputation to support their anticipated IPO. The Control Environment Southwest's accountant, Bob Smith, prepares financial statements and various financial statistics for the officers to review monthly. The Board reviews similar statistics on a quarterly basis at the regular Board meetings and questions the officers closely about what is going on in the business. In addition, Mr. Navarro personally follows sales figures and gross profit margins. 4 Supervisors interview all perspective employees for positions they supervise. In addition, at least one of the corporate officers also interviews each perspective employee. Most of the key employees, including the officers, have been with Southwest for more than ten years. However, due to the high demand for accountants, Bob Smith and most of the accounting staff have been employed at Southwest for less than 3 years. While Southwest checks references for any prospective employee, they do not check criminal records or perform other forms of background checks. A computer network and personal computers support Southwest's accounting and inventory management systems. Personal computers are located in the offices and warehouse and a central server handles all accounting and inventory files. Printers are located in areas where employees need printed documents and other records routinely. The computer is used to control and process most transactions, to print documents, prepare accounting records, and prepare periodic financial statements. Southwest uses commercial software recommended by their auditor. To date, they have had only the usual startup problems; it has been in use two years and upgraded once. Southwest only issues accounts and passwords to employees with jobs requiring computer data entry or access to file information and reports. Passwords are required to enter the system. Access is limited such that employees only have access to the information they need to perform their duties. Access is also limited in nature such that some employees who do not have the authority to enter data have read-only access while those whose jobs require data entry have both read and write access. Normal access to the files takes place via the software, which subjects any input to various logical and numerical tests. Most input is backed up by paper trails of source documents and other business papers. In addition, the firm uses an Internet service to back up all files on the Internet. Southwest manually runs a backup at the end of each day. They have no other Internet presence other than an informational Website that does not allow potential customers to order merchandise. Southwest has a complete set of policies, procedures, and manuals that management requires employees to use. Management is aggressive about updating the manuals and training new employees to ensure they understand the policies and procedures that affect their duties. Management also requires employees to attend brief review seminars on the policies and procedures that affect their positions once a year. These policies include a code of conduct and employees are required to sign a statement agreeing to it when they are hired. Sales and Collection Processing Sales Requisitions Southwest uses the PC network to manage inventory, sales requisitions, and sales orders. Sales clerks who can read the perpetual inventory records via their PCs take customer orders. Most orders originate from phone requests, but a few arrive in a walkin basis and some occasionally come in the mail. Usually, building contractors or their representatives call to get current price quotes and find out if specific appliances are in 5 stock. When goods are available and the price is satisfactory, a sales clerk originates a sales requisition and the process of approving and filling it begins if customers plan to pick up their order the same day. Orders received after 4:00 PM cannot be delivered the same day; buyers are so informed. In addition, sales clerks can immediately inform a caller about out-of-stock items and establish a back order for the customer. Back orders are processed early each day, but before they are filled, the buyers are called back to confirm that the orders are still valid. To originate a sales requisition, the sales clerk types the appropriate information into his or her PC: customer number, the product(s) identification, and order quantity. The computer system enters the customer's name and address, and the date of the requisition automatically on all requisitions as originated. The computer keeps track of all customer requisition and order information, and prints a requisition form with today's date on it for transmittal to the controller, Jane Jones. Sales clerks cannot set up new customers in Southwest's computer system. If a new customer calls to place an order, they are referred to Ms. Jones, the controller, who is the only person authorized to set up new customers in the system. The computer updates the perpetual inventory records by flagging the items as on order as soon as the sales clerk enters the requisition into the system to avoid overcommitment of goods not available due to existing orders that are pending credit approval. However, this is the only way that a sales clerk can alter the perpetual inventory records (i.e., by initiating a sales requisition). Order Approval Every few minutes (immediately if things are slow), one of the sales clerks hand-carries the pending requisitions to Jane Jones, the controller. The secretary presents them to Ms. Jones who approves them either immediately, based on first-hand knowledge of the customer's credit record, or after reviewing the customer's account record on her PC. Ms. Jones initials the requisition to indicate approval of the sale and enters an approval for the requisition in the accounting system. When Ms. Jones enters her approval code, the system creates and prints three copies of a sales order form; assigns a sequential number to it; and moves the sales order record in the computer to the open sales order file. Copies one and two of the sales order are sent to the warehouse where they are held until they can be filled. The approval copy of the requisition form is attached to copy three of the sales order and forwarded to the bookkeeper, Frank Harris. These forms are filed in the open sales order (physical) file for later matching with delivery advices. The computer system notifies the sales clerk who originated the requisition when Ms. Jones approves or disapproves the requisition. If the customer has requested an update on the order, the sales clerks call back the customer to let them know their orders have been approved and that delivery to their driver has been authorized. 6 If Ms. Jones disapproves the requisition, the computer system reverses the perpetual inventory entry for the pending sale and removes the record from the temporary customer order file. Sales clerks then call customers Ms. Jones did not approve to inform them of the situation. If they dispute the denial of credit, they are transferred to Ms. Jones' telephone extension. Delivery The sales order forms sent to the warehouse represent authorizations to deliver to the contractors or their representatives. The warehouse supervisor assigns one warehouse clerk to fill each order. This clerk typically retrieves each item with a forklift and brings it to the loading dock area of the warehouse. If the receiving driver is already there, the items are loaded directly, one at a time, until the order is complete. Otherwise, the warehouse clerk gathers all of the items and wraps a length of plastic ribbon around the ordered items to keep them separate from other orders. If the loading area becomes congested, the clerk fills the orders only after drivers have arrived. After the warehouse clerk fills an order, he enters the product quantities, product number, date, and customer number into a warehouse PC. This triggers the printing of a computer dated sequentially numbered four-copy delivery advice. The customer's driver signs the delivery advice (all copies) to indicate receipt of the complete order and receives the first two copies. Copy three goes into a warehouse file in numerical order. Copy four, along with one copy of the sales order, is delivered to Mr. Harris. The warehouse clerk's working copy of the sales order is usually discarded. Billing When Mr. Harris receives a delivery advice he matches them with the open sales orders and reviews them for agreement in products and quantities ordered and delivered. If they match, Mr. Harris initials the delivery advice and enters the date of delivery into the open sales order file on the PC. The computer automatically prices the products, calculates product amounts, totals the invoice, and calculates the cash discount, which is 2/10 net 30. The computer then prints a sequentially numbered, four-part sales invoice and writes the specifics of the sale to a daily-computerized sales file. The bookkeeper records gross sales, not net. Copies one and two of the invoice are mailed to the customer. Copy three is filed by the customer and copy four, along with the delivery advice, sales order, and approved sales requisition, are filed by invoice number. In the afternoon, Mr. Harris uses the sales recording software to access the daily sales record, the accounts receivable subsidiary ledger file, and the sales journal file. Sales for the day are posted at their gross amounts to the individual customer's subsidiary accounts receivable and to the sales journal file. The latter file is accessed monthly by the software to summarize sales by product and to make monthly postings to the general ledger. The subsidiary ledger is used to review customer credit worthiness, to manage collections, and to determine write-offs. 7 Collections Management and Write-offs The controller, Ms. Jones, whose secretary runs the software to produce an aged account receivable trial balance by customer, manages collections. A working trial balance is generated at least once a week and more frequently if collections lag. Ms. Jones decides what to do about specific accounts. Menu-driven software permits the Secretary to look up individual customer accounts, to write off invoices or whole accounts, and to generate customer statements for invoices past due by any specified number of days. The software also permits the printing of pre-drafted letters to the customers to accompany any of these actions. It is normal practice for Ms. Jones to consider write-offs only once at the end of the month. Southwest's general policy is to write off any invoice exceeding six months from the time of sale. However, Ms. Jones is authorized to make all final write-off decisions. The bookkeeper credits the allowance account if write-offs are subsequently collected. The accounts receivable subsidiary ledger is reconciled to the general ledger monthly. Once each month, another software routine is used to add interest to customers' accounts equal to 1% of all invoices past due by 30 or more days. This routine also lists the interest charges by invoice by account in an interest journal, summarizes transactions for the month, and posts the total to the interest revenue and accounts receivable accounts in the general ledger. Sales Returns If customers receive incorrect or damaged items, they typically call and indicate they want to return the goods. One of the officers approves the return and notifies the warehouse to accept the returned goods. When the customer returns the goods, a warehouse clerk completes a receiving report. The warehouse retains one copy, the customer's representative receives a copy, and the bookkeeper receives a copy. Mr. Harris enters the data for the return and the original sale into his PC. The computer records the return in an open credit memorandum file and prints a two-copy credit memorandum. Mr. Harris sends the credit memorandum to the controller, Ms. Jones for approval; she then returns it to Mr. Harris. Upon receipt of the signed credit memorandum, Mr. Harris enters Ms. Jones initials into the credit memorandum record on his PC. The computer then posts the credit to the customers' accounts receivable and transfers the credit memorandum information to the sales return file, from which the entries in the Sales Returns Journal are made by the computer system monthly. Southwest exchanges defective goods with the good's supplier for undamaged goods or, if the supplier prefers, the damaged units are disposed of and an allowance is received on the next purchase. Cash Receipts The receptionist opens the mail daily, restrictively endorses all checks received, and routes the other mail to appropriate personnel. She separates the checks from the remittance advice (copy two of Southwest's sales invoice) and sends the checks to the Secretary-treasurer, Cecilia Cheng, who prepares the bank deposit slip and takes the deposit to the bank. The bank deposit form is a three-copy form. The first and second 8 copies go to the bank with the checks, and Mr. Smith, the accountant receives the third copy. The receptionist forwards the remittance advices to Mr. Smith, who first reviews them for appropriateness of any discounts taken and enters them into a daily cash receipts file on his PC. After printing a listing of the remittance file and reconciling it to the deposit slip copy provided by Ms. Cheng, Mr. Smith runs software that posts the individual receipts, to include the amount of any cash discounts, to the customers' accounts receivable and the total to the cash receipts journal file. The day's remittance advices are filed by customer number and the copy of the deposit slip is filed by date. Purchases and Payments Processing Merchandise Purchases Each morning before the first sales orders are processed, the bookkeeper, Mr. Harris, runs the software routine that combines (1) the current perpetual inventory quantity, less items flagged as on order by customers, plus any inventory orders in transit for each inventory item with (2) the reorder stock quantities for each item set by Mr. Navarro and the warehouse foreman. When the current quantity of an item is below the reorder level, telephone price quotes for the standard order quantity are sought from various distributors. The computer prints a sequentially numbered, five-copy purchase order form addressed to the supplier who quoted the lowest price. The computer automatically adds the quantity ordered to the inventory-in-transit files. The inventory-in-transit will be counted in the daily reorder calculation, until the goods arrive and are included in inventory. Mr. Harris calls the supplier to place a purchase order. Subsequently, he mails purchase order copies one and two to the supplier. Copy three of the purchase order is filed in numerical order; copy four goes to the warehouse, with quantities omitted, as authorization to receive goods; and copy five goes to Mr. Smith who places it in an unmatched purchase order file. The following table summarizes the distribution of purchase order copies: PO Copy # 1&2 3 4 5 Mailed to the supplier Filed in numerical order Sent to the warehouse as authorization to receive goods Sent to Mr. Smith who places it in an unmatched purchase order file Receipt of Goods All merchandise is purchased Free on Board (FOB) Southwest's railroad siding so Southwest does not pay the incoming freight costs nor take title to the inventory until it arrives at their railroad siding. When merchandise arrives, the appropriate purchase order is identified by reference to the accompanying shipping documents. Warehouse personnel count the shipment and inspect it for exterior evidence of damage (e.g., punctures in the cartons or crates). The warehouse only accepts clearly undamaged 9 goods. The warehouse clerk enters quantities received on copy four of the purchase order and signs that copy to acknowledge receipt of the goods. Signed copies of purchase orders are then forwarded to Mr. Smith as receiving advices. Vouching and Recording Payables for Merchandise On receipt of signed receiving advices from the warehouse, Mr. Smith enters the quantities received into the perpetual inventory file via a PC. As a byproduct, the computer purges the purchase order from the inventory-in-transit file and produces a message indicating any difference between the quantity ordered and the quantity received. A copy of the purchase order is then attached to copy five in the numerical unmatched purchase order file. It is matched with the vendor's invoice when the latter arrives. When the receptionist opens the mail, she forwards any vendor invoices to Mr. Smith who matches them with the unmatched purchase orders and receiving advices. If a receiving advice is not on file for the invoice, he places it in an unmatched invoice file pending receipt of goods. Mr. Smith attempts to match the open purchase orders and unmatched invoices on a daily basis. When Mr. Smith matches an invoice with the corresponding receiving advice, he compares quantities and prices on the purchase order and receiving advice to the vendor's invoice and tests the arithmetic accuracy of the invoice. Mr. Smith initials the invoice to indicate that this has been done and then keys the vendor, product quantity, price, date of receipt of goods, and discount information into an open voucher file on the computer. The terms are customarily 2/10 net 30. The information is automatically added to the voucher register file and a sequentially numbered voucher is printed to control subsequent disbursement and to serve as the control document for recording the liability and purchase. The computer software summarizes the voucher register file monthly and posts the summary figures to the general ledger accounts. Other software produces a trial balance of the open voucher file any time, either by date due or by vendor. The vouchers (now with the vendor's invoice, receiving advices, and copy five of the purchase orders attached) are held in a physical open voucher file in due-date order. The discount date is used unless otherwise ordered by Ms. Cheng. Non-merchandise Purchases and Services Received The purchases of supplies and other goods are handled in exactly the same way as purchases of merchandise with two exceptions. First, Mr. Smith, using software that prints the purchase order and adds the information to the open purchase order file, originates purchase orders for such items as a new PC. Second, all such purchases not involving capital assets are posted to expense accounts directly. No inventory accounts are maintained for these items. When the receptionist opens the mail, invoices for services, such as utilities, are sent to Ms. Cheng for approval. If she approves them, they become the equivalent of a 10 purchase order and receiving advice. Ms. Cheng stamps her approval, signs, and forwards them to Mr. Smith. Mr. Smith periodically (usually once a month) enters the data from such items, including appropriate payment date and terms, into the open voucher file. The invoices and/or statements are attached to the vouchers that are printed by the software program. These voucher packages are placed in the physical open voucher file and are treated the same as the vouchers for purchases of merchandise. Cash Disbursements Each morning, Ms. Cheng, the Secretary-treasurer, reviews Southwest's short-term cash situation. This process is aided by software that summarizes the vouchers due on that day. Ms. Cheng compares the summarized amount due on that day to the available ready cash and a float factor based on the average daily disbursements and the average number of days it takes for checks to clear the bank. If the cash less float exceeds the amount of vouchers due by at least the minimum cash balance set by Ms. Cheng, she authorizes the payment of all vouchers due on that day. Ms. Cheng then transfers the excess cash from Southwest's demand account to a money market account that earns interest. If the difference is less than the minimum cash balance set by Ms. Cheng and there is cash available above the minimum balance required in the money market account, Ms. Cheng authorizes payment of the vouchers due that day and transfers funds from the money market account to Southwest's demand account. If sufficient funds are not available in the combined demand and money market accounts, Ms. Cheng considers borrowing from the bank on the prearranged line of credit. If the line of credit is also inadequate, which is rare, Ms. Cheng confers with Mr. Navarro. Ms. Cheng and Mr. Navarro generally meet at least once a month to plan for intermediate and long-term financing needs. After Ms. Cheng authorizes the day's payments, the approved voucher packages are forwarded to Ms. Jones who compares the information to the supporting documents. If the voucher data are accurate, Ms. Jones initials the face of the voucher and enters an authorization code via PC into the open voucher file. This triggers the printing of a prenumbered check and detachable remittance advice based on the data in the open voucher file. The disbursement data are automatically transferred to the cash disbursements journal file and purged from the open voucher file. Ms. Jones signs the checks and forwards them to Mr. Navarro's Secretary. Mr. Navarro's secretary cancels the voucher document packages, presents the checks to Mr. Navarro for counter signature, mails the checks to the vendors, and returns the documents to Mr. Smith for filing in voucher number order. Bank Reconciliations Upon receipt of the bank statements each month, Ms. Cheng reconciles the beginning and ending balances and the receipts and disbursements to the book amounts. She forwards the reconciliations to Mr. Navarro for review. He then returns them to Ms. Cheng for filing. 11 Inventory and Cost of Goods Sold Southwest maintains perpetual inventory records on each appliance. Each sale and purchase transaction is entered in the subsidiary ledgers for the particular item sold or purchased as described above. At the end of the month, a worksheet is prepared to cost the ending inventory on a FIFO. Mr. Smith uses a software package to accomplish the costing of ending inventory. The software is able to access both the perpetual inventory ledger and the voucher register file. At the end of the costing routine, the software produces the journal entry to recognize ending inventory and cost of goods sold for the month and enters the latter in the appropriate general ledger accounts. IV. Steps to Completion 1) Client Acceptance and Preliminary Risk assessment Tasks Do an Internet and/or library search to determine the current state of the US economy and the household appliance industry. Client acceptance report. Prepare a client acceptance report to the partner in charge of your engagement. Because so much of the data involved in a client acceptance decision are proprietary and confidential, a simulated case coupled with a public information search will only provide part of the information needed. Therefore, your report will need to contain lists of additional information the audit firm would need to gather before the client acceptance decision is finalized. Address the report to the partner in charge of the audit, which you can assume is your instructor. Your report should contain the following sections: A summary of possible client audit and fraud risks that you develop from your review of the publicly available information on the US economy and the firm's unaudited 2015 financial statements as well as the limited industrial data provided in the case. A description of items you recommend the audit firm research concerning Southwest's managers that would address their ethical character and qualifications to run a firm like Southwest along with a list of possible information sources. Include a short discussion of why you included each item by discussing how it would affect audit and fraud risk. Include three sources of information. A description of items you recommend the audit firm research concerning Southwest's relationships with third parties to include customers, vendors, financial institutions the work with, and legal counsel that would be relevant to assess audit risk. Include possible sources of information for each. Include a 12 short discussion of why you included each item by discussing how it would affect audit and fraud risk. Include three sources of information. A description of items you recommend the audit firm review internally to determine the need for outside experts on the audit and whether the audit firm is sufficiently independent of Southwest. Just provide a general discussion of the sources you would use here. (Hints: The text provides limited information on where to look for client acceptance information in its discussion of the process. However, the sources are similar to the ones it discusses in covering inherent risk assessment. The main difference between the two uses of the information is client confidentiality. Once you have accepted the client, you have much greater access to information. Before you have accepted the client, you will need the client's permission to contact third parties or the third parties will risk legal liability for violating Southwest's confidentiality. Thus, your report should consider getting the client's permission where necessary. In addition, client acceptance decisions involve different components of the risk model. When the risk of accepting this client, you need to be clear on which component is at risk. For example, audit risk issues involve risk to the auditor from such things as the risks of future litigation that don't directly affect the risk of material misstatement. Inherent risks involve features of the firm and its environment that will increase the risk of material misstatement.) Draft engagement letter Prepare a draft engagement letter for Southwest. Fill in as much of the normal sections of the letter as possible given the information you have gathered. The engagement will only cover the financial statements and not any additional services. Deliverables Your Client Acceptance Report - You report should be between two and three singlespaced pages using 1" margins and 12-point font. You also don't need to include more than three suggested sources for each section of the report. Name you file with your name and "SW Client," and then attach it to the Southwest 1 assignment in LEO. Your draft Engagement Letter - Your engagement letter should be between one and two single-spaced pages using 1" margins and 12-point font. Name your file with your name and "SW Engagement," e.g. "Jim Peters SW Engagement.docx" and attach it to the Southwest 1assignment in LEO. 2) - Inherent Risk and Materiality Tasks Perform the following tasks and document them in the Southwest Risk and Material Memo Template Word document. Preliminary Inherent Risk Assessment - Review the description of Southwest Appliances, Inc. and identify four inherent risks based on the information provided. I 13 have listed one potential inherent risk area as an example and you need to add four more to the list. 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 it increases or decreases inherent risk. Make sure your "how" 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 text information in the case to the Sales and Collection Processing section and not the financial statement data or detailed description of the sales and purchasing processes. Part b. covers risks identified using analytical procedures based on the financial data. You will be asked to identify transaction process risks associated with sales and purchases in another task. Preliminary Analytical Procedures - Review Southwest Appliance's financial statements, ratios, and industrial data presented at the end of this document. Identify four accounts that you believe need additional audit scrutiny and explain why. I have included one example and you will need to add four more to the list. Copies of Southwest's audited 2014 and unaudited 2015 financial statements are included after these requirements. Some common ratios for Southwest and their industry are also included. Preliminary Materiality Judgments- Set two preliminary materiality levels for the Southwest audit - one for the balance sheet and one for the income statement. Document your materiality level and explain why you chose it. Deliverable Completed Southwest Inherent Risk and Materiality Memo Template file containing the results of your inherent risk assessments, preliminary analytical review, and materiality level determination. Rename you file with your name and "SW 2, e.g. "Jim Peters SW 2.docx," and then attach it to the Southwest 2 assignment in LEO. 14 15 16 17 18 19 3) - Evaluating Controls Tasks Review the Southwest case to evaluate their control environment strengths and weaknesses. For each strength, provide a short description of the activity or feature you believe is a strength and then explain how it strengthens their control environment. For each weakness, provide a description of the activity or feature that you believe is a control environment weakness, an explanation of how it weakens the control environment, and a recommended improvement. Limit your answer to three major strengths and three major weaknesses. I have provided one example of each in the template file and you need to add three more strengths and three more weaknesses to the table in the template file. Review their specific controls over sales and collections and purchases and payments to evaluate transaction control weakness. a) Describe the control weakness (just a short statement of weakness); b) Describe how the weakness could create a material error in the financial statements including which general ledger accounts and audit objective might be affected(be clear on which category is involved, balance, transaction, or presentation and disclosure) and provide an explanation of how the weakness might lead to a violation of the audit objective; c) Make a recommendation on how their controls could be improved to mitigate this weakness; and d) Discuss some potential weaknesses in the control you suggest (e.g., how it might be overridden). e) Limit your answers to the four most serious weaknesses you find in the sales and collection processes and the four most serious in the purchases and payments processes. The template file has separate sections for each step in these processes to help you structure your answer. The four weaknesses in each or the processes can be spread in any way across the steps and you are not required to have any minimum number in any step. Your control weaknesses and recommendations need to be specific to the case and sensitive to the size of the organization. The following are some examples of recommendations that would not be appropriate for Southwest: They are too small and cannot afford to establish and internal audit department nor contract out those services to an outside auditor. They cannot afford to make significant changes to the their current computer systems and so recommendations to computerize their current manual operations are not practical. However, all their 20 information is currently stored electronically and so you may suggest simple ways they could more effectively share or control that data. The operations of their EDP environment are completely described in the case. Thus your critique of their controls should be limited to those portions of their EDP environment that are included in the case description. Deliverables Document your findings in the Southwest Controls Template file. Rename your file with your name and "SW 3," e.g. "Jim Peters SW 3.docx" before attaching it to the Southwest 3 assignment in LEO. 21