Overview The goal of this discussion is to use ratios to test the reasonableness of data. Case You are a new staff accountant with a large regional accounting firm, participating in your first audit. You recall from your Accounting 202 class that CPAs often use ratios to test the reasonableness of accounting numbers provided by a client. Since ratios affect the relationship among various account balances, if it is assumed that prior relationships still hold, prior years' ratios can be used to estimate what current balances should approximate. However, you have never actually performed this kind of analysis until now. The CPA in charge of the audit for Covington Pike Corporation brings you the list of ratios show below and tells you these reflect the relationships maintained by Covington Pike in recent years. Profit Margin on Sales - 5% Retum on Assets - 7.5% Gross Profit Margin = 40% Inventory Turnover Ratio = 6 times Receivables Turnover Ratio = 25 times Acid-test Ratio = 0.9 to one Current Ratio = 2 to one Retum on Equity = 10% Debt to Equity Ratio = 1/3 Times Interest Earned Ratio - 12 times Jotted in the margins are the following notes: 1. Net Income - 15,000 2. Only one short-term note ($5,000); all other current liabilities are trade accounts 3. Property, Plant, and Equipment are the only non-current assets 4. Bonds Payable are the only noncurrent liabilities 5. The effective interest rate on short-term notes and bonds is 8% 6. No investment securities 7. Cash Balance totals $15,000 To Do: You are requested to: 1. Approximate the current year's balances in the form of a Balance Sheet and Income Statement. 2. Accompany those financial statements with the calculations you used to estimate each amount reported. You can print out this Chapter 4 Case worksheet to work through this case on paper. Balance Sheet $ Assets Cash Accounts receivable (net) Inventory Prepaid expenses and other current assets Current assets Property, plant, and equipment (net) Liabilities and Shareholders' Equity Accounts payable Short-term notes Current liabilities Bonds payable Shareholders' equity Income Statement Net sales Cost of goods sold Gross profit Operating expenses Interest expense Income tax expense Net income Calculations ($ in 000s): a. Profit margin on sales = Net income - Net sales = 5% Net sales = b. Return on assets = Net income - Total assets = 7.5% Total assets = c. Gross profit margin = Gross profit - Sales = 40% Gross profit = Cost of goods sold = Net sales - Gross profit d. Inventory turnover ratio = Cost of goods sold Inventory = 6 Inventory = e. Receivables turnover ratio = Net sales - Accounts receivable = 25 Accounts receivable = f. Acid-test ratio = Cash + AR + ST Investments Current liabilities = 9 Current liabilities = g. Accounts payable = Current liabilities - Short-term notes h. Current ratio = Current assets - Current liabilities = 2 Current assets - i. Prepaid expenses and other current assets - Current assets - (Cash + AR + Inventory) j. Property, plant, and equipment = Total assets - Current assets k. Return on equity = Net income + Shareholders' equity=10% Shareholders' equity - 1. Debt to equity ratio = Total liabilities + Shareholders' equity = 1/3 Total liabilities = Bonds payable = Total liabilities - Current liabilities m. Interest expense = 8% *(Short-term notes + Bonds) Interest expense - n Times interest earned ratio = (Net income + Interest +Taxes) + Interest = 12 Tax expense = o. Operating expenses = (Net sales - Cost of goods sold Interest expense - Income tax expense) - Net income