Question

8-33 (Objective 8-4) You have performed preliminary analytical procedures on one of your audit engagements and observed the following independent situations:

1. The allowance for obsolete inventory increased from the prior year, but the allowance as a percentage of inventory decreased from the prior year.

2. Long-term debt increased from the prior year, but total interest expense decreased as a percentage of long-term debt.

3. The dollar amount of operating income is consistent with the prior year, although the entity was more profitable on a net income basis.

4. The quick ratio decreased from the prior year, although the amount of cash and net accounts receivable is almost the same as the prior year.

Required Below are possible explanations for each of the observed changes in the financial statement amounts and ratios. For each observed change, select the most likely explanation(s) from the list below. Note: There may be more than one explanation for a given observed change, and an explanation can be used more than once.

a) Shipments of inventory sold prior to year end were included in the client’s inventory counts as of the balance sheet date.

b) Selling and general administrative expenses were lower this year relative to last year.

c) Sales have decreased compared to the prior year, and the client is maintaining less inventory as a result.

d) Portions of existing long-term debt were refinanced at lower interest rates.

e) The effective tax rate decreased, as compared to the prior year.

f) The client purchased a large block of inventory on account close to year end.

g) Sales increased at a greater percentage than cost of goods sold, as compared to the prior year.

h) Client inventory items are off-site on consignment at retailers and are thus excluded from the year-end inventory counts.

i) Short-term borrowings were refinanced on a long-term basis at lower interest rates.

Answer 1

OBSERVATIONS	EXPLANATIONS
1. The allowance for obsolete inventory increased from the prior year, but the allowance as a percentage of inventory decreased from the prior year.	f) The client purchased a large block of inventory on account close to year end.
2. Long-term debt increased from the prior year, but total interest expense decreased as a percentage of long-term debt.	d) Portions of existing long-term debt were refinanced at lower interest rates.
3. The dollar amount of operating income is consistent with the prior year, although the entity was more profitable on a net income basis.	d) Portions of existing long-term debt were refinanced at lower interest rates.
	i) Short-term borrowings were refinanced on a long-term basis at lower interest rates.
4. The quick ratio decreased from the prior year, although the amount of cash and net accounts receivable is almost the same as the prior year.	None of the reasons is suitable. The reason is that current liabilities would have increased during the current year.