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Survey of Accounting (Accounting I)

8th Edition
Carl Warren
ISBN: 9781305961883

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Survey of Accounting (Accounting I)

8th Edition
Carl Warren
ISBN: 9781305961883
Textbook Problem

Receivables and inventory turnover
Thornhy Inc. completed its fiscal year on December 31- The auditor, Kim Holmes, has approached the CFO. Brad Potter, regarding the year-end receivables and inventory levels of Thornby Inc. The following conversation lakes place:

Kim: We are beginning our audit of Thornby Inc. and have prepared ratio analyses to determine if there have been significant changes in operations or financial position. This helps us guide the audit process. This analysis indicates that the inventory turnover has decreased from 5-1 to 3.8, while the accounts receivable turnover has decreased from 12.5 to 9. I was wondering if you could explain this change in operations.
Brad: There is little need for concern. The inventor)- represents computers llial we were unable to sell during the holiday buying season. We are confident, however, that we will be able to sell these computers as we move into the next fiscal year.
Kim: What gives you this confidence?
Brad: We will increase our advertising and provide some very attractive price concessions to move these machines. We have no choice. Newer technology is already out there, and we have to unload this inventory. Kim: ... and the receivables?
Brad: As you may be aware, the company is under tremendous pressure to expand sales and profits. As a result, we lowered our credit standards to our commercial customers so that we would be able to sell products to a broader customer base. As a result of this policy change, we have been able to expand sales by 28%. Kim: Your responses have not been reassuring to me.
Brad: I'm a little confused. Assets are good, right? Why don't you look at our current ratio? It has improved, hasn't it? I would think that you would view that very favorably.
Why is Kim concerned about the inventory and accounts receivable turnover ratios and Brad's responses to them? What action may Kim need to take? How would you respond to Brad's last comment?

To determine

Introduction:

Inventory turnover measures how many times inventory is purchased and sold. Receivable turnover measures how quickly trade receivables are collected.

To discuss:

The reasons for decline in inventory turnover and receivable turnover.

Explanation

The main reason for declining Inventory turnover is that the business is holding inventory for too long. There are several disadvantages for the same:

  • Computer equipment are prone to become obsolete quickly due to rapid change in technology.
  • When a business hold inventory it attracts additional cost such as storage cost insurance etc.
  • Holding too much inventory means holdingcash. In long run, it may lead to shortage of cash, business need to spend on advertising for sale of this before it become obsolete.

Accounts receivable turnover shows how quickly receivables are collected, declining receivable turnover shows inefficient credit management.

  • If receivables are not collected on time there will be a risk of increase in bad debts.
  • If receivables collection takes long time may lead to shortage of cash to run day to day activities of business.

This is the reason auditors are worried.

The following actions Kim need to take to improve Inventory turnover and Receivable turnover:

To improve inventory turnover Kim may:

  • Try to improve sales by reducing prices and sales promotion.
  • Focus on better order management for purchase of inventory.
  • Reduce safety stock and old inventory or reduce purchase quantity...

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