MEMO
To: Files, The Lakeside Company
From: Pravesh Mathur, Section 002
Date: February 27, 2012
Subject: Analysis of Audit Risk and Analytical Procedures
________________________________________________________________________
Purpose:
The purpose of this memo is to document how we calculated financial ratios, our opinions
regarding the ratios, and our inherent risk concerns that we will apply to our performance
evaluation of Lakeside Company during our engagement.
We have organized this memo into two broad categories, Analytical Procedures and Overall
Inherent
Risks levels. They are further broken down into four parts and are as follows:
●
●
●
●
Analysis of annual financial ratios
Analysis of financial ratios compared to the industry
Analytical review of financial statements
Assessment of overall inherent risk
Conclusion:
During our planning stage, we realized that Lakeside Company is not performing on par with
its competitors in the consumer electronics industry. They are showing signs of a retracting
company, even though they have aspirations to expand.
We must apply a higher inherent risk guidance to this engagement, to ensure we gather enough
information prior to issuing a standard unqualified opinion with reasonable assurance.
1
Exhibit 1
The Lakeside Company
Analytical Review Procedures
December 31, 2012
Prepared by: Team 3
Date: February 27, 2012
(a) Compute the financial ratios for Lakeside for the years ended December 31, 2010 and
December
31, 2011. Comment on any large fluctuations, unusual fluctuations, or lack of expected
fluctuations.
Also, give an overall conclusion as to the significance of the change in Lakeside’s liquidity,
solvency, and profitability positions from 2010 to 2011. Use the following format.
Ratio
Current
2010 2011
Significance of Change
1.35 1.35 No significant fluctuation, indicating a stable liquidity position
(based on this measure of liquidity)
Average Days
93 100.52 An increase in Average Days inventory on hand indicates a
Inventory on
days potentially deteriorating liquidity position, especially
Hand
considering the relationship between Lakeside’s number and the
industry average. Because of this change, we should look into
Lakeside’s sales and shipment records.
Average Days to 20.6 64.22 Again, with an significantly increasing Average Days to Collect
Collect
Receivables Ratio, Lakeside should be concerned about their
Receivables
liquidity position. During our review, we should seek to
understand the reason for this significant change, and pay
special attention to sales and cash collection records.
Debt-to-Total
0.74 .75 Just as we saw no fluctuation in the current ratio, we wouldn’t
Assets Ratio
expect to see a meaningful fluctuation in the Debt-to-Total
Assets Ratio. Both Lakeside’s debt and assets increased in a
relatively consistent manner; therefore, we’d expect to see a
small increase in the Debt-to-Total Assets Ratio. This indicates
a stable solvency position.
Times Interest
Earned
3.57
2.79 A decrease in Times Interest Earned indicates potential solvency
issues. While Lakeside is currently still able to make it’s interest
payments, we can assume that the decrease might be a result of
the increase in Average Days to Collect Receivables and
Average Days Inventory on Hand. However, a downward trend
is something to keep an eye on.
2
Profit Margin
0.03
.02
No significant fluctuation in profit margin indicates that the
profitability of Lakeside has remained stable from 2010 to 2011.
Return on Assets 0.08
.07
Again, no significant fluctuation indicates a relatively stable
level of profitability for the company over the past two years.
Return on Equity 0.33
.26
A decrease in return on equity results from the decreased Net
Income from 2010 to 2011. As Return on Equity lends to the
profitability of the firm, continued ROE decreases could be
potentially harmful to the future of the company.
Days Payable
Outstanding
18.5 17.63
A decrease in days payable outstanding is again, generally a
good sign for the company. Although the change is not
monumentally significant, it will be important to keep an eye
on this ratio in future periods, seeing as this could eventually
lead to cash flow issues. This would be negative for
stakeholders because the company would have less free cash
flow to use in other areas of the business.
Dupont
Analysis
.38
The DuPont Analysis is a measure of the firm’s asset use and
operating efficiency, as well as it’s financial leverage position.
While the decrease is only minor, a decrease in this ratio is
something to keep an eye on.
.25
Overall Conclusion:
In general, Lakeside’s performance has slightly decreased from 2010 to 2011. While none of the
changes are extremely significant, a downward trend is something to keep an eye on. We should
exercise extra care in our review of Lakeside’s statements in order to ensure that this overall
downward
movement is reflective of the actual financial position of the company.
3
Exhibit 2
The Lakeside Company
Analytical Review Procedures
December 31, 2012
Compare the year 2011 financial ratios computed for Lakeside in Exhibit 1 to the industry
average ratios. Comment on any large fluctuations, unusual fluctuations, or lack of expected
fluctuations. Also, give an overall conclusion as to the significance of the difference between
Lakeside’s liquidity, solvency, and profitability positions in 2011 and the industry average
positions. Use the following format:
Ratio
Current
Industry Lakeside Best
Ave.
2011
Buy
2.16
1.35
1.2
Significance of Change
Lakeside is below the industry average. They are,
however, performing better than Best Buy.
Unfortunately, this may still indicate short-term
solvency problems.
Average Days 69 days
Inventory on
Hand
100.52
days
48.78 Lakeside’s inventory holding period is significantly
days longer than the industry average. This could indicate
liquidity issues which could affect Lakeside’s ability
to meet its debt-repayment obligations. Additionally,
with Best Buy performing better than the industry
average, we can see that there may be issues with
Lakeside’s inventory reporting.
Average Days 15 days
to Collect
Receivables
62.22
days
17.05 Lakeside’s Average Days to Collect Receivables is
days alarmingly high compared to the industry average
and Best Buy’s individual ratio. Coupled with the
high number of days that inventory is held, this
raises a red-flag related to Lakeside’s ability to meet
its repayment obligations. We should review
Lakeside’s receivables collection procedures.
Debt-to-Total
Assets Ratio
75%
59% A high Debt-to-Assets ratio indicates that the
majority of the firm’s assets are financed by debt.
While a high percentage is common in the industry,
again, Lakeside’s percentage tops the industry
average. This could be a cause for concern related to
Lakeside’s relationship with its creditors, who could
eventually become uncomfortable with such a highly
debt-leveraged firm.
52%
4
Times Interest
Earned
9.16
times
2.79
times
2.89 Times Interest Earned indicates the number of times
times a company can make its required interest payments
in a period. Obviously, the higher the number, the
better. Lakeside, with a Times Interest Earned
number below 3.0, is in a poor position for making
its interest payments in a timely manner. When
comparing Lakeside’s ratio with the industry
average of 9.16, we see that again, Lakeside falls
short of aligning with average performance.
Profit Margin
4.2%
2%
3%
The Profit Margin ratio provides us with a tool to
assess possible misstatements in operating expense
and related balance sheet accounts. Seeing as
Lakeside’s profit margin is relatively in-line with the
industry average, their operating expenses may not
prove to be much of a concern to us.
Return on
Assets
8.1%
7%
7%
Lakeside’s Return on Assets is relatively aligned
with the industry average. This indicates that the
overall profitability of the company is similar to
other company’s in the industry.
Return on
Equity
19.3%
26%
18% Lakeside’s Return on Equity is higher than the
industry average. This indicates that Lakeside is able
to generate more of a profit than the average
company in the electronics industry.
Overall Conclusion:
The results of this ratio analysis raises a red flag. In each category, Lakeside under-performs
compared to the industry except for the Profit Margin, Return on Assets and Return on Equity
categories. It seems abnormal that Lakeside would under-perform compared to the industry in
every category, but would have the ability to generate a relatively higher profit than the average
company in the electronics industry. Poor performance in the Average Days to Collect
Receivables, Average Days Inventory on Hand, Debt-to-Total Assets, and Times Interest Earned
5
categories indicates a firm that is performing poorly in comparison; therefore, we would expect
to see that Lakeside’s Return on Assets, Profit Margin, and Return on Equity are lower than the
industry average. Because of this, we will lower our level of acceptable audit risk and perform
more thorough tests to validate Lakeside’s reported revenues and profits.
6
Exhibit 3
The Lakeside Company
Analytical Review Procedures of Financial Statements
December 31, 2012
© Scan each of the financial statements (Balance Sheet, Income Statement, Statement of Cash
Flows) and the trial balances. Comment on any unusual accounts, account balances, or large,
unusual, or lack of expected fluctuations from the previous year.
Procedure
Findings
Scan the trial 1. (Acct 103-3) There is an
balance.
increase in inventory of store
number 3 from 2011 to 2012 of
$41,200 (6.3%).
Significance
1. This increase in inventory balance is an area
of concern because there is the potential that the
inventory may become obsolete, therefore not
providing an accurate representation of assets.
2. Lakeside is already struggling to generate
enough profits to sufficiently repay existing
interest payments. An increase in debt represents
2. (Acct 200-1) An increase of
a going concern for the company, its stake
$108,000 (16.6%) in a credit line holders, and potential users because Lakeside is
with the Security National Bank leveraging themselves poorly and creditors may
from 2011 to 2012.
become concerned with their ability to repay
future obligations in a timely manner. If this is
the case, qualifying for future loans could
become a problem and hinder expansion
aspirations.
3. This increase in A/P is significant because it
solidifies the fact that Lakeside is continually
failing to reduce its liabilities effectively. The
increase A/P would be reasonable if Lakeside
were growing its bottom line year over year.
However, at this pace, Lakeside is continuing on
the trend of over extending themselves without
generating enough revenue to cover their
liabilities.
3. (Acct 210-1) There is an
increase of $90,200 (27.9%) from
2011 to 2012 on A/P to Cypress.
4. The numbers presented in the inventory and
sales of Store 3 do not correlate. An overall
increase in inventory of 6% seems to low to
4. (Acct 500-3) The sales of Store provide a same store sales increase of over 90%.
3 nearly doubled increasing by There may be errors in the completeness or
$445,000 (94%). This seems like occurrence of the existing control systems when
an unusual fluctuation because
recording transactions. This could potentially be
7
the inventory of Store 3 also
increased drastically (See Acct
103-3).
an area of concern for the firm because they may
lack necessary accounting systems to expand
efficiently in the future.
5. This increase is significant because a higher
percentage of items returned to Cypress, requires
a more careful evaluation of completeness and
tracking of transactions. There is greater risk that
misstatements occur in both the balance sheet
and income statement, if the costs are not
5. (Acct 520-2)The sales returns properly allocated. Again, Lakeside needs to
for the distributorship increased ensure an effective control system is in place to
by $152,600 or nearly 50% from reduce the risk of mistakes.
the previous year.
6. This decrease of 18% does not reflect the
opening of a new store. We need to clarify that
this account was correctly calculated, as a
decrease in expenses does not correlate well with
a company that is expanding their operations.
7. Bad accounts may be increasing or a debit
entry misposted. Allowance for Doubtful
6. (Acct 660-1) A decrease in
Accounts is a liability account and should have a
overall utility expense of $16,400 normal credit balance.
from the prior year.
7. A debit balance appears in the
“Allowance for Doubtful
Accounts” account.
Scan the
income
statement.
1. A large fluctuation ($200,000) 1. The implementation of a new bonus plan is
occurs in Salaries, Commission, the likely driver of an increase in this expense.
Bonuses between 2010 and 2011. However, Lakeside should consider other
liabilities before committing to higher
compensation packages, because their
profitability and leverage ratios are suffering.
This is a concern moving forward for two
reasons. First, it provides an opportunity for
employees to overstate their financial reports.
8
Secondly, when creditors and investors notice
management’s priorities for fulfilling their debt
obligations, it may deter them from continuing
to do business with Lakeside in the future.
2. An 11% increase in sales shows a positive
trend for growth. Lakeside should utilize this
2. Total sales increased by $1.2M momentum to improve their bottom line moving
(11%), from 2010 to 2011.
forward. If they can successfully reduce
expenses, it will enable them to capture a greater
portion of the market share within the industry.
Scan the
balance
sheet.
3. Lakeside has taken on additional debt. Rising
interest expense is a poor management decision.
In the tough consumer electronics industry,
3. Interest Expense increased by Lakeside is falling behind the industry average
about $60,000 from 2010 to 2011 in numerous categories. If Lakeside is unable
leverage themselves more effectively there is an
increased chance that Lakeside will not be able
to survive in the continually changing
environment.
1. Accounts Receivable increased 1. Lakeside has a very high Average Days to
by $180,000 (32%) from the
Collect Receivables (about 60 days), four times
previous year.
greater than the industry average. An increasing
amount in accounts receivable could lead to a
higher chance of default on payments. Lakeside
should refrain from extending this account
because it constricts their cash flows. Allowing
this account to continually increase will hurt
Lakeside’s ability to reduce overall debt to meet
payment obligations.
2. Inventory increased by
$320,000 (20%) from the
previous year’s total.
2. Days inventory on hand is 100 days. Lakeside
does not have a very high inventory turnover.
This can lead to high carrying costs and result in
a lower net income. Also, the consumer
electronics industry is an inherently fast paced
industry. If Lakeside allows for a larger
percentage of their current assets to remain in
inventory, it is possible that it will become
obsolete. This will force Lakeside to reduce the
value of the overall inventory, decreasing the
value of their operations moving forward.
3. Current Liabilities increased drastically from
2010. Notes Payable, Accounts Payable, and
9
3. Current Liabilities increased
18% from the previous year.
Scan the
1. Cash Paid to Suppliers
statement of increased by over $800,000
cash flows.
2. Net Cashflow for Investing
Activities decreases by 71%
Accrued Expenses &Taxes Payable, all showed
an increase. Lakeside, should be making a
conscious effort to reduce all liabilities. Moving
forward, Lakeside should be concerned with the
fact that they are allowing for a high accounts
receivable and increasing liabilities. These two
together could prove to be a problem since
Lakeside will have difficulty making payments
in a timely manner.
1. Lakeside is overextending themselves. The
new store that isn’t profitable and is weighing
down their cash flows. Lakeside should position
themselves more efficiently so cash is more
readily available to help pay-off liabilities as
they come due.
2. There were less new acquisitions of PP&E
and Leasehold improvements in 2011 than in
2010. This could be a good signal for Lakeside,
because it allowed them to refrain from spending
more money on expanding a franchise that is not
performing well compared to the competitors.
3. A 50% increase in net cash is very high. It is
good to see growth in this account, but there is a
possibility it was misstated. It is difficult to
3. Lakeside had a net increase in understand how a company who is in the midst
cash at the year end 2011 of
of a failed expansion effort was able to generate
$6,000 - an increase of $2000
a positive cash flow by the year end. This
from the previous year or 50%. account shows the end result of cash operations
and should be more carefully examined to ensure
Lakeside correctly allocated cash flows
throughout the year.
10
Exhibit 4
Overall Inherent Risk Level
Client: The Lakeside Company
Balance Sheet Date: December 31, 2011
Prepared by: Team 3
Inherent risk (IR) is a measure of the susceptibility of material misstatement before considering
the effectiveness of the internal control. Determine the appropriate level of inherent risk for the
audit engagement as a whole, using qualitative terms (high, moderate or low inherent risk).
Complete the following:
Factor
Nature of Client’s
Business
Results of Previous
Audits
Discussion
Low Moderate High
The consumer electronics industry is subject to
X
swings in the economy and is very competitive.
Because Lakeside is in the electronics industry, the
likelihood of inventory becoming obsolete is higher
than that of other industries because technology is
continuously changing. Because of this possibility of
obsolescence and it’s affect on the going concern of
the business, we apply a higher level of risk in this
area.
The predecessor auditor issued a qualified opinion
X
due to to impairment of the sixth store. Rogers was
opposed to writing down the value of the asset
determined by the predecessor auditor. He will most
likely not change his opinion in regards to the value
of this building. After becoming more familiar with
this engagement, we can lower this risk if
management is more cooperative than they were with
this particular issue.
Initial Versus Repeat This is a first year engagement so we will assess a
Engagement
higher inherent risk and reduce it in future years as
we gain more knowledge and understanding about
the client.
Quantity of Related We know that Rogers owns a subsidiary companyParty Transactions
the construction company that will be responsible for
building the seventh store. Although the seventh
store has yet to be built and will not affect this year’s
financial statements, they will affect them in the
future. This will be important for future users of the
financial statements because after the seventh store is
built, it will materially affect the statements. These
companies are obviously not independent of each
other because Rogers owns both of them. How will
X
X
11
they materially affect?
Quantity of nonRecent property acquisitions such as the acquisitions
routine transactions of the sixth and seventh stores are examples of nonroutine transactions. The client may lack knowledge
about recording these transactions because they are
unfamiliar with them. In order to decrease this risk,
we must understand how the client has
recorded/records these types of transactions.
Reviewing any meeting minutes and understanding
the way the firm operates will also prove to be an
effective way to reduce this risk.
Quantity of estimates Inherent risk for Allowance for Doubtful Accounts
and judgment
should increase inherent risk because these are
required for accounts estimates based on management’s professional
judgement. Since they are only estimates based on
judgement and past experiences, this increases the
likelihood of misstatements.
Also, Lakeside has a very generous return policy.
They will allow customers to return 20% of their
products within four months as long as the
merchandise is not damaged. Customers have a large
window of time in which they can return
merchandise and many will probably take advantage
of this. If Lakeside does not account for these returns
and allowances, there may be a material
misstatement. If a significant amount of sales returns
occur, recorded revenues will be too high and will
not be offset by the returns.
Potential for
With the new bonus plan that has taken effect in the
fraudulent financial last year, managers may have more incentive to
reporting (fraud risk record higher sales. Managers that lack integrity
factors)
could abuse the bonus plan for personal gain
opportunities.
Potential for
In the electronics industry, a lot of inventory is on
misappropriation of hand at any given time and is more susceptible to
assets (fraud risk
theft by employees. We assess this factor at a high
factors)
level of risk because we need to have a certain level
of skepticism when it comes to the integrity of the
employees.We should also check for separation of
duties, to ensure theft can not be easily covered up by
a given individual.
Interest Rates
Interest rates are always subject to change. This
may affect our client’s capability of meeting shortterm cash payments. This factor will affect our
opinion about the going concern of the firm.
X
X
X
X
X
12
Relationships with
Vendors
Availability of
Financing
Cypress is Lakeside’s sole vendor. If Cypress
faces any economic or financial distress, this would
directly affect Lakeside. Lakeside would need to
find another source of inventory immediately in
order to continue operations.
X
If interest rates increase, this may affect the way our X
client can borrow money. They may not be able to
borrow as much capital (a decrease in the availability
of financing). This may also affect our opinion of
going concern for the firm because they may not be
able to keep all of their stores in operation without
financing.
Sales and
Collection Cycle
(A/R)
If payment is made in cash, it can be easily
pocketed by employees. This can be covered up by
failing to record the sale.
Payroll
Few misstatements should occur in regards to
payroll. Payroll is typically a uniform process
performed by upper management. Management
should be very experienced when it comes to
payroll because these transactions occur
consistently throughout the business cycle. Also,
we should not have any problems finding or using
documentation backing up payroll expenses.
Conclusion: Overall Discussion for overall level is below.
inherent risk level
X
X
X
Discussion: Overall inherent risk for this client should be placed at a moderate-high level.
Because the Lakeside Company engagement is a first year engagement, we will place this overall
risk a little higher than we normally would in order to compensate for any uncertainties or areas
where we may lack knowledge about the client. Subsequently, a high inherent risk will decrease
the level of planned detection risk and we will have to gather more evidence for this firm in the
first few years of engagement. After a few years, we will be able to lower this level of inherent
risk, and eventually we will not need to gather as much evidence as the planned detection risk
increases.
13