Question

Marilyn Terrill is the senior auditor for the audit of Uden Supply Company for the year ended December 31, 20X4. In planning the audit, Marilyn is attempting to develop expectations for planning analytical procedures based on the financial information for prior years and her knowledge of the business and the industry, including these:

1. Based on economic conditions, she believes that the increase in sales for the current year should approximate the historical trend.

2. Based on her knowledge of industry trends, she believes that the gross profit percentage for 20X4 should be about 2 percent less than the percentage for 20X3.

3. Based on her knowledge of regulations, she is aware that the effective tax rate for the company for 20X4 has been reduced by 5 percent from that in 20X3.

4. Based on a review of the general ledger, she determined that average depreciable assets have increased by 10 percent. Purchases of equipment occurred relatively evenly throughout the year.

5. Based on her knowledge of economic conditions, she is aware that the effective interest rate on the company’s line of credit for 20X4 was approximately 12 percent. The average outstanding balance of the line of credit is $3,500,000. This line of credit is the company’s only interest-bearing debt.

6. Based on her discussions with management the advertising and sales commission percentages are expected to stay the same. Based on her knowledge of the industry, she believes that the amount of other expenses should be consistent with the trends from prior years.

Comparative income statement information for Uden Supply Company is presented in the below table.

UDEN SUPPLY COMPANY

Comparative Income Statements

Years Ended December 20X1, 20X2, and 20X3

(Thousands)

20X1 Audited 20X2 Audited 20X3 Audited 20X4 Expected

Sales 12,300 13,100 13,900

Cost of goods sold 8,490 9,050 9,620

Gross profit 3,810 4,050 4,280

Sales commissions 860 920 970

Advertising 246 260 280

Salaries 1,121 1,154 1,187

Payroll taxes 196 201 206

Employee benefits 179 184 189

Rent 72 75 78

Depreciation 72 75 78

Supplies 38 41 44

Utilities 33 36 39

Legal and Accounting 46 49 52

Miscellaneous 24 27 30

Interest Expense 354 372 384

Net income before taxes 569 656 743

Income taxes 128 148 167

Net income 441 508 576

Required:

b. Determine the expected amounts for 20X4 for each of the income statement items. (Round gross profit ratio and income taxes ratio to nearest four decimal places. Round other ratios to nearest two decimal places. Round all other intermediate computations to the nearest whole value. Enter your answers in thousands.)

c. Uden’s unaudited financial statements for the current year show a 30.79 percent gross profit rate. Assuming that this represents a misstatement from the amount that you developed as an expectation, calculate the estimated effect of this misstatement on net income before taxes for 20X4. (Enter your answers in thousands.)

Answer 1

Part (b)

	Linkage	20X1	20X2	20X3		Assumption for 20X4
Gross profit ratio	B / A	0.3098	0.3092	0.3079		Figure for 20X3 - 2% = 0.2879
Sales commission ratio	C / A	0.07	0.07	0.07		0.07
Advertising ratio	D / A	0.02	0.02	0.02		0.02
Income tax ratio	F / E	0.22	0.23	0.22		Figure for 20X3 - 5% = 0.17
		20X1	20X2	20X3	20X4	How figure for 20X4 has been calculated?
Sales	A	12,300	13,100	13,900	14,700	Annual increase is 800; add 800 to 20X3 figure
Cost of goods sold		8,490	9,050	9,620	10,468	First calculate gross profit as per next line, this figure = Sales - Gross profit = 14,700 - 4,232
Gross profit	B	3,810	4,050	4,280	4,232	Sales x 0.2879
Sales commissions	C	860	920	970	1,029	14,700 x 0.07
Advertising	D	246	260	280	294	14,700 x 0.02
Salaries		1,121	1,154	1,187	1,220	Annual increase is 33; add 33 to 20X3 figure
Payroll taxes		196	201	206	211	Annual increase is 5; add 5 to 20X3 figure
Employee benefits		179	184	189	194	Annual increase is 5; add 5 to 20X3 figure
Rent		72	75	78	81	Annual increase is 3; add 3 to 20X3 figure
Depreciation		72	75	78	86	10% growth over 20X3 figure
Supplies		38	41	44	47	Annual increase is 3; add 3 to 20X3 figure
Utilities		33	36	39	42	Annual increase is 3; add 3 to 20X3 figure
Legal and Accounting		46	49	52	55	Annual increase is 3; add 3 to 20X3 figure
Miscellaneous		24	27	30	33	Annual increase is 3; add 3 to 20X3 figure
Interest Expense		354	372	384	420	Average loan x interest rate =3500000*12% = 420,000; express in thousands
Net income before taxes	E	569	656	743	521	Gross profit - all expenses
Income taxes	F	128	148	167	91	0.17 x net income before taxes = 0.17 x 521
Net income		441	508	576	430	Net income before taxes - income taxes

Part (c)

Gross profit will be overstated. Gross profit = 30.79% x Sales = 30.79% x 14,700 = $  4,526

Overstatement in gross profit = 4,526 - 4,232 (calculated in the table above) = $ 294

Overstatement in net income before taxes of 20X4 = Overstatement in gross profit = $ 294

Hence, net income of 20X4 will be overstated by $ 294 (expressed in thousands)