The following situations represent errors and irregularities that can occur in financial statements.
Your requirement is to state how the ratio in question would compare (greater, equal, or less) to what the ratio “should have been” had the error or irregularity not occurred.
a. The company recorded fictitious sales with credits to sales revenue accounts and debits to accounts receivable. Inventory was reduced and cost of goods sold was increased for the profitable “sales.” Is the current ratio greater than, equal to, or less than what it should have been?
b. The company recorded cash disbursements paying trade accounts payable but held the cheques past the year-end date—meaning that the “disbursements” should not have been shown as credits to cash and debits to accounts payable. Is the current ratio greater than, equal to, or less than what it should have been? Consider cases in which the current ratio before the improper “disbursement” recording would have been (1) greater than 1:1, (2) equal to 1:1 and (3) less than 1:1.
c. The company uses a periodic inventory system for determining the balance sheet amount of inventory at year-end. Very near the year-end, merchandise was received, placed in the stockroom, and counted, but the purchase transaction was neither recorded nor paid until the next month. What was the effect on inventory, cost of goods sold, gross profit, and net income? How were these ratios affected, compared with what they would have been without the error: current ratio, return on beginning equity, gross margin ratio, cost of goods sold ratio, inventory turnover, and receivables turnover?
d. The company is loath to write off customer accounts receivable, even though the financial vice-president makes entirely adequate provision for uncollectible amounts in the allowance for bad debts. The gross receivables and the allowance both contain amounts that should have been written off long ago. How are these ratios affected compared with what they would be if the old receivables were properly written off: current ratio, days’ sales in receivables, doubtful account ratio, receivables turnover, return on beginning equity, working capital/total assets?
e. Since last year, the company has reorganized its lines of business and placed more emphasis on its traditional products while selling off some marginal businesses merged by the previous go-go management. Total assets are 10% less than they were last year, but working capital has increased. Retained earnings remained the same because the disposals created no gains, and the net income after taxes is still near zero, the same as last year. Earnings before interest and taxes remained the same, a small positive EBIT. The total market value of the company’s equity has not increased, but that is better than the declines of the past several years. Proceeds from the disposals have been used to retire long-term debt. Net sales have decreased 5%, because the sales decrease resulting from the disposals has not been overcome by increased sales of the traditional products. Is the discriminant Z score (see Appendix 5A) of the current year higher or lower than that of the prior year?