Rows for account Rows Formulas for for Solomon Columns Amounts 05-02 is a highly successful, closely held
held Boston, Massachusetts,companythat Columns for years 05-02 for years ratios various manufacturesandassemblesautomobilespecialtypartsthataresoldinautopartsstoresinthe ratios
East.Salesandprofitshaveexpandedrapidlyinthepast few years, and the prospects for futureyearsareeverybitasencouraging.Infact,theSolomonbrothersarecurrentlyconsidering headings eithersellingouttoalargecompanyorgoingpublictoobtainadditionalcapital.Thecompanyoriginated in1980whenFrankSolomondecidedtomanufacturetooledparts.In1995,thecompanychanged overtotheautopartsbusiness.Fortunately,ithasneverbeennecessarytoexpandthefacilities,but spaceproblemshaverecentlybecome severe and expanded facilities will be necessary. Land and building costs in Boston are currentlyextremelyinflated. Managementhasalways reliedonyouforhelpinitsproblemsbecausethetreasurerissalesorientedandhaslittlebackground in the controllership function. Salaries of all officershavebeenfairlymodestinordertoreinvest earningsinfuturegrowth.Infact,thecompanyisorientedtowardlongrunwealthofthebrothersmore thantowardshortrunprofit.Thebrothershavealloftheirpersonalwealthinvestedinthefirm.Amajorreason forthesuccessofSolomonhasbeenthesmallbutexcellentsalesforce.Thesalespolicyistoselltosmallauto shopsathighprices.Thispolicyisresponsiblefor fairly high credit losses, but the profit margin is high and the results have been highlysuccessful.Thefirmhaseveryintentionof continuingthispolicyinthefuture.YourfirmhasbeenauditingSolomonsince1990,andyouhavebeenonthejob forthepast3years.Theclienthasexcellentinternalcontrolsandhasalwaysbeencooperative.Inrecentyears, the client has attempted to keep net income at a high level because ofborrowing needsandfutureselloutpossibilities.Overall,theclienthasalwaysbeenpleasanttodeal withandwillingtohelpinanywaypossible.Therehaveneverbeenanymajor audit adjustments, and anunqualifiedopinionhasalwaysbeenissued. Required Inthecurrentyear,youhavecompletedthetestsofthesalesandcollectionarea.The tests of controlsandsubstantivetestsoftransactionsforsalesandsalesreturnsand allowances wereexcellent,andextensiveconfirmationsyieldednomaterialmisstatements.Youhavecarefullyreviewedthe cutoffforsalesandforsalesreturnsandallowancesandfindthesetobeexcellent.Allrecordedbad debtsappearreasonable,andareviewoftheagedtrialbalanceindicatesthatconditionsseemabout thesameasinpastyears. a. Evaluatetheinformationinthecase(seebelow)toprovideassistancetomanagementfor improved operation of its business. Prepare the supporting analysis using an electronicspreadsheetprogram(instructoroption). b. Do youagree that sales,accounts receivable,andallowance for doubtful accounts are probablycorrectlystated?Showcalculationstosupportyourconclusion.
ANSWER: When the computer option is assigned, an Excel spreadsheet (Filename P839.xls) is used to computeasetofratiosaswouldbedonemanually(asshownbelow.)Fivespecificaspectsofusing thecomputerindoingthisarediscussedbelow.Thefirstappliestoboththemanualandthe computerapproach. 1. Computationofratios.Theselectionofratiosisarbitraryandshouldincludeaset thatgivesagoodoverviewofallaspectsofthecompany'sfinancialstatementsthat theuserisinterestedin.And,incomputingspecificratios,certaindecisionsmust bemade,suchaswhethertousenetsalesorgrosssales.Theformulasfortheratios selectedforthissolutionareshownbelow.Note:wherepossible,thesolutionuses averagebalances(inventoryandaccountsreceivable,forexample)whenrequiredby the ratio formulas. Since 2001 balances are not available for computing 2002 averageinventoryandreceivables,thesolutiondoesnotcalculateaverageinventory andcalculateaverageinventoryandaccountsreceivableturnoverratiosfor2002. Quick ratio= (cash +accounts receivable allowancefordoubtful accounts) / currentliabilities
Grossmargin/sales=grossmargin/grosssales Averageinventoryturnover=(costofgoodssold)/averageinventory Currentratio=Currentassets/currentliabilities Averagedaystocollectreceivables=(averageaccountsreceivablex360)/(net sales) Netincome/totalassets=(selfexplanatory) Netincome/sales=netincome/grosssales Sales/equity=Grosssales/equity Debt/equity=(totalliabilities)/totalequity (continued) Netincome/equity=(selfexplanatory) Allowancefordoubtfulaccounts/accountsreceivable=(selfexplanatory) Baddebts/sales=baddebts/grosssales Salesreturnsandallowances/sales=salesreturnsandallowances/grosssales 2. Setup.Excelspreadsheetsmustbeplannedinadvance.Thiscanbereferredtoas "setup."Ausefultechniqueistouseablockdiagramtoplanthesetup.Thishelps seetheoverallshapeandcontentofthespreadsheetandishelpfulforguidingits detailedpreparationandhowoutputswillbecontrolledandformatted.Ablock diagramforthisspreadsheetfollows.Itshowsthespreadsheetdividedintothree sections:theheading,theinputsection,wheredatawillbeentered,andtheresults sectionwheretheratioswillbecalculated.Averticalstructureisusedtofacilitate printoutsthatwillfitinan81/2x14inchformat.Thestructurecouldjustaseasily besidebyside.
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(continued)
A1
G2
A5
G43
A47
G71
1. Checkonaccuracyofinputs.Amajorconcernisknowingthatinputdatahasbeenentered accurately. This can usually be achieved by two alternative procedures. The first is computingtotalsandcomparingthemtocheckfigures.Forexample,thedetailsofassets canbecomputedandaddedto100.Thesecondprocedureisverificationofdetailsona figurebyfigurebasisbacktothesource. 38. (continued) 4. Treatmentofnegativevalues.Negativevaluescanbeenteredasnegativeinputsor positiveinputs.Itisimportanttorespondproperlytothetreatmentusedwhenthe valuesareincludedincomputations. Check on accuracy of formulas. One of the biggest problems with using spreadsheetsiserrorsinthedevelopmentofformulas.Oneuseofeachformula shouldbedonemanuallytocheckitscorrectnessandtheformulasshouldreceivea carefulsecondpartyreview.Ifthissecondstepisimpractical,asecondpartyshould atleastreviewtheresultsforreasonableness. TemplatesforthecomputersolutionspreparedusingExcelareincludedon the Companion Website and on the Instructors Resource CDROM, which is availableuponrequest.
5.
SolomonBros.ManufacturingCo. AnalyticalProcedures Calculatedfrom adjustedyearendbalances KEYRATIOS 2005 2004 2003 2002
Quick Grossmargin/sales Averageinventoryturnover Current Averagedaystocollectreceivables Netincome/totalassets Netincome/sales Sales/equity Debt/equity Netincome/equity Allowance for doubtful accounts/accountsreceivable Baddebts/sales Sales returns and allowances/gross sales
.96 21.0% 1.79 2.19
.83 22.1% 1.82 1.96
.81 23.2% 1.93 1.91
.74 25.0% NA 1.75
131.10 3.9% 5.0% 3.89:1 4.02:1 .19:1
123.94 3.9% 5.2% 4.37:1 4.82:1 .23:1
116.06 3.9% 5.3% 4.88:1 5.64:1 .26:1
NA 4.3% 6.1% 5.27:1 6.42:1 .32:1
10.6% 3.7%
11.5% 4.0%
12.5% 4.1%
14.8% 4.6%
3.1%
3.0%
3.0%
2.9%
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(continued) TheSolomonbrothersareconsideringgoingpublictoexpandthebusinessatatimethat landandbuildingcostsinBostonareatextremelyinflatedvalues.Presentlygrossprofit marginsare21%ofsalesandnetincomeis5%ofsales.Bothratiosdecreasedduringthe pastyear.Tofinanceexpansion,additionaldebtisoutofthequestionbecauselongterm debtispresentlyextremelyhigh(debttoequityratiois4.02).Depreciationonnewplant and equipment at the inflated prices will cause high depreciation charges, which may significantlyreducetheprofitmargins.
b.
Theaccountthatisofthegreatestconcernisallowanceforuncollectibleaccounts. The following are three key analytical procedures indicating a possible misstatementofallowanceforuncollectibleaccounts: Breakdownofthe aginginpercent 2005 2004 2003 2002
1.
030days39.8% 42.1% 46.0% 49.9% 3160days 33.5% 33.3% 32.0% 30.1% 61120days 19.1% 17.6% 16.0% 15.0% over120days 7.6% 7.0% 6.0% 5.0% 100.0% 100.0% 100.0% 100.0% 2. 3. Allowance/accounts receivable 10.6% Baddebts/sales
11.5% 3.7%
12.5% 4.0%
14.8% 4.1%
4.6%
Itappearsthattheallowanceisunderstated: 1. 2. 3. Ifaccountswereascollectibleasbefore,allowance/accountsreceivableshouldbe aboutconstant. Ifaccountsbecomelesscollectible,allowance/accountsreceivableshouldincrease. Number2seemstobethecase.
Theagingofaccountsreceivableshowsadeteriorationintheoverallaging(030decreased significantlyinthepastseveralyears,whilethoseinallothercategoriesincreased),while the allowance for uncollectible accounts as a percentage of accounts receivable has decreased from 14.8% to 10.6%. This indicates that the allowance for uncollectible accountsmaybeunderstated,especiallyconsideringthetrendbetween2002and2004. AccountsReceivable. Theaveragedaystocollectreceivableshasincreasedsteadilyoverthefouryearperiod, whichindicatesthatsomeaccountsmaynotbecollectible.Thisideaissupportedbythe deteriorationinoverallagingnotedabove. (continued) Sales.
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Finally,grossmarginasapercentageofsaleshasdeclinedsteadilyoverthefouryearperiodfrom 25%to21%.NetIncome/Saleshasalsodeclined.Theauditorshouldseekanexplanationfromthe clientforthesetrends.
