Question

You are the auditor of Sanders Castillo Ltd, a distributor of griddles and grills. Using the company’s financial report, its budget for the year under review and industry benchmarks, as well as your understanding of the entity, you have compiled the following information:  Sanders Castillo operates in a low gross margin environment, meaning that large volumes are required to cover overhead costs and generate profits. It also means that overheads need to be kept under control to ensure that a net profit results from its operations. Financial gearing also plays a role in keeping interest costs down and maintaining a margin for solvency during economic downturns.  Sanders Castillo did not reach industry benchmarks with regard to profitability in the previous year, and budgeted to better this in the current year. Sanders Castillo’s intended strategy was to keep its costs down in relation to sales, while allowing its gross profit ratio to drop, and plan to generate a large volume of sales.  The company also planned to improve its working capital management by reducing levels of inventory and accounts receivable. It budgeted for a drop in gearing levels, thus indicating that it expected to produce a healthy cash flow to enable it to do so.

Ratio	Actual	Budgeted	Prior Year	Industry
Current ratio	2.02	1.60	1.55	1.80
Quick asset ratio	0.95	0.87	0.93	1.20
Times interest earned ratio	7.20	7.70	7.50	6.85
Debt to equity ratio	0.66	0.44	0.55	0.50
Days in inventory	43.20	32.40	34.30	33.30
Days in receivables	53.20	49.50	51.20	49.20
Gross profit ratio %	8.90	9.40	9.50	9.10
Admin. expenses/Sales %	1.15	1.80	1.87	2.31
Marketing expenses/Sales %	3.31	2.21	2.21	2.55

Required:

1. List the two ratios from the table above that the auditor would be most interested in when planning the audit of Sanders Castillo. Explain why you chose these ratios for each of them.
2. For each ratio you listed in part (a) indicate what general ledger account is primarily affected.
3. For each ratio you listed in part (a) indicate what assertion is most at risk. Explain why you believe this assertion is at risk for each of them.

Answer 1

1. Select two ratios that an auditor would be most interested in and explain why
As an auditor, my main objective is to ensure that the financial statements provide a true and fair view of business affairs to shareholders. Shareholders usually consider, profitability and the operations of a business as very important as these are primary elements for growth. Financial gearing also plays an important role as a higher debt to equity ratio shows a large debt component and this means that a greater chunk of revenue that could have been paid as dividends or reinvested for the company's growth is instead used to pay off interest expense.

I would like to choose gross profit ratio and current ratio, to understand verious elements of business. The gross profit ratio is a great base to understand the operational efficiency of the company and look more carefully into the revneues and costs. From an audit perspective, many companies may want to overstate their revenues or understate their cost to show more profits.
The reason I chose current ratio is because I can check mainly inventory and accounts receivable - 2 very material components of any balance sheet. If the company is planning to reduce its inventories and receivables, it will have to either sell these off or expedite receivable collections and sell on cash basis.

2. What General Ledger A/c is affected
For Gross Profit ratio the main A/c affected would be Sales and various operating expenses (material, labour etc.)
For current ratio the main A/cs that would be affected are all current assets and liabilities especially inventories, accounts receivable, cash and accounts payables.

3. Assertions affected
For Gross Profit ratio, assertions related to income statement are affected
ie. Occurence (whether the recorded sale has actually occured)
Completeness (Are there any sales or expense transactions that are not recorded)
Cut off (only amounts relating to the reporting period have to be recorded in that period)
Classification (Mismatch of revenue and capital expenses is an eg.)
Accuracy of amount
Basically, this ensures that revenues/ expenses are not over/understated to influence porfits

For current ratio Balance sheet assetions are affected
ie. Rights/Obligations (does the company actually have a right on a debtor balance)
Completeness, Classification and Accuracy (refer previous Para)
example, if credit is provided and there is a balance in a debtor's account, it shouldn't be classified as an advance/ loan. Confirmation procedures is an example of an audit procedure to check accuracy and existence of accounts receivable and payables balances