You are the audit manager of a medium-sized firm and have just received a package from Rachel Jones, the financial controller of Futuristic Toys Ltd, a toy manufacturer. This is your firm's first year as auditor of Futuristic Toys. The information shown on the next page was prepared for a board meeting and Rachel felt it might be assist your preparation of the forthcoming audit for the year ended 30 June 2015.
During a brief telephone call with Rachel, you made the following notes:
1) One of the conditions of the long-term loan is that the company is not to exceed a debt-to- equity ratio of 2:1 at any time. The loan is reviewed each year on 30 June.
2) Provision for inventory obsolescence is now a flat rate of 10% of closing inventory. The amount provided in previous years was 20%. Rachel said that the company believes it has been overly conservative in previous years and 10% is a more realistic level, given the nature of its products.
3) The long-term loan receivable is from a company involved in the development and production of computer software. The company is owned by one of the directors.
The 2015 pre-audit financials have been received, together with the actual figures for 2014 and 2013. The details for the Income Statement and Balance Sheet are provided below.
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Futuristic Toys Ltd
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Income Statement
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2015
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2014
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2013
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|
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$'000
|
$'000
|
$'000
|
|
Sales
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72,945
|
74,927
|
89,734
|
|
Cost of sales
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51,840
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51,765
|
63,066
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|
Gross profit
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21,105
|
23,162
|
26,668
|
|
Depreciation
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5,595
|
4,332
|
2,796
|
|
Inventory obsolescence
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1,650
|
2,346
|
1,439
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Marketing expense
|
1,345
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1,980
|
2,548
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Administration
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8,925
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8,727
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11,516
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Interest expense
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1,040
|
1,275
|
1,140
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Total expenses
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18,555
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18,660
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19,439
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Profit before tax
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2,550
|
4,502
|
7,229
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Tax expense
|
918
|
1,621
|
2,386
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Profit after tax
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1,632
|
2,881
|
4,843
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Futuristic Toys Ltd
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Balance Sheet
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2015
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2014
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2013
|
|
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$'000
|
$'000
|
$'000
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|
Current assets
|
|
|
|
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Cash
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1,586
|
1,743
|
830
|
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Inventory
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16,498
|
11,731
|
7,197
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Trade debtors
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12,134
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10,700
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9,323
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Total current assets
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30,218
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24,174
|
17,350
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Non-current assets
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|
|
|
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Property, plant and equipment
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14,606
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12,840
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9,572
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Long-term loan receivable
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5,200
|
3,600
|
3,300
|
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Total non-current assets
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19,806
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16,440
|
12,872
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Total assets
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50,024
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40,614
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30,222
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Current liabilities
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|
|
|
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Trade payables
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9,012
|
6,288
|
2,021
|
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Provisions
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4,875
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3,821
|
4,577
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Total current liabilities
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13,887
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10,109
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6,598
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Non-current liabilities
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|
|
|
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Long-term loan payable
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20,000
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16,000
|
12,000
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|
Total liabilities
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33,887
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26,109
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18,598
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Net assets
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16,137
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14,505
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11,624
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Shareholders' equity
|
|
|
|
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Share capital
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2,000
|
2,000
|
2,000
|
|
Retained earnings
|
14,137
|
12,505
|
9,624
|
|
Total shareholders' equity
|
16,137
|
14,505
|
11,624
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You have obtained the following industry averages:
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2015
|
2014
|
|
Current ratio
|
1.8
|
1.6
|
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Quick ratio
|
1
|
0.8
|
|
Receivables turnover
|
7
|
6.6
|
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Inventory turnover
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3.7
|
3.8
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Gross Profit
|
0.3
|
0.33
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|
Profit after tax
|
0.06
|
0.06
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Return on assets
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0.07
|
0.05
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Return on shareholder equity
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0.11
|
0.13
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Debt to equity ratio
|
2
|
2
|
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Times interest earned
|
4.5
|
5.5
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Required:
(a) Explain the use of ratios in the audit process.
(b) Using the financial data provided perform ratio calculations as part of your preliminary analytical procedures. Present your information in a table format.
(c) Analyse the background information and the results of preliminary ratio analysis to identify and explain three (3) key areas that would require special attention during the audit of the 30 June 2015 financial statements.