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. Write 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:

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

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.

The company has never paid dividends on its common stock and has no plans for a dividend.

EXHIBIT 4.55.2 Prior Year (Audited) Current Year (Unaudited) Percent Change 4.57 18.40 0.0800 2.0 16.44 0.0750 132.65 0.56 -56.34% -10.63 -6.25 54.66 40.89 85.77 0.35 Balance sheet ratios: Current ratio Days' sales in receivables Doubtful accounts ratio Days' sales in inventory Debt/equity ratio Operations ratios: Receivables tumover Inventory tumover Cost of goods sold/sales Gross margin % Return on equity 19.57 4.20 69.96% 30.04% 6.61% 21.89 2.71 65.00% 35.00% 9.80% 11.89 - 35.34 -7.08 16.49 48.26 Current Year (Unaudited) Balance Common Size Change Amount Percent 12.32 $ 484,000 400,000 (30,000) 1,940,000 2,794,000 4,000,000 (1.800.000) S4,984,000 9.68% 8.01 -0.00 38.85 55.55 80.10 -36.04 100.00% $(116,000) (100.000) 10,000 440,000 -19.33% -20.00 -25.00 29.33 9.14 33.33 20.00 33.00% 3395 1,000,000 (300,000) $ 834,000 33.33% NA EXHIBIT 4.55.1 Retail Company Prior Year (Audited) Balance Common Size Assets: Cash $ 600,000 14.78% Accounts receivable 500,000 Allowance doubt accts. (40,000) -0.99 Inventory 1,500,000 38.95 Total current assets 25BUTOOO 63705 Fixed assets 3,000,000 7389 Accum. depreciation (1,500,000) Total assets 34,000,000 100.00% Liabilities and equity: Accounts payable $ 450,000 11.08% Bank loans, 11% 0.00 Accrued interest 50,000 Accruals and other 80,000 148 Total current liab. 5807000 Long-Term debt, 10% 500,000 1232 Total liabilities 1,0801000 25.11 Capital stock 2,000,000 49.26 Retained earnings 1,000,000 2463 Total liabilities and equity 34080000 TO00% Statement of operations: Sales (net) 39,000,000 100.00% Cost of goods sold 6295,000 69.96 Gross margin 2704000 3004 General expense 2,044,000 22.71 Depreciation 300,000 3.33 Operating in come 3807000 2000 Interest expense 50,000 056 Income taxes (40%) 124,000 138 Net income 3 181000 1.23 $ 800,000 750,000 40,000 10,000 1,400,000 400,000 1,800,000 2,000,000 1,194,000 4.984,000 12.01% 15.02 0.80 0.20 28.00 8.01 $ 150,000 750,000 (10,000) (50,000) 840,000 (100,000) 7407000 13.79 -20.00 -8933 150.00 -20.00 69.81 40.06 23.91 100.0% 194,000 934.000 19.40 23.00% $8,100,000 5 265,000 265,000 2,006,000 300,000 500,000 40,000 196,000 $ 24,000 100.00% 65.00 35.00 24.75 3.70 $(900,000) (1,031,000) 131,000 (39,000) -10.00% -1638 4.84 -1.91 0 47.22 -20.00 58.06 58.06% 0.49 2.42 3.6 170,000 (10,000) 72,000 $108.000 "NA" means not applicable. EXHIBIT 4.55.2 Prior Year (Audited) Current Year (Unaudited) Percent Change 4.57 18.40 0.0800 2.0 16.44 0.0750 132.65 0.56 -56.34% -10.63 -6.25 54.66 40.89 85.77 0.35 Balance sheet ratios: Current ratio Days' sales in receivables Doubtful accounts ratio Days' sales in inventory Debt/equity ratio Operations ratios: Receivables tumover Inventory tumover Cost of goods sold/sales Gross margin % Return on equity 19.57 4.20 69.96% 30.04% 6.61% 21.89 2.71 65.00% 35.00% 9.80% 11.89 - 35.34 -7.08 16.49 48.26 Current Year (Unaudited) Balance Common Size Change Amount Percent 12.32 $ 484,000 400,000 (30,000) 1,940,000 2,794,000 4,000,000 (1.800.000) S4,984,000 9.68% 8.01 -0.00 38.85 55.55 80.10 -36.04 100.00% $(116,000) (100.000) 10,000 440,000 -19.33% -20.00 -25.00 29.33 9.14 33.33 20.00 33.00% 3395 1,000,000 (300,000) $ 834,000 33.33% NA EXHIBIT 4.55.1 Retail Company Prior Year (Audited) Balance Common Size Assets: Cash $ 600,000 14.78% Accounts receivable 500,000 Allowance doubt accts. (40,000) -0.99 Inventory 1,500,000 38.95 Total current assets 25BUTOOO 63705 Fixed assets 3,000,000 7389 Accum. depreciation (1,500,000) Total assets 34,000,000 100.00% Liabilities and equity: Accounts payable $ 450,000 11.08% Bank loans, 11% 0.00 Accrued interest 50,000 Accruals and other 80,000 148 Total current liab. 5807000 Long-Term debt, 10% 500,000 1232 Total liabilities 1,0801000 25.11 Capital stock 2,000,000 49.26 Retained earnings 1,000,000 2463 Total liabilities and equity 34080000 TO00% Statement of operations: Sales (net) 39,000,000 100.00% Cost of goods sold 6295,000 69.96 Gross margin 2704000 3004 General expense 2,044,000 22.71 Depreciation 300,000 3.33 Operating in come 3807000 2000 Interest expense 50,000 056 Income taxes (40%) 124,000 138 Net income 3 181000 1.23 $ 800,000 750,000 40,000 10,000 1,400,000 400,000 1,800,000 2,000,000 1,194,000 4.984,000 12.01% 15.02 0.80 0.20 28.00 8.01 $ 150,000 750,000 (10,000) (50,000) 840,000 (100,000) 7407000 13.79 -20.00 -8933 150.00 -20.00 69.81 40.06 23.91 100.0% 194,000 934.000 19.40 23.00% $8,100,000 5 265,000 265,000 2,006,000 300,000 500,000 40,000 196,000 $ 24,000 100.00% 65.00 35.00 24.75 3.70 $(900,000) (1,031,000) 131,000 (39,000) -10.00% -1638 4.84 -1.91 0 47.22 -20.00 58.06 58.06% 0.49 2.42 3.6 170,000 (10,000) 72,000 $108.000 "NA" means not applicable