Question

Activa Leisure Co. (ALC), a retailer of high-quality activewear, has been considering a number of different expansion opportunities in recent years. One option is to purchase Quantum Athletics (Quantum), a manufacturer and distributor of sporting good equipment. The company's sole shareholder is Mike. Quantum's manufacturing facility is in Winnipeg, and it has sales and distribution branches in Mississauga, Ontario, and in Montreal.

ALC is considering the acquisition to expand into this market. However, before moving any further with this idea, ALC has requested an audit of Quantum. Clarke and Lunn Chartered Professional Accountants (CL) have been engaged to perform the year-end audit. You, CPA, are the audit manager on the Quantum year-end audit and are meeting with Mike to discuss the results for the year. Mike has brought the company's draft financial statements to your office (see Exhibit I).

Mike: It has been a challenging year. Most of our customers are in Ontario and Quebec. This year, we began selling into the United States (U.S.) and Brazil. We attended major trade shows in the U.S. and Brazil early in the year to promote our company and products. It was the first time we had attended these types of events, and the related travel and advertising costs were over $40,000.

We received a number of orders, and in anticipation of the increased demand, we purchased raw materials. Things were looking great and then there was a financial crisis. Demand for sporting equipment fell dramatically. In order to remain competitive, we had to reduce our selling prices; even so, a number of our customers have gone bankrupt or are having significant difficulty. I have been really busy and have not spent much time following up with customers and reviewing their outstanding balances.

At the same time, the bank imposed a new covenant requiring that the debt-to-equity ratio remain below 1.0. To avoid any staff reductions, the administrative staff agreed to take a week off without pay and forgo raises for the year. In addition, although I received a $75,000 bonus last year, I didn't take a bonus this year. Unfortunately, one of our main pieces of manufacturing equipment unexpectedly broke down during the year, and we incurred close to $30,000 in costs to repair it.

Exhibit I Quantum Athletics Balance sheets As at December 31 (Prepared in accordance with ASPE) Current year (draft —prepared by management)                             Prior year                               (audited) Assets Current assets: Cash $1,140 $16,635 Accounts receivable 377,602 252,477 Inventory 283,906 195,632 Prepaid expenses 26,744 30,611 689,392 495,355 Property, plant, and equipment (net) 1,840,415 1,788,420 $2,529,807 $2,283,775 Liabilities and shareholders' equity Current liabilities: Demand bank loan $61,600 $65,100 Accounts payable and accruals 319,720 295,793 Income taxes payable 402 638 Current portion of term bank loan 28,000 28,000 409,722 389,531 Term bank loan 658,000 686,000 1,067,722 1,075,531 Share capital 1,000 1,000 Retained earnings 1,461,085 1,207,244 $2,529,807 $2,283,775

Quantum Athletics Statements of income and retained earnings For the years ended December 31 (Prepared in accordance with ASPE) Current year (draft — prepared by management)                             Prior year (audited) Sales $2,791,275 $2,705,030 Cost of sales 1,396,238 1,379,658 Gross profit 1,395,037 1,325,372 Expenses: Amortization 214,105 249,866 Bad debts 11,060 14,004 Interest and bank charges 83,748 93,488 Professional fees 34,221 5,060 Repairs and maintenance 70,530 20,535 Salaries and wages 527,063 553,040 Selling, general, and administrative 142,242 189,273 Income before taxes 312,068 200,106 Income taxes 58,227 34,088 Net income 253,841 166,018 Retained earnings, opening 1,207,244 1,041,226 Retained earnings, closing $1,461,085 $1,207,244

Required

You are beginning the risk assessment for the upcoming audit of Quantum. Perform a year-over-year comparison of key ratios including accounts receivable turnover, inventory turnover, current ratio, gross profit margin, and debt to equity, and identify accounts that are at a risk of material misstatement and would warrant further investigation during the audit, given the changes in ratios and considering the provided case facts. In addition, include a procedure to address the identified risks.

A FULL RESONSE MUST ADDRESS ALL OF THESE ELEMENTS. YOUR AUDIT PARTNER IS LAZY, AND WILL NOT READY ANYTHING PAST 5 PAGES IN LENGTH.

Answer 1

Comparison of key ratios

Ratio Current year    Prior year Variaton

1) Accounts receivables ratio = Net credit sales = 2791275 =    2705030

average receivables 377602 252477

= 7.392 : 1 = 10.713 : 1    -3.321:1

2) Inventory turnover ratio = Cost of goods sold =  1396238 =   1379658

average inventory 283906 195632

= 4.917 : 1 = 7.0623 :1 -2.145 :1

3) Current ratio = Current asset = 689392 = 495355

Current liabilities 409722 389531

=1.682:1 = 1.271 : 1 0.411:1

4) Debt- Equity ratio = Debt = 658000 = 686000

Equity 1462085 1208244

=0.45:1 = 0.567 : 1 -0.117:1

5) Gross profit margin ratio = gross profit * 100 = 1395037 = 1325272

Net sales   2791275 2705030

= 49.9%    = 48.9%      1%

Here in this case accounts receivables ratio decreases by 3 which shows a poor turnover of receivables into cash . And Inventory turnover ratio decreases by 2 which shows that inventories being converted into cash take longer period than prior period which is not favourable . the ratio of current assets to current liabilities increases which shows a better performance, means company can pay off their current liabilties via current assets in a easy way as they have plenty of current assets to pay off their curent liabilities. and our ideal current ratio is 2:1 so our companys ratio is turning into favourable posotion.

Debt- equity ratio is decreasing which is an unfavourable as ideal debt- equity ratio is 2:3 and our ratio is decreasing which shows that we are less dependent on creditors and more on equity. variation in gross profit margin ratio is very less which is a good sign infact there 1% increase in gross profit ratio which ius favourable.

Risks could be there in inventory lag and creditors lag as well, which means our money can loose money and more of bad debts may be created.