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Supreme Inc. wanted to expand its sales and manufacturing facilities. The company applied for a loan from Royal Bank, presenting the prior-year audited financial statements

Supreme Inc. wanted to expand its sales and manufacturing facilities. The company applied for a loan from Royal Bank, presenting the prior-year audited financial statements and the forecast for the current year shown in Exhibit 1. (Supreme Inc.s fiscal year-end is December 31.) The bank was impressed with the business prospects and granted a $2,187,500 loan at 8 percent interest on April 1, to finance working capital and the new facilities that were placed in service July 1 of the current year. Because Supreme Inc. planned to issue stock for permanent financing, the bank made the loan due on December 31 of the following year. Interest is payable each calendar quarter on October 1 of the current year and January 1, April 1, July 1, October 1 of the following year.

The auditors interviews with Supreme Inc. management near the end of the current year produced the following information: The facilities did not cost as much as previously anticipated. However, sales were slow and the company granted more liberal credit and return privilege terms than in the prior year on sales made in the last quarter. These sales amounted to $375,000. Officers wanted to generate significant income to impress Royal Bank, however, internally they are aware that they cannot pay a dividend to the shareholders this year.

A new accounting clerk was hired in November. He only records invoices related to accrued expenses when the invoice is received by his department. This clerk is also responsible for recording the interest expense and payable entries related to the bank loan from Royal Bank.

The new facilities were depreciated using a 25-year life from the date of opening. There were no new additions or disposals of fixed assets, except for the new facilities.

Supreme Inc. has now produced the current-year financial statements (Exhibit 1,

Current Year column) for the auditors work on the current audit. The company has already paid the current years taxes based on the current year unaudited figures.

Required:

As part of the Risk Assessment process, the audit manager has asked you the audit senior to perform preliminary analytical procedures on the current-year unaudited financial statements for the purpose of identifying accounts that could contain errors or frauds.

  1. Calculate comparative change in the financial statement accounts from last year to current year, in terms of amount and percentage. (13.5 marks)
  2. Common-size current and prior year financial statements using total assets as the base for balance sheet and net sales as the base for the income statement. (6 marks)
  3. Based on your calculations and case facts, identify the income statement and balance sheet accounts that could be misstated. Calculate the potential errors in the accounts identified. Hint: Discuss each error from a double entry perspective. (20 marks)
  4. Calculate the overall impact of the potential errors on net income and total assets/equity and liabilities, indicating whether it is an over or understatement. (2.5 marks)
  5. Comment on the overall risk level of this engagement supported by your reasons and the steps you as the auditor, can take to mitigate this risk to an acceptable level. (3 marks)

Exhibit 1: Also provided in the excel file.

Supreme Inc.

Prior Year (audited)

Forecast

Current Year (unaudited)

Revenue and Expense:

Sales (net)

$ 11,250,000

$ 12,375,000

$ 12,150,000

Cost of goods sold

7,870,000

8,657,500

8,750,000

Gross margin

3,380,000

3,717,500

3,400,000

General expense

2,555,000

2,500,000

2,503,750

Depreciation

375,000

418,750

418,750

Operating income

450,000

798,750

477,500

Interest expense

75,000

137,500

93,750

Income taxes (40%)

150,000

265,000

154,000

Net income

225,000

396,250

229,750

Assets:

Cash

750,000

1,100,000

863,500

Accounts receivable

625,000

750,000

1,125,000

Allowance for doubtful accounts

(50,000)

(60,000)

(112,500)

Inventory

1,875,000

1,875,000

1,687,500

Total current assets

3,200,000

3,665,000

3,563,500

Fixed assets

3,750,000

5,875,000

5,625,000

Accumulated depreciation

(1,875,000)

(2,293,750)

(2,293,750)

Total assets

$ 5,075,000

$ 7,246,250

$ 6,894,750

Liabilities and Equity:

Accounts payable

$ 562,500

$ 562,500

$ 412,500

Bank loans, 8%

0

2187500

2187500

Accrued interest

75,000

50,000

50,000

Accrued expenses and other

62,500

75,000

40,000

Total current liabilities

$ 700,000

$ 2,875,000

$ 2,690,000

Long-term debt, 10%

750,000

500,000

500,000

Total liabilities

$ 1,450,000

$ 3,375,000

$ 3,190,000

Capital stock

2,500,000

2,500,000

2,500,000

Retained earnings

1,125,000

1,371,250

1,204,750

Total liabilities and equity

$ 5,075,000

$ 7,246,250

$ 6,894,750

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