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