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. Prepare 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:

1. The new bank loan, obtained on July 1 of the current year, requires maintenance of a 2:1 current ratio.
2. 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.
3. Thecompanyhasneverpaiddividendsonitscommonstockandhasnoplansforadividend.

Retained earnings 1,000,000 24.63 1, 194,000 23.91 194,000 19.40 Total liabilities and equity $4,060,000 100.00% $4,994,000 100.00% 934,000 23.00% Statement of operations: Sales (net) $9,000,000 100.00% $8,100,000 100.00% $ (900,000) -10.00% Cost of goods sold 6,296,000 69.96 5,265,000 65.00 (1,031,000) -16.38 Gross margin 2,704,000 30.04 2,835,000 35.00 131,000 4.84 General expense 2,044,000 22.7 2,005,000 24.75 (39,000) -1.91 Depreciation 300,000 3.33 300,000 3.70 0 0 Operating income 360,000 4.00 530,000 6.54 170,000 47.22 Interest expense 50,000 0.56 40,000 0.49 Income taxes (40%) (10,000) -20.00 124,000 1.38 196,000 2.42 72,000 58.06 Net income $ 186,000 2.07% $ 294,000 3.63% $ 108,000 58.06% "NA" means not applicable.EXHIBIT 4.53.1 Retail Company Prior Year (Audited) Current Year (Unaudited) Change Balance Common Size Balance Common Size Amount Percent Assets: Cash $ 600,000 14.78% $ 484,000 9.69% $ (116,000) -19.33% Accounts receivable 500,000 12.32 400,000 8.01 (100,000) -20.00 Allowance doubt. accts. (40,000) -0.99 (30,000) -0.60 10,000 -25.00 Inventory 1,500,000 36.95 1,940,000 38.85 440,000 29.33 Total current assets 2,560,000 63.05 2,794,000 55.95 234,000 9.14 Fixed assets 3,000,000 73.89 4,000,000 80.10 1,000,000 33.33 Accum. depreciation (1,500,000 -36.95 (1,800,000) -36.04 (300,000) 20.00 Total assets $4,060,000 100.00% $4,994,000 100.00% $ 934,000 23.00% Liabilities and equity: Accounts payable $ 450,000 11.08% $ 600,000 12.01% $ 150,000 33.33% Bank loans, 11% 0 0.00 750,000 15.02 750,000 NA Accrued interest 50,000 1.23 40,000 0.80 (10,000) -20.00 Accruals and other 60,000 1.48 10,000 0.20 (50,000 -83.33 Total current liab. 560,000 13.79 1,400,000 28.03 840,000 150.00 Long-term debt, 10% 500,000 12.32 400,000 8.01 (100,000) -20.00 Total liabilities 1,060,000 26. 11 1,800,000 36.04 740,000 69.81 Capital stock 2,000,000 49.26 2,000,000 40.05 0 0EXHIBIT 4.53.2 Retail Company Prior Year (audited) Current Year (unaudited) Percent Change Balance-sheet ratios: Current ratio 4.57 2.0 -56.34% Days' sales in receivables 18.40 16.44 -10.63 Doubtful accounts ratio 0.0800 0.0750 -6.25 Days' sales in inventory 85.77 132.65 54.66 Debt/equity ratio 0.35 0.56 40.89 Operations ratios: Receivables turnover 19.57 21.89 11.89 Inventory turnover 4.20 2.71 -35.34 Cost of goods sold/sales 69.96% 65.00% -7.08 Gross margin % 30.04% 35.00% 16.49 Return on equity 6.61% 9.80% 48.26