Accounting Project

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I. Title: Marco Appliances Inherent Risks and Control Design Project

II. Introduction

After working as a financial accountant for several years, you decide to apply for a position you

learned about during a virtual career fair offered by UMGC’s Career Services. The most

prestigious accounting firm in the District of Columbia, Levin, Lombard, & Wolod, LLC, were

looking to hire several accountants and preferred UMGC graduates given the reputation of its

graduate accounting programs. Shortly after the virtual fair, you receive a certified letter in the

mail stating: “The Supervising Senior Auditor approved your application for an auditing position.

Please contact our Human Resources Department at 201-000-0000 to continue in the hiring

process. We look forward to having you on the Levin, Lombard, & Wolod, LLC team.”

Within a few months, the Supervising Senior Auditor (your professor) assigns you to a team

auditing Marco Appliances, Inc. The Supervising Senior Auditor calls to say “I’m assigning you

to this particular audit team because it will provide a good opportunity for you to demonstrate

your knowledge and skills on a portion of the audit process of a valued client, Marco Appliances,

Inc. a small appliance wholesaler.” You are familiar with Marco Appliances (Marco) because

your parents, who owned a retail appliance store decades ago, purchased inventory from

Marco. You recall the store’s address because it is the same as your birthday; 18 January

Lane in Annapolis, MD 21401. The Supervising Senior Auditor leads the audit teams and

makes recommendations, including structuring the parts of the audit and presenting the results

of a preliminary review to the Manager.

During the last five years, a small local CPA firm has been conducting the Marco Appliances

audit. Feeling a need for greater diversity, Marco Appliances selected your firm to conduct its

2015 audit. Marco is a small company with 50 employees including the corporate officers that

specializes in supplying a line of high-quality household appliances to residential construction

contractors in a large and growing metropolitan area. Marco has a list of customers, mostly

custom builders of single-family dwellings and some builders of single and multiple family units.

Marco’s basic marketing strategy is to ensure all inventory items are in stock and offered at

competitive prices. At the end of every quarter, Drew Black, Marco’s President, reviews product

costs and adjusts the authorized selling prices of products, as necessary. He makes the selling

price adjustments based on his assessment of how his competitors may change their pricing in

the coming year. Drew also considers his fiduciary duty to maximize shareholders’ wealth.

The 2008 global recession affected the wholesale appliance industry, which has had a slow

economic recovery but is showing signs of improvement. Before the recession, the industry's

gross sales were growing at a real rate of approximately 7% per year, with the usual wide

variations from year to year due to fluctuations in the residential housing industry. During the

recession, Marco sales fell 15%. Fortunately, real growth rates for the industry are starting to

increase to around 3% in the current year. Marco management expects future growth in the

industry to be about the same level for the next three to five years. There is some concern that

the Marketing Manager’s marketing strategy is ineffective because Marco sales fell more than

the industry during the recession and have not grown as fast as the industry in recent years.

Marco facilities consist of a single warehouse and office building next 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 pick up all purchases at this

location; thus, the company avoids maintenance expenses on its vehicles, which would be

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incurred if Marco delivered to its customers. To further trim costs, Marco contracts with the

trucking business next door to deliver goods (FOB shipping) to some customers. All sales are

final when appliances leave the Marco loading dock for customer pick up orders and deliveries.

Marco is a privately held corporation that was incorporated in the same state in which its home

office is located. It operates in its home state and three surrounding states. Shareholders

include approximately 300 individuals and businesses. Currently, Marco ’s top management

owns over 50% of the outstanding stock. The Board of Directors voted to expand operations

and is planning to go public with an initial public offering (IPO) within the next year. Executing an

IPO will require the Board to disclose historical financial information.

Marco currently provides audited financial statements to banks when seeking loans and,

therefore, has incurred audits in each of the last five years by the same accounting firm.

Because Marco is a small company, their local bank insisted on adding restrictive covenants to

the firm's last loan agreement. These covenants include a provision that allows the bank to call

the loan immediately and in full if Marco’s current and debt to equity ratios fall below specified

levels. The covenants also set limits on the dollar amount of dividends the firm can pay.

To help stimulate sales and operating efficiency, Marco recently instituted a profit-sharing bonus

agreement for its employees, including top management. The impetus behind the profit-sharing

agreement arose because employees had gone without raises for several years. The

agreement bases employee bonuses on unaudited net income from last year to adjust

employees' salaries at the beginning of the next 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

amount available to pay bonuses. Management bases individual bonuses on an employee's

position, length of service, and certain specific negotiated terms with individual officers.

Marco’s Board of Directors includes Drew Black, its current president; Dakota Amalia, the

Controller; Harper Kim, the Secretary/Treasurer; two shareholders, each of whom own a five

percent interest in the firm; and one retired CPA, Montana Green. 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.

Marco 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 seek new insights into

their operations and preferred working with a more diverse audit firm. Further, they wanted to

hire a larger auditing firm with a more established reputation to support their anticipated IPO.

Table 1 lists the position and name of major stakeholders associated with Marco.

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Table 1: A summary of the major stakeholders and positions in the company

Position Name Chairman of the Board Harley Magenta (major shareholder) Board Member Montana Green, CPA (retired) Board Member Mr. Washington President Drew Black Controller Dakota Amalia Secretary/Treasurer Harper Kim Accountant Stephen Violet Bookkeeper Cooper Teal Marketing Manager Mr. Zen

The Control Environment

Marco’s accountant prepares financial statements and various financial statistics for the officers

to review monthly. The Board reviews similar statistics quarterly at the regular Board meetings

and questions the officers about what is going on in the business. The Marketing Manager

personally follows sales figures and gross profit margins.

Supervisors interview all prospective employees for positions they supervise. At least one of

the corporate officers also interviews each prospective employee. Most of the key employees,

including the officers, have been with Marco for more than ten years. However, due to the high

demand for accountants, Marco’s accountant, and most of the accounting staff have been

employed at Marco for less than three years. While Marco 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 Marco’s accounting and inventory

management systems. Personal computers are located in the offices and warehouse, but a

central server handles all accounting and inventory files. Printers are 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. Marco uses commercial accounting software recommended by

their auditor. To date, they have had only the usual startup problems. Marco has used the

software for two years and upgraded it once.

Marco 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 and the firm uses an Internet service to back

up all files to the Cloud. Marco 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.

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Marco 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. When hired, employees must read the

policies, including a code of conduct, and sign a statement agreeing to the policies.

Sales and Collection Processing

Sales Requisitions

Marco 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 on a walk-in basis, and some

occasionally arrive in the mail. Usually, building contractors or their representatives call to get

current price quotes and find out if specific appliances are in 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; the buyers are informed their delivery

will occur the following day. In addition, sales clerks can immediately inform a caller about out-

of-stock items and establish a backorder for the customer. Backorders 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 requisitions and ordering

information and prints a requisition form with today's date on it for transmittal to the Controller.

Sales clerks cannot set up new customers in Marco’s computer system. If a new customer calls

to place an order, they are referred to 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 over-commitment 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 the Controller’s office. The Controller’s secretary gives the requisitions

to the Controller, 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. The

Controller initials the requisition to indicate approval of the sale and enters an approval for the

requisition in the accounting system.

When the Controller 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

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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 orders and sent to the bookkeeper. 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 the Controller

approves or disapproves the requisition. If the customer has requested an update on the order,

the sales clerks call the customer to inform them that their orders have been approved and

delivery to their driver has been authorized. If the Controller 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 the Controller

did not approve to inform them of the situation. If they dispute the denial of credit, they are

transferred to the Controller’s 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

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, which prints 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 the bookkeeper. The warehouse clerk's working copy of the sales order is usually

discarded.

Billing

When the bookkeeper 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, the bookkeeper 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 the 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, the bookkeeper 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

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summarize sales by product and to make monthly postings to the general ledger. The

subsidiary ledger is used to review customer creditworthiness, to manage collections, and to

determine write-offs.

Collections Management and Write-offs

The Controller, 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. The Controller 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 standard practice for the

Controller to consider write-offs only once at the end of the month. Marco’s general policy is to

write off any invoice exceeding six months from the time of sale. However, the Controller 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 and 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. The bookkeeper 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. The bookkeeper sends the credit memorandum

to the Controller for approval; she then returns it to the bookkeeper. Upon receipt of the signed

credit memorandum, the bookkeeper enters the Controller’s 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. Marco 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 Marco’s sales invoice) and sends the checks to the Secretary-treasurer, Harper

Pink, 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 copies go to the bank with the checks and the

accountant receives the third copy.

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The receptionist forwards the remittance advices to the Accountant, 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 the Secretary/Treasurer, the Accountant runs software that posts the individual

receipts of any cash discounts to the customers' accounts receivable and the total amount to

the cash receipts journal file. The day's remittance advices are filed by customer number and a

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 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 the Marketing Manager’s 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. The bookkeeper 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 the Accountant who places it

in an unmatched purchase order file. The following table summarizes the distribution of

purchase order copies:

PO Copy # Status 1 & 2 Mailed to the supplier

3 Filed in numerical order 4 Sent to the warehouse as authorization to receive goods 5 Sent to the Accountant who places it in an unmatched purchase order file

Receipt of Goods

All merchandise is purchased Free on Board (FOB) Marco’s railroad siding, so MARCO 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 undamaged 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 the Accountant as receiving advices.

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Vouching and Recording Payables for Merchandise

On receipt of signed receiving advices from the warehouse, the Accountant 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 the Accountant, 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.

Daily, the Accountant attempts to match the open purchase orders and unmatched invoices.

When the Accountant 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. He also 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 due date 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 the Secretary/Treasurer.

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, the Accountant, 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 the

Secretary/Treasurer for approval. If she approves them, they become the equivalent of a

purchase order and receiving advice. The Secretary/Treasurer stamps her approval, signs, and

forwards them to the Accountant. He periodically (usually once a month) enters the data from

such items, including appropriate payment dates 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, the Secretary-Treasurer, reviews Marco’s short-term cash situation. This

process is aided by software that summarizes the vouchers due on that day. The

Secretary/Treasurer compares the summarized amount due on that day to the available ready

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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 the Secretary/Treasurer, she authorizes the

payment of all vouchers due on that day. The Secretary/Treasurer then transfers the excess

cash from Marco’s demand account to a money market account that earns interest. If the

difference is less than the minimum cash balance set by the Secretary/Treasurer and there is

cash available above the minimum balance required in the money market account, she

authorizes payment of the vouchers due that day and transfers funds from the money market

account to Marco’s demand account.

If sufficient funds are not available in the combined demand and money market accounts, the

Secretary/Treasurer considers borrowing from the bank on the prearranged line of credit. If the

line of credit is also inadequate, which is rare, the Secretary/Treasurer confers with the

Marketing Manager. The Secretary/Treasurer and Marketing Manager generally meet at least

once a month to plan for intermediate and long-term financing needs.

After the Secretary/Treasurer authorizes the day's payments, the approved voucher packages

are forwarded to the Controller, who compares the information to the supporting documents. If

the voucher data are accurate, the Controller initials the face of the voucher and enters an

authorization code via PC into the open voucher file. This triggers the printing of a pre-

numbered 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. The Controller signs the checks and forwards them to the

Marketing Manager’s Secretary.

The Marketing Manager’s secretary cancels the voucher document packages, presents the

checks to the Marketing Manager for counter signature, mails the checks to the vendors, and

returns the documents to the Accountant for filing in voucher number order.

Bank Reconciliations

Upon receipt of the bank statements each month, the Secretary/Treasurer reconciles the

beginning and ending balances and the receipts and disbursements to the book amounts. She

forwards the reconciliations to the Marketing Manager for review. He then returns them to her

for filing.

Inventory and Cost of Goods Sold

Marco 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. The Accountant 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.

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III. Steps to Completion

1. Conduct Internet and library research

Do an Internet and or library search to determine the current state of the U.S. economy and the

household appliance industry. This will be the bases for your summary of possible client audit

and fraud risks that will be included in your report below. You need at least three sources of

information for the U.S. economy and industry analysis; be sure to cite your sources in your

report. You can use the most recent years for your internet search of the U.S. economy and

industry. Do not go back to the years stated in the annual report for the project.

In other words, the Marco financial statements are dated 2014 and 2015. You should conduct your internet research on the two years preceding the year you are taking this course and assume the Marco statements are also from the same two years. For example, if you are taking this course in the year 202X you would conduct your research on 202X - 2 years and 202X - 1 year and also assume the Marco financial statements are dated 202X - 2 years and 202X - 1 year, whereby X could equal any digit between 0 and 9. Specifically, if this year were 2029, you would conduct research on 2028 and 2027.

2. Prepare a client acceptance report

Prepare a client acceptance report to the partner in charge of your engagement. Use your own

words to prepare a report to the partner. There is no standard way to write a report, and there is

no template for a client acceptance report. Internal reports such as a client acceptance report

are proprietary and confidential. Information and data that would be included in a client

acceptance report will vary depending on the audit firm and the client involved. Your report will

need to contain lists of additional information the audit firm would need to gather before the

client acceptance decision is finalized.

Create a letterhead for the accounting firm where you work: Levin, Lombard, & Wolod, LLC and

use the letterhead to write your client acceptance report. Address the report to the partner in

charge of the audit (your professor). This is not a standard audit report; you may format it as a

memo to your supervisor that contains the required information and sections discussed below.

Page 97 of your Auditing textbook discusses the client acceptance process. The client

acceptance report is important because it aids in the process of evaluating whether or not to

accept a client. The report would probably be written by an audit manager and addressed to the

partner in charge of the audit, assuming the client was accepted for the audit. There are a

number of points on pages 97 through 100 that you should consider for inclusion in your client

acceptance report.

Your client acceptance 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 U.S. economy and the firm's unaudited 2015 financial

statements as well as the limited industrial data provided in the project. As a reminder, you may

use the most recent two years preceding the year you are taking this course. You must use at

least three sources of information. Cite: a) sources for the economy and industry analysis, and

b) sources in your client acceptance report.

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A description of items you recommend the audit firm research concerning Marco’s managers

that would address their ethical character and qualifications to run a firm like Marco along with a

list of possible information sources. Include a brief discussion of why you included each item by

discussing how it would affect audit and fraud risk. Include three sources of information where

you would expect to find this information. A source of information is somewhere you would look

to develop this information and can be internal information within the firm, public source, or

discussions with parties that might be familiar with Marco’s management. Cite your sources.

Provide a description of items you recommend the audit firm research concerning Marco’s

relationships with third parties including:

▪ customers,

▪ vendors,

▪ financial institutions, and

▪ legal counsel that would be relevant to assess audit risk.

Include possible sources of information for each third party and where you would expect to find

the information. Further, include a brief discussion of why you included each item by discussing

how it would affect audit and fraud risk. You must cite at least 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 Marco.

Provide a general discussion of the sources you would use here.

The grading for the report has a style component.

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 those discussing 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 must obtain the client's permission to

contact third parties. Without permission, the third parties’ risk legal liability for violating Marco’s

confidentiality. Thus, your report should consider getting the client's permission when

necessary. In addition, client acceptance decisions involve different components of the risk

model. When assessing the risk of accepting a client, you need to identify the risk component.

For example, audit risk issues involve the auditors’ risks of future litigation that do not 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.

It may be challenging to find sources detailing a client acceptance report however there are

many sources of information about a client engagement letter. Search the internet for the

information and include the same type of information that you find for a client engagement letter

in your client acceptance report.

3. Write the engagement letter

The auditors prepare the engagement letter and sign it. The auditors present the signed

engagement letter to the auditee for her/his signature. Once signed, the engagement letter

represents a contract between the two parties. More details of the engagement letter are on

Page 100 of your Auditing textbook. The engagement letter is important because it is a legally

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binding contract between the auditor and the auditee. Use the Levin, Lombard, & Wolod, LLC

letterhead and address your engagement letter to your potential client. Add need lines at the

bottom of the engagement letter for partner and client signatures and dates.

Prepare an engagement letter for Marco on the Levin, Lombard, & Wolod, LLC letterhead you

created for the Client Acceptance Report. 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; not any additional services. You may search the Internet for sources of information

that would be included in a client engagement letter. Include some of the information that you

have included in your client acceptance report.

You can indicate the signatures and dates in a manner similar to the example following

(electronic signatures are unacceptable):

Levin, Lombard, & Wolod

By: _______________________________ Date: ______________

Auditor (Your handwritten signature)

By: ________________________________ Date: ______________

Marco Appliances, Inc.

By: ________________________________ Date: ______________

There are a number of items on pages 97 through 100 in the textbook that should be included in

your engagement letter.

4. Write the Inherent Risk and Materiality Memo

A) Preliminary Inherent Risk Assessment - Review the description of Marco Appliances, Inc.

and identify four entity-level inherent risks based on the information provided. I have listed one

potential inherent risk area as an example; 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

operating or business performance for the firm.

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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 response to "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 following sections of the project:

a) Description of Firm and Market Conditions

b) The Control Environment (only identify issues related to inherent risk)

B) Identify risks using analytical procedures based on the financial data.

1. Perform Preliminary Analytical Procedures and Document

Review Marco 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 - you need to add four more to the list. Copies of

Marco’s audited 2014 and unaudited 2015 financial statements are included after these

requirements. Some common ratios for Marco and their industry are also included.

Content/Course Resources includes the Accounting and Finance Ratios and Formulas

document.

2. Preliminary Materiality Judgments

Set two preliminary materiality dollar amounts for the Marco audit - one for the Balance Sheet

and one for the Income Statement. Document how you calculated your materiality amounts and

explain why you chose that approach. The following resources offer guidance in making

materiality judgments: Public Company Accounting Oversight Board (PCAOB), AICPA, the

Journal of Accountancy and page 4 of the Statement of Auditing Standards Amendments to the

Description of the Concept of Materiality. You can select the materiality judgment approach you

prefer – remember you need to explain the approach that would be best for the client.

Remember the materiality level sets the level for transactions that an auditor will look at; below

that level the auditor may not look at the transaction unless there is a high risk for that particular

type of transaction.

Complete the Marco Inherent Risk and Materiality Memo Template file containing the results of

your inherent risk assessments, preliminary analytical review, and materiality level

determination. The Marco Inherent Risk and Materiality Memo Template is in Course

Resources/Projects & Rubrics.

5. Complete the Controls Template

Review the Marco project to evaluate its control environment strengths and weaknesses. For

each strength, provide a short description of the activity or feature and explain how it

strengthens the 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; you need to add three more strengths and three more weaknesses to the table in the

template file.

Page 14 of 24

Review the company’s specific controls over sales and collections (i.e., based on the Sales and

Collection Processing section of the project) and purchases and payments (i.e., based on the

Purchasing and Payments Processing section of the project) to evaluate transaction control

weakness.

Describe the control weakness (just a short statement of weakness)

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. Make a

recommendation on how the company’s controls could be improved to mitigate this weakness

and discuss some potential weaknesses in the control you suggest (e.g., how it might be

overridden).

Limit your answers to the four most serious weaknesses you find in the:

a) sales and collection processes, and the

b) 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 of the processes can be distributed in any way

across the steps; you are not required to have a minimum number in any step.

Your control weaknesses and recommendations need to be specific to the project and sensitive

to the size of the organization. The following are some examples of recommendations that

would be inappropriate for Marco:

▪ 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 their current computer systems and

so recommendations to computerize their current manual operations are not practical.

However, all their information is currently stored electronically and so you may suggest

simple ways they could more effectively share or control that data.

The operations of the company’s EDP environment are not completely described in the project.

Thus, your critique of the controls should be limited to those portions of their EDP environment

that are included in the project description.

Document your findings in the Marco Controls Template file. The Marco Controls Template is in

Course Resources/Projects & Rubrics.

6. Create a PDF file

Combine all deliverables into one PDF document and submit the PDF file to your assignment

folder in the LEO classroom.

IV. Deliverables

Cite all sources used to prepare your deliverables and provide a reference page at the end of

each deliverable.

Submit one PDF file to your Assignment folder in LEO that includes the following reports

Page 15 of 24

1. Client Acceptance Report

Your report should be two and three single-spaced pages using 1" margins and 12-point

font. Include up to three suggested sources for each section of the report. The client

acceptance report is a report written by an audit manager to an audit manager – these

people would work for the same firm.

2. Engagement Letter

Your engagement letter should be between one and two single-spaced pages using 1"

margins and 12-point font. An engagement letter is written by the partner of the audit

firm to the potential audit client – these people work for two separate firms. You must

sign the engagement letter.

3. Inherent Risk and Materiality Memo

Complete the Inherent Risk and Materiality Memo Template provided in Course

Resources/Projects & Rubrics

4. Evaluation of Controls

Complete the Controls Template provided in Course Resources/Projects & Rubric

5. Reference list

Prepare a Reference list of sources used to prepare the final deliverable. The reference

list must be in APA format. The APA provides guidance on preparing a reference list:

https://apastyle.apa.org/style-grammar-guidelines/references

V. Rubric:

Review the rubric before you begin this project to ensure you know You will find the rubric in

LEO under Contents>Course Resources>Projects & Rubrics/Project 2 Rubric.

VII. Helpful hints:

Guidance to enhance your final deliverables:

▪ Read the grading rubric before starting this project to ensure you know what is required

and how each deliverable will be graded.

▪ Write the deliverables in your own words and note that all graduate accounting writing

assessments are automatically submitted to TurnItIn.com, which generates a similarity

score. To avoid a high similarity score, per APA requirements, cite all sources you used

to write the deliverables for this project.

• You can find APA Style resources in Content/Course Resources/Writing

Resources.

• Also, the American Psychological Association (APA) offers excellent free learning

resources at:

https://apastyle.apa.org/?_ga=2.27869692.1347213869.1579885233-

1499247400.1567390091.

• Plagairism.org is another excellent resource for learning how to avoid plagiarism.

▪ Consider incorporating feedback you receive from family and friends you asked to read

your deliverables.

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▪ Submit your documents to the graduate writing tutors at least 1 week before the project

due date. This free resource can be accessed in your LEO classroom. Make edits to

your deliverables after reviewing feedback from the writing center tutors.

▪ Submit all required files on or before the due date.

• If relevant, review the Departmental Late Policy, which is in syllabus and is

strictly enforced. Note: no assignments are accepted after the last day of class.

Page 17 of 24

Appendices

Appendix Page #

Appendix A: Balance Sheet

17

Appendix B: Income Statement

19

Appendix C: Financial Ratios

21

Appendix D: Comparative Balance Sheets for the Wholesale Heating and AC Industry

22

Appendix E: Comparative Income Statements for the Wholesale Heating and AC Industry

23

Page 18 of 24

Appendix A: Balance Sheet

Marco Appliances, Inc.

Balance Sheets

(U.S. Dollars)

Assets

Current Assets 2018 2019

2018 % of

Assets

2019 % of

Assets % Change

Cash and cash equivalents $ 22,045 $ 10,867 1.94 0.79 (50.71)

Money market funds 31,510 16,000 2.78 1.16 (49.22)

Accounts receivable 301,713 425,755 26.60 30.83 41.11

Allowance for doubtful accounts (31,916) (33,779)

(2.81)

(2.45) (5.84)

Inventory 307,701 503,091 27.13 36.43 63.50

Total Current Assets 631,053 921,934 55.65 66.76 46.09

Property and Equipment

Plant $ 625,000 $ 625,000 $ 55.11 $ 45.26

Accumulated depreciation - plant (220,000) (240,000) (19.40) (17.38) (9.09)

Equipment 120,000 120,000 10.58 8.69

Accumulated depreciation - equipment (72,000) (96,000)

(6.35)

(6.95) (33.33)

Land 50,000 50,000 4.41 3.62 -

Net Property and Equipment 503,000 459,000 44.35 33.24 (8.75)

Total Assets $ 1,134,053 $ 1,380,934 100 100 21.77

Page 19 of 24

Liabilities and Stockholders' Equity

Current Liabilities

Accounts payable 145,031 387,757 12.79 28.08 167.36

Payroll taxes payable 8,524 17,436 0.75 1.26 104.55

Income taxes payable 30,235 4,125 2.67 0.30 (86.36)

Dividends payable 14,197 3,203 1.25 0.23 (77.44)

Total Current Liabilities 197,987 412,521 17.46 29.87 108.36

Notes payable 215,000 185,000 18.96 13.40 (13.95)

Total Long-term Liabilities 215,000 185,000 18.96 13.40 (13.95)

Stockholders' Equity

Capital stock 300,000 300,000 26.45 21.72

Paid-in capital 100,000 100,000 8.82 7.24

Retained earnings 321,066 383,413 28.31 27.76 19.42

Total Stockholders' Equity 721,066 783,413 63.58 56.73 8.65

Total Liabilities and Equity $ 1,134,053 $ 1,380,934 100 100 21.77

Page 20 of 24

Appendix B: Income Statement

Marco Appliances, Inc.

Income Statements

(U.S. Dollars)

2018 2019 2018 2019 %

Change

Sales $ 2,756,561 $ 3,307,873 100.00

100.00 20.00

Sales discounts (8,371) (9,207) (0.30)

(0.28) (9.99)

Sales returns (33,809) (51,559) (1.23)

(1.56) (52.50)

Bad debt expenses (27,565) (33,078) (1.00)

(1.00) (20.00)

Net Sales 2,686,816 3,214,029 97.47

97.16 19.62

Cost of goods sold 2,159,042 2,601,646 78.32

78.65 20.50

Gross margin 527,774 612,383 19.15

18.51 16.03

Salaries expense $ 259,287 $ 290,400 9.41

8.78 12.00

Payroll tax expense 18,434 21,199 0.67

0.64 15.00

Fringe benefits 14,357 16,081 0.52

0.49 12.01

Rent 6,491 7,140 0.24

0.22 10.00

Utilities 21,943 25,673 0.80

0.78 17.00

Insurance 6,149 6,456 0.22

0.20 4.99

Supplies expense 3,067 3,650 0.11

0.11 19.01

Postage expense 974 1,140 0.04

0.03 17.04

Advertising expense 4,636 5,100 0.17

0.15 10.01

Professional fees 11,386 11,500 0.41

0.35 1.00

Miscellaneous 980 1,225 0.04

0.04 25.00

Purchase discounts lost 42,374 53,815 1.54

1.63 27.00

Page 21 of 24

Interest expense 9,215 12,164 0.33

0.37 32.00

Depreciation expense 44,000 44,000 1.60

1.33 -

Total operating expenses 443,293 499,543

16.08

15.10 12.69

Operating Income 84,481 112,840 3.06

3.41 33.57

Interest revenue 22,864 28,580 0.83

0.86 25.00

Income before income taxes 107,345 141,420

3.89

4.28 31.74

Income taxes 25,114 37,508 0.91

1.13 49.35

Net Income $ 82,231 $ 103,912 2.98

3.14 26.37

Beginning retained earnings $ 271,728 $ 321,067

Net income 82,231 103,912

Dividends (32,892) (41,565)

Ending retained earnings $ 321,067 $ 383,414

Page 22 of 24

Appendix C: Financial Ratios

Marco Appliances, Inc.

Financial Ratios (Amounts in U.S. Dollars)

2018 2019

Operating Performance

Overall Performance

Return on Assets 7.3% 7.5%

Return on Equity 11.4% 13.3%

Asset Turnover 2.4 2.4

Cash Conversion Cycle

Days cash in receivables 40.0 47.0

Days cash in inventories 52.0 70.6

Days needs 92.0 117.6

Days cash in payables and accrued liabilities 23.0 50.8

Net conversion cycle 69.0 66.8

Financial Position

Short-term

Current Ratio 3.19 2.23

Quick Ratio 1.79 1.10

Dividend payout 92.6%

Long-term

Total debt to equity 0.57 0.76

Long-term debt to equity 0.30 0.24

Effective Tax Rate 23.4% 26.5%

Page 23 of 24

Appendix D: Wholesale Heating and AC Industry

Comparative Balance Sheet Percentages

12/31/2018 12/31/2019

% of Assets % of Assets

Cash and Equivalents 5.00 4.50

Accounts Receivable (net) 35.00 37.00

Inventory 40.00 39.00

Other Current Assets 1.50 1.40

Total Current Assets 81.50 81.90

Fixed Assets (net) 17.50 17.00

Intangible Assets (net) 1.00 1.10

Other Non-Current Assets 18.50 18.10

Total Assets 100.00 100.00

Liabilities

Accounts Payable 28.50 30.50

Short-term Loan Payables 13.50 14.00

Income Taxes Payable 2.00 2.20

Other Current Liabilities 1.40 1.30

Total Current Liabilities 45.40 48.00

Long-term Debt 8.90 8.50

Net Worth 45.70 43.50

Total Liabilities and Net Worth 100.00 100.00

Page 24 of 24

Appendix E: Wholesale Heating and AC Industry

Comparative Income Statement Percentages

Net Sales 100.00 100.00

Cost of Goods Sold 79.00 79.50 Gross Margin 21.00 20.50

Total Expenses 16.50 17.00

Income before Taxes 4.50 3.50

Asset Turnover 2.60 2.55

Return on Assets 6.20% 5.90%

Current Ratio 1.80 1.71

Quick Ratio 0.88 0.86

Total Debt to Equity 1.19 1.30

Long-term Debt to Equity 0.19 0.20