Relco is a high technology company, which, over its 13-year history, has grown rapidly.

Relco operates in an industry characterized by heavy expenditures in research and development and products that are regularly updated and revised. Despite aggressive competition, by the end of 2004 its total assets had reached $250 million, revenues had reached $500 million, and net income was $50 million.

During the second quarter of 2005, Relco acquired a major division fro1n another company in exchange for $150 million in cash, stock, and debt. The transaction was accounted for as a purchase with $100 million attributed to identifiable assets such as inventory ($30 million) and property, plant, and equipment ($70 million), and the remainder to goodwill. The acquisition represents and effort by Relco to broaden its product line in order to compete more effectively with its main rival in the industry. The acquired division develops and manufacturers a product, Wordup, which, while distinct from Relco's cu1Tent offerings, can be bundled with Relco's existing products.

The Wordup product has historically yielded a 30 percent return on assets. However, recent innovations by Relco's rival, which were made public late in the third quarter of 2005, suggest that the industry is headed into a period of intense competition. In the past Relco has developed its major products internally and this purchase represents the first time Relco has acquired significant technology from another company. For the end of 2005 Relco's trial balance shows total assets of $420 million (including $45 million of Wordup inventory), revenues of $700 million, and net income of $60 million. Theses results include the eight months of 2005 following the Wordup acquisition. You have been assigned to make some of the risk assessments for the 2005 audit of Relco.

Required:

a. Based on the above facts, identify three balance sheet accounts with at least one "red flag" that the auditor should consider as indicating a high inherent risk. Describe the red flags for each account and the type of misstatements about which the auditor should be concerned.

b. Make a preliminary assessment of materiality for this audit and justify your conclusion.

c. The Wordup inventory is to be used as security for a loan and is the subject of a special report. Make a preliminary assessment for the Wordup inventory.