General Accounting 1

7-20 LO 2,3 The following table contains calculations of several key ratios for a fictional company,
Indianola Pharmaceutical Company, a maker of proprietary and prescription drugs.

Indianola Pharmaceutical Company is a small-to medium-sized publicly held pharmaceutical company.

Approximately 80% of its sales has been in prescription drugs; the remaining 20% is in medical supplies
normally found in a drugstore. The primary purpose of the auditor's calculations is to identify potential
risk areas for the upcoming audit.

The auditor recognizes that some of the data might signal the need to gather other industry- or
company-specific data. A number of the company's drugs are patented. Its best-selling drug, Anecillin,
which will come off patent in two years, has accounted for approximately 20% of the company's sales
during the past five years. The auditor's expectation is that the company's own trends from the past few
years should be relatively consistent with this year's trends, and that the company will not have
significant deviations from industry norms.

A. What major conclusions regarding financial reporting risk can you draw from this information? Be
specific in identifying specific account balances that have a high risk of material misstatement. How will
you use this risk analysis in planning the audit? Identify a minimum of four financial reporting risks that
you will address during the audit and discuss how you will address those risks.

b. What other critical background information will you want to obtain when planning the audit? What
information would you gather during the conduct of the audit? Briefly indicate the prob- able sources of
that information.

c. What major actions did the company take during the immediately preceding year?
A…………………………………………………………………………………………………………………………………………………………..

Current Ratio = Current Assets/Current Liabilities

Current Ratio also known as working capital ratio measures the business’s ability to meet its short-term
liabilities when they come due.

Quick Ratio = (Current Assets – Inventory) / Current Liabilities

Quick Ratio measures the company’s ability to pay off its short-term debts using only its most liquid
assets.

Analysis:

There is a noteworthy trend to a diminishing current and the quick ratio that will point toward the
liquidity difficulties intended for company, frequently connecting to the operating difficulties.

Time Interest Earned Ratio = EBITDA / Interest Expense

“EBITDA” earnings before interest, taxes, depreciation, and amortization

Time Interest Earned Ratio measures the company's ability to meet its debt obligations based on its
current income or on a periodic basis.

Analysis:

The Interest coverage has reduced considerably and is significantly lower industry average,
representative that company is susceptible to any decline in operations or alterations in interest rates.
While it might not instantly signal problems as for the remaining on a going concern, it can specify that
such difficulties can faced in the close future.

Days' Sales in Accounts Receivable = Number of days in the year (use 360 or 365) / Accounts
Receivable Turnover Ratio during a past year.

Accounts Receivable Turnover= Net Sales / Average Accounts Receivable

Average Accounts Receivable = (Beginning AR + Ending AR) / 2

The days' sales in accounts receivable ratio (also known as the average collection period) tells you the
number of days it took on average to collect the company's accounts receivable during the past year.

Analysis:

There is an important rise in the number of the day of sales in receivables that is a key danger signal to
any company having this kind of nature. The intensification can reflect probable problems through
quality of product, less severe credit policies, the governmental concerns to the product, unrecorded
product returns, or fictitious sales.
Inventory Turnover Ratio = Cost of Goods Sold/ Average Inventory

Average Inventory = (Beginning inventory + Ending inventory) / 2

Inventory Turnover Ratio is the number of times a company has sold and replenished its inventory over
a specific amount of time.

Analysis:

Inventory turnover is progressively increasing, which reflects the deterioration of major product of the
company and the incapability for introduction of new products in market. It may lead to the problems of
reliability associated to the future operating in addition to inventory problems.

Days Sales of Inventory = (Average Inventory / COGS) x 365

Days Sales of Inventory concept is important in a company's inventory management as it informs

managers on the number of days the stock will last in the stores.

Analysis:

The number of days of sales in inventory is progressively increasing. That is the equally problematic as
the declining in the inventory turnover as recognized above. Certain people discovery that this ratio
superior pictures the problem.

Research & Development to Sales Ratio = R&D expenditure / Total Sales

The Research & Development to Sales ratio is a measure to compare the effectiveness of R&D
expenditures between companies in the same industry. This is measured on a Trailing Twelve Month
basis.

Analysis:

Indianola has progressively decreased the R&D investment, to a present level which is less than the 33
percent in industry average. This signs probable indicate the long-run difficulties to the company, for the
reason that unless fruitful R&D is the main for getting succeeded in a pharmaceutical industry, a
company progresses and fruitfully presents the new products, faces the possible going-concern
difficulties.

Cost of Goods Sold (COGS) as a Percentage of Sales or Revenue = COGS / Total Sales or Revenue

Cost of Goods Sold (COGS) as a Percentage of Sales or Revenue measures the direct cost attributed to
the production of products sold.

Higher COGS results to lower Gross margin which may result to lower net income
Analysis:

Cost of goods sold to percentage of sales appears may be an optimistic development. On supplementary
analysis, nevertheless, there might be clouds in the silver lining too firstly the main production of the
older products as compare to an introduction of the new products or / and second is accounting errors
in the recording of receivables, sales, or inventory.

Debt-to-equity Ratio = Total debt or Total Liabilities / Total Shareholders Equity

Debt-to-equity (D/E) ratio is used to evaluate a company's financial leverage or shows how much debt a
company has compared to its assets.

A higher D/E ratio means the company may have a harder time covering its liabilities.

Analysis:

The debt to equity ratio has improved significantly. There is presence of less interest coverage in this. It
might be also concerns to the debt covenants which might have being violated.

Earnings Per Share (EPS) = (Net Income – Preferred Dividends) / Weighted Average Number of
Common Shares

EPS indicates how much money a company makes for each share of its stock and is a widely used metric
for estimating corporate value.

A higher EPS indicates greater value because investors will pay more for a company's shares if they think
the company has higher profits relative to its share price.

Analysis:

The noteworthy decrease in EPS hampers the ability of company for raising the new capital. The
noteworthy reduction which took place in the former three years might cause the investors for
questioning the ability of the current management. Probable suits might be carried against the
management in case there are marks for mismanagement. The sum and degree of the personal bonuses
or the potential misappropriation of the corporate funds convert to be vital and intensify the awareness
of an auditor of probable abuses and lesser the qualitative materiality intended for the examining
corporate expenditures which provide or reimburse the benefits for the management.

Sales To Tangible Assets Ratio = Net sales/ Tangible or Fixed Assets (or Total Assets- Intangible
Assets)
High sales to fixed asset ratio imply that the business is efficiently using its fixed assets to generate
revenues while a low ratio shows that the fixed assets of the company do not help generate revenue
efficiently.

Analysis:

The sales to tangible asset ratio designates which the company is not able to generate an industry with
normal volume for the assets. This might show presence of extensive idle capacity otherwise that the
new capacity has not up till now gone on line. The implication of new capacity is carried by the rise in
the debt to equity ratio. There might be complications with the capitalization interest or excess capacity
write-offs.

Sales To Total Assets Ratio = Net sales/ Total Assets

The sales to total assets ratio measures the ability of a business to generate sales on as small a base of
assets as possible and is under the asset management ratio category.

Higher sales to total assets ratio it implies that management is able to wring the most possible use out
of a small investment in assets.

Analysis:

The sales to total assets ratio is also less than the industry average. Nonetheless more noteworthy is the
circumstance that it is obviously less as compare to the average of sales to tangible assets. These will
signpost that the company possesses the considerable capitalized intangible assets. The company
operations and profitability are decreasing; there might be considerable valuation problems related to
these intangible assets.

Sales growth = (Current period Net Sales – Prior period Net Sales) / Prior period Net Sales

The positive sales growth rate indicates that your sales and revenues are growing. In contrast, a negative
value shows that your sales and revenues are declining.

Analysis:

Sales growth is improved but less as compare to the industry average. This evidences that the growth is
coming with the poorer credit.

Conclusion:

The previous analysis indicates various areas on that the audit consideration is focused. The company is
traded publicly and the SEC reports are essential. The dependency on one chief product to the patent
about to die, diminished R&D, and reduced operating performance entirely point for probable
realization difficulties. The audit work would likely be altered as under.
• Audit risk would be fixed at the level which is lower than the norm of an industry, imitating the
improved engagement risk related to the client.

• Effort on the specific audit areas extra probable for containing the misstatements for example
receivables and inventory would be lengthened.

• There would be more concentration on the reliability problems, particularly in the intangibles area.

Approach of the audit would display an excessive skepticism deal and would need for corroborating all
the vital management demonstrations.

B…………………………………………………………………………………………………………………………………………………………..

Other the information which may be collected as portion of the audit engagement will comprise the
following.

• Industry product trends analysis counting the competitor products identification and the additional
new product developments through industry journals.

• The position of drugs of the client gives in to for approval through the Food and Drug Administration
and competitor products position

• Client plans regarding the new products and make usage of new capacity by management.

• Management's strategy, operating plans, and budget to deal with the current problems.

• Financial adviser’s correspondence regarding the loan covenants, debt structuring, and so on such as
company files review, financial advisers approval.

• Management analysis and strengthen of internal and external control, legal compliance, control over
risk and any transaction or activities that affects the business operation and etc.

C
…………………………………………………………………………………………………………………………………………………………..

Current ratio decreases slightly by 0.04 which may indicate that there was an increased in current debts
incurred by the company or the currents assets has decreased due to usage or increased in expenses
incurred.

Quick ratio decreases slightly by 0.08 which may indicate that either the company increases it’s
inventory or non liquid assets by purchases or its current debts incurred are increased by purchasing
nonliquid asset on account.
Time Interest Earned Ratio decreases by 0.59 which may indicates that EBITDA “earnings before
interest, taxes, depreciation, and amortization” may had decreased due to decrease in sales or there
was a significant increased in interest expense caused by the current period transactions.

Conclusion:

Actions which are taken in the previous year will probably have comprised of the following.

• A chief issuance for debt reflected in debt to equity ratio.

• The purchase of a new company or of new intangible assets imitated in the reduction in the sales to
total assets ratio that has diminished additional than the sales to tangible assets ratio. This likelihood is
proved by the growth 15 % in sales as compared to the earlier year, the growth considerably more than
the prior finest year growth by 4 percent.

• A chief sale difficult might be present with noteworthy increases in the number of day's sales in
inventory growing imitating certain panic thinking at the company part.