Thornby Inc. has completed its fiscal year on December 31. The auditor, Kim Holm
ID: 2490125 • Letter: T
Question
Thornby Inc. has completed its fiscal year on December 31. The auditor, Kim Holmes, has approached the CFO, Brad Potter, regarding the year-end receivables and inventory levels of Thornby Inc. The following conversation takes place: Kim: We are beginning our audit of Thornby Inc. and have prepared ratio analyses to determine if there have been significant changes in operations or financial position. This helps us guide the audit process. This analysis indicates that the inventory turnover has decreased from 5.1 to 3-8, while the accounts receivable turnover has decreased from 12.5 to 9- I was wondering if you could explain this change in operations. Brad: There is little need for concern. The inventory' represents computers that we were unable to sell during the holiday buying season. We are confident, however, that we will be able to sell these computers as we move into the next fiscal year. Kim: What gives you this confidence? Brad: We will increase our advertising and provide some very attractive price concessions to move these machines. We have no choice. Newer technology is already out there, and we have to unload this inventory. Kim: ... and the receivables? Brad: As you may be aware, the company is under tremendous pressure to expand sales and profits. As a result, we lowered our credit standards to our commercial customers so that we would be able to sell products to a broader customer base. As a result of this policy change, we have been able to expand sales by 28%. Kim: Your responses have not been reassuring to me. Brad: I'm a little confused. Assets are good, right? Why don't you look at our current ratio? It has improved, hasn't it? I would think that you would view that very favorably. Why is Kim concerned about the inventory and accounts receivable turnover ratios and Brad's responses to them? What action may Kim need to take? How would you respond to Brad's last comment?Explanation / Answer
Kim was concerned about the inventory and accounts receivable turnover ratios because
a. Decrease in the inventory turnover ratio shows that Operation cycle has been widened and in the current year, the company were rotated the inventories only 3.8 times in comparison to the last year's 5.1 times. This indicates that the company has less sales in the current year.
b. Decrease in the accounts receivable turnover ratio shows that the collection cycle has been widened to 365/9=41 days in current year from 365/12.5=29 days in last year. This shows that the company has less return on the employed working capital.
Brad has responded to these negative figures with the facts about the sales in the current year and credit policy of the company. The sales has decreased due to the buying holidays of the custormers and introduction of new technology. The negative cash collection is due to providing more credit period to the customer to expand the sales.
The action required on the part of Kim is that the marketing department should be motivated to enhance the sales so that they should not be compled to provide excess credit period to the customer.
Brad was looking the current assets in totality and not looking at inventory and accounts receivables in issolation and in analytical comparitive position. Alongwith the Cash equavilents and Prepaid advances, the current ratio is showing a positive position, so Brad is happy with overall Asset position, particularly the current assets. So, Brad being the CFO of the company should go through the analysis of the balance sheet and provide actual comparitive position before the management.
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