Company Background

J & M Lumber Corporation (J & M), an audit client, was formed in Ohio in 20X0 to provide high-quality lumber packages for builders in the central Ohio region.Ed Jensen and Pat Murphy founded the company and serve as chief executive officer and chief financial officer, respectively. Until this past year under audit (20X6), the company operated out of one location.In 20X6 it added two locations to better serve customers and to expand the sales area to a broader portion of central Ohio.
J & M has earned a reputation for excellence both in providing customer service and high-quality materials.When business is lost by J & M, it is generally due to lower prices offered by competitors.
J & M's products and species of lumber are particularly suited for the central Ohio climate. The company uses a wide base of suppliers and is able to supply various species and trade names of lumber and specialty products within a short lead time.The Company's trucks are cell phone dispatched and equipped with forklifts to deliver material in a timely manner, when and where customers need it delivered.Customers include builders, carpenters, concrete contractors, general contractors and homeowners.
The company experienced a level of profitability in 20X6 of about the same as that of 20X5—but this is well below the net incomes of the preceding years.Ed and Pat had hoped for a more profitable year in 20X6 as a significant amount of the company's long-term debt is payable in 20X7.The company is currently involved in discussions with the bank on refinancing.
Until 20X6 and 20X5 most of earnings were distributed through dividends to J & M's 5 shareholders—CEO Ed Jensen, Ed's wife Madonna Jensen, CFO Pat Murphy and two college friends of Ed and Bill who invested in the company, Sally Adams and Jody Jengelen.This year, in reaction to pressure from a bank that provides a significant portion of the financing, J & M established an audit committee composed of Pat Murphy, Sally Adams and Jody Jengelen.
Operationally, J & M generally grants credit to customers.In most cases the company retains a security interest in the form of lien rights until paid.Therefore, the company's exposure to loss is limited to the difference between the receivable and the value of any liened collateral.The company's operations are dependent on economic conditions which affect the construction industry, and changes in those conditions may affect the company's continuing operations.
This is your firm's fifth audit of J & M—no audit was performed in 20X0 and 20X1.There have been no disagreements over accounting issues in any of the audits.

Industry

Historically, J & M has competed, and continues to compete, primarily against four other suppliers in central Ohio.While two competitors have sales approximately 50% higher, the other two have about the same level of sales as J & M.J & M has proven itself an able competitor over the years.
Within the past three years new competition has begun as organizations and individuals in several eastern European countries have begun to sell European lumber and related products directly to some of J & M's larger residential customers.To this point, while their prices have been lower, the Europeans have had quality issues as well as difficulties in delivering product on a timely basis.A significant portion of this wood is imported from Siberia.
The nature of most of J & M's products makes them relatively unaffected by changes in technology or obsolescence, but sales rely heavily upon both the residential and commercial construction markets.Since J & M's inception in 20X0, the construction industry has been relatively profitable and that trend is expected to continue at least for the coming several years.Lumber production has increased at approximately 3% per year during this time period, as has construction within the central Ohio area.
The housing market in central Ohio has been particularly healthy as much land previously used for farming has been converted to residential housing property.A significant portion of this land is on desirable locations and has attracted "high-end" residential housing contractors.
The most significant question facing the industry is whether the strong construction will continue as expected.During the past two years the economy of the United States has been in a recovery period, yet unemployment remains high as compared to previous periods of recovery.Thus there are questions concerning the continuing construction demand.

Required

1. A risk factor relating to misstatements arising from fraudulent financial reporting is

A. Earnings this year are lower than management had hoped.
B. Overly complex transactions.
C. Sales are made to both residential and commercial purchasers.
D. The industry faces great technological changes in its products.