ACFI1001 Lecture Notes - Lecture 7: Profit Margin, Capital Structure, Accounts Receivable
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Analytical Procedures
You have been assigned to the 2015 audit of Perkins Corp. Youmet with the controller of the company who provided you with the2015 operatung results shown below. Your supervisor has asked youto perform the preliminary analytic review. The supervisor hasasked you to use the audited data from the prior four year (shownbelow) as part of your reveiw. The supervisor has also provided youwith a few ratios that she would like you to look at.
Required:
A. Prepare a horizontal AND a vertical analysis using the 5 yearsof financial data provided. (HINT: Another term for horizantalanalysis is "trend" analysis. Vertical analysis is also referred toas "common size" analysis.) You do not need to prepare thisanalysis for the two balance sheet account shown.
B. Determine the ratios that were requested by your supervisor foreach year (below).
C. MOST IMPORTANT: Identidy five account, ratios, or trends thatmight concern you as the auditor of the 2015 statements. Remember,you're looking for unusual relationships or significantchanges that might identify an area that will need moretesting.
| Operating Results | |||||
| 2011 | 2012 | 2013 | 2014 | 2015 | |
| Revenues | 1,750,000 | 1,872,500 | 2,033,575 | 1,883,361 | 2,034,029 |
| Cost of goods sold | (1,050,00) | (1,217,125) | (1,362,431) | (1,205,351) | (1,261,098) |
| Gross Profit | 700,000 | 655,375 | 641,144 | 678,010 | 772,931 |
| Salaries expense | 350,000 | 360,500 | 367,710 | 360,356 | 374,770 |
| Advertising expense | 91,000 | 87,500 | 35,000 | 40,250 | 122,500 |
| Facilities expense | 85,000 | 86,700 | 88,868 | 87,090 | 91,445 |
| Payroll tax expense | 38,500 | 37,853 | 42,287 | 42,882 | 29,982 |
| R & M expense | 28,000 | 29,120 | 30,139 | 31,345 | 21,001 |
| Depreciation expense | 14,500 | 14,500 | 13,775 | 13,637 | 10,910 |
| Interest expense | 8,300 | 8,317 | 8,135 | 8,053 | 7,973 |
| Legal fees expense | 3,500 | 4,200 | 3,800 | 5,600 | 14,562 |
| (618,800) | (628,590) | (589,713) | (589,214) | (673,142) | |
| Operation Income | 81,200 | 26,786 | 51,431 | 88,796 | 99,789 |
| Selected accounts from balance sheet | |||||
| Average pp&e | 145,000 | 131,818 | 172,188 | 123,975 | 181,830 |
| Average Debt | 166,000 | 161,118 | 135,581 | 129,895 | 130,704 |
Selected ratios: (do for each year)
A) Depreciation as a % of PP&E
B) R&M as a % of PP&E
C) Interest as a % of Debt
D) Payroll taxes as a % of Salaries
1. Apply to actual companies the basic knowledge and analytical techniques learned from our course.
2. Prepare common-size financial statements, comparative financial statements, and various profitability and risk ratios.
3. Compare the calculated results with competitors and across different years.
4. Summarize the analyses and make investment recommendations.
You will be analyzing the following firms:
Williams-Sonoma, Inc.
Pier 1 Imports, Inc.
For these firms, download the most recent annual report (10-K report) to begin your work. In 10-K reports, you can find companiesâ basic information, financial statements, footnotes to the financials, and the management discussions and analyses. Please download the 10-K reports from the following web links:
10-K reports (fiscal year 2016) for Williams-Sonoma, Inc.
https://www.sec.gov/Archives/edgar/data/719955/000119312517104341/d265187d10k.htm
10-K reports (fiscal year 2015) for Williams-Sonoma, Inc.
https://www.sec.gov/Archives/edgar/data/719955/000119312516525847/d120289d10k.htm
10-K reports (fiscal year 2014) for Williams-Sonoma, Inc.
https://www.sec.gov/Archives/edgar/data/719955/000119312515118009/d851953d10k.htm#tx851953_13
10-K reports (fiscal year 2016) for Pier 1 Imports, Inc.
https://www.sec.gov/Archives/edgar/data/278130/000119312517136345/d343458d10k.htm
10-K reports (fiscal year 2015) for Pier 1 Imports, Inc.
https://www.sec.gov/Archives/edgar/data/278130/000119312516556025/d133529d10k.htm
10-K reports (fiscal year 2014) for Pier 1 Imports, Inc.
https://www.sec.gov/Archives/edgar/data/278130/000119312515153179/d881010d10k.htm#toc881010_13
For your convenience, I also provided the balance sheet and income statement of each company for the most recent years at the end (page 5-8; Table 1-4). Please use them to prepare common-size financial statements and comparative financial statements.
Guidance
The required tasks are detailed below:
(1) Prepare common-size balance sheets and income statements for both companies. Note: Compute for the most recent THREE years.
(2) Prepare comparative analysis (i.e., change of percentage analysis) on income statement and balance sheet for both companies. You should compute for the most recent THREE years.
(3) Prepare ratio analyses (for the same THREE year time period) for both companies. At least, you should include the following ratios in your computations: (1) current ratio, (2) acid-test ratio, (3) receivables turnover, (4) inventory turnover, (5) asset turnover, (6) profit margin on sales, (7) rate of return on assets, (8) rate of return on common stock equity, (9) earnings per share, (10) payout ratio, (11) debt to total assets ratio, (12) times interest earned, (13) cash debt coverage ratio, and (14) book value per share.
(4) Comment on the analytical results of the two companies. Your comments should concentrate on the trends across the companies. In addition to contrasting the ratios between the companies, you should interpret the numbers and make suggestions as to why the ratio of one company might be higher/lower than the other.
(5) Write a conclusive summary on the firms you have studied. Based upon your conclusions, recommend the better performing firm for potential investment. Your conclusions should be based upon, and specifically reference, the analyses prepared in this report.
(6) Read sample project to get some ideas.
Report Format Requirements:
A. Report body requirements:
Cover page. List the title of the project, your names, and semester/year.
Abstract or Executive Summary. This is a separate page. It should cover the purpose of the project, the major findings, and the conclusions/recommendations, in summary form.
Table of Contents.
Main body. Use the following sequence for report content:
Introduction to the two companies and to the purpose of the report
Analytical section. This should include all your numerical analyses. This is where you will discuss the results of, comments on, and conclusions about the vertical and horizontal common-size statements, comparative analysis (i.e., change of percentage analysis), and the ratio analyses for both companies.
Comparisons of companies and all other analysis (observations and/or interpretations). (You may combine b and c if you wish, as long as both are well covered.)
Conclusions and recommendation for investment.
References. List all major reference sources.
Appendices. Include tables and graphs of your numerical analyses. For reference convenience, assign a title to each separate item, such as Table 1, Exhibit 1, etc.
B. Typesetting requirements:
Use size 12 font. Times New Roman is preferred.
Double space between lines.
Number pages in accordance with the APA style guide.
One inch on all sides.
Do not right justify text. Use left justify.
Minimum length: 8 pages. (Note: You can easily meet the minimum length requirement since you will have a lot of tables in the paper.)
The submitted work should be in ONE file with a word or pdf format. An Excel spreadsheet file is NOT acceptable.
Plagiarism
Plagiarism will not be tolerated. Evidence of plagiarism will result in a grade of âFâ to the course and be subject to appropriate disciplines.
NOTES:
A portion of your grade will be assessed based on the overall report quality, clarity, format, and cohesiveness.
A FREE RIDER in the group will not be tolerated. However, to report an alleged free rider, you should send me a formal written complaint. You should carefully manage your group over the semester to ensure that no teammate will take the chance of turning into a free rider. Try to contact/manage your teammates frequently and inform me if any member is not willing to participate the group work so we can address this issue ASAP. A free rider will receive his/her group project grades solely based on what he/she has contributed to the projects. If there is a free-rider in your group or a member drops the class, the rest of the group members are still expected to submit a COMPLETE paper.
Again, the balance sheet and income statements are provided at the end. Please use them to prepare common-size and comparative financial statements.
Table 1. Williams-Sonoma, Inc ----Balance Sheet
| Williams-Sonoma, Inc. | ||||
| BALANCE SHEET | ||||
| Fiscal Years 2016, 2015, 2014, 2013 | ||||
| (In thousands) | FY 2016 | FY 2015 | FY 2014 | FY 2013 |
| ASSETS | ||||
| Current assets | ||||
| Cash and cash equivalents | $ 213,713 | $ 193,647 | $ 222,927 | 330121 |
| Restricted cash | â | â | â | 14289 |
| Accounts receivable, net | 88,803 | 79,304 | 67,465 | 60,330 |
| Merchandise inventories, net | 977,505 | 978,138 | 887,701 | 813,160 |
| Prepaid catalog expenses | 23,625 | 28,919 | 33,942 | 33,556 |
| Prepaid expenses | 52,882 | 44,654 | 36,265 | 35,309 |
| Deferred income taxes, net | â | â | 130,618 | 121,486 |
| Other assets | 10,652 | 11,438 | 13,005 | 10,852 |
| Total current assets | 1,367,180 | 1,336,100 | 1,391,923 | 1,419,103 |
| Property and equipment, net | 923,283 | 886,813 | 883,012 | 849,293 |
| Deferred income taxes, net | 135,238 | 141,784 | 4,265 | 13,824 |
| Other assets, net | 51,178 | 52,730 | 51,077 | 54,514 |
| Total assets | $ 2,476,879 | $ 2,417,427 | $ 2,330,277 | 2,336,734 |
| LIABILITIES AND STOCKHOLDERSâ EQUITY | ||||
| Current liabilities | ||||
| Accounts payable | $ 453,710 | $ 447,412 | $ 397,037 | 404791 |
| Accrued salaries, benefits and other liabilities | 130,187 | 127,122 | 136,012 | 138,181 |
| Customer deposits | 294,276 | 296,827 | 261,679 | 228,193 |
| Income taxes payable | 23,245 | 67,052 | 32,488 | 49,365 |
| Current portion of long-term debt | â | â | 1,968 | 1,785 |
| Other liabilities | 59,838 | 58,014 | 46,764 | 38,781 |
| Total current liabilities | 961,256 | 996,427 | 875,948 | 861,096 |
| Deferred rent and lease incentives | 196,188 | 173,061 | 166,925 | 157,856 |
| Long-term debt | 1,968 | |||
| Other long-term obligations | 71,215 | 49,713 | 62,698 | 59,812 |
| Total liabilities | 1,228,659 | 1,219,201 | 1,105,571 | 1,080,732 |
| Stockholdersâ equity | ||||
| Preferred stock: $.01 par value; 7,500 shares authorized; none issued | â | â | â | 0 |
| Common stock: $.01 par value; 253,125 shares authorized; | ||||
| 87,325 and 89,563 shares issued and outstanding at | 873 | 896 | 919 | 941 |
| January 29, 2017 and January 31, 2016, respectively | ||||
| Additional paid-in capital | 556,928 | 541,307 | 527,261 | 522,595 |
| Retained earnings | 701,702 | 668,545 | 701,214 | 729,043 |
| Accumulated other comprehensive loss | (9,903) | (10,616) | (2,548) | 6524 |
| Treasury stock â at cost: 20 and 29 shares as of January 29, 2017 and January 31, 2016, respectively | (1,380) | (1,906) | (2,140) | (3,101) |
| Total stockholdersâ equity | 1,248,220 | 1,198,226 | 1,224,706 | 1,256,002 |
| Total liabilities and stockholdersâ equity | $ 2,476,879 | $ 2,417,427 | $ 2,330,277 | 2,336,734 |
Table 2. Williams-Sonoma, Inc --- Statement of Income
| Williams-Sonoma, Inc. | ||||
| STATEMENT OF INCOME | ||||
| Fiscal Years 2016, 2015, 2014,2013 | ||||
| (In thousands) | FY 2016 | FY 2015 | FY 2014 | FY 2013 |
| E-commerce net revenues | $ 2,633,602 | $ 2,522,580 | $ 2,370,694 | $ 2,115,022 |
| Retail net revenues | 2,450,210 | 2,453,510 | 2,328,025 | 2,272,867 |
| Net revenues | 5,083,812 | 4,976,090 | 4,698,719 | 4,387,889 |
| Cost of goods sold | 3,200,502 | 3,131,876 | 2,898,215 | 2,683,673 |
| Gross profit | 1,883,310 | 1,844,214 | 1,800,504 | 1,704,216 |
| Selling, general and administrative expenses | 1,410,711 | 1,355,580 | 1,298,239 | 1,252,118 |
| Operating income | 472,599 | 488,634 | 502,265 | 452,098 |
| Interest (income) expense, net | 688 | 627 | 62 | (584) |
| Earnings before income taxes | 471,911 | 488,007 | 502,203 | 452,682 |
| Income taxes | 166,524 | 177,939 | 193,349 | 173,780 |
| Net earnings | $ 305,387 | $ 310,068 | $ 308,854 | $ 278,902 |
Background
You are a manager in the audit division at Miller Yates Howarth (MYH), an accounting firm with offices throughout the major regional centres of NSW and Queensland. Although a medium sized firm by national standards, MYH is the second largest regional accounting firm in Australia. Most of MYHâs audit clients are in the agriculture, mining, manufacturing and property industries. All of those industries are currently under pressure, either from a downturn in commodity prices or fierce competition from overseas competitors.
You are gathering information in order to prepare the audit plan of GPSA Limited for the year ended 30 June 2017. Along with Morgan Fertilisers, GPSA is one of MYHâs most significant and longstanding clients. The following information has been gathered to date.
Principal activities of GPSA
⢠research and development of technologies relating to medical equipment;
⢠manufacture and distribution of medical equipment;
⢠investment of surplus funds; and
⢠investment in the property market.
GPSA was incorporated in 1992 and has operated successfully and profitably since that date. In the last few years it has branched out into the property market, acquiring a number of commercial properties which are let mainly to medical practitioners.
The directors of GPSA are:
⢠Mr. John Stanton, Chairman
⢠Ms Jane Quade, Chief Executive Officer
⢠Mr. Joe Quade
⢠Dr Barry Jones
⢠Dr Beryl Yeo
Doctors Jones and Yeo are independent non-executive directors and have been directors since 2003. The other three executive directors have been employed by the company since its incorporation and have considerable experience in the industry. Mr Stanton controls a number of private companies.
In prior years MYH placed reliance on internal controls based on satisfactory results of extensive tests of control. Recent discussions with the client have revealed no changes in the system of internal control since last year. The company does not have an internal audit function.
In February 2016, research activities relating to a new laser surgery device commenced. Significant costs were incurred in relation to this research. In April 2017 a competitor announced that it had successfully developed and patented a similar device. In order to finance the research activities noted above the company borrowed from its bankers an additional $5 million during the year. The loan agreement contains a covenant to the effect that should the company's debt to equity ratio (measured as total liabilities: shareholders' equity) increase above 1.2:1.0 at any time, the bankers have the right to demand immediate repayment.
Throughout the 2017 financial year, the property market has been in decline. The end of financial year audit is scheduled to start on 1 August 2017 and should take about two weeks to complete. The client completed a stock count on 30 June 2017. The directors require the signed audited final financial report by 28 August 2017.
Your audit partner, John Richards, has approached you and advised that there are several areas he is concerned about and he wants to you to report back to him about these areas before you complete your audit program. These areas and accounts are:
⢠Accounts receivable
⢠Current investments
⢠Property assets
⢠Intangible assets
⢠Research and development capitalisation
Ratios extracted from an unaudited set of financial reports at 30 June 2017 together with audited comparatives for the year ended 30 June 2016 and 2015 are set out below for your review.
| Ratio | 2017 (Unaudited) | 2016 (Audited) | 2015 (Audited) |
| Return on equity % | 7.19 | 18.61 | 22.17 |
| Return on total assets % | 4.86 | 13.7 | 15.52 |
| Gross margin % | 31.76 | 30.00 | 24.94 |
| Net profit margin % | 10.38 | 20.27 | 17.85 |
| Times interest earned | 1.90 | 3.51 | 4.10 |
| Days in inventory | 166.53 | 127.89 | 115.85 |
| Days in accounts receivable | 83.07 | 60.65 | 53.24 |
| Current ratio : 1 | 1.80 | 1.54 | 1.66 |
| Quick asset ratio : 1 | 0.89 | 0.78 | 0.82 |
| Debt to equity ratio : 1 | 1.11 | 1.02 | 1.04 |
Internal controls
The financial controller at GPSA has been refining the system of internal controls and informs you, at the planning stage of the current year's audit, that he has put together an internal control manual for the company. He has stated that this manual will create greater awareness of controls in the company, particularly with management which, in the past, has not been overly conscious of the need to implement and enforce effective internal controls.
Management staff receive bonuses based on certain agreed-upon target ratios which include measures such as targeted monthly sales volumes, variance of actual to budget departmental overheads and profit before interest and tax. The major shareholder takes an active interest in the performance of the company and is quick to request explanations on variances from the agreed-upon monthly budgets.
Two years ago, the company devoted significant time and resources to the development and implementation of a new IT system. All teething problems associated with the implementation phase have now been resolved, and the financial controller is satisfied that the automated controls in place are assisting in producing accurate and complete accounting records. The sales director also looks after the IT function as the position is not regarded by management as being a full-time job. Once application programs have been tested, strict password control exists over access to the programs. Passwords are not required for access to databases.
To assist in the planning for the current year's audit engagement, you extracted the following information from a review of the systems notes in the permanent file and perusal of the new internal control manual:
manual delivery notes for dispatch of tiles to customers are raised by the dispatch department from the sales order form. Where a delivery is only partially filled, the delivery note is marked 'hold for invoice' and placed on the incomplete deliveries file. At month end, the supervisor of the dispatch department is responsible for follow-up of the reasons why incomplete deliveries have been outstanding for greater than 30 days.
returns of medical equipment by customers due to inferior quality, incorrect specifications or oversupply are received by the dispatch department where staff are required to check quantity and condition of the returned tiles. Details noted by the dispatch personnel, including the reason for the return, are recorded on a âgoods returnedâ note. Once completed, this document is passed on to the trade receivables clerk who raises a credit note and sends it to the customer.
once a delivery has occurred, the office copy manual delivery note is forwarded to the trade receivables clerk who is responsible for generating an invoice on the computer system. An invoice is raised by inputting the total quantity delivered (Note: this could be a number of partial deliveries) and the stock code which is also recorded on the delivery note. The computer then automatically retrieves the stock code price from the selling price master file. Posting to the debtors account occurs automatically once the trade receivables clerk has performed a screen check on the accuracy of the input of delivery details.
for valued customers, discounts are applied in accordance with the company's volume rating system. The trade receivables clerk is responsible for updating the individual customer volume ratings every six months after preparing the 'sales volume analysis by customer' report. This report is authorised by the sales director prior to updating the customer discounts.
a sales journal summarising all sales invoices is prepared monthly by the computer system. This journal is then used by the trade receivables clerk for posting to the general ledger.
receipts from debtors are passed on to the trade receivables clerk after having been opened by the mail room. The trade receivables clerk lists all receipts from the debtors and then prepares a bank deposit slip. The list prepared by the trade receivables clerk is used to enter the debtorsâ payments on the computer system. The batch total of postings to the individual debtorsâ accounts is balanced to the bank deposit slip before processing occurs on the system. At each month end, the trade receivables clerk prepares a reconciliation of the trade receivables ledger to the debtors control account in the general ledger.
the computer generates an aged analysis at month end based upon all invoices that have been processed onto the system for the period up until the last day of the month.
the financial controller obtains the latest trade receivables aged analysis at the end of each month and reviews all amounts outÂstanding for longer than 90 days. The trade receivables clerk is required to detail reasons for delays in payment by long outstanding debtors and the financial controller discusses items of concern with the clerk.
usually an action plan is agreed for follow-up; this may include involvement of debt collectors or the issuing of writs. Where necessary the financial controller records details of amounts that should be provided for as doubtful debtors. Whilst performing this re view, the financial controller notes the level of individual debtorsâ balances and, in instances where he is uncomfortable with the level of this balance, he instructs the dispatch area to withhold any shipments until a minimum prescribed payment is received.
John Richards your partner on the audit has mentioned to you that, in the past, a substantive approach had been adopted for the audit of GPSA. He now feels that, with the improvements that the client claims to have made to the systems of internal control, an opportunity exists to place reliance on the internal controls and therefore reduce the extent of substantive work.
Required
Write a report, including a brief executive summary, to your managing partner that addresses the questions below. Where indicated, use the required format to answer that question.
Question 1A 8%
Analyse the ratios and additional information associated with the five accounts listed by your audit partner, John Richards. Identify the potential audit risks and any particular audit steps that need to be undertaken to reduce audit risk.
Answer this question using the following headings:
(a) Account (b) Analysis (c) Audit risk (d) Audit steps to reduce risk
Question 1B 2%
Analyse the ratios and additional information to outline business risks that GPSA faces.
Question 2A 7%
Identify the internal controls in the system that are potentially effective, the risk that the control could alleviate and one test of control for each of the identified potentially effective controls.
Answer this question using the following headings:
(a) Effective control (b) Risk alleviated (c) Test of control
Question 2B 2%
List and justify the weaknesses in internal control for sales and trade receivables.
