Completed Preliminary Analysis (SAS99)

Our previous preliminary analytical review procedures has shown SDE to be at risk for material misstatement whether it be due to error or fraud in it’s financial statement The at risk areas involve its unaudited sales, cost of goods sold, gross profit margin, and current assets. In all areas, these values are significantly higher than what we at Palm Springs Audit & Assurance Services have expected.

Here is a following of some of the key ratios of our previous work that has lead towards the deviations from what we expected and what they have reported.

Key Ratios

Asset Management Ratios and Profitability Ratios

1. Inventory Turnover Ratio (IT ratio):
2. Assets to Sales Ratio (A/S ratio):
3. Return On Assets Ratio (ROA):
4. Return On Sales Ratio (ROS):

From these ratios we have derived the following expectations…

“Accounts Expectation

Sales: We do not expect sales to be as strong as $352,523 for SDE in 2011 because SDE vs Industry ratio comparison indicates that SDE have a poor sales and have a hard time to sell its inventories. Therefore, $222,086 is an appropriate expected sales number for SDE in 2011.

Cost of Goods Sold: We also do not expect CoGS to be as strong as $272,255 for SDE in 2011 because SDE's Inventory turnover ratio is very low compared to industry's. Therefore, $169,245 is an appropriate expected CoGS number for SDE in 2011.

Gross Profit Margin: We do not expect Gross profit margin of SDE to be as strong as $80,268 in 2011 because SDE's ROS decrease sharply in 2011. Furthermore, SDE ROA also decline significantly in 2011. Therefore, $52,841 is an appropriate expected Gross Profit Margin number for SDE in 2011.

Current Assets: We do not expect current assets of SDE to be as high as $261,861 in 2011, because its assets to sales ratio is very low. Therefore, $128,846 is an appropriate expected Current Assets number for SDE in 2011. However, we still need to investigate the huge increase in short term investments.

Along with these deviations we have also found their free cash flow to be in the negatives. Also throwing up another red flag.

• SDE Free Cash Flow 2010 = -13277
• SDE Free Cash Flow 2011 = -110978”

With these findings, we conclude SDE is at high risk for material misstatement. How can a company boast such high numbers in their unaudited financial data when our basic methods analysis tells us that this should not be the case.

To complete our preliminary analytical review procedures we would have to fulfill the requirements of SAS 99.

1. We would have to inquire management about the discrepancies as for them to explain why their numbers are so far apart from ours. We need to list all of their reasons, gather evidence, and if those reasons do not pass testing, we must consider intentional fraud risk factors.
2. We would have to inquire management, audit committee, internal audit personnel and others within SDE about their understanding and awareness of fraud, and the types of controls that will deter fraud.
3. We would have to consider fraud risk factors and other information that may be pertinent towards its fraud risk.   

With the additional information provided, if we were to accept the company as a client for our firm we would have to do so knowingly that the client poses a high risk of fraud for the following reasons.

1. Is there an incentive or pressure that provides a reason to commit fraud? Yes, SDE is under pressure to gain investors since the company has turned public. Additional information has shown that SDE is striving to show investors that they are making great sales and growth, when we know this to be not the case.
2. Is there an opportunity for fraud to be perpetrated? Yes, the board members are made up of entirely extended relatives of the owner, Eduardo Entar, and the CFO is his first cousin. There is opportunity for fraud to be perpetrated through the power of related parties.
3. Do the individuals committing the fraud possess an attitude that enables them to rationalize the fraud? Yes, Eduardo Entar, has shown to possess the dispossession to commit fraud. He has sold overvalued warranties to his customers, and falsely advertises low pricing when similar pricing can be had elsewhere, and has ignored the requests of his suppliers to stop trans shipping. The man relies on marketing tricks and pushy tactics to overturn a profit rather than providing real value.   

There are more additional procedures to be carried out due to alarming additional information.

“Among other problems uncovered by the underwriter and their auditor were extensive related-party transactions, interest-free loans to employees, and speculative investments unrelated to the company’s principal line of business.  The underwriting firm was also disturbed to find that nearly all of the company’s key executives are members of the extended Antar family.  Certain of these individuals, including Antar’s wife and mother, are receiving salaries and bonuses approaching $150,000 per annum.”

As Auditors, we would have to inquire and find out the reasons for the interest free loans to employees, and the nature of speculative investments. We would also have to observe and verify the competency of the executives of the extended Antar family to see if their work justifies their salaries, bonuses’ and positions.

“Despite the underwriter’s concern, Antar hired his first cousin, Serapio E. Antar, to serve as CFO.”

We would have to inquire as to why Antar has ignored the underwriters concern and validate the credentials of his first cousin.

“Following the public offering, Antar worked hard to convince the investment community…that his firm was financially strong and well managed.  At every opportunity, Antar has painted a picture of continued growth and increased market share for SDE.

            One tactic Antar used to convince financial analysts that the company has a rosy future is to invite them to a store and demonstrate in person his uncanny ability to “close” sales.  Such tactics worked to perfection as analysts from the most prominent investment firms have released glowing reports regarding SDE’s management team and the company’s bright prospects.  One analyst wrote, “SDE is a disciplined, competently organized firm with a sophisticated management and a well-trained, dedicated staff.”

We would have to verify that this is true through observation that is without surveillance and thorough as such an observation entailed above can be deceptive.

Summary

What has been done for our preliminary analytical review procedures was a comparative analysis of our expected values in sales, cost of goods sold, gross profit margin, current assets and the company’s unaudited values. Since there is such a high discrepancy and additional information has thrown further red flags up into the air, the next step is to further investigate as to why there exists such a discrepancy and resolve all points of deviation, through inquiry, observation, additional evidence gathering and testing.