Introduction to Costco Wholesale Corporation
In 1983, Costco Wholesale Corporation began its operations in Seattle, Washington. It is an industry that puts its focus on the operation of membership warehouses that sell high-quality merchandise at low costs to its members. Costco offers various merchandise that includes food, sundries, hardlines, softlines, and ancillaries. They also provide online services that are not found in any of its warehouses such as e-commerce, business delivery, travel and various others that are in certain countries (Mergent Online). Due to a high volume of competition in the retail industry, Costco has to compete with companies worldwide. Some of its general merchandise retail competitors includes Target, Kroger, and Amazon; however, its main competitors for warehouse club operations are Walmart, Sam’s Club, and BJ’s Wholesale Club.
Overview of Business and Operating Risks
Though Costco may be doing well in its operations, risks in any company are inevitable. The risks that Costco disclosed in its 10-K describe risks that can materially and adversely affect its business. There are three categories for risks: business and operating risks, market and other external risks, and legal and regulatory risks. These risks associated with Costco’s industry, in fact, may affect the auditor’s assessments of the risk of material misstatement and client business risk. A risk of material misstatement is Costco’s reliance on information technology. The process of transactions and managing of its business are dependent on the system. If Costco fails to properly monitor or update the system when needed, it can affect the financial and operational conditions and cause errors by employees. Any material disruption in these systems could lead to understatements and overstatements of its financial statements. Another risk of material misstatement that Costco faces are payment-related risks. Due to the numerous forms of payment, this increases the possibility of fraudulent activities. The payment methods that are accepted includes cash, checks, credit and debit cards, and proprietary cash cards which can lead to a higher fraud loss. Relying on third parties to provide transactions processing services can cause an issue if these companies become hesitant and unable to offer these services to us. Also, having their internal system breached can lead to a failure to accept payments, which can adversely affect the corporation. However, as they offer new payments options to its members, additional rules and regulations need to be implemented to reduce fraud (Costco Annual Report, 2018).
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Market and External Risks Facing Costco
Costco also faces client business risks. One is the economic factor, domestically and internationally that may adversely affect its business. Higher energy and gasoline costs, inflation, unsettled financial markets, levels of unemployment, and other economic factors could affect the demand of its products and services. These factors could increase its merchandising costs and selling and general and administrative expenses. Costco is required to comply with federal, state, regional, local, and international laws and regulations and failure to do so could impact its financial and operating conditions. This is another risk that it face regarding client business risks. These laws and regulations includes the use, storage, discharge, and disposal of hazardous waste and materials and other environmental matters. If Costco do not abide by the laws, it can bring forth harm to its environment and will have to pay penalties. Another risk that is associated with client business risks is the vendors. The company face vendors being unable to supply merchandise in a timely manner at competitive prices. This results in decline in sales and profit margins. Its inability to acquire satisfactory merchandise on acceptable terms or the loss of key vendors will negatively affect the company. Costco may have problems with the suppliers that can possibly delay or prevent delivery of merchandise. This risk could lead to tarnishing the reputation and the impact on the company (Costco Annual Report, 2018).
Understanding Costco's Business for Effective Auditing
It is vital for an auditor to know its company thoroughly. This will help the auditor to properly do the audit by understanding Costco’s business and industry. By management being held responsible for establishing and maintaining adequate internal control over financial statements, they can ensure that it is in accordance with GAAP. In addition, understanding its business operations and processes can be effective information in doing the audit. Gathering as much information about the company as possible can help the auditor to analyze the operations well.
Costco's Global Operations and Membership Model
Costco is headquartered in Issaquah, Washington but holds different operations in numerous countries. As of September 2, 2018, Costco operated 762 warehouses worldwide, including 527 in the United States, 100 in Canada, 39 in Mexico, 28 in the United Kingdom, 26 in Japan, 15 in Korea, 13 in Taiwan, 10 in Australia, two in Spain, one in Iceland, and one in France (NetAdvantage). Also, the company operates e-commerce sites in the United States, Canada, the United Kingdom, Korea, Taiwan, and Mexico. Costco attempts to make up for its revenue by charging an annual membership fee of $55 for business, business add-on membership and executive membership of $110, offering products which the groceries account for more than half of its revenues, and doing operations domestically accounts for about 55% of it total revenues (Nasdaq). In the Stock Analysis on Net report, it showed the significant asset: cash and cash equivalents- $6,055,00; merchandise inventories- $11,040,000; and net property and equipment- $19,861,00. The key suppliers that are important to Costco are the food processing, office supplies, and furniture and fixtures industries (CISMarket). Within the Form 10-K, some forms of external financing are long-term debt and short-term borrowing that helps to sustain the needs of the company. Costco is a big corporation that is continuously evolving. It has several subsidiaries- Costco Wholesale Korea, Costco Wholesale Membership, Inc., NW Re Ltd, Costco Costco Wholesale Canada, Ltd., and Costco Wholesale Taiwan, Ltd. This means they control companies by owning 50% or more of their voting stocks.
Executive Compensation and Governance
Costco is a company that has beneficial programs that motivates its employees to participate in its growth and development. The President and Chief Executive Officer of the company is W. Craig Jelinek. At the end of the fiscal year for 2018, Mr. Jelinek earned a cash bonus of $97,000. During the duration of the year, the total compensation is $7,408,513. His salary for that year totaled to be $800,000; however, the most significant component of his compensation is stock awards with the amount of $6,295,829. Stock awards represents the grant-date fair value of performance-based RBUs. The Executive Vice President and the Chief Financial Officer of Costco is Richard A. Galanti. He received a bonus of $59,040. Mr. Galanti’s compensation totaled to be $4,286,893. At the end of the fiscal year, his salary totaled to be $740,000; however, his most significant compensation is also the stock awards of $3,150,444. Both, Jelinek and Galanti attained the performance criteria that allowed each of them to execute their duties well (Costco Proxy Statement, 2018).
Auditor's Perspective on Costco's Financial Health
The auditor must know who is in control or the company in which they are auditing to ensure there is not any material misstatements. The auditor also must be able and willing to perform a preliminary analytical procedures to better understand Costco’s business and industry and to assess client business risk. The auditor must compare Costco’s ratios to the industry to provide insight on how the company is performing. Compared to the industry, the company is doing well. This is represented well in the probability ratios. The return of assets (ROA) is 7.3% while the industry is 4.0%. For return on equity, the Costco is twice as high as the industry which it increased by 16.4%. They are performing well because they are making some sort of profit. There is significant changes in some of the ratios; however for some, there is little to no changes from years. While ratios such as the current ration and quick ratio would not affect the auditor’s assessment. That is because it had no change from the previous to the current year. Costco’s account receivable turnover is 91.3 which is higher than the industry ration of 31.7x. This demonstrates that the company is faster at converting its accounts receivable into cash. From analyzing the ratios, it is evident that Costco is more liquid in earning cash and it has the ability to meet its long-term liabilities. Lastly, the industry’s 23.9% of gross profit is greater than the company’s ration of 13%. Financially, Costco did not do so bad considering the previous year, as well as, the industry (NetAdvantage). These differences results in a good chance of affecting the assessment of the auditor on risk of material misstatements.
An auditor must understand a client’s financial statements such as the balance sheet and income statement. For instance, last year’s total assets and liabilities were $36,347,000 while this year’s total is $40,830,000 which signifies an 11% increase. This increase on this account can materially affect the financial statement. The auditor should be cautious when it comes to these occurrences because they often involve manipulation in accounts. Also, a high risk of material misstatement can be considered since there was a significant change in cash and equivalents of 33%. From this, it can be implied that the company might have a problem in converting accounts receivable into cash. As for the income statement, the significant changes can be found in the expenses and net sales. These accounts are the ones that reflect the financial condition of the company. They both increased by 10% so it is fair to assume a medium risk of material misstatement.
After completing the audit for Costco and having a complete understanding of the industry, as well as, the financial health of the company, Costco could have a low acceptable audit risk and a low risk of material misstatement. Though it is a very large company, its financial statements are presented fairly in all material aspects. The accounts were carefully analyzed and confirmed by higher managers. The realizable value of inventory, however, can be looked as a higher risk because the company is worldwide. Costco is selling a variety of high-quality products for a low price.
The auditor will have to perform numerous steps in performing the audit. As stated, gaining an understanding of the company is vital to learning how the company runs. However, all procedures must be done with cautious to thoroughly investigate and analyze the fluctuations on different accounts. Costco will need to implement the audit 1 evidence mix- extensive amount of testing controls and substantive analytical procedures and small substantive tests of transactions and tests of details of balances. By doing this audit plan procedure, its financial report will be accurate and contain the appropriate information.
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