Lakeside Case 3 Ex 1

This suggested solution is directly taken from Trussel & Frazer (12th ed). You may have based your analysis on a template that was available and so your response may be added to the spreadsheet – simply a facsimile of the Exhibits in the Case Study.

Can you find justification for this analysis from the standards? Well, the question is asking you to perform analytical procedures … for risk assessment purposes as you begin planning your audit now that the decision to take Lakeside on as a new client has been made by your firm. The temptation is to check out ASA 520, but there you will only find discussion of analytical procedures as substantive tests … focus on the reason you are using the analytical procedures in the exercise … risk assessment (risk of material misstatement, or more simply, what areas of concern are you able to identify for us to pay attention to as we plan the allocation of our limited audit resources? So, which ASA deals with Assessing the Risks of Material Misstatement?

Accordingly, the important thing about checking this suggested solution is that you have the conclusions about your analysis documented in some way; this feedback follows the format suggested in the question. Also, bear in mind that in practice, several years (not just two) would likely be analysed for trends. I hope you found ASA 315.6(b), A14-A17. The following is one example of how the documentation of your analysis might look (the substance is far more important than the form!).

a) Ratio analysis from 2010 to 2011 (only the results shown, assumes you can do handle the calculations as per your earlier studies … note the conclusion … it is important to be able to suggest what areas of the financial statements the results might cause you to focus on or be concerned about; it is insufficient to be able to simply do the calculations – they mean very little without meaningful interpretation).

Ratio	2010	2011	Significance
Current	1.35	1.35	No significant change
# Days inventory on hand	93	101	Increase may indicate obsolete or slow-moving inventory on hand
Receivable collection period (days)	21	25	Slight increase may indicate relaxing of credit policies and/or possible understatement of allowance
Debt-to-total-assets	74.4%	74.5%	No significant change; however, the high ratio indicates significant leverage and potential solvency problems if additional debt is needed
Times interest earned	3.6 times	2.8 times	Decline indicates reduced ability to meet interest payments through operations
Profit Margin	2.79%	2.27%	No significant change
Return on Assets	8.47%	6.73%	Declining return results from a combination of declining net income and increasing total asset base.
Return on Equity	33.2%	26.4%	Decline in return results from a combination of declining net income and increasing equity base.

Conclusion: Lakeside had no significant changes in its liquidity or solvency levels; however, the company appears to be experiencing a decline in its profitability level. The audit staff should pay particular attention to revenue-enhancing or expense-reducing areas, such as fictitious sales or improper capitalization of expenses to halt this downward trend.

Ratio analysis: comparison to industry.

Ratio	Industry Avg.	Lakeside 2011	Significance
Current	2.16	1.35	Lakeside is below the industry average. This may indicate short-term solvency (liquidity) problems.
Days inventory on hand	69	101	Lakeside is well above the industry average. This may indicate short-term solvency problems.
Receivables collection period	15	25	Lakeside is well above the industry average. This may indicate short-term solvency problems.
Debt-to-total-assets	52%	74.5%	Lakeside is significantly above the industry average; this may indicate long-term solvency problems.
Times interest earned	9.2 times	2.8 times	Lakeside is significantly below the industry average; this may indicate solvency problems.
Profit Margin	4.2%	2.27%	Lakeside is only slightly below the industry average.
Return on Assets	8.1%	6.73%	Lakeside is only slightly below the industry average.
Return on Equity	19.3%	26.4%	Lakeside is above the industry average. Its large amount of debt is leveraging up the return on equity.

Conclusion: Lakeside is well below the liquidity level of the industry, and the company is in a significantly worse solvency level than the industry. Auditors should be aware of methods to enhance the liquidity and solvency levels, such as unrecorded liabilities. Lakeside profitability is about the same as the industry average, except for return on equity, in which it is well above the industry (primarily due to the high level of leverage).

c. Scan the financial statements and the trial balances.

Procedure	Results	Significance
Scan the income statement [Note: Instructors may want to suggest that students prepare a common size income statement.]	The company's stores continue to report an overall loss, which is increasing in amount.	These losses suggest the possibility that the stores will eventually be discontinued by Lakeside or drastically altered in some manner.
Scan the balance sheet [Note: Instructors may want to suggest that students prepare a common size balance sheet.]	Significant increases in short-term borrowings.	The short-term nature of the borrowing could result in short-term solvency and liquidity problems.
Scan the cash flow statement	Cash flow from operations declined significantly in 2011.	The cash flow problems combined with the solvency problems may indicate a problem with the company's ability to continue as a going concern.
Scan the trial balance	Something appears to be wrong with the information generated by Store Three. The sales for that store have increased by approximately 94% since the previous year. At the same time, the cost of the goods sold has dropped from 58.5% of sales (which is consistent with the other stores) to only 50.3% of sales. Also, the inventory held by this store has risen by over 50%.	These fluctuations could indicate recording errors or an employee attempting to inflate the earnings being reported for Store Three. This problem is more germane than might be encountered normally because of the profit-sharing bonus system that rewards employees for reporting high income figures.
Scan the trial balance	Sales Commissions for District D in 2012 appear to be slightly out of line. All of the other commissions are approximately 5.7% of sales, while this account is nearly 7% of the applicable sales figure.	Although not necessarily a material figure, the potential error should be investigated so that Lakeside can make the appropriate corrections if needed.
Scan the trial balance	Rent expense on vehicles and equipment has decreased in 2012.	Such a decrease often serves to indicate that the company has acquired new property.
Scan the trial balance	The Repairs and Maintenance account has increased by over 150% since 2011.	This significant increment may indicate a posting error that will require correction. Conversely, actual repairs may have been made by Lakeside. In that situation, the auditor needs to verify that all capitalized costs have been segregated and properly accounted for within the company records.
Scan the trial balance	The "Gain on Disposition of Fixed Asset" balance of $14,000 warrants investigation.	Often a company will fail to remove the appropriate cost and related accumulated depreciation when a plant asset is sold. The auditor should also ascertain that the current year depreciation expense has been properly recognized. Finally, the sale of an asset can lead to the acquisition of a new asset as a replacement. The independent auditor should follow up on this possibility to assure that any replacement is appropriately capitalized.
Scan the trial balance	The Allowance for Doubtful Accounts balance shows a debit balance on September 30, 2012, compared to a credit balance one year earlier.	The auditor should determine if the client has written off an especially large group of accounts. Perhaps bad debt experience is changing and a larger allowance is required.
Scan the trial balance	The company's two bank credit lines now have a total balance that exceeds the $750,000 maximum that was indicated in an earlier case.	The auditor should verify that no loan covenants have been broken. In addition, because of disclosure requirements as well as the effects on the interest expense account, the auditors will need to review any new borrowing agreement.
Scan the trial balance	The long-term notes payable have increased by $50,000. The auditor would certainly be interested in the application of those funds as well as the loan agreement signed by the company.	The auditor should determine the application of those funds as well as the loan agreement signed by the company.
Scan the trial balance	Sales returns have increased significantly for both the company stores and the distributorship.	The auditors need to ascertain the reasons for such an increase. Any change in the trend for sales returns would lead the auditors to reevaluate year-end accruals.
Scan the trial balance	The equipment account shows an increase from the previous year.	If the company has acquired additional equipment during the year, the auditor needs to verify that capitalization and depreciation were given proper treatment.
Scan the trial balance	The estimated bonus expense has increased.	That increase is probably due to the profit-sharing plan having been in effect for all nine months of 2012, but the increase should be investigated.