Chapter 4, Problem 58EP

To determine

Perform the preliminary analytical procedures for the purpose of identifying accounts that might contain errors. Compute the value of comparative, common-size financial statements and relevant ratios. Also, identify the accounts that might be misstated.

Explanation of Solution

Analytical procedure: Analytical procedure is a method by which standard balances are compared with actual balances. The standards are developed at the time of planning the audit and compared at the time of review of the audit

A loan was applied by D for the expansion of its manufacturing and sales facilities business. The credit was granted by the bank to D is $17,500,000 at the interest rate of 8%. The interview of D with the auditor produced the information related to the facility cost. The facility cost was less than anticipated cost due to which the sales of an organization is less.

	Prior year (audited)	Current Year (unaudited)
	Balance ($)	Size (%)	Balance ($)	Size (%)	Percent Amount ($)	Change (%)
Revenue & expense
Net sales	9,000,000	100	9,720,000	100	720,000	8
COGS	6,296,000	69.96	7,000,000	72.02	704	11.18
Gross Margin	2,704,000	30.04	2,720,000	27.98	16,000	0.59
Expense (general)	2,044,000	22.71	$2,003,000	20.61	(41,000)	(2.01)
Depreciation	300,000	3.33	334,000	3.44	34,000	11.33
Operating Income	$360,000	4.00	$383,000	3.94	$23,000	6.39
Interest expense	60,000	0.67	75,000	0.77	15,000	25.00
Income taxes (40%)	120,000	1.33	123,200	1.27	3,200	2.67
Income (net)	$180,000	2.00	$184,800	1.90	$4,800	2.67
Assets:
Cash	$600,000	14.78	690,800	12.52	90,800	15.13
Account receivable	500,000	12.32	900,000	16.31	400,000	80
Allowance doubtful accounts (40,000)		(0.99)	(90,000)	(1.63)	(50,000)	125
Inventory	1,500,000	36.95	1,350,000	24.47	(150,000)	(10)
Total current assets	$2,560,000	63.05	$2,850,000	51.67	$290,800	11.36
Fixed assets	3,000,000	73.89	4,500,000	81.57	1,500,000	50
Accumulated depreciation	(1,500,000)	(36.95)	(1,834,000)	(33.24)	(334,000)	22.27
Liabilities and Equity
Accounts payable	$450,000	11.08	$330,000	5.98	($120,000)	(26.67)
Bank loans (8%)	0	0	1,750,000	31.72	1,750,000
Accrued interest	60,000	1.48	40,000	0.73	(20,000)	(33.33)
Accruals and other	50,000	1.23	32,000	0.58	(18,000)	(36)
Total current liabilities	$560,000	13.79	$2,152,000	39.01	$1,592,000	284.29
Long-term debt (10%)	600,000	14.78	400,000	7.25	(200,000)	(33.33)
Total liabilities	$1,160,000	28.57	$2552,000	46.26	$1,392,000	120
Capital stock	2,000,000	49.26	2,000,000	36.25		0
Retained earnings	900,000	22.17	964,800	17.49	64,800	7.20
Total liabilities and equity	$4,060,000	100	$5,516,800	100	$1,456,800	35.88

Table (1)

The officers tried and wanted to impress the First bank by generating substantial income and protect the dividend of the company; whereas the target inventory level set by production manager was 14.0 turnover ratios. By using a 25-year life from the date of opening, the new facilities was depreciated.

Preliminary analytical procedure on the financial statement (current year):

Ratios	Prior Year	Current Year	Percentage Change
Balance sheet ratios:
Current ratio	4.57	1.32	(71.02%)
Day’s sales in receivables	18.40	30.00	63.04%
Doubtful accounts ratio	0.0800	0.1000	25.00%
Day’s sales in inventory	85.77	69.43	(19.05%)
Debt/equity ratio	0.40	0.86	115.19%
Operations ratios	0
Receivables turnover	19.57	12.00	(38.67%)
Inventory turnover	4.20	5.19	23.54%
Cost of goods sold/sales	69.96	72.02%	2.95%
Gross margin %	30.04%	27.98%	(6.86%)
Return on beginning equity	6.62%	6.37%	(3.71%)
Financial distress ratios (A)
Working capital/ Total assets	0.49	0.13	(3.71%)
Retained earnings/Total assets	0.22	0.17	(21.11%)
EBIT/total assets	0.09	0.07	(21.70%)
Market value equity/Total debt	32.59	1.18	(54.55%)
Net sales/total assets	2.22	1.76	(20.52%)
Discriminant Z score	4.96	3.09	(37.67%)
Market value of equity	$3,000,000	$3,000,000

Table (2)

The conclusions are based by taking the preceding year being the best sign of current year’s accurate figures:

• There might be an overstatement of $300,000 in the receivable of sales and accounts receivable. An early recording of sale and receivables might have been caused due to ‘More liberal return privileges’. The accounts receivable will be reached near the gross total of prior year due to the error of $300,000.
• It is required that the allowance for bad debts should be greater than the preceding year because the terms of credit and return made it $90,000 on $600,000 receivables. It can be seen that this 15% ratio is more than the preceding year’s 8%. With the ratio 8%, the allowance for bad debt might be overstated by $42,000.
• The depreciation expense has been computed on the basis of the additional capital of $1,700,000 instead of actual documented amount of $1,500,000.
• Expense accruals might have been lost accrued expenses were carried to the amount of previous year in the amount of $18,000.
• For 4^th quarter, it is seen that the amount of accrual of bank loan interest is unnoticed. For both the months, interest expense should be $70,000 plus the long term debt amount of $40,000.

	Current (unaudited)	Potential error	Current as affected
Revenue and expense: Net Sales Cost of goods sold	$9,720,000 7,000,000	($300,000) (216,000)	$9,420,000 6,784,000
Gross margin General expense Depreciation	$2,720,000 2,003,000 334,000	($84,000) 18,000 (4,000)	$2,636,000 2,021,000 330,000
Operating Income Interest expense Income taxes	$383,000 75,000 123,200	($98,000) 35,000 (53,200)	$285,000 110,000 70,000
Net income	$184,800	($79,800)	$105,000
Assets: Cash Accounts receivable Allowance doubtful accounts Inventory Tax receivable	$690,800 900,000 (90,000) 1,350,000	$0 (300,000) 0 216,000 53,200	$690,800 600,000 (90,000) 1,566,000 53,200
Total current assets Fixed assets Accumulated depreciation	$2,850,000 4,500,000 (1,834,000)	($30,8000) 0 4,000	$2,820,000 4,500,000 (1,830,000)
Total assets	$5,516,800	($26,800)	$5,490,000

Table (3)

In this case, the information that is causing problem is not obvious. It seems that the paid dividends of $120,000 are the problematic information. If this is not the case, then there is a debit of $120,000 that is submerged in the account of retained earnings.