7.7 Select types of misstatements for which the SEC has expressed concerns that a quantitatively small misstatement may be material from a qualitative viewpoint because of its nature. Check all that apply.

b. the misstatement hides a failure to meet analysts' consensus expectations for the company

c. the misstatement has the effect of increasing management's compensation

d. the misstatement involves concealment of an unlawful transaction
e. the misstatement concerns a segment of the entity that operates in a foreign country 7.8

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 clients performance in the current year would be similar to its performance in the prior year.

Select the potential risk factor that matches the risk analysis described.

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 the problems identified by the increase in inventory and decrease in cost of goods sold. There are substantial obsolescence problems, material items are not correctly recorded. Or the inventory has been intentionally increased in anticipation of some unusual event early next year as mentioned in the accounts payable increase.

b.	This ratio has increased substantially and is double the industry average. The company has become highly leveraged. The increased leverage has three implications the auditor ought to address: the existence of new debt covenants that ought to be addressed as part of the audit; a potential problem of remaining a going concern should there be a downturn in operations or a significant increase in interest rates; there may be concern with how the debt proceeds have been utilized by the company.

c.	The increase could reflect credit problems or other financing problems. Such problems could make it difficult for the company to carry out its on-going activities. It may simply reflect the purchase of an unusual amount of inventory just before year-end.

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

e.	There is a substantial increase both in dollar terms and as a percentage of sales, which could indicate potential problems with new products, with obsolescence, or with competitiveness with other products. It may indicate an increase of just before year-end in anticipation 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 company exceeds the industry average. An alert auditor should wonder however, how the company is able to maintain a superior return when there are problems with inventory and receivables.

g.	Has decreased to 55 percent of sales at the same time inventory has increased. One explanation is that costs have not been booked for some significant sales. There may also be a change in product mix.

h.	This is more difficult to interpret, but there is a 60 percent increase over previous years to a rate that is double that of the industry. This might indicate problems with morale, quality control, or other dissatisfaction with the manner in which the company is being run.