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:

	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