Macro Appliances Inherent Risk Assessment

Accurate Auditing, Inc.

78243 Brownsville

TX 987-210-1892

Date: May 2, 2019

To: Arely Davies, Partner in Charge

From: Peter Rogers, Senior Staff Auditor

Subject: Client Acceptance Report

On May 4, 2019, Mr. Davies, the partner in charge, requested my team to carry out a preliminary evaluation of Macro Appliances, Inc. The assessment should be conducted on inherent risks and control design of the company in order to determine its financial health and provide an opinion regarding Macro’s financial statements. In response to the request, my team has carried out assessments on Macro and obtained some of its financial reports that are critical in the preliminary feasibility assessment.

Macro Appliances Inc. is a small company that supplies a small line of high-quality household appliances to its customers. With a workforce of 50 total employees including corporate officials, the company provides high-quality household appliances to residential contractors. Prior to the 2008 global financial recession, the wholesale appliance industry experienced gross sales at a rate of 7% annually. However, this industry was significantly affected by the recession, which resulted in decline in sales. During this period, Macro’s sales declined by 15%. However, the wholesale appliance industry experienced a slow economic recovery after the recession as reflected in the annual increase in the real growth rates by approximately 3%.

The appliances industry accounted for 27.8% of revenue share in 2016 with an estimated growth rate of approximately 5.4% between 2018 and 2025 (Bhandalkar & Das par, 1). During this period, this industry was valued at $43.34 billion (Grand View Research par, 1). In 2018, the household appliance industry grew by 4.5% (Wolf par, 2). Most of the items in this industry experienced an increase in sales by between 3.5% and 7.8%.

As real growth rates for the industry have started to increase by about 3%, Macro has started to recover and capitalize on the market to expands its operations and profitability. Macro’s opportunity for growth is also attributable to the changing lifestyle of consumers and the booming housing market. These trends are expected to enhance the growth of the company, which deals directly with contractors. Therefore, the development of more houses due to the booming housing market implies that the future of Macro Appliances, Inc. looks bright.

Conducting this preliminary analysis entailed obtaining and examining the audited financial statements of Macro. My team obtained unaudited financial statements for the year ended December 2018 and 2019. These financial statements were critically studied in order to identify accounts that could have significant impacts on its financial health. The scrutiny of these financial statements revealed the followings:

· During the period between 2018 and 2019 financial year, Macro’s sales increased by approximately 20% and accounts receivable increased by 41.11%. Since the financial statements are unaudited, the growth in sales and account receivables could be brought about by some possibilities. It is possible that the firm’s sales and accounts receivables increased because of probable inflation or due to poor strategies in the collection of receivables.

· Secondly, Macro reported a dramatic increase in its sales return from 2018 to 2019 i.e. by 52.50%. This dramatic in the firm’s sales return requires additional scrutiny to ensure it accurately reflects Macro’s financial status and health. Additionally, comprehensive scrutiny of this financial measure would help determine whether Macro is using an appropriate framework to estimate allowance for sales return.

· Macro Appliances Inc. reported a 20.5% increase in its cost of goods sold during the same period. To account for the cost of goods sold, Macro utilizes FIFO method and the ending inventory. It is necessary to examine whether the company’s increase in cost of goods sold is attributable to decline in the price of materials or another factor in its operations.

· The firm’s cash and cash equivalents as well as money market funds declined by 50.71% and 49.22% respectively from 2018 to 2019. This raises significant concerns given that the firm’s account receivables increased by 41.11% during the same period. It could be an indicator that Macro is selling its products to credit unworthy clients. This implies a need to examine Macro’s credit approval policy and whether its collection department is effective in its work or operations.

· The other area of concern in the company’s financial operations and statements relates to accounts payable. The firm reported a 167.36% increase in its accounts payable and a 108.33% in current liabilities.

The auditing process for Macro Appliances, Inc requires getting in touch with the previous auditor, which will require authorization by the company’s management. This will help obtain additional information about the qualifications, integrity, and ethics of the management. Obtaining such information is essential to understand the current internal control framework and structure of Macro. By obtaining such information, the team will ensure that Macro prepares its financial statements based on the current accounting regulations and principles.

Apart from contacting the previous auditor, the team will also need to obtain internal evidence by having full access to relevant financial documents. Some of the relevant internal financial documents include receipts, checkbooks, sales orders, invoices, and purchase orders. External evidence from relevant government agencies, creditors, customers, and vendors will also be obtained and used in the auditing process. This will require management authorization and provision of the contacts of vendors, customers, creditors, investors, and previous auditors.

My team will also examine the accuracy of Macro’s current accounting system to ascertain that it’s not the probable cause of inaccurate financial statements.

Thank you!

Accurate Auditing, Inc.

Peter Rogers

Macro Appliances, Inc.

May 3, 2019

Dear Mr. Cheney,

This letter confirms our understanding and acceptance of the terms and objectives of the engagement.

We will review/audit the balance sheet of Macro Appliances Inc. as of December 31, 2019, and the related income statements and cash flow for the year. The main objective of our audit will be to express an opinion regarding Macro’s financial statements for the year ended December 2019. Therefore, we will provide our professional opinion regarding these financial statements based on this audit. We understand that the financial statements are the responsibility of Macro’s management team. To this extent, our responsibility as your auditor is to express a professional opinion regarding them based on our audit.

Our audit will be carried out in accordance with the International Standards on Auditing and based on Statements on Standards for Accounting and Review Services stipulated by the American Institute of Certified Public Accountants. Additionally, we will audit the financial statements in accordance with generally accepted auditing standards. These standards require that we prepare and conduct the audit to obtain reasonable assurance that the financial statements are accurate and do not contain any material misstatements.

Our audit will basically entail inquiry of the firm’s personnel and analytic procedures, which will require a client representation letter from you. As part of the audit, we will obtain internal and external financial documents. Some of the relevant internal financial documents for the audit include receipts, checkbooks, sales orders, invoices, and purchase orders. On the other hand, external financial documents include evidence from relevant government agencies, creditors, customers, and vendors. To obtain internal and external evidence, we will require management authorization and provision of the contacts of vendors, customers, creditors, investors, and previous auditors.

The audit will also seek to examine the current internal control structure at the company. This will help to ascertain that the internal control structure is suitable and does not contribute to any material misstatement in the financial statements.

We look forward to full cooperation with your staff and trust that they will provide the relevant documentation or information requested for the purpose of the audit. Billing for the audit will be done as the work progresses and depending on the time required by the assigned individuals to carry out their respective tasks.

Unless it is amended, superseded, or terminated, this letter will be effective for future years.

If this letter accurately expresses your understanding of the engagement, please sign the attached copy and return it to us.

We are grateful for the opportunity to serve you and hope that this will be the beginning of a long and meaningful relationship.

Sincerely,

Executive Director

Accurate Auditing, Inc.

Acknowledged on behalf of

Macro Appliances, Inc. by

___________________________ Date: _____________________

[Name]

[Title]

Marco 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.

Management policy that customers pickup all goods from the single warehouse – The requirement that customers pickup all goods from one location increases the risk of theft or fraud because of the potential collusion between the company’s staff and customers. By requiring customers to pick up all goods from the warehouse, this policy provides a loophole Macro’s employees to collude with customers to steal some of the goods. This would in turn create a material misstatement on the financial statements because the stolen goods would not be accurately recorded. Due to the increased risk of misstating inventory, some of the purchases would be damaged because of mishandling. Thus, I would recommend that the management needs to identify and designate a different location for customers to pick up their purchases in order to lessen the inherent risk.

Approval of return of goods via a phone call – The current sales returns policy allows customers to return goods via a typical phone call if they receive incorrect or damaged goods. While this enhances convenience for customers, it increases the risk of material misstatement during documentation if the returned items are not scrutinized properly. The inherent risk in the practice is the likelihood of failure to check returned goods properly, which would contribute to material misstatement in the financial records. Therefore, I would recommend that returned items are examined first before being accepted. Moreover, auditors should be allowed to conduct further assessments on the returned goods.

Changing authorized selling prices based on competitive evaluation – The authorized selling prices of goods are adjusted based on an assessment of competitors in order to increase Macro’s profitability. The inherent risk in this practice is potential understating or overstating Macro’s sales. Inaccurate recording of sales prices increases the risk of material misstatement of Macro’s balance sheet and income statement. Thus, I would recommend that auditors recommend the limits of price adjustments in order to minimize this inherent risk.

Profit-sharing bonus agreement for Macro’s employees – Macro instituted a policy that allows bonus agreement for employees and the top management in order to increase sales and operating efficiency. The inherent risk in this practice is that auditors are unlikely to determine the accurate profits of the firm because profit-sharing bonus agreements are based on unaudited net profits. My recommendation is that the company should utilize audited net profits as the basis for profit-sharing agreement for its employees and the top management.

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.

Accounts Receivable Increase – Accounts receivable increased from $301,713 to $425,755 i.e. by 41.11% in 2019. This substantial one-year increase is fairly large and poses a risk to some of the company’s credit sales. In this case, some of Macro’s credit sales could have been turned to doubtful debts that are in turn written off. Additional scrutiny is required to help determine treatment of some of the credit sales.

Cash and Cash Equivalents – Despite reporting an increase in financial activity between 2018 and 2019, the firm’s cash and cash equivalents declined by more than 50% i.e. from $20,045 to $10,876. According to Bryant, a business with an increase in cash and cash equivalents has higher liquidity, which implies that it is healthier and poses less risk (par, 1). Macro’s cash and cash equivalents require further audit scrutiny because the substantial decline poses significant liquidity risk and implies that it cannot meet its daily financial obligations.

Days Cash in Payables and Accrued Liabilities – Macro posted an increase in days cash in payables and accrued liabilities from 23.0 in 2018 to 50.8 in 2019. This implies that there was an increase in the number of days the company paid its creditors. This financial ratio requires additional audit scrutiny because an increase in days of paying creditors implies that the firm is unable to meet its short-term financial obligations as agreed. This essentially poses a negative image of the company to its creditors.

Sales Return Increase - Macro reported a 52.50% increase in sales return from 2018 to 2019. The substantial increase requires additional audit scrutiny to determine whether the firm is using an appropriate framework to estimate allowance for sales return. This would help determine whether the increase accurately reflects Macro’s financial status and health.

Preliminary Materiality

Balance Sheet – The materiality amount for the items in the balance sheet was determined using the single rule, which involves applying a fixed percentage rate on a selected concrete financial indicator (Lakis & Masiulevicius, p.120). For Macro, the selected financial indicator is assets and the fixed percentage rate is 2%. This fixed percentage rate is suitable for the company since there are few individuals involved in the business, which enhances the risk of material misstatement of the financial statements. Therefore, 2% of the company’s total assets would be:

Materiality = Percentage*Computation base (Vilsanoiu & Buzenche, p.939).

Income statement – The single rule proposed by Lakis & Masiulevicius is used to determine the materiality of a financial indicator in the income statement. 1% fixed percentage rate will be utilized on sales revenue, which is an important financial indicator in the income statement. Therefore, 1% of the firm’s sales revenue would be:

Materiality = Percentage*Computation base (Vilsanoiu & Buzenche, p.939).

Marco Appliances Inc.

WP C.1.

Evaluation of Control Environment

Potential Control Strengths

Potential Misstatement Detected or Corrected

Marco uses a distributed computer system that gives employees who need access to data the appropriate access.

This improves the control environment because it all employees are working with one database, which reduces potential errors from multiple recording of data.

Macro uses passwords to limit access to computer system applications

This ensures that only authorized personnel have access to the computer system, which in turn safeguards financial records. The use of passwords guarantees security of the financial records by preventing unauthorized access.

Macro’s management carries out regular employee training to enhance the standards of operations

This ensures that the firm’s employees are competent and possess necessary skills to perform their respective duties. Employee training helps lessen chances of unethical and fraudulent activities through enhancing compliance with established procedures and standards of operations.

Back-up input of computer transactions using source documents and paper trails

This ensures that a redundant system exists and can be utilized in case of computer system failure. Additionally, it helps to minimize errors or manipulation and safeguards against misstatement.

Marco Appliances Inc.

WP C.1.

Evaluation of Control Environment

Potential Control Weakness

Potential Misstatement

Recommended Correction

The case describes extensive use of policies and procedures; training new employees in these policies and procedures; and having yearly retraining sessions. However, it doesn't mention any on-going monitoring of employee behavior nor any use of employees' record of compliance with them in annual performance reviews.

Having clear policies and procedures with excellent training is good, but you also need some form of monitoring system to insure the emphasis and training is working.

Recommend that Marco implement annual reviews that include evaluation of how effectively employees are implementing firm policies and procedures.

Macro’s hiring system and process involves carrying out an evaluation of references. However, the case does not mention any criminal or background checks conducted on potential employees.

While references help in providing vital information regarding a potential employee, background checks are necessary to help ascertain information provided by references. This also helps the management to avoid theft, fraud, or mismanagement by new hires.

Macro should conduct extensive background and criminal checks when hiring to ensure potential employees will meet operational standards.

Macro’s accounting staff have limited experience, which generates concerns regarding the accuracy and reliability of its financial statements.

The lack of in-depth knowledge on accounting by the firm’s accounting staff increases the risk of misstatement of the financial records.

Macro should incorporate training on accounting processes and practices as part of its existing regular employee training program.

The case describes how the company uses computer system for its everyday operations. However, it does not mention how this system is maintained and processes for system fixes.

Computer start-up issues and other problems with the system remain a major challenge for Macro. These issues increase the likelihood of loss of financial records.

System upgrades should be carried out regularly to safeguard financial records.

Marco Appliances Inc.

WP C.2.

Evaluation of Transaction Processing Control Design

Potential Control Weakness

Potential Misstatement

Recommended Correction

Possible Weakness

Sales

Insufficient credit checks for new clients

Likelihood of bad debts that increases loss of revenue

Designating a senior manager to examine the creditworthiness of new clients before any transactions

Bouncing checks because of insufficient funds

Lack of proper monitoring of inventory levels

Probable overstatement of revenue because of back-ordering transactions. Sales could be recorded without actual delivery of orders

Establishment of a system for inventory monitoring

Could be a time- consuming process resulting in order cancellations

Lack of separation of duties as sales clerk records orders and generates sales requisitions

Likelihood of inaccurate records due to errors

Designate a different employee to generate sales requisition after orders are recorded

Could be a time-consuming process

Failure to deliver orders within the required time because of early cut-off

Misleading balance of inventory because of challenges in inventory count

Orders should be delivered on the same day they are accepted

Likelihood of selling orders that are not delivered to another customer

Delivery

Collection of goods at the firm’s warehouse

Possibility of collusion with the company’s employees to steal goods or overstate the cost of goods resulting in revenue loss

Designating a different pickup location for items and assigning sales clerk to check orders

Loss of company revenue

Deleting the copy of sales orders

Likelihood of over- or under-stating sales revenues

Establish a system to preserve documents and maintain backup copies

Generating a large paper trail that could be difficult to properly manage

Lack of proper handling or packaging

Increased likelihood of damaged goods

Establish proper packaging procedures

Likelihood of damages if the packages fall

Requiring customers to return goods via a typical phone call

Material misstatement due to the failure to check returned goods

Assign staff to check returned goods first before acceptance

Could result in delays in the process of returning damaged goods

Marco Appliances Inc.

WP C.2.

Evaluation of Transaction Processing Control Design

Potential Control Weakness

Potential Misstatement

Recommended Correction

Possible Weakness

Billing

Sales are recorded at the gross amount

Misleading sales value because revenues or profits are overstated

Net amount should be used as the basis for recording sales

The overall amount of sales discount could be misleading

Sales amounts in individual customers’ accounts and sales journal are based on gross amount

Sales revenue and accounts receivables are overstated

Net amount should be used for recording account receivables

Failure to comply with relevant accounting principles and practices for recording transactions

Variations in manual and computerized records

Likelihood of errors in customers’ orders and sales invoice

Matching manual and computerized records

Inaccurate verification and authorization of orders

Assigning a single employee to carry out all billing processes

Likelihood of inaccurate records due to errors

Assign additional staff to support the employee

Inaccurate billing and financial records

Collections Management and Write-offs

Considering write-offs once a month

Errors relating to cut-off

Establishment of measures for doubtful debts

Increased likelihood of writing off debts

Decision-making by a single individual

Likelihood of increased debtors because of protracted credit days

Assigning additional staff to help in the decision-making

Likelihood of fraudulent activities through collusion with some clients

Reconciling receivables ledger and the general ledger monthly

Over- and under-statement of bad debts and receivables

Reconcile the two ledgers on a weekly basis

Negative balance in receivables

Analysis of aged receivables by the secretary