1) Eight analytical procedures for both the years 2017 and 2018 to help identify the potential audit risks relevant to TFW
Based on the Balance Sheet and Income statement provided for the year 2018 for Top Fashion Warehouse Limited (TFW), the analytical procedures for the company showed the following results in the shape of financial ratios.
Short-term Liquidity Ratios:
These are the ratios which show the ability of the firm to fulfill its financial obligations as they become due. These ratios show the ability of the company to pay its short-term dues in time (Palepu & Healy, 2007). The ratios computed under this category are.
Current Ratio:
The current ratio of TFW shows that the company’s ability to fulfill its short-term obligations has declined in 2018 as compared to last year. It is because of the considerable increase in the current liabilities of the company. One important component here is the deferred revenue, which has been accounted for as a current liability in 2018. Other than that, provisions account has also increased substantially in 2018. Furthermore, the ratio is also lower than the one showing that liabilities are greater than current assets.
Acid Test Ratio:
The Acid test or quick ratio for TFW shows the similar story as the current ratio. The comparison of the quick and current ratio shows that about half of the current assets of the company is tied in inventory. Thus, it is not a good position regarding short-term liquidity of the company.
Activity Ratios:
The activity ratios show the operational efficiency of the company. The ratios computed under this category are.
Inventory Turnover Ratio:
This ratio shows how many times TFW has sold and replaced its whole inventory in the year 2017 and 2018. The year 2017 seems to be better as the company has replaced its inventory about 1 more time as compared to 2018. The declining inventory turnover can signal the unexpected lower sales demand for the company. It shows the company can be holding the inventory for a long time.
Account Receivable turnover:
This ratio is important to see how efficiently TFW is issuing credit to its clients and then collecting funds against it in a timely fashion. The declining account receivable turnover implies that TFW sees more delinquent clients and its efficiency in processing credit is declining. The deferred revenue account in 2018 shows a similar scenario.
Profitability Ratios:
Profitability ratios are used to show the profitability of the operations of TFW. The ratios used are.
Profit Margin:
The profit margin of TFW is extremely low. It forgoes most of its earned revenue in expenses and costs. Only 2 to 3% of the whole earned amount remains as income. However, it is to be noted that profitability has increased from 1.59% to 2.44%. It is because of the better gross profit margin, which shows TFW has reduced its cost of sales.
Gross Profit Margin:
The Gross profit of the company is around 25% to 27%, which is also very low. The company forgoes about 75% of its revenue in its cost of sales. Even though the company has reduced it in 2018 by 1%, it is still very high.
Solvency Ratios:
The solvency ratios show the long-term solvency of the company. It shows if TFW would be able to meet its long-term obligations. The ratios conducted are.
Debt to Equity Ratio:
The debt-to-equity ratio of the company is an important indicator of the dependency of the company financing of equity and debt financing. The company TFW has a debt-to-equity ratio of 0.55 in 2017. It should be lower than 0.5. However, it goes as high as 0.98 in 2018 which is very concerning to note. The company is about 98% dependent on debt financing in 2018. It shows the vulnerability of the company because if its sales decline, it won’t be able to meet its long-term financing obligations (Tracey, 2012).
Debt Ratio:
Like Debt-to-Equity ratio, this ratio also shows a similar scenario. TFW has increased its dependency on debt financing by more than 40% in one year showing that TFW has been aggressive in financing its growth with debt sources of funds. It is a sign of high risk for the company.
2) TWO KEY inherent risk factors that arise from the nature of TFW’s business operations and explain why they are risks specific to TFW
Inherent Risks:
Inherent Risks are just one component of the audit risk. It shows the risk of arriving at the wrong audit conclusion because of the nature of the business of TFW. This risk is posed by factors other than the ones which are under the control of TFW. It occurs mostly when there are complexities in the transactions reporting or ambiguity involved in estimation and judgment (Gray & Manson, 2007). The business of TFW poses inherent risks of;
Rapid Change in consumer tastes:
The nature of the business of TFW depends highly on the fashion trends revolving at the time. The inventory can become obsolete in months if a new fashion trend replaces the old one. The company has to be aware of the changes in consumer preferences and latest fashion trends ahead of its time to manufacture the clothing lines which do not become quickly obsolete.
Availability of financing:
Another external factor which is important for TFW is its interest rates and the availability of financing. The company has recently put on a high-interest long-term liability which has shifted its debt ratio to 98%. Other than this, the company is also not in a condition to adequately compensate for its short-term obligations. In worst conditions, the lack of availability of low-interest rate loan in the future can become a difference between its staying in or out of business.
3) Four key accounts at risk and explain why they represent a significant audit risk
Account Receivable:
The company TFW has shown that it sells clothing to department and boutique stores. However, the credit terms for both are different. The Boutique has a 30-day credit term while the department stores have 60-day credit terms. It shows that the account receivable account can have any material misstatements in light of the assumption that the complexity of the credit terms and types of receivables can become a reason of misjudgment or error in reporting posing a material audit risk.
Allowance for doubtful debts:
The company allowance for doubtful debts has been increasing considerably in three years as compared to its account receivable account. Furthermore, TFW is likely using a lump-sum amount without needed analysis to allocate on the bad debts account as depicted from the figures. It added 90000 in 2017 and 40000 in 2018 to this account.
Deferred Revenue:
It is one important account which shows that the company revenue has been deferred for some reason which has been reported in 2018 with a much significant amount as well. The company here is using the deferred revenue expenditure account to report the revenue incurred during this period, however its benefits would be derived in the future accounting periods. It shows that the company sales revenue account consists of a section of revenue, which is going to be derived in future periods. However, it has been reported in this period as well. The complexity of this reporting poses higher audit risk.
Provisions:
Provisions are the account which is used to set aside a portion of cash from profits to business to cover any future known liability or for depreciation of the asset. The ambiguity of the nature of this account and the considerable increase in it in 2018 makes it key account for audit risk.
4) Identify the key assertion at risk
Audit assertions:
Account Receivable:
The assertion type for this account is classification. The management is claiming that all transactions in this account have been classified and reported fairly in the statements.
Allowance for Doubtful Debts:
The assertion for this account is that of occurrence and accuracy. The management is claiming that all transactions that are recognized have occurred in this period and relate to TFW, while it is also recorded accurately.
Deferred Revenue:
The assertion for this account is that of Cut-Off, as the management is claiming that all transactions recorded in this period are recognized in the correct period in which they are incurred.
Provisions:
For this key account, the assertion which should be audited is that the management is claiming that the provisions recorded are accurate, cut-off and occurred related to an entity.
(Whittington & Delaney, 2011)
References:
Gray, I., & Manson, S. (2007). The Audit Process: Principles, Practice and Cases. Cengage Learning.
Palepu, K. G., & Healy, P. M. (2007). Business Analysis and Valuation. Cengage Learning.
Tracey, A. (2012). Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet. Ratio Analysis.net.
Whittington, O. R., & Delaney, P. R. (2011). Wiley CPA Exam Review 2012, Auditing and Attestation. John Wiley & Sons.
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