Bond, CPA, is considering audit risk at the financial statement level in planning the audit of Toxic Waste Disposal (TWD) Company's financial statements for the year ended December 31, 2004. TWD is a privately owned company that contracts with municipal governments to remove environmental wastes. Audit risk at the overall financial statement level is influenced by the risk of material misstatements, which may be indicated by a combination of factors related to management, the industry, and the company. Required:
Based only on the information below, indicate whether each of the following factors (Items 1 through 15) would most likely increase overall audit risk, decrease overall audit risk, or have no effect on overall audit risk. Discuss your reasoning.
Company Profile
1. This was the first year TWD operated at a profit since 2000 because the municipalities received increased federal and state funding for environmental purposes.
2. TWD's board of directors is controlled by Mead, the majority stockholder, who also acts as the chief executive officer.
3. The internal auditor reports to the controller and the controller reports to Mead.
4. The accounting department has experienced a high rate of turnover of key personnel.
5. TWD's bank has a loan officer who meets regularly with TWD's CEO and controller to monitor TWD's financial performance.
6. TWD's employees are paid biweekly.
7. Bond has audited TWD for five years.
Recent Developments
8. During 2004, TWD changed its method of preparing its financial statements from the cash basis to generally accepted accounting principles.
9. During 2004, TWD sold one-half of its controlling interest in United Equipment Leasing
(UEL) Co. TWD retained significant interest in UEL.
10. During 2004, litigation filed against TWD in 1996 alleging that TWD discharged pollutants into state waterways was dropped by the state. Loss contingency disclosures that TWD included in prior years' financial statements are being removed for the 2004 financial statements.
11. During December 2004, TWD signed a contract to lease disposal equipment from an entity owned by Mead's parents. This related-party transaction is not disclosed in TWD's notes to its 2004 financial statements.
12. During December 2004, TWD completed a barter transaction with a municipality. TWD removed waste from a municipally owned site and acquired title to another contaminated site at below-market price. TWD intends to service this new site in 2005.
13. During December 2004, TWD increased its casualty insurance coverage on several pieces of sophisticated machinery from historical cost to replacement cost.
14. Inquiries about the substantial increase in revenue TWD recorded in the fourth quarter of 2004 disclosed a new policy. TWD guaranteed several municipalities that it would refund the federal and state funding paid to TWD if any municipality fails federal or state site clean-up inspection in 2005.
15. An initial public offering of TWD's stock is planned for late 2005.
Using the above information assume that your firm is considering taking on Toxic Waste Disposal Company (TWD) as a client. Considering the 15 items listed, discuss the risks associated with taking on TWD as a client. Be sure to take into account the provisions of SAS 99 and to identify potential fraud areas. Recommend ways to mitigate the risk associated with taking on TWD as a client.