Auditing Marco Appliances, Inc.: A Case Study

Overview of the Marco Appliances audit engagement

Task:

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.

Background information on Marco Appliances

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 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.