Bronys Bikes Module I: Assessment of Inherent Risk

In this module, you assess inherent risk after you have done the following:

1. Analyzed Bronys Bikes organizational structure and prepared an organization chart;

2. Applied preliminary analytical procedures to Bronys Bikes financial data; and

3. Studied Bronys Bikes business operations and the bicycle manufacturing industry generally.

In completing this assignment, you may assume that Derick has decided on the following initial risk assessments:

• Inherent risk: 100%
• Control risk: 100%
• Audit risk: 5%

Overview of Bronys Bikes Business and Industry

As part of his continuing study of Bronys Bikes operations, Derick has extracted the following additional data from the computerized permanent file entitled Business and Industry.

1. In 20X9, in the face of increasing liquidity problems, payment of trade accounts payable within the specified credit terms became increasingly difficult. After much discussion with Harvey Bombenmyr, the president of Bank Two, and Bank Twos lending officers, Lawton was able to negotiate a ten-year 12% note payable for $45 million. The note is unsecured and is payable in equal annual installments, together with interest, beginning March 1, 20X9, and contains restrictive covenants. Those relevant to the Bronys Bikes audit are the following:

a. A minimum balance of $10 million must be maintained in Bronys Bikes demand deposit account with Bank Two;

b. Further borrowing is prohibited until the Bank Two note has been amortized below $10 million; and

c. Dividends may be declared only from retained earnings in excess of $45 million.

d. In April 2008, Lawton borrowed $3 million from the company in exchange for an unsecured note. The transaction resulted in a debit to Account 1203 - Notes Receivable, Officers. According to Groth, Lawton planned to repay this note prior to December 31, 20X9.

2. Legal action against the company was initiated by Rollfast, a competitor, in late 20X8. The suit alleges that Bronys Bikes infringed on a process already patented by Rollfast. The process, according to Rollfasts attorneys, enables a bicycle manufacturer to produce a frame in one piece, thereby adding strength to the bicycle by eliminating welding. Bronys Bikes has responded to the action by demonstrating the unique characteristics of its bicycle frame, which is also patented. By July 20X9, the suit had neither been heard by the court nor settled outside the courts by the litigants. Rollfast is suing Bronys Bikes for $50 million.

3. Although Lawton and Groth have intensified efforts in recent years to establish and implement a sound internal control system, the independent auditors have not seen fit to reduce the assessed level of control risk below the maximum level. If it is determined that the auditors 20X8 recommendations have been implemented, however, Derick anticipates a reduction in the assessed level of control risk in one or more of the significant transaction cycles.

4. In the past, the audit team has used the internal audit staff only when necessary to assist in various phases of the Bronys Bikes audit.

Note that all requirements for Modules I XV ignore the income tax effects of audit adjustments.

We recommend only printing the results of these requirements if your instructor requires you to submit your work in paper form.

Your instructor may require you to submit your completed workpapers in paper or electronic form for all 15 modules. Follow your instructors directions on this.

Module I Requirements

1. Prepare a complete organization chart for Bronys Bikes based on the narrative contained in Bronys Bikes Intro and Module 1, the section titled Bronys Bikes Personnel and identify the major strengths and weaknesses in Bronys Bikes organizational structure.

2. Download the Excel file 20X9 Analytic Procedures WP A.1-7 The 20X9 Analytic Procedures file contains seven worksheets. Each workpaper (WP) is on a separate worksheet tab in the Excel file.

WP A.1- Comparative income statements

WP A.2 - Sales and cost of goods soldby product line

WP A.3 - Comparative schedule of manufacturing overhead and operating expenses

WP A.4 - Inventories

WP A.5 - Budget vs Actual Income Statements (prepared by client - no calculations required)

WP A.6 - Comparative Common Sized Balance Sheets

WP A.7 - Wheels 4U Financial Statements 20X8 and 29X9 (These financial statements were obtained from Wheels website - no calculations required).

3. In completing the preliminary analytical procedures (See AU 315 Understanding the Entity and Its Environment and AU 520 Analytical Procedures), the audit teams expectations are that there will be some growth over the prior year, the relationships among financial statement items will remain relatively stable, and Bronys Bikes ratios will be comparable to reported industry and Wheels 4U ratios. (For help with the cell equations in WP A.1-4, examine the comparable cells for 20X8.) After scrutinizing the documentation, perform the following:

a. Using the Comparative Income Statements data in WP A.1, prepare a common-sized income statement for 20X9.

b. Using the Sales and Cost of Goods Sold - By Product Line data in WP A.2, prepare a common-sized cost per unit calculation as a percentage of sales price for 20X9 by product line.

c. Using the Comparative Schedule of Manufacturing Overhead and Operating Expenses data in WP A.3, prepare a common-sized components calculations as a percentage of sales for 20X9.

d. Using the product line data from requirement (b) and the Inventories data from WP A.4, calculate finished goods inventory turnover for 20X9 by product line. Calculate materials and purchased parts turnover for 20X9 by component. In WP A.4 inventory turnover is calculated in units instead of dollars. Whether calculated in units or dollars, the result should be the same.

4. Open the Excel file 20X9 Analytic Procedures WP A.1-7. Examine WP A 1-5 carefully. WP A.5 contains the following schedules:

WP A.5 - Budget vs. actual income statements for 20X9

Schedule 1 - Cost of goods manufactured 20X9

Schedule 2 - Operating expenses 20X9

Compare with the results of requirement 3 WP A.1-4. Do any of the variances, when considered in relation to the results of requirement 3, raise warning signals?

5. Open the Excel file 20X9 Analytic Procedures WP A.1-7. Examine WP A.6 carefully. WP A.6 contains the following schedules:

Comparative percentage balance sheets for 20X9 and 20X8

Comparative ratios: 20X9 vs. 20X8

Industry ratios for 20X8

After reviewing the documentation, perform the following:

a. Using WP A.6 complete a common sized balance sheet for 20X9. You may be able to copy the 20X8 balance sheet formulas with some editing into the 20X9 column.

b. Using WP A.6 calculate the following ratios for 20X9:

• Current ratio
• Quick ratio
• Times interest earned
• Return on stockholders equity

c. Compare these four ratios calculated in part b with industry averages (these are located next to the 20X8 Bronys Bikes ratios in WP A.6). Are there any significant disparities between Bronys Bikes ratios and the industry averages?

d. Wheels 4U Company is a competitor in the bicycle industry. Open WP A.7, which contains 20X9 Wheels 4U financial statements. Excel file named 20X9 Wheels 4U. Using the data contained in that report, perform the following:

1). Compare Wheels 4Us common-sized income statements with Bronys Bikes common-sized income statements for the same years.

2). Go to Wheels 4Us comparative common-sized balance sheets and income statements and calculate the same ratios that you calculated for Bronys Bikes in (b) above

3). On the basis of (1) and (2) above, what strengths and weaknesses of Bronys Bikes relative to Wheels 4U can you identify?