Question
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.
- Calculate comparative change in the financial statement accounts from last year to current year, in terms of amount and percentage. (13.5 marks)
- 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)
- 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)
- 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)
- 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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