Potential Areas Of Risk At Capitol Equipment Company

MEMORANDUM

To: A. G. Ressive, Partner at Zurawski & Rolfe

Date: May 5, 2007

Re: Potential areas of risk at Capitol Equipment Company (CEC)

Upon the acceptance of CEC as a client, we began investigation procedures to determine potential risks and the roles they would play in the design of the engagement. The investigation is completed and the results and recommendations are listed below.

Our contact with CEC's predecessor auditors, Nit Pickers, LLP (NP), has resulted in positive remarks about the company. CEC has always received standard unqualified opinions from NP and NP believes CEC has an excellent reputation. However, upon further inquiries, there are some areas of concern which may change the amount of work we assign for the engagement as the acceptable audit risk has been set at 5% and the potential for future growth and success with the company is high.

High AAR

CEC is a public company that is expected to grow significantly in the future. As the company grows in size, more assets or revenues will be affected and more financial statements will be highly relied on by external users. Therefore, more appropriate that the AAR should be decreased, I recommend decreasing CEC's AAR to 3%.

Communications with the Previous Auditor

NP is a public accounting firm with a very good reputation in the industry, so we initially concluded that manager's integrity should not affect the AAR. However, we noticed that there is a discrepancy in the comments gave on the reasons for the disengagement between NP and CEC. The CEO of CEC claimed that the change was made because he believe that NP has been slow to respond to his questions and requests, and wants a more responsive auditing firm. We encourage the firm to further inquire with the mangers of CEC and NP to confirm that there is no other underlying factors that caused the termination of their engagement.

Code of Ethics

Mr. Guano, the Chairman and CEO of CEC, mentioned that senior management has not adopted a code of ethics. Part of accessing a company's control environment is gauging the tone at the top and getting a sense of their attitude towards internal control. This is done by observing senior management's philosophy and operating style. A code of conduct applied to the senior management reflects the importance of honesty and integrity based on the entire company's core value. If there is no control over senior management's integrity, there will be a higher risk for fraudulent activities. The lack of a code of ethics may indicate that management does not value integrity because that value was not passed to its personnel through policies and procedures. If ethics is not encouraged entity-wide, the likelihood of fraud and abuse increases. This affects the engagement's control risk because unethical management working in collusion with one another can override any controls; therefore, increasing the likelihood that misstatements will exceed a certain amount. CEC should be encouraged to adopt a Code of Ethics entity-wide, and training on this issue should be required for all personnel to help alleviate this risk. Also, a procedure for reporting fraud should be drafted, implemented and all personnel should be aware of it. There should be a whistle-blower policy to protect those that are reporting fraud from possible retaliation from management or colleagues.

Accounting: Leases and Inventory

NP mentioned that they did have a disagreement with CEC about how to account for certain leases. CEC was accounting for these leases as operating, whereas NP believed they should be classified as capital leases. CEC did adjust its financial statements to comply with the auditor's recommendations. However, I think we should ask ourselves why CEC would consider using the operating method versus capitalizing. We know that accounting for leases as operating will result in the creation of an operating expense. Also, the capital lease method results in the present value of the lease expense being treated as a debt. A firm would not elect to use the capital method because it can increase the debt shown on the balance sheet substantially. This would especially be an issue if the company has debt covenants.

Also, we discovered that CEC uses the LIFO method of accounting for its inventory. As we know, the utilization of the LIFO method creates layers that benefit the company because the earlier layers were bought at a lower price. The company experiences lower COGS and therefore a higher earnings number. This method is often criticized because of the ability of management to manipulate income by permitting inventory to decline and old. While there is nothing wrong with this method, we should consider why CEC is utilizing it. It may be another indicator of concern regarding management's incentives.

While CEC did comply with NP's recommendation and NP gave no reason why we should doubt management's integrity, we should continue to be on the lookout for areas where multiple accounting treatments exist. If CEC continually chooses methods that are most favorable towards their financial position rather what most accurately reflects that true condition of the transactions, it may suggest a possible change in management's integrity.

Management Incentives

We discovered management compensation is closely tied to stock options and bonuses are based on reported earnings. Also, the CEO of CEC owns 20% of the outstanding stock and the VP of Finance and Marketing are both members of the family. Any time compensation is tied to reported earnings; this is a red flag for possibility of misstatements. With such a heavy interest in the company, the CEO would certainly want to see the company perform well. The market often judges performance based on Earnings per Share. With public opinion and compensation tied to the reported earnings, this may be a strong enough of an incentive to cause the CEO to commit fraud. Also, the fact that CEC has financed so much of its growth through debt financing is an area of concern. With debt covenants dependent on debt/equity ratios, management may manipulate earnings, or choose accounting methods that will help keep these ratios favorable.

CEC's likelihood of financial failure will decrease the acceptable audit risk which will result in an increase for the need of more audit evidence. CEC should tie management's compensation and bonus packages to the fulfillment