Horizontal analysis refers to changes in financial statement numbers and ratios across two or more years. Vertical analysis refers to financial statement amounts expressed each year as proportions of a base, such as sales for the income statement accounts, and total assets for the balance sheet accounts.

Exhibit EP 7-4–1 contains the Retail Company’s prior year (audited) and current year (unaudited) financial statements, along with amounts and percentages of change from year to year (horizontal analysis) and common-size percentages (vertical analysis).

Exhibit EP 7-4–2 contains selected financial ratios based on these financial statements. Analysis of these data may enable auditors to discern relationships that raise questions about misleading financial statements.

Required:

Study the data in Exhibits EP 7-4–1 and EP 7-4–2. Write a memo identifying and explaining potential problem areas where misstatements in the current year financial statements might exist.

Additional information about Retail Company is as follows:

• The new bank loan, obtained on July 1 of the current year, requires maintenance of a 2:1 current ratio.

• Principal of $100,000 plus interest on the 10% long-term note obtained several years ago in the original amount of $800,000 is due each January 1.

• The company has never paid dividends on its common shares and has no plans for a dividend.

EP 7-4–1

EP7-4–2

Cheque numb Front SMITH &CHANG DEVELOPERS, INC 4270 Regal Road Scarborough, Ontario M1M 1R6 1038 August 21, 20X3 PAY TO THE ORDER OF Mech anical Parts, Inc Four Hundred Sevent ,100 $470.00 Re Earnest Money Contract DOLLARS Smith & Chang Developers, Inc THE BANK OF NOVA SCOTIA 2479 KINGSTON ROAD AT MIDLAND SCARBOROUGH, ONTARIO M1M 1V4 PER PER Cheque number Transit number identifies drawee bank Bank identification number (parent bank) Drawee's account number Bank where deposited (Date, bank name, bank transit number) Back Payee endorsemen ROYAL BANK OF CANADA MISSISSAUGA, ONTARIO 114911 Sept 3 X3 -