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Auditing: Pinnacle Manufacturing Company

Year-to-Year Change Trend Analysis

Account balance % change 2012 – 2013 % change 2011 – 2012
Net sales 1.45% 2.70%
Cost of goods sold 2.85% 4.18%
Operating expenses -2.51% 2.40%
Income from operations 1.87% -23.10%
Net receivables 51.30% 8.61%
Inventory 26.23% 1.05%
Account payable 37.09% 24.71%
Long-term debt 9.30% -0.17%

Debt to Equity, Net Income Before Tax/Sales, Gross Margin Percentage, and
Inventory Turnover Calculations

Ratio 2013 2012 2011
Current ratio 1.75 1.93 2.19
Debt to equity 90.5% 73.9% 70.8%
Net income before taxes / sales 1.39% 1.28% 2.11%
Gross margin 27.50% 28.49% 29.51%
Inventory turnover 3.8 4.2 4.0

Observations About Pinnacle’s Business

There was growth in both net sales and cost of sales in 2012 and 2013. Further, the increase in cost of sales is higher than that of sales. This explains the decline in gross profit margin. There was also a drop in operating expenses by 2.51% in 2013. This led to growth in income from operations by 1.87% in 2013. The ratio of net income before tax to sales indicates that the company is profitable.

The current ratio decreased. It shows a decline in liquidity. The values of the ratio are high and the decline is not a cause of concern. Net receivables and inventory grew by a large percentage in 2013. An increase in receivables shows that the company is experiencing a problem in collecting debts. Increase in inventory may cause an increase in handling costs and obsolescence. It also causes a drop in inventory turnover ratio. The debt to equity ratio grew and it is not a cause of concern.

Common Size Income Statement

2013 2012 2011
Sales 100.00% 100.00% 100.00%
Sales Returns and Allowances 0.12% 0.12% 0.12%
Cost of Sales* 72.41% 71.43% 70.40%
Gross Profit 27.47% 28.45% 29.48%
OPERATING EXPENSES-Allocated
Salaries-Management 1.51% 1.61% 1.58%
Salaries-Office 0.21% 0.20% 0.21%
Licensing and certification fees 0.13% 0.12% 0.11%
Security 0.36% 0.43% 0.44%
Insurance 0.06% 0.07% 0.07%
Medical benefits 0.02% 0.02% 0.02%
Advertising 0.11% 0.12% 0.11%
Business publications 0.00% 0.00% 0.00%
Property taxes 0.01% 0.12% 0.12%
Bad debts 0.56% 0.70% 0.68%
Depreciation expense 3.54% 3.12% 3.02%
Accounting fees 0.18% 0.20% 0.21%
Total operating expenses-Allocated 6.69% 6.70% 6.58%
OPERATING EXPENSES-Direct
Salaries-Sales 9.92% 10.30% 10.29%
Wages Rental 0.33% 0.40% 0.40%
Wages-Mechanics 0.74% 0.90% 0.92%
Wages-Warehouse 3.24% 3.59% 3.78%
Garbage collection 0.02% 0.02% 0.03%
Payroll benefits 1.76% 1.97% 2.00%
Rent- Warehouse 0.53% 0.51% 0.52%
Telephone 0.02% 0.03% 0.04%
Utilities 0.17% 0.18% 0.19%
Postage 0.06% 0.09% 0.10%
Linen service 0.01% 0.01% 0.01%
Repairs and maintenance 0.11% 0.11% 0.12%
Cleaning service 0.06% 0.05% 0.05%
Legal service 0.26% 0.13% 0.11%
Fuel 0.19% 0.23% 0.19%
Travel and entertainment 0.07% 0.07% 0.07%
Pension expense 0.15% 0.16% 0.09%
Office supplies 0.10% 0.10% 0.12%
Miscellaneous 0.20% 0.07% 0.10%
Total operating expenses-Direct 17.94% 18.94% 19.13%
Total Operating Expenses 24.63% 25.63% 25.71%
Operating Income 2.83% 2.82% 3.77%
Other Expense-Interest 1.45% 1.55% 1.66%
Income Before Taxes 1.39% 1.28% 2.11%
Federal Income Taxes 0.59% 0.58% 0.93%
Net Income 0.80% 0.70% 1.19%

Accounts With Concern About Material Misstatements

Account Estimate of dollar amount of potential misstatement
Depreciation expense The expense increased by $694,801. This increase is partly due to growth in property, plant and expense but it appears overstated.
Property taxes The expense declined by $155,424 despite the increase in balance of properties. It is an indication of misstatement.
Federal income tax The FIT as a percentage of net income before tax is 45.21% in 2012. Thus, FIT is expected to be $947,585.19 in 2013. It indicates an understatement by $64,148.

Conclusion

The information in part d and e is appropriate for investigating the potential misstatements in all accounts except direct expenses. For the direct expenses, it is suitable to use the accounting information for each division.

There is a low probability that the company will fail financially in the next twelve months. The company has been profitable and there are no indications of financial difficulties. Some ratios such as debt to equity and current ratios were declining but they are not a cause of concern.