ABC Appliance Inc. Case Study

Preliminary Inherent Risk Assessment/ Internal Control

·                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.

·                Top Management holding 50% of the stock –The management holds half of the stock and in addition to that they carry the task of running the company. This creates an inherent risk as there is a conflict of interest and the management are forced to choose between what is best for them and what is best for the company. I would recommend that high level executives should be limited on the amount of stock that they can hold. The majority shareholders can be in the board but not management.

·                Profit sharing based on unaudited Financial Statements – Profit sharing is a good incentives to improve the performance of the employees. However, it should be based on audited statements as unaudited statement brings an element of risk whereby, the managers can exaggerate the numbers so that they can be paid. My advice is that it should be prepared by a neutral party with no personal stake in it.

·                Lack of Background Check – When hiring new employees, the auditee does not check on their criminal records and other background information. This increases the risk of hiring people with falsified documentations or potential criminals. To avoid this, I recommend that the company should do a proper background check on all employees including their past employment and records with law enforcement agencies.

·                Lack of separation of Duty- As much as there are a lot of duties separated, there duties are still done by a few people and in some cases one person does it for example in cash disbursement where Ms. Cheng does all the work in the initial stages without supervision. This raises the risk of fraud or collusion among employees. My recommendation is that no single employee should be in charge of a process in which he or she can change up digits without it being detected.

Preliminary Analytical Procedures

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

·                Dividend Payout- The dividend payout by 92.6% in 29015 is unusually large. This means that instead of the profits being reinvested, they are paid out to shareholders. Considering that the top management has an over 50% of the stock.

·                Days of cash payable and accrued liabilities – The days have more than doubled from 23days in 2014 to slightly over 50 days in 2015. This shows a deviation from the norm which needs a closer look as it increases the risk of insolvency.

·                Accounts Receivable – The accounts receivable have also increased by more than 41% in 2015 from what was in 2014. This might show the inability of the firm to collect debts which is a risk on its own. More attention should be given so as to determine the reason behind this and how to improve on the same.

·                Money market funds – The money market fund is a volatile industry in which the business has no expertise in. Thus, a 49% change should be looked at more closely. It could signal that the business is making losses in it or a tool to defraud cash of the company.

Preliminary Materiality

·         Balance Sheet – 2% of the total assets. Total assets value for year 2015 is $ 1,255,934 therefore, 2% will be $25,118.68 and that will be my materiality amount.

·         Income statement – 5% of profit before tax. The income before tax for the year 2015 is $142,420. Thus 5% of $142,420 is $7,121 which will be my materiality amount in the income statement.

The percentages are from ISA 320 Materiality (Quantitative factors). I have chosen the performance materiality to reduce an appropriately low level probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole. Another reason for choosing it is because in ABC, a number of transactions have been combined to form the materiality. It is also appropriate as I will be using it to test individual transactions, account balances and disclosure.