For each of the items in Problem 1 above, discuss what procedure you would follow to investigate whether the change in the ratio resulted from the normal business event you hypothesized. What other ratios may give you some clues to aid your investigation?

Problem 1

Assume that as an audit manager of a large multinational manufacturer of athletic apparel (e.g., Adidas, Nike, Reebok), you perform high-level preliminary analytical procedures on the unaudited financial statements at the beginning of the audit engagement and discover the following fluctuations:

a. Inventory turnover increased from 2.5 times to 3.75 times.

b. Depreciation expense has been about 2 percent of total assets for several years. This year it was only 1 percent of total assets.

c. Interest expense has been about 6 percent of total debt; this year it was 8 percent.

d. The quick ratio has decreased from 1.45 to 0.95 .

e. Average days payable decreased from 35 days to 29 days.

f. Average days receivable increased from 28 days to 35 days.

g. Return on assets increased from 2.5 percent to 4 percent.

Assuming that each of these is considered material to the audit risk assessment, generate two hypotheses that might explain each change in the client's ratios: one that suggests a normal consequence of business; and one that would suggest increased audit risk.