Đang tải... (xem toàn văn)
(BQ) Part 1 book Auditing and assurance services has contents: Materiality and risk, fraud auditing, the impact of information technology on the audit process, overall audit strategy and audit program, audit sampling for tests of controls and substantive tests of transactions, audit sampling for tests of details of balances, audit of cash and financial instruments,...and other contents.
www.downloadslide.com CHAPTER MATERIALITY AND RISK Explain To Me One More Time That You Did A Good Job, But The Company Went Broke Maxwell Spencer is a senior partner in his firm, and one of his regular duties is to attend the firm’s annual training session for newly hired auditors He loves doing this because it gives him a chance to share his many years of experience with inexperienced people who have bright and receptive minds He covers several topics formally during the day and then sits around and “shoots the breeze” with participants during the evening hours Here we listen to what he is saying Suppose you are a retired 72-year-old man You and your wife, Sarah, live on your retirement fund which you elected to manage yourself, rather than receive income from an annuity You decide that your years in business prepared you with the ability to earn a better return than the annuity would provide So when you retired and got your bundle, you called your broker and discussed with him what you should with it He tells you the most important thing is to protect your principal and recommends that you buy bonds You settle on three issues that your broker and his firm believe are good ones, with solid balance sheets: (1) an innovative natural gas distribution company, (2) a fast-growing telecom company, and (3) a large national cable company Now all you have to is sit back and collect your interest LEAR N I N G O B J ECTIVES After studying this chapter, you should be able to 9-1 Apply the concept of materiality to the audit 9-2 Make a preliminary judgment about what amounts to consider material 9-3 Determine performance materiality during planning 9-4 Use materiality to evaluate audit findings 9-5 Define risk in auditing 9-6 Describe the audit risk model and its components 9-7 Consider the impact of engagement risk on acceptable audit risk 9-8 Consider the impact of several factors on the assessment of inherent risk 9-9 Discuss the relationship of risks to audit evidence 9-10 Discuss how materiality and risk are related and integrated into the audit process Ah, but the best laid plans of mice and men. . . First, the natural gas company goes broke, and you can look forward to recovering only a few cents on the dollar over several years Then, the telecom company fails, and you might get something back — eventually Finally, the cable company has a scandal and has to default on all of its outstanding bonds A recovery plan is initiated, but don’t hold your breath Your best strategy is to apply for a job at McDonald’s They hire older people, don’t they? Now what could the auditors of these three entities ever say to you about how they planned and conducted their audits and decided to issue an unqualified opinion that would justify that opinion in your mind? You don’t care about business failure versus audit failure, or risk assessment and reliability of audit evidence, or any of that technical mumbo jumbo The auditors were supposed to be there for you when you needed them, and they weren’t And materiality? Anything that would have indicated a problem is material to you The message is, folks, that it’s a lot easier to sweat over doing a tough audit right than it is to justify your judgments and decisions after it’s too late And good luck if you think that a harmed investor will ever see things from your point of view www.downloadslide.com Accept client and perform initial planning Understand the client’s business and industry Assess client business risk Perform preliminary analytical procedures Set materiality and assess acceptable audit risk and inherent risk Understand internal control and assess control risk Gather information to assess fraud risks Develop overall audit strategy and audit program The auditor’s responsibility section in an audit report includes two important phrases (italicized below) that are directly related to materiality and risk • We conducted our audits in accordance with auditing standards generally accepted in the United States of America Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement The phrase obtain reasonable assurance is intended to inform users that auditors not guarantee or ensure the fair presentation of the financial statements Some risk that the financial statements are not fairly stated exists, even when the opinion is unqualified The phrase free of material misstatement is intended to inform users that the auditor’s responsibility is limited to material financial information Materiality is important because it is impractical for auditors to provide assurances on immaterial amounts Materiality and risk are fundamental to planning the audit and designing an audit approach In this chapter, we will show how these concepts fit into the planning phase of the audit Note that the topic of this chapter is closely related to earlier discussions of auditor’s responsibilities, transaction cycles, and audit objectives (Chapter 6) and planning the audit (Chapter 8) In this chapter, we apply both materiality and risk to the concepts studied in Chapter We introduce the fifth step in planning the audit, which builds on the first four steps that were covered in Chapter When auditors decide materiality and assess risks, they use a considerable amount of the information acquired and docu mented during the first four parts of audit planning MATERIALITY OBJECTIVE 9-1 Apply the concept of materiality to the audit Materiality is a major consideration in determining the appropriate audit report to issue The concepts of materiality discussed in this chapter are directly related to those we introduced in Chapter FASB Concept Statement defines materiality as: • The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement [italics added] Because auditors are responsible for determining whether financial statements are materially misstated, they must, upon discovering a material misstatement, bring it to the client’s attention so that a correction can be made If the client refuses to correct the statements, the auditor must issue a qualified or an adverse opinion, depending on the materiality of the misstatement To make such determinations, auditors depend on a thorough knowledge of the application of materiality A careful reading of the FASB definition reveals the difficulty that auditors have in applying materiality in practice While the definition emphasizes reasonable users who rely on the statements to make decisions, auditors must have knowledge of the likely users of the client’s statements and the decisions that are being made For example, if an auditor knows that financial statements will be relied on in a buy-sell agreement for the entire business, the amount that the auditor considers material may be smaller than that for an otherwise similar audit In practice, of course, auditors may not know who all the users are or what decisions they may make based on the financial statements Determining materiality requires professional judgment Auditors follow five closely related steps in applying materiality, as shown in Figure 9-1 The auditor first 248 Part / THE AUDIT PROCESS www.downloadslide.com determines materiality for the financial statements as a whole Second, the auditor determines performance materiality, which is materiality for segments of the audit (classes of transactions, account balances or disclosures) as shown in the first bracket of the figure These two steps, which are part of planning, are our primary focus for the discussion of materiality in this chapter Step occurs throughout the engagement, when auditors estimate the amount of misstatements in each segment as they evaluate audit evidence Near the end of the audit, during the engagement completion phase, auditors proceed through the final two steps These latter three steps, as shown in the second bracket in Figure 9-1, are part of evaluating the results of audit tests MATERIALITY FOR FINANCIAL STATEMENTS AS A WHOLE Auditing standards require auditors to decide on the combined amount of misstatements in the financial statements that they would consider material early in the audit as they are developing the overall strategy for the audit We refer to this as the preliminary judgment about materiality It is called a preliminary judgment about materiality because, although a professional opinion, it may change during the engagement This judgment must be documented in the audit files The preliminary judgment about materiality for the financial statements as a whole (step in Figure 9-1) is the maximum amount by which the auditor believes the statements could be misstated and still not affect the decisions of reasonable users (Conceptually, this is an amount that is $1 less than materiality as defined by the FASB We define preliminary materiality in this manner for convenience.) This judgment is one of the most important decisions the auditor makes, and it requires considerable professional wisdom Auditors set a preliminary judgment about materiality to help plan the appropriate evidence to accumulate The lower the dollar amount of the preliminary judgment, the more evidence required Examine the financial statements of Hillsburg Hardware Co., in the glossy insert to the textbook What combined amount of misstatements will affect FIGURE 9- 1 OBJECTIVE 9-2 Make a preliminary judgment about what amounts to consider material Steps in Applying Materiality Step Set materiality for the financial statements as a whole Step Determine performance materiality Step Estimate total misstatement in segment Step Estimate the combined misstatement Step Compare combined estimate with preliminary or revised judgment about materiality Planning extent of tests Evaluating results Chapter / MATERIALITY AND RISK 249 www.downloadslide.com decisions of reasonable users? Do you believe that a $100 misstatement will affect users’ decisions? If so, the amount of evidence required for the audit is likely to be beyond that for which the management of Hillsburg Hardware is willing to pay Do you believe that a $10 million misstatement will be material? Most experienced auditors believe that amount is far too large as a combined materiality amount in these circumstances During the audit, auditors often change the preliminary judgment about materiality We refer to this as the revised judgment about materiality Auditors are likely to make the revision because of changes in one of the factors used to determine the preliminary judgment; that is because the auditor decides that the preliminary judgment was too large or too small For example, a preliminary judgment about materiality is often determined before year-end and is based on prior years’ financial statements or annualized interim financial statement information The judgment may be reevaluated after current financial statements are available Or, client circumstances may have changed due to qualitative events, such as the issuance of debt that created a new class of financial statement users Factors Affecting Preliminary Materiality Judgment Set materiality for the financial statements as a whole Determine performance materiality Estimate total misstatement in segment Estimate the combined misstatement Compare combined estimate with preliminary or revised judgment about materiality 250 Several factors affect the auditor’s preliminary judgment about materiality for a given set of financial statements The most important of these are: Materiality Is a Relative Rather Than an Absolute Concept A misstatement of a given magnitude might be material for a small company, whereas the same dollar misstatement could be immaterial for a large one This makes it impossible to establish dollar-value guidelines for a preliminary judgment about materiality that are appli cable to all audit clients For example, a total misstatement of $10 million would be extremely material for Hillsburg Hardware Co because, as shown in their financial statements, total assets are about $61 million and net income before taxes is less than $6 million A misstatement of the same amount is almost certainly immaterial for a company such as IBM, which has total assets and net income of several billion dollars Benchmarks Are Needed for Evaluating Materiality Because materiality is relative, it is necessary to have benchmarks for establishing whether misstatements are material Net income before taxes is often the primary benchmark for deciding what is material for profit-oriented businesses because it is regarded as a critical item of information for users Some firms use a different primary benchmark, because net income often fluctuates considerably from year to year and therefore does not provide a stable benchmark, or when the entity is a not-for-profit organization Other primary benchmarks include net sales, gross profit, and total or net assets After establishing a primary benchmark, auditors should also decide whether the misstatements could materially affect the reasonableness of other benchmarks such as current assets, total assets, current liabilities, and owners’ equity Auditing standards require the auditor to document in the audit files the preliminary judgment about materiality and the basis used to determine it Assume that for a given company, an auditor decided that a misstatement of income before taxes of $100,000 or more would be material, but a misstatement would need to be $250,000 or more to be material for current assets It is not appropriate for the auditor to use a preliminary judgment about materiality of $250,000 for both income before taxes and current assets Instead, the auditor must plan to find all misstatements affecting income before taxes that exceed the preliminary judgment about materiality of $100,000 Because almost all misstatements affect both the income statement and balance sheet, the auditor uses a primary preliminary materiality level of $100,000 for most tests The only other misstatements that will affect current assets are misclassifications within balance sheet accounts, such as misclassifying a longterm asset as a current one So, in addition to the primary preliminary judgment of materiality of $100,000, the auditor will also need to plan the audit with the $250,000 preliminary judgment about materiality for misclassifications of current assets Qualitative Factors Also Affect Materiality Certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same For example: Part / THE AUDIT PROCESS www.downloadslide.com • Amounts involving fraud are usually considered more important than unin tentional errors of equal dollar amounts because fraud reflects on the honesty and reliability of the management or other personnel involved For example, most users consider an intentional misstatement of inventory more important than clerical errors in inventory of the same dollar amount • Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations Say that net working capital included in the financial statements is only a few hundred dollars more than the required minimum in a loan agreement If the correct net working capital were less than the required minimum, putting the loan in default, the current and noncurrent liability classifications would be materially affected • Misstatements that are otherwise immaterial may be material if they affect a trend in earnings For example, if reported income has increased percent annually for the past years but income for the current year has declined percent, that change may be material Similarly, a misstatement that would cause a loss to be reported as a profit may be of concern Accounting and auditing standards not provide specific materiality guidelines to practitioners The concern is that such guidelines might be applied without considering all the complexities that should affect the auditor’s final decision However, in this chapter, we provide guidelines to illustrate the application of materiality These are intended only to help you better understand the concept of applying materiality in practice The guidelines are stated in Figure 9-2 in the form of policy guidelines of a FIGURE 9- 2 Illustrative Guidelines Illustrative Materiality Guidelines BERGER AND ANTHONY, CPAs Gary, Indiana 46405 POLICY STATEMENT No 32IC Title: Materiality Guidelines Charles G Berger Joe Anthony Professional judgment is to be used at all times in setting and applying materiality guidelines As a general guideline, the following policies are to be applied: The combined total of misstatements in the financial statements exceeding percent is normally considered material A combined total of less than percent is presumed to be immaterial in the absence of qualitative factors Combined misstatements between percent and percent require the greatest amount of professional judgment to determine their materiality The percent to percent must be measured in relation to the appropriate benchmark Many times there is more than one benchmark to which misstatements should be compared The following guides are recommended in selecting the appropriate benchmark: a Income statement Combined misstatements in the income statement should ordinarily be measured at percent to percent of operating income before taxes A guideline of percent to percent may be inappropriate in a year in which income is unusually large or small When operating income in a given year is not considered representative, it is desirable to substitute as a benchmark a more representative income measure For example, average operating income for a 3-year period may be used as the benchmark b Balance sheet Combined misstatements in the balance sheet should originally be evaluated for current assets, current liabilities, and total assets For current assets and current liabilities, the guidelines should be between percent and percent, applied in the same way as for the income statement For total assets, the guidelines should be between percent and percent, applied in the same way as for the income statement Qualitative factors should be carefully evaluated on all audits In many instances, they are more important than the guidelines applied to the income statement and balance sheet The intended uses of the financial statements and the nature of the information in the statements, including footnotes, must be carefully evaluated Chapter / MATERIALITY AND RISK 251 www.downloadslide.com CPA firm Notice that the guidelines are formulas using one or more benchmarks and a range of percentages The application of guidelines, such as the ones we present here, requires considerable professional judgment Application to Hillsburg Hardware Using the illustrative guidelines in Figure 9-2 (p 251), let’s examine a preliminary judgment about materiality for Hillsburg Hardware Co The guidelines are as follows: Preliminary Judgment About Materiality (Rounded, in Thousands) Earnings from operations Current assets Total assets Current liabilities Minimum Maximum Percentage Dollar Amount $ 221 1,531 614 396 Percentage Dollar Amount $ 442 3,062 1,841 793 If the auditor for Hillsburg Hardware decides that the general guidelines are reasonable, the first step is to evaluate whether any qualitative factors significantly affect the materiality judgment Assuming no qualitative factors exist, if the auditor concludes at the end of the audit that combined misstatements of operating income before taxes are less than $221,000, the statements will be considered fairly stated If the combined misstatements exceed $442,000, the statements will not be considered fairly stated If the misstatements are between $221,000 and $442,000, a more careful consideration of all facts will be required The auditor then applies the same process to the other three bases DETERMINE PERFORMANCE MATERIALITY OBJECTIVE 9-3 Determine performance materiality during planning 252 Performance materiality is defined as the amount(s) set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole Determining performance materiality (step in Figure 9-1 on page 249) is necessary because auditors accumulate evidence by segments rather than for the financial statements as a whole, and the level of performance materiality helps them decide the appropriate audit evidence to accumulate Performance materiality is inversely related to the amount of evidence an auditor will accumulate For an accounts receivable balance of $1,000,000, for example, the auditor should accumulate more evidence if a misstatement of $50,000 is considered material than if $300,000 were considered material However, if auditors assigned the same level of materiality to each segment of the audit that was assigned for the overall financial statements, there would likely be unidentified misstatements that exceed materiality for the financial statements as a whole Performance materiality can vary for different classes of transactions, account balances, or disclosures especially if there is a focus on a particular area For example, users of financial statements might expect disclosures of related-party transactions involving the CEO or the purchase price of a newly-acquired subsidiary to be more precise, and therefore auditors might set a lower materiality level in these audit areas In addition, overall audit assurance and the cost of audit evidence are considered when determining performance materiality, as discussed further below We refer to the process of determining performance materiality as the allocation of the preliminary judgment about materiality to segments in our discussion that follows Most practitioners allocate materiality to balance sheet rather than income statement accounts, because most income statement misstatements have an equal effect on the balance sheet due to the nature of double-entry accounting For example, a $20,000 overstatement of accounts receivable is also a $20,000 overstatement of sales It is inappropriate to allocate the preliminary judgment to both income statement and balance sheet accounts because doing so will result in double counting This enables Part / THE AUDIT PROCESS www.downloadslide.com auditors to allocate materiality to either income statement or balance sheet accounts Because most audit procedures focus on balance sheet accounts, materiality should be allocated only to balance sheet accounts The determination of performance materiality is based on professional judg ment and reflects the amount of misstatement an auditor is willing to accept in a particular segment For example, if an auditor decides to allocate $100,000 of a total preliminary judgment about materiality of $200,000 to accounts receivable, this means the auditor is willing to consider accounts receivable fairly stated if it is misstated by $100,000 or less PCAOB auditing standards refer to this amount as tolerable misstatement, whereas AICPA standards define tolerable misstatement as the application of performance materiality to a particular sampling procedure We use the term performance materiality rather than tolerable misstatement throughout this chapter to be consistent with AICPA and IAASB standards Auditors face three major difficulties in allocating materiality to balance sheet accounts: Auditors expect certain accounts to have more misstatements than others Both overstatements and understatements must be considered Relative audit costs affect the allocation All three of these difficulties are considered in the allocation in Figure 9-3 It is worth keeping in mind that at the end of the audit, the auditor must combine all actual and estimated misstatements and compare them to the preliminary judgment about materiality In determining performance materiality levels, the auditor is attempting to the audit as efficiently as possible FIGURE 9- 3 Performance Materiality Levels for Hillsburg Hardware Co Balance 12-31-13 (in Thousands) Cash Trade accounts receivable (net) Inventories Other current assets Property, plant, and equipment Total assets Trade accounts payable Notes payable — total Accrued payroll and payroll tax Accrued interest and dividends payable Other liabilities Capital stock and capital in excess of par Retained earnings Total liabilities and equity Performance Materiality (in Thousands) $ 828 18,957 29,865 1,377 10,340 $61,367 $ 6 (a) 265 (b) 265 (b) 60 (c) 48 (d) $ 4,720 28,300 1,470 2,050 2,364 8,500 13,963 $61,367 90 (e) (a) 60 (c) (a) 72 (c) (a) NA ( f ) $ 884 (2 × $442) NA = Not applicable (a) Small performance materiality because account can be completely audited at low cost and no misstatements are expected (b) Large performance materiality because account is large and requires extensive sampling to audit the account (c) Large performance materiality as a percent of account because account can be verified at extremely low cost, probably with analytical procedures (d) Small performance materiality as a percent of account balance because most of the balance is in land and buildings, which is unchanged from the prior year and need not be audited further this year (e) Moderately large performance materiality because a relatively large number of misstatements are expected ( f ) Not applicable — retained earnings is a residual account that is affected by the net amount of the misstatements in the other accounts Chapter / MATERIALITY AND RISK 253 www.downloadslide.com Allocation Illustrated Set materiality for the financial statements as a whole Determine performance materiality Estimate total misstatement in segment Estimate the combined misstatement Compare combined estimate with preliminary or revised judgment about materiality 254 Figure 9-3 illustrates the allocation approach used to establish different performance materiality levels across segments of the financial statements for the audit of Hillsburg Hardware Co It summarizes the balance sheet, combining certain accounts, and shows the allocation of total materiality of $442,000 (6 percent of earnings from operations) Moore’s allocation approach uses judgment in the allocation, subject to the following two arbitrary requirements established by Berger and Anthony, CPAs: • Performance materiality for any account cannot exceed 60 percent of the preliminary judgment (60 percent of $442,000 = $265,000, rounded) • The sum of all performance materiality levels cannot exceed twice the pre liminary judgment about materiality (2 × $442,000 = $884,000) The first requirement keeps the auditor from allocating all of preliminary materiality to one account If, for example, all of the preliminary judgment of $442,000 is allocated to trade accounts receivable, a $442,000 misstatement in that account will be acceptable However, it may not be acceptable to have such a large misstatement in one account, and even if it is acceptable, it does not allow for any misstatements in other accounts There are two reasons for the second requirement, permitting the sum of performance materiality to exceed overall materiality: • It is unlikely that all accounts will be misstated by the full amount of performance materiality If, for example, other current assets have a performance materiality of $100,000 but no misstatements are found in auditing those accounts, it means that the auditor, after the fact, could have allocated zero or a small performance materiality to other current assets It is common for auditors to find fewer misstatements than performance materiality • Some accounts are likely to be overstated, whereas others are likely to be understated, resulting in a net amount that is likely to be less than the preliminary judgment Notice in the allocation that the auditor is concerned about the combined effect on operating income of the misstatement of each balance sheet account An over statement of an asset account will therefore have the same effect on the income statement as an understatement of a liability account In contrast, a misclassification in the balance sheet, such as a classification of a note payable as an account payable, will have no effect on operating income Therefore, the materiality of items not affecting the income statement must be considered separately Figure 9-3 (p 253) also includes the rationale that Moore followed in deciding performance materiality for each account For example, she concluded that it was acceptable to assign a small amount of performance materiality to notes payable, even though it is as large as inventories If she had assigned $132,500 to each of those two accounts, more evidence would have been required in inventories, but the confirmation of the balance in notes payable would still have been necessary It was therefore more efficient to allocate $265,000 to inventories and a small amount to notes payable Similarly, she allocated $60,000 to other current assets and accrued payroll and payroll tax, both of which are large compared with the recorded account balance Moore did so because she believes that these accounts can be verified within $60,000 by using only analytical procedures, which are low cost If performance materiality were set lower, she would have to use more costly audit procedures such as inspection and confirmation In practice, it is often difficult to predict in advance which accounts are most likely to be misstated and whether misstatements are likely to be overstatements or understatements Similarly, the relative costs of auditing different account balances often cannot be determined It is therefore a difficult professional judgment to allocate the preliminary judgment about materiality to accounts Accordingly, many accounting firms have developed rigorous guidelines and sophisticated methods for doing so These guidelines also help ensure the auditor appropriately documents the overall materiality level and performance materiality levels and the factors considered in determining those amounts in the audit files Part / THE AUDIT PROCESS www.downloadslide.com To summarize, the purpose of allocating the preliminary judgment about materiality to balance sheet accounts is to help the auditor decide the appropriate evidence to accumulate for each account on both the balance sheet and income statement An aim of the allocation is to minimize audit costs without sacrificing audit quality Regardless of how the allocation is done, when the audit is completed, the auditor must be confident that the combined misstatements in all accounts are less than or equal to the preliminary (or revised) judgment about materiality ESTIMATE MISSTATEMENT AND COMPARE WITH PRELIMINARY JUDGMENT The first two steps in applying materiality involve planning (see Figure 9-1 on page 249) and are our primary concern in this chapter The last three steps result from performing audit tests These steps are introduced here and discussed in more detail in subsequent chapters When auditors perform audit procedures for each segment of the audit, they document all misstatements found Misstatements in an account can be of two types: known misstatements and likely misstatements Known misstatements are those where the auditor can determine the amount of the misstatement in the account For example, when auditing property, plant, and equipment, the auditor may identify capitalized leased equipment that should be expensed because it is an operating lease There are two types of likely misstatements The first are misstatements that arise from differences between management’s and the auditor’s judgment about estimates of account balances Examples are differences in the estimate for the allowance for uncollectible accounts or for warranty liabilities The second are project ions of misstatements based on the auditor’s tests of a sample from a population For example, assume the auditor finds six client misstatements in a sample of 200 in testing inventory costs The auditor uses these misstatements to estimate the total likely misstatements in inventory (step 3) The total is called an estimate or a “projection” or “extrapolation” because only a sample, rather than the entire population, was audited The projected misstatement amounts for each account are combined on the worksheet (step 4), and then the combined likely misstatement is compared with materiality (step 5) Table 9-1 (p 256) illustrates the last three steps in applying materiality For simplicity, only three accounts are included The misstatement in cash of $2,000 is a known misstatement related to unrecorded bank service charges detected by the auditor Unlike for cash, the misstatements for accounts receivable and inventory are based on samples The auditor calculates likely misstatements for accounts receivable and inventory using known misstatements detected in those samples To illustrate the calculation, assume that in auditing inventory the auditor found $3,500 of net overstatement amounts in a sample of $50,000 of the total population of $450,000 The $3,500 identified misstatement is a known misstatement To calculate the estimate of the likely misstatements for the total population of $450,000, the auditor makes a direct projection of the known misstatement from the sample to the population and adds an estimate for sampling error The calculation of the direct projection estimate of misstatement is: Direct projection Total recorded Net misstatements in the sample ($3,500) estimate of × population value = misstatement Total sampled ($50,000) ($450,000) ($31,500) OBJECTIVE 9-4 Use materiality to evaluate audit findings Set materiality for the financial statements as a whole Determine performance materiality Estimate total misstatement in segment Estimate the combined misstatement Compare combined estimate with preliminary or revised judgment about materiality (Note that the direct projection of likely misstatement for accounts receivable of $12,000 is not illustrated.) The estimate for sampling error results because the auditor has sampled only a portion of the population and there is a risk that the sample does not accurately Chapter / MATERIALITY AND RISK 255 www.downloadslide.com TABLE 9- 1 Illustration of Comparison of Estimated Total Misstatement to Preliminary Judgment about Materiality Account Cash Accounts receivable Inventory Total estimated misstatement amount Preliminary judgment about materiality Performance Materiality Known Misstatement and Direct Projection $ 4,000 $ 2,000 NA $ 2,000 20,000 36,000 12,000 31,500 6,000 15,750 18,000 47,250 $45,500 $16,800 $62,300 Sampling Error $ Total $50,000 NA = Not applicable Cash audited 100 percent represent the population (We’ll discuss this in more detail in chapters 15 and 17) In this simplified example, we’ll assume the estimate for sampling error is 50 percent of the direct projection of the misstatement amounts for the accounts where sampling was used (accounts receivable and inventory) There is no sampling error for cash because the total amount of misstatement is known, not estimated In combining the misstatements in Table 9-1, we can observe that the known mis statements and direct projection of likely misstatements for the three accounts adds to $45,500 However, the total sampling error is less than the sum of the individual sampling errors This is because sampling error represents the maximum misstate ment in account details not audited It is unlikely that this maximum misstatement amount exists in all accounts subjected to sampling Table 9-1 shows that total estimated likely misstatement of $62,300 exceeds the preliminary judgment about materiality of $50,000 The major area of difficulty is inventory, where estimated misstatement of $47,250 is significantly greater than performance materiality of $36,000 Because the estimated combined misstatement exceeds the preliminary judgment, the financial statements are not acceptable The auditor can either determine whether the estimated likely misstatement actually exceeds $50,000 by performing additional audit procedures or require the client to make an adjustment for estimated misstatements If the auditor decides to perform additional audit procedures, they will be concentrated in the inventory area If the estimated net overstatement amount for inventory had been $28,000 ($18,000 plus $10,000 sampling error), the auditor probably would not have needed to expand audit tests because it would have met both the tests of performance materiality ($36,000) and the preliminary judgment about materiality ($2,000 + $18,000 + $28,000 = $48,000 < $50,000) In fact, the auditor would have had some leeway with that amount because the results of cash and accounts receivable procedures indicate that those accounts are within their performance materiality limits If the auditor approaches the audit of the accounts in a sequential manner, the findings of the audit of accounts audited earlier can be used to revise the performance materiality established for accounts audited later In the illustration, if the auditor had audited cash and accounts receivable before inventories, performance materiality for inventories could have been increased AUDIT RISK OBJECTIVE 9-5 Define risk in auditing 256 Auditing standards require the auditor to obtain an understanding of the entity and its environment, including its internal control, to assess the risk of material misstatements in the client’s financial statements Chapter described how the auditor Part / THE AUDIT PROCESS www.downloadslide.com Rick Chulick, President and Chief Operating Officer DEAR SHAREHOLDERS March 29, 2014 We are proud to announce another year of noticeable improvement In last year’s letter we stated, “We are committed to increasing the efficiency and effectiveness of operations through cost savings and productivity improvements, in light of current economic conditions In addition, we intend to maintain and further develop our customer base through recently implemented post-sale service programs.” The operating results in this report demonstrate that our objectives have been achieved, resulting in a net income increase of $740,000 from 2012 to 2013 This amounts to 15 cents per share, a 23.2% increase from last year Our goal in the current year is to further improve the results of operations and create value for shareholders In doing so, we will focus primarily on the following three strategic components of our business plan: Post-sale service arrangements designed to further develop and maintain our customer base Aggressive advertising campaigns that allow us to penetrate markets dominated by national wholesale hardware store chains Implementation of new warehouse technology designed to increase productivity and reduce stocking and distribution costs We will report our progress throughout the year Christopher J Kurran Rick Chulick Chief Executive Officer President and Chief Operating Officer Business www.downloadslide.com History Hillsburg Stores Inc began operations in 1984 in Gary, Indiana, as a retail hardware store chain On September 25, 1990, Hillsburg merged with Handy Hardware and Lumber Company, which established the concept of selling high-quality hardware through wholesale distribution outlets, to form Handy-Hillsburg, Inc., a Washington corporation On June 5, 1994, after spinning off all of its lumber-related assets to Handy Corporation, the company changed its name to Hillsburg Hardware, Inc On October 22, 1996, the company reincorporated from Washington to Delaware and changed its name to Hillsburg Hardware Company (hereafter referred to as “the Company”), which trades on the NASDAQ under the symbol “HLSB.” Overview Hillsburg Hardware Company is a wholesale distributor of hardware equipment to a variety of independent, high-quality hardware stores in the midwestern part of the United States The primary products are power and hand tools, landscaping equipment, electrical equipment, residential and commercial construction equipment, and a wide selection of paint products More than 90% of the Company’s products are purchased from manufacturers and shipped either directly to customers or to the main warehouse in Gary, Indiana, where shipments are combined to minimize the costs of freight and handling Hardware retailers, now more than ever, find it advantageous to purchase from us rather than directly from manufacturers We make it possible for smaller, independent retailers to purchase on an as-needed basis, rather than in bulk Moreover, we offer our customers a range of high-quality products that cannot be found at most national chains We also offer far more post-sale services to customers than are offered by manufacturers and other national distributors We simplify the purchasing process by assigning each customer a permanent salesperson Each salesperson becomes involved in the sales process, and also acts as a liaison between the customer and post-sale service areas For example, when customers experience technical problems with recently purchased hardware, their salesperson has the responsibility to coordinate both exchanges and warranty repairs with the manufacturer This process adds value for customers and makes post-sales service more efficient and less problematic Low turnover and extensive training of our salespeople enhance this service To further encourage customer loyalty, each customer is given access to our internal database system—ONHAND (Online Niche-Hardware Availability Notification Database) The ONHAND system lets customers check the availability of hard-to-find products instantly over the Internet Moreover, the system includes data such as expected restock dates for items that are currently sold out and expected availability dates for items that will soon be introduced to the market Because of the two aforementioned processes, we have managed to maintain a repeat-customer base Nearly 75% of all first-time customers make at least one additional purchase within one year of their first purchase Recently, there have been major consolidations in the wholesale hardware industry We believe this consolidation trend is advantageous to our operations as a distributor of hard-to-find, high-quality hardware equipment The recent consolidation of Builder’s Plus Hardware, Inc., one of the top ten largest national hardware store chains, is a case in point One month after the consolidation, Builder’s Plus decided not to carry high-end construction and landscaping equipment in order to focus on what it called the “typical hardware customer.” Products To more effectively manage inventory, we carefully monitor the composition of net sales by category of items sold The following chart indicates the percentage of net sales by class of merchandise sold during the years 2013, 2012, and 2011: 25% % OF NET SALES 2013 20% 2012 15% 2011 10% 5% 0% Power Tools Hand Tools Landscaping Equipment Electrical Equipment MERCHANDISE TYPE Residential Construction Commercial Construction Paint Products www.downloadslide.com Marketing Program This year, the Company made a significant investment in a new advertising campaign Various Internet, radio, newspaper, magazine, and television advertisements were purchased at the local and regional levels using the Company’s new catchphrase, “Hardware for Hard Workers.” The new jingle has been partially responsible for the fiscal 2013 increase in sales of 9% Customers The majority of our customers are located in Illinois, Michigan, Wisconsin, Ohio, and Missouri Our current customer base consists of more than 400 independently owned hardware stores Approximately 25% of our customers make up more than 80% of total sales revenue To promote long-standing relationships with customers, we offer an array of incentive and customer appreciation programs Since these programs were implemented in 2004, customer satisfaction ratings have improved steadily in each subsequent year Business Competitors There are other regional wholesale hardware distributors that compete with the Company, but national wholesale hardware store chains dominate the industry Most of our competitors are not only larger, but have greater financial resources than our company Ten national chains exist in the geographic area in which Hillsburg Hardware Co operates Of the ten national chains, Hardware Bros., Tools & Paint, and Construction City account for a significant portion of the wholesale hardware market share and also carry the hard-to-find and high-quality items we provide The success of our business depends on our ability to keep distribution costs to a minimum and our customers satisfied through superior customer service The chart below is a breakdown of market share in the wholesale hardware market by competitor category, including the 2% market share held by the Company The chart illustrates that we have considerable opportunity for sales growth Employees Hillsburg Hardware currently employs 319 individuals The majority of our employees are involved in day-to-day sales Because of our marketing and customer relations strategy, we make significant investments in ongoing training and professional development activities Each year employees are required to attend 75 hours of professional training Each employee receives a performance evaluation at least four times per year, usually once each quarter Our turnover is among the lowest in the industry because of our compensation, training, and evaluation programs We regard our employees as our most valuable asset Hillsburg Hardware Co 2% Other Regional Wholesale Hardware Distributors 5% Tools & Paint 17% Suppliers We purchase hardware and other products from more than 300 manufacturers in the United States No single vendor accounted for more than 5% of our purchases during fiscal 2013, but our 25 largest vendors accounted for nearly 35% We currently have long-term supply agreements with two vendors: Mechanical Tools and Painter’s Paradise These agreements are in effect until the end of fiscal year 2014 The combined dollar amount of each contract is not expected to exceed 5% of total purchases for the year Other National Wholesale Hardware Store Chains 39% Construction City 15% Hardware Bros 22% Business www.downloadslide.com Properties The Company owns and operates its main warehouse and an administrative office The main warehouse and administrative office are in the same 475,000 square-foot building We also rent a second warehouse for which rental fees are $312,000 annually The building, located in Detroit, Michigan, serves as an off-site storage facility Legal Proceedings On September 3, 2012, a suit was filed in the Circuit Court in Gary, Indiana, against the Company The product liability suit, “Don Richards v Hillsburg Hardware Co.” is related to injuries that resulted from an alleged defective design of a tractor manufactured by Silo-Tractor, a U.S corporation The suit is currently in pretrial proceedings In the opinion of our legal counsel the suit is without merit We intend to vigorously defend our position The Company does not believe any other legal issues materially affect its finances Executive Officers The following list provides names, ages, and present positions of the Company’s officers: NAME AGE POSITION John P Higgins 55 Chairman of the Board Christopher J Kurran 47 Chief Executive Officer (b) Rick Chulick 48 President and Chief Operating Officer (a) Avis A Zomer 44 Chief Financial Officer Brandon S Mack 51 Vice President Sales and Marketing Mary R Moses 36 Vice President Merchandising Vanessa M Namie 53 Vice President Operations (c) Joseph A Akins 64 Vice President Quality Assurance (d) (a) Mr Chulick has been President and Chief Operating Officer of the Company for ten years, since November 2003 Mr Chulick was Chairman of the Board from 2006 to 2008 (b) Mr Kurran has been Chief Executive Officer of the Company since September 2003 Prior to his role as CEO, Mr Kurran was employed from 1994-2002 by Trini Enterprises, an industrial distributor (c) Ms Namie has been employed by the company since its inception in 1996 She has held her current position since 2002 and served as an operations manager from 19962002 (d) Mr Akins was Chief Operating Officer and President of Hardware Bros., one of the ten largest wholesale hardware chains in the nation, from 2000-2005 www.downloadslide.com Controls and Procedures Pursuant to Section 404 of the Sarbanes–Oxley Act of 2002 and related Exchange Act Rules, we have carefully evaluated the design and operating effectiveness of our internal control over financial reporting After careful review of all key controls over financial reporting, our Chief Executive Officer and Chief Financial Officer implemented new controls over the internal verification and timely recording of sales transactions In compliance with Section 404 and related Exchange requirements, management has issued its report that internal controls over financial reporting are operating effectively as of December 31, 2013 based on criteria established in the COSO Internal Control-Integrated Framework Business “We offer our customers a range of high-quality products that cannot be found at most national chains.” Information Regarding Common Equity Hillsburg Hardware Company’s common stock currently trades on the NASDAQ under the symbol “HLSB.” The following chart shows the high and low prices of the Company’s common stock by quarter for the years 2013 and 2012: 2013 2012 HIGH LOW HIGH LOW Quarter 22.50 19.05 23.30 20.00 Quarter 22.55 20.10 22.75 20.25 Quarter 22.30 20.99 24.10 19.75 Quarter 22.40 17.95 21.50 18.20 On March 23, 2014, there were 1,250 shareholders of our common stock Dividend Policy Dividend payments on common stock are authorized annually by the Board of Directors For 2013, dividend payments totaled $1.9 million, which is $.38 per share www.downloadslide.com REPORT OF INDEPENDENT REGISTERED ACCOUNTING FIRM Board of Directors and Stockholders Hillsburg Hardware Company We have audited the accompanying balance sheets of Hillsburg Hardware Company as of December 31, 2013 and 2012, and the related statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the threeyear period ended December 31, 2013 We have also audited Hillsburg Hardware Company, Inc.’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) Hillsburg Hardware Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying report, Management’s Responsibility for the Financial Statements Our responsibility is to express an opinion on these financial statements and an opinion on the company’s internal control over financial reporting based on our audits We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States) Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk Our audits also included performing such other procedures as we considered necessary in the circumstances We believe that our audits provide a reasonable basis for our opinions A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding the prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Hillsburg Hardware Company, Inc as of December 31, 2013 and 2012, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2013, in conformity with accounting principles generally accepted in the United States of America Also in our opinion, Hillsburg Hardware Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) Berger & Anthony, LLP Berger and Anthony, LLP Gary, Indiana March 21, 2014 www.downloadslide.com The accompanying financial statements of Hillsburg Hardware Company have been prepared by management, which is responsible for their integrity and objectivity The statements have been prepared in conformity with accounting principles generally accepted in the United States of America and include amounts based on management’s best estimates and judgments Management has also prepared information elsewhere in this Annual Report that is consistent with data in the financial statements The Company’s financial statements have been audited by Berger and Anthony, independent Certified Public Accountants Our auditors were given unrestricted access to all financial records and related data, including minutes of the meetings of the Board of Directors We believe all representations made to Berger and Anthony were legitimate and appropriate The management of Hillsburg Hardware Company is responsible for establishing and maintaining adequate internal control over financial reporting Hillsburg Hardware Company’s internal control system was designed to provide reasonable assurance to the company’s management and board of directors regarding the preparation and fair presentation of published financial statements Hillsburg Hardware Company management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2013 In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework Based on our assessment we believe that, as of December 31, 2013, the company’s internal control over financial reporting is effective based on those criteria Financial Statements Management’s Responsibility for the Financial Statements To Our Shareholders: Hillsburg Hardware Company’s independent auditors have issued an audit report on our financial statements and internal control over financial reporting This report appears on the preceding page John P Higgins Chairman of the Board Christopher J Kurran Chief Executive Officer Avis A Zomer Chief Financial Officer Balance Sheet www.downloadslide.com Hillsburg Hardware Company Balance Sheets (in thousands) December 31 ASSETS 2013 2012 Current assets Cash and cash equivalents $ Trade receivables (net of allowances of $1,240 and $1,311) Other receivables Merchandise inventory Prepaid expenses Total current assets 828 $ 743 18,957 16,210 945 915 29,865 31,600 432 427 51,027 49,895 3,456 3,456 32,500 32,000 Property and equipment Land Buildings Equipment, furniture, and fixtures Less: accumulated depreciation Total property and equipment (net) Total assets $ 6,304 8,660 (31,920) (33,220) 10,340 10,896 61,367 $ 60,791 LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities Trade accounts payable $ 4,720 $ 4,432 Notes payable 4,180 4,589 Accrued payroll 1,350 715 120 116 2,050 1,975 Accrued payroll tax Accrued interest and dividends payable Accrued income tax Total current liabilities Long-term notes payable 796 523 13,216 12,350 24,120 26,520 Deferred income taxes 738 722 Other long-term payables 830 770 Capital stock ($1 par value; 5,000,000 shares issued) 5,000 5,000 Capital in excess of par value 3,500 3,500 Retained earnings 13,963 11,929 Total stockholders’ equity: 22,463 20,429 61,367 $ 60,791 STOCKHOLDERS’ EQUITY Total liabilities and stockholders’ equity See Notes to Financial Statements 10 $ www.downloadslide.com Statement of Operations Hillsburg Hardware Company Statement of Operations (in thousands) Year Ended December 31 2013 2012 2011 $ 143,086 $ 131,226 $ 122,685 103,241 94,876 88,724 39,845 36,350 33,961 32,475 29,656 28,437 7,370 6,694 5,524 2,409 2,035 2,173 (720) — — Total other income/expense (net) 1,689 2,035 2,173 Earnings before income taxes 5,681 4,659 3,351 Provision for income taxes 1,747 1,465 1,072 Net sales Cost of sales Gross profit Selling, general and administrative expenses Operating income Other income and expense Interest expense Gain on sale of assets Net income $ 3,934 $ 3,194 $ 2,279 Earnings per share $ 0.79 $ 0.64 $ 0.46 Stockholders’ Equity See Notes to Financial Statements Hillsburg Hardware Company Statement of Stockholders’ Equity (in thousands) Common Stock Shares Par value Balance as of December 31, 2010 5,000 $ 5,000 Paid-in Capital Retained Earnings Total Stockholders’ Equity $ 3,500 $ 10,256 $ 18,756 Net income 2,279 2,279 Dividends paid (1,900) (1,900) $ 10,635 $ 19,135 Balance as of December 31, 2011 5,000 $ 5,000 $ 3,500 Net income Dividends paid Balance as of December 31, 2012 5,000 $ 5,000 $ 3,500 3,194 3,194 (1,900) (1,900) $ 11,929 $ 20,429 Net income 3,934 3,934 Dividends paid (1,900) (1,900) $ 13,963 $ 22,463 Balance as of December 31, 2013 5,000 $ 5,000 $ 3,500 See Notes to Financial Statements 11 Cash Flows www.downloadslide.com Hillsburg Hardware Company Statement of Cash Flows (in thousands) Year Ended December 31 OPERATING ACTIVITIES Net income 2013 2012 2011 $ 3,934 $ 3,194 $ 2,279 1,452 1,443 1,505 — — Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization (Gain) or Loss on sale of assets (720) Deferred income taxes increase (decrease) 16 (8) 43 Trade and other receivables (2,777) (393) (918) Merchandise inventory Changes in assets and liabilities: 1,735 (295) (430) Prepaid expenses (5) (27) (55) Accounts payable 288 132 76 Accrued liabilities 714 77 142 Income taxes payable 273 23 13 4,910 4,146 2,655 (10,500) (1,800) (2,292) Net cash provided by operating activities INVESTING ACTIVITIES Capital expenditures Sale of equipment — 10,324 Net cash used in investing activities — (176) (1,800) (2,292) Dividend payment (1,900) (1,900) (1,900) Proceeds (repayments) from borrowings (net) (2,749) (423) 1,602 (4,649) (2,323) (298) FINANCING ACTIVITIES Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year See Notes to Financial Statements 12 $ 85 23 65 743 720 655 828 $ 743 $ 720 www.downloadslide.com Allowance for Doubtful Accounts: Our allowance for doubtful accounts is maintained to account for expected credit losses Estimates of bad debts are based on individual customer risks and historical collection trends Allowances are evaluated and updated when conditions occur that give rise to collection issues Merchandise Inventory: Merchandise inventory is presented at the lower of average cost or market To present accurately the estimated net realizable value of the accounts, we adjust inventory balances when current and expected future market conditions, as well as recent and historical turnover trends, indicate adjustments are necessary Property, Plant and Equipment: Land, buildings, computers and other equipment, and furniture and fixtures are stated at historical cost Depreciation is calculated on a straight-line basis over estimated useful lives of the assets Estimated useful lives are 20 to 35 years for buildings and to 10 years for equipment and furniture and fixtures Revenue Recognition: Revenues are recognized when goods are shipped, title has passed, the sales price is fixed, and collectibility is reasonably assured A sales returns and allowance account is maintained to reflect estimated future returns and allowances Adjustments to the sales returns and allowance account are made in the same period as the related sales are recorded and are based on historical trends, as well as analyses of other relevant factors Sales are recorded net of returns and allowances in the statements referred to in this report Income Taxes: The deferred income tax account includes temporary differences between book (financial accounting) income and taxable income (for IRS reporting purposes) The account consists largely of temporary differences related to (1) the valuation of inventory, (2) depreciation, and (3) other accruals Other Receivables The other receivables balance consists largely of vendor allowances and vendor rebates When vendor allowances and vendor rebates are recognized (all activities required by the supplier are completed, the amount is determinable, and collectibility is reasonably certain), they are recorded as reductions of costs of goods sold Notes Payable Notes payable for the year ended December 31, 2013, consists of three notes payable to the bank Each note carries a fixed interest rate of 8.5% One note for $4,180,000 matures in June 2014 and the other two mature on December 31, 2016 During 2013, there was an additional note outstanding in the amount of $4,400,000, which was paid off during October 2013 Commitments The Company is currently committed to an operating lease that expires in 2017 Rental payments for the remainder of the contract are set at $312,000 per annum Segment Reporting The Company operates in one segment The breakdown of revenues (in thousands) from different products is listed in the chart below: SEGMENT REPORTING 2013 2012 2011 $ 31,479 $ 27,557 $ 26,991 Hand Tools 21,463 19,684 18,403 Landscaping Equipment 14,309 15,645 13,494 Electrical Goods 17,170 15,849 11,042 Residential Construction Equipment 21,463 18,372 15,949 Commercial Construction Equipment 11,447 10,498 9,815 25,755 23,621 26,991 $143,086 $ 131,226 $122,685 Power Tools Paint Products Notes to Financial Statements Description of Significant Accounting Policies and Business We are a wholesale distributor of high-quality power tools, hand tools, electrical equipment, landscaping equipment, residential and commercial construction equipment, and paint products The majority of our customers are smaller, independent hardware stores located in Illinois, Michigan, Wisconsin, Ohio, and Missouri Earnings Per Share Earnings per share calculations for 2013, 2012, and 2011 were computed as follows: Numerators (net income in thousands): $3,934, $3,194, and $2,279 Denominators (shares of common stock): (unchanged for all years) 5,000,000 Diluted earnings per share was the same as basic earnings per share for all years 13 Management’s Discussion www.downloadslide.com Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of the results of our operations and our financial condition are based on the financial statements and related notes included in this report When preparing the financial statements, we are frequently required to use our best estimates and judgments These estimates and judgments affect certain asset, liability, revenue, and expense account balances Therefore, estimates are evaluated constantly based on our analyses of historical trends and our understanding of the general business environment in which we operate There are times, however, when different circumstances and assumptions cause actual results to differ from those expected when judgments were originally made The accounting policies referred to in Note to the financial statements, in our opinion, influence the judgments and estimates we use to prepare our financial statements Results of Operations For the year ended December 31, 2013, gross profit increased by 9.6% or $3,495,000 from 2012 This increase in gross profit more than offsets the increase in operating expenses from 2012 to 2013 of $2,819,000 or 9.5% The increase in gross margin largely explains the operating income increase of $676,000 For the year ended December 31, 2012, gross profit increased by $2,389,000 or 7% from 2011 Total operating expenses increased by $1,219,000 or approximately 4.3% from 2011 The increase in gross profit offset the total operating expense increase, and the net result was a $1,170,000 increase in operating income Net Sales: From 2012 to 2013 net sales increased by $11,860,000 or 9% The increase in net sales can be explained largely by an aggressive advertising campaign that the Company organized during the second half of 2013 Net sales for 2012 increased by $8,541,000 or 7.0% from 2011, which is consistent with industrywide average revenue growth of 7% from 2011 to 2012 Gross Profit: Gross profit as a percentage of net sales stayed relatively stable at 27.68% and 27.70% in 2011 and 2012, respectively, but increased to 27.85% in 2013 The 2013 increase is mostly due to improved vendor incentive programs, our focus on cost containment, and increases in the resale values of certain commodities such as PVC piping material and certain types of metal wiring While gross profit percentages in the industry have declined somewhat, our position as a niche provider in the overall hardware market allows us to charge premium prices without losing customers Selling, General, and Administrative Expenses: Selling expenses increased by $1,911,000 or 14.8% from 2012 to 2013 and by $805,000 or 6.7% from 2011 to 2012 As a percentage of net sales, selling expenses increased by 0.52% since 2012 and decreased by 0.03% from 2011 to 2012 The increase in selling expenses as a percentage of net sales from 14 2012 to 2013 is due to our new advertising campaign and increased expenditures on sales meetings and training General and administrative expenses increased by $908,000 or 5.4% from 2012 to 2013 and by $414,000 or 2.5% from 2011 to 2012 As a percentage of net sales, general and administrative expenses decreased by 0.42% since 2012 and decreased by 0.55% from 2011 to 2012 The overall increase from 2012 to 2013 was caused mostly by unexpected repairs needed to reattach and replace damaged shelving units in our main warehouse building Interest Expense: In 2013, interest expense increased by $374,000, or approximately 18.4%, compared to 2012 The increase was due to an overall interest rate increase and the restructuring of debt covenants that are less restrictive but demand higher interest rates In 2012 interest expense decreased by $138,000 or 6.4% compared to 2011 The 2012 decrease was mainly due to the Company’s decision to decrease the level of long-term debt The average interest rates on short- and long-term debt during 2013 were approximately 10.5% and 8.5% respectively Liquidity During 2013, our working capital requirements were primarily financed through our line of credit, under which we are permitted to borrow up to the lesser of $7,000,000 or 75% of accounts receivable outstanding less than 30 days The average interest rate on these short-term borrowings in 2013 was approximately 10.5% Cash provided by operating activities for 2013 and 2012 was $4,910,000 and $4,146,000 respectively The change from 2012 to 2013 is primarily due to the increase in net income Increases in receivables were largely offset by decreases in inventories and increases in payables and other current liabilities The increase in cash provided from operating activities of $1,491,000 from 2011 to 2012 is largely the result of the increase in net income and smaller increases in receivables and merchandise inventory in 2012 compared to 2011 We believe that cash flow from operations and the available short-term line of credit will continue to allow us to finance operations throughout the current year Statement of Condition Merchandise inventory and trade accounts receivable together accounted for over 95% of current assets in both 2013 and 2012 Merchandise inventory turned over approximately 3.4 times in 2013 and 3.0 times in 2012 Average days to sell inventory were 108.6 and 120.9 in 2013 and 2012 respectively Net trade receivables turned over approximately 7.6 times in 2013 and in 2012 Days to collect accounts receivable computations were 48.1 and 48.0 in 2013 and 2012 respectively Both inventory and accounts receivable turnover are lower than industry averages We plan for this difference to satisfy the market in which we operate Our market consists of smaller, independent hardware stores that need more favorable receivable collection terms and immediate delivery of inventory Because we hold large amounts of inventory, we are able to fill orders quicker than most of our competitors even during the busiest times of the year www.downloadslide.com Hillsburg Hardware Company Five-Year Financial Summary (in thousands) BALANCE SHEET DATA: 2013 2012 2011 $ 51,027 $ 49,895 $ 49,157 Total assets 61,367 60,791 Current liabilities 13,216 12,350 Long-term notes payable 24,120 Total stockholders’ equity Current assets 2010 2009 47,689 $ 46,504 59,696 57,441 51,580 12,173 12,166 9,628 26,520 26,938 25,432 25,223 22,463 20,429 19,135 18,756 15,764 $ 143,086 $ 131,226 $ 122,685 $ 120,221 $ 117,115 $ Five-Year Summary Information Concerning Forward-Looking Statements This report contains certain forward-looking statements (referenced by such terms as “expects” or “believes”) that are subject to the effects of various factors including (1) changes in wholesale hardware prices, (2) changes in the general business environment, (3) the intensity of the competitive arena, (4) new national wholesale hardware chain openings, and (5) certain other matters influencing the Company’s ability to react to changing market conditions Therefore, management wishes to make readers aware that the aforementioned factors could cause the actual results of our operations to differ considerably from those indicated by any forward-looking statements included in this report Outlook During 2013 we experienced another year of noticeable improvement, despite the economic environment The Company’s financial performance can largely be attributed to (1) a continued focus on cost containment, (2) productivity improvements, (3) aggressive advertising, and (4) the implementation of programs designed to enhance customer satisfaction During 2014, we will continue to apply the same strategic efforts that improved 2013 performance We are also implementing a new warehouse information system designed to increase productivity and reduce stocking and distribution costs Management believes that earnings growth will be primarily driven by (1) continued focus on customer satisfaction, (2) penetration into markets currently dominated by national wholesale hardware store chains, and (3) the use of technology to attract additional customers and promote more efficient operations INCOME STATEMENT DATA: Net sales Cost of sales 103,241 94,876 88,724 88,112 85,663 Gross profit 39,845 36,350 33,961 32,109 31,452 Earnings before income taxes 5,681 4,659 3,351 3,124 1,450 Net income 3,934 3,194 2,279 2,142 994 Cash provided by operating activities 4,910 4,146 2,655 1,811 1,232 Per common share data: Net income $ 0.79 $ 0.64 $ 0.46 $ 0.43 $ 0.22 Cash dividends per share $ 0.38 $ 0.38 $ 0.38 $ — $ — Common shares outstanding 5,000 5,000 5,000 5,000 4,500 27.68% 26.71% 26.86% KEY OPERATING RESULTS AND FINANCIAL POSITION RATIOS: Gross profit (%) Return on assets (%) Return on common equity (%) 27.85% 27.70% 9.30% 7.73% 5.72% 5.73% 2.86% 26.49% 23.55% 17.69% 18.10% 9.50% 15 www.downloadslide.com www.downloadslide.com Summary of the Audit Process PHASE I Plan and design an audit approach Accept client and perform initial planning Understand the client’s business and industry Assess client business risk Perform preliminary analytical procedures Set materiality and assess acceptable audit risk and inherent risk Understand internal control and assess control risk Gather information to assess fraud risks Develop overall audit strategy and audit program PHASE II Perform tests of controls and substantive tests of transactions Plan to reduce assessed level of control risk? No Yes Perform tests of controls* Perform substantive tests of transactions Assess likelihood of misstatements in financial statements PHASE III Perform analytical procedures and tests of details of balances Low Medium High or unknown Perform analytical procedures Perform tests of key items Perform additional tests of details of balances PHASE IV Complete the audit and issue an audit report Perform additional tests for presentation and disclosure Accumulate final evidence Evaluate results Issue audit report Communicate with audit committee and management * The extent of testing of controls is determined by planned reliance on controls For public companies required to have an audit of internal control, testing must be sufficient to issue an opinion on internal control over financial reporting ... 64,100 141,6 62 7,993 ,21 7 — 46,737 6,171,875 — 38,546 5,5 42, 084 417,607 (196,700) 4 72, 566 (21 7 ,20 0) 469, 921 (21 4,100) 22 0,907 25 5,366 25 5, 821 (20 ,700) $ 20 0 ,20 7 — $ 25 5,366 — $ 25 5, 821 Consolidated... the 52 Weeks Ended March 31, 20 12 April 1, 20 11 $ 8,351,149 59,675 8,410, 824 $ 6,601 ,25 5 43,186 6,644,441 $ 5,959,587 52, 418 6,0 12, 005 5,197,375 4,005,548 3,675,369 2, 590,080 2, 119,590 1, 828 ,169... Thousands) $ 828 18,957 29 ,865 1,377 10,340 $61,367 $ 6 (a) 26 5 (b) 26 5 (b) 60 (c) 48 (d) $ 4, 720 28 ,300 1,470 2, 050 2, 364 8,500 13,963 $61,367 90 (e) (a) 60 (c) (a) 72 (c) (a) NA ( f ) $ 884 (2