The auditor for a fictional company, ABC Wholesaling, has just begun to perform preliminary analytical procedures as part of planning the audit for the coming year. ABC Wholesaling is in a competitive industry, selling products such as STP Brand products and Ortho Grow products to companies such as Wal-Mart, Kmart, and regional retail discount chains. The company is privately owned and has experienced financial difficulty this past year. The difficulty could lead to its major line of credit being pulled if the company does not make a profit in the current year. In performing the analytical procedures, the auditor notes the following changes in accounts related to accounts receivable:

The auditor had expected the receivables balance to remain stable, but notes the large increase in receivables. After considering possible reasons for this increase, the auditor decides to make inquiries of management. Management explains that the change is due to two things: (1) a new computer system that has increased productivity, and (2) a new policy of rebilling items previously sold to customers, thereby extending the due dates from October to April. The rebilling is explained as follows: Many of the clients' products are seasonal-for example, lawn care products. To provide better service to ABC's customers, management instituted a new policy whereby management negotiated with a customer to determine the approximate amount of seasonal goods on hand at the end of the selling season (October). If the customer would continue to purchase from the client, management would rebill the existing inventory, thereby extending the due date from October until the following April, essentially giving an interest-free loan to the customer. The customer, in turn, agreed to keep the existing goods and store them on its site for next year's retail sales.
The key to planning analytical procedures is to identify areas of heightened risk of misstatement and then plan the audit to determine whether potential explanations satisfy all the unexpected changes that are observed in account balances. Further, it is important to be professionally skeptical of management-provided explanations. For example, does the explanation of a new computer system and the rebilling adequately explain all the changes? Whether the answer to that question is yes or no, are there other explanations that are equally viable? The auditor must be able to answer these questions to properly apply the risk-based approach to auditing. There are several factors that would indicate to a skeptical auditor that the explanations offered by ABC management might not hold:
● The company has a large increase in gross margin. This seems unlikely, because it is selling to large chains with considerable purchasing power. Further, other competitors are also likely to have effective computer systems.
● If the rebilling items are properly accounted for, there should not be a large increase in sales for the last two months of this year when the total sales for the previous year is practically the same as that of the preceding year.
● If the rebillings are for holding the inventory at customers'
locations, the auditor should investigate to determine (a) if the items were properly recorded as a sale in the first place or if they should still be recorded as inventory, (b) what the client's motivation is for extending credit to the customers indicated, and (c) whether it is a coincidence that all of the rebilled items were to large retailers who do not respond to accounts receivable confirmations received from auditors.
a. What potential hypotheses would likely explain the changes in the financial data given? Identify all that might explain the change in ratios, including those identified by management.
b. Of those identified, which hypothesis would best explain all the changes in the ratios and financial account balances? Explain the rationale for your answer.
c. Given the most likely hypothesis identified, what specific audit procedures do you recommend as highest priority?Why?

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Sales Accounts receivable Percent of accounts receivable current No. of days' sales in aocounts receivable Gross margin Industry gross margin Increase in Nov-Dec. sales over previous year Gurrent Year (000 omitted) $60,000 $11,000 72% 64 18.7% 16.3% 12% Previous Year (000 omitted) $59,000 $7,200 65% 42 15.9% 16.3% 3.1%