Question

Analytical Data for Jones Manufacturing

	Prior Period 000 omitted	% of Sales	Current Period 000 omitted	% of Sales	% Change	Industry Average as % of Sales
Sales	$10,000	100	$11,000	100	10	100
Inventory	$2,000	20	$3,250	29.5	57.5	22.5
Cost of goods sold	$6,000	60	$6,050	55	0.83	59.5
Accounts payable	$1,200	12	$1,980	18	65	14.5
Sales commissions	$500	5	$550	5	10	N/A
Inventory turnover	6.3	—	4.2	—	(33)	5.85
Average number of days to collect	39	—	48	—	23	36
Employee turnover	5%	—	8%	—	60	4
Return on investment	14%	—	14.3%	—	2.1	13.8
Debt/Equity	35%	—	60%	—	71	30

Assume that the auditor expected that the client’s performancein the current year would be similar to its performance in theprior year.

Select the potential risk factor that matches the risk analysisdescribed.

Accounts payable increase

Average number of days to collect

Cost of goods sold decrease

Debt/equity ratio

Employee turnover

Inventory increase

Inventory turnover

Return on investments

Risk Analysis		Potential Risk Indicator
a.	Has decreased by 33 percent. This points to and confirms theproblems identified by the increase in inventory and decrease incost of goods sold. There are substantial obsolescence problems,material items are not correctly recorded. Or the inventory hasbeen intentionally increased in anticipation of some unusual eventearly next year as mentioned in the accounts payable increase.

b.	This ratio has increased substantially and is double theindustry average. The company has become highly leveraged. Theincreased leverage has three implications the auditor ought toaddress: the existence of new debt covenants that ought to beaddressed as part of the audit; a potential problem of remaining agoing concern should there be a downturn in operations or asignificant increase in interest rates; there may be concern withhow the debt proceeds have been utilized by the company.

c.	The increase could reflect credit problems or other financingproblems. Such problems could make it difficult for the company tocarry out its on-going activities. It may simply reflect thepurchase of an unusual amount of inventory just beforeyear-end.

d.	This ratio has increased by 23 percent over the previous yearand is 33 percent above the industry average. The increase in theratio could represent a number of problems: less stringent creditstandards; warranty problems; unrecorded returned items or asignificant lag in issuing credit memos associated with returneditems.

e.	There is a substantial increase both in dollar terms and as apercentage of sales, which could indicate potential problems withnew products, with obsolescence, or with competitiveness with otherproducts. It may indicate an increase of just before year-end inanticipation of rise in cost, a strike, or unusually heavy demand.Could be overstated due to misstatements of quantities or prices.This could also affect the COGS change.

f.	This ratio does not indicate a problem. In fact, the companyexceeds the industry average. An alert auditor should wonderhowever, how the company is able to maintain a superior return whenthere are problems with inventory and receivables.

g.	Has decreased to 55 percent of sales at the same time inventoryhas increased. One explanation is that costs have not been bookedfor some significant sales. There may also be a change in productmix.

h.	This is more difficult to interpret, but there is a 60 percentincrease over previous years to a rate that is double that of theindustry. This might indicate problems with morale, qualitycontrol, or other dissatisfaction with the manner in which thecompany is being run.