You are working on your firms fifth audit of SSC. The previous audits have all resulted in standard unqualified audit reports. Read the following write-up from your audit files concerning SSC and its industry, and then reply to the questions that follow.

Company Information

In 20X1, Gary Sherwood founded Sherwood Stone Company (SSC). In the middle of its second year of existence, the company completed development of a large extraction pit area and constructed an aggregate processing plant that is equipped to crush, screen, and wash aggregate products. By 20X4, the sand and gravel operation was profitable and growing market conditions justified modifications and expansion. Currently, SSC produces a wide range of sand and stone products from its pit near Bisbee, Arizona. The materials it develops are composed of sand and stone materials for commercial construction and highway projects.

SSC sells to a wide variety of commercial and governmental customers, with only one of its numerous customersWingo Corporationaccounting for more than 5 percent of total sales. In total, Wingo has represented approximately 30 percent of sales (and receivables) for the past few years. Wingo Corporation is by far Arizonas largest street and road contractor and seems solid financially. Virtually all of SSCs sales are on credit, although all but the smallest contracts require progress billings that result in payment being received by SSC on a pro rata basis with delivery of materials to the customer. Payments from customers are made directly to the companys lockbox system with SSCs local bank. All transactions occur in U.S. dollars, and SSC maintains both a general checking account and a payroll account.

SSC has worked closely with Wingo Corporation in developing a superior road paving product (QuietRide). Not only is the car ride relatively quiet on QuietRide roads, but it is also relatively cool (thus lengthening the life of automobile tires) and less likely to lead to cars sliding in rainy conditions. Although Wingo Corporation holds the overall patent, SSC has patented a critical component that is used in the product (the component is QSand). The product now accounts for approximately 25 percent of the companys sales (all to Wingo Corporation) and 33 percent of its profits.

The success of QSand has led SSC to start developing another product, QDeck. QDeck will be a final finishing coat over the pool deckthe concrete walking and lounging area that surrounds a swimming pool. QDeck is intended to address two problems: (1) individuals slipping and falling on pool decks while walking with wet feet and (2) individuals burning their feet on the deck on particularly hot days. Gary indicates that the current compound seems to allow good traction and decks remain much cooler than with products of other companies. The problem being addressed at this point is that the current compound seems to crack easily and has a relatively short useful life. Indeed, in one test of the product on the deck at Garys home, Garys wife Madonna cut her foot on one of the cracks and required several stitches to close the wound. Gary laughed and said that at least she didnt slip or burn her feet on that hot day when it happened. More seriously, he suggested that this deficiency is currently being worked on and must be solved before the product goes to market. The product is being independently developed and is intended for both residential and commercial markets.

In 20X8, the company experienced a level of profitability just slightly above that of 20X7but this was well below the net incomes of the preceding few years. Gary suggested to you that, surprisingly, intense price competition from several smaller competitors in the Bisbee area caused the somewhat low level of profitability. But, he added, he didnt expect the problem to last for long because he doubted that those companies could continue to operate selling at those lower prices. Gary had hoped for a more profitable year in 20X8, as a significant amount of the companys long-term debt is payable in 20X9. SSC is currently involved in discussions with the bank on refinancing.

SSC added significant additional crushing and washing plant and equipment during 20X8 to increase production in the future by more than 100 percent while expanding capabilities to produce custom specification materials.

No dividends have been paid during the past two years, although previously most of the earnings were distributed through dividends to SSCs five shareholdersCEO and Chair of the Board of Directors Gary Sherwood, his wife Madonna Sherwood, CFO Jane Zhan, and two college friends of Garys who invested in the company, Cindy Stone and Kelly Higgins. These five individuals make up the companys board of directors.

The Bank of Arizona is the financial institution with which SSC maintains its two cash accounts (general and payroll cash accounts) and from which it obtains a significant portion of its financing; the inventories are pledged on the Bank of Arizona loan. This year, in reaction to pressure from the bank, SSC established an audit committee composed of Madonna Sherwood, Cindy Stone, and Kelly Higgins.

Industry Information

The industry activities consist of the extraction and preparation of sand and rock products. These activities include the cleaning, separating, and sorting of quarried sand and the process of crushing rocks. The products are in the form of sand used in making concrete; sand used in laying bricks (which contains little soil); sand used for fill (which contains a large amount of soil); and quartz sand. It excludes the products of gravel quarrying (sandstone, gravel stone, and iron sand).

While sales within the industry are relatively unaffected by changes in technology or obsolescence, industry sales rely heavily upon both the residential and commercial construction markets as well as government spending. During the past five years, construction has performed well and that trend is expected to continue for at least the next several years. Sand and gravel production has increased at approximately 4 percent per year during this time period, as has construction within the central Arizona area.

a. Which of the following represents a correct statement concerning the risk of misappropriation of cash for SSC?