Question

Horizontal and Vertical Analysis. Horizontal analysis refers to changes of financial statement numbers and ratios across two or more years. Vertical analysis refers to financial statement amounts expressed each year as proportions of a base such as sales for the income-statement accounts and total assets for the balance-sheet accounts. Exhibit 4.55.1 contains Retail Company's prior-year (audited) and current-year (unaudited) financial statements, along with amounts and percentages of change from year to year (horizontal analysis) and common-size percentages (vertical analysis). Exhibit 4.55.2 contains selected financial ratios based on these financial statements. Analysis of these data can enable auditors to discern relationships that raise questions about misleading financial statements Required Study the data in Exhibits 4.55.1 and 4.55.2. Write a memorandum identifying and explaining potential problem areas where misstatements in the current-year financial statements could exist Additional information about Retail Company is as follows The new bank loan, obtained on July 1 of the current year, requires maintenance of a 2:1 current ratio Principal of $100,000 plus interest on the 10 percent long-term note obtained several years ago in the original amount of $800,000 is due each January 1 The company has never paid dividends on its common stock and has no plans for a dividend.

Answer 1

Memorandum on problem identified in current year's results:
Following points raised doubts of mis-statement of current year's results.
The potential problematic areas in the balance sheet are:
1) High stock of inventory in the current year.
2) The percentage of current assets in total assets has reduced from 63% to 56%.
3) The bank loan has been shown as current liability, payable within one year.
4) creditors has risen 33% since prior year.
5) Accruals seems to be not properly booked, as the same has reduced 83% since last.
The potential problems in the operation statement are:
a) Sales has reduced by 10%.
b) Cost of goods sold are not properly booked as the same has reduced by 16%.
c) The point b has again raised doubt as gross margin raised from 30% to 35%. Normally it remain constant.
d) The depreciation is showing constant figure though fixed assets got raised 33%.
e) The non payment of the dividend would raise doubt on profitability and cash flow.
The potential problems connected with desired ratios are:
i) The desired current ratio is 2 and the same is displayed in the current period.
ii) The inventory concentration has been too much in current year as half year's sales is in stock.
iii) Debt has raised in current year but are within acceptable level.
iv) Point ii also raised when we see the inventory turnover going half in current.
v) Audit of COGS should be there to clear the doubt of rise in gross margin and equity return raised by 48%, though sales reduced.