AP4.6. (LO 2, 3) Analytical procedures for liquidity and solvency issues Bright Spark Fashion has retail outlets in six large regional cities in the eastern United States. The shops are run by local managers, but purchasing decisions for all stores are handled by Ray Bright, the owner of the business. Fashion is an extremely competitive business. Bright Spark Fashion sells only for cash and generates sales through a reputation of low prices for quality goods. The winter clothing moves quite slowly, but summer fashion sells very well, providing a disproportionate amount of the business's sales and profits. Ray is constantly monitoring cash flow and negotiating with suppliers about payment terms and with banks about interest rates and extensions of credit.

Jenna Kowalski has the tasks of assessing the liquidity and solvency of Bright Spark Fashion and identifying the audit risks arising from this aspect of the business. She discovers a major long-term debt is due to be retired two months after the close of the fiscal year, but Ray is having difficulty obtaining approval from his current bank for a renewal of the debt for a further two-year term. In addition, interest rates have risen since the last fixed rate was agreed to two years ago, adding an additional 2% to the likely rate for the new debt (if it is approved).

The seasonality of the business means that inventory levels fluctuate considerably. At the end of the year (January 31), Ray has placed prepaid orders for the summer fashion and the goods have started arriving in the stores by March.

Required

a. What liquidity and solvency issues does Bright Spark Fashion face? Evaluate the likely impact of each issue on liquidity and solvency ratios.

b. Advise Jenna Kowalski about the audit risks for Bright Spark Fashion and propose how she could take these into account in the audit plan.