Student Forums CIA Part 2: Practice of Internal Auditing Section III: Performing the Engagement 42. Question ID: CIA 595 1.50 (Topic: 2D. Apply Analytical Review Techniques)

42. Question ID: CIA 595 1.50 (Topic: 2D. Apply Analytical Review Techniques)

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  • #237850

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    This forum is restricted to members of the associated course(s).

    Denny Benjamin
    Participant

    Hi Brian,

    The suggested answer to the question “Which of the following would not explain the decrease in cost of goods sold as a percentage of sales ratio? The division” is :

    B. Liquidated inventory in conjunction with a plan to bring its current ratio more in line with the industry average.

    The explanation for the answer states “This is not a potential explanation because (1) there has been an increase in inventory, and (2) a liquidation would have resulted in a write-down of the costs of inventory which would have caused the ratio to move the other way.”

     

    Can you explain which ratio shows an increase in inventory?  Is it the quick ratio? 

    Doesn’t the lower days in inventory mean there is more efficient management of inventory?

    Additionally, what is the reason for the decrease in net income?  Is it due to factors not mentioned in the table? Couldn’t lower COGS lead to an increase in net income?

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  • #237853

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    Lynn Roden
    HOCK international

    Hello Denny Benjamin,

    1 – “Can you explain which ratio shows an increase in inventory? Is it the quick ratio?”

    The Days Sales in Inventory increased from 92 in 2008 to 148 in 2010. That would be due to either a large increase in inventory or a large decrease in sales, or some of both. The quick ratio would not be affected by any change in inventory, since inventory is not included in the calculation of the quick ratio.

    2 – “Doesn’t the lower days in inventory mean there is more efficient management of inventory?”

    A lower Days Sales in Inventory can mean there is more efficient management of inventory, or it can mean something else. For example, there may be shortages in the market and the company has not been able to obtain some inventory items, resulting in inventory outages. However, I am not sure why you say there is a lower Days Sales in Inventory. The Days Sales in Inventory increased from 92 in 2008 to 148 in 2010. It did not decrease.

    3 – “Additionally, what is the reason for the decrease in net income? Is it due to factors not mentioned in the table? Couldn’t lower COGS lead to an increase in net income?”

    Yes to both. You are correct that lower COGS should increase net income, assuming sales have held steady or increased, which it appears is the case since the sales growth is positive from year to year. You are also correct that there must be other information not shown in the table that might explain the decrease in net income. For example, no information on selling and administrative expenses is given, and that expense may have increased. Or, the company may have recorded a loss on the sale of an asset that decreased net income without decreasing operating income.

    Does that answer all your questions?

    Lynn

    #237863

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    Denny Benjamin
    Participant

    Thanks Lynn for your response.

    1. Oops.  I got the question wrong. 
    2. I was looking at 2009 to 2010 where there was a decrease in Day sales in Inventory from 167 to 148.
    3. Yes I have an additional question.   How do you deduce that there has been an increase in inventory from the figures in the table?  Is it because from 2009 to 2010, there is an increase in Current Ratio from 1.89 to 1.94 and a decrease in Quick Ratio from 0.88 to 0.66?

    Thanks 

    Denny 

     

    #237873

    This forum is restricted to members of the associated course(s).

    Lynn Roden
    HOCK international

    Hello Denny Benjamin,

    Actually, it is really hard to tell what is going on just based on the information given. The actual numbers are not given, and the ratios that are given seem to be contradictory.

    We can see that the Days Sales in Inventory increased between 2008-2009 from 92 in 2008 to 167 in 2009. That could be due to a large increase in Inventory or a large decrease in Sales, or some of both. However, the Sales Growth as given in the table for 2009 is a positive 0.16 or 16%, so the increase in Days Sales in Inventory from 2008 to 2009 is probably not due to a decrease in Sales. That leaves an increase in Inventory for 2009 as the cause.

    However, from 2009-2010, Days Sales in Inventory decreased from 167 to 148. That could be due to a decrease in Inventory or an increase in Sales, and Sales Growth is given as a positive 0.03 or 3% for 2010. So it may be that Inventory did not change much in 2010 while Sales increased. However, it is hard to tell without being able to see the actual values of Inventory on the balance sheet and Sales on the income statement. But comparing 2010 to 2008, probably Inventory was higher in 2010 then it was in 2008.

    You are correct that Inventory is the largest item that is different between the numerator of the Current Ratio and the numerator of the Quick Ratio. An increase in the Current Ratio coupled with a decrease in the Quick Ratio would lead to a conclusion that probably Inventory increased. That happened between 2009-2010, but it did not happen between 2008-2009. Both the Current Ratio and the Quick Ratio decreased from 2008-2009, so not much can be concluded from that about a change in Inventory in 2009. But from 2009-2010, the Current Ratio increased whereas the Quick Ratio decreased, so that could suggest that perhaps Inventory increased in 2010.

    However, the conclusions drawn from looking at the Current Ratio and Quick Ratios contradict the conclusions drawn from looking at the change in Days Sales in Inventory between 2008-2009 and between 2009-2010.

    Days Sales in Inventory: 2009 – Inventory increased; 2010 – Inventory unchanged

    Current and Quick Ratios: 2009 – Inventory change inconclusive; 2010 – Inventory increased

    So it is hard to tell exactly what is going on by just looking at the ratios. To really analyze the financial statements, you would need to see the actual statements. And the contradictory conclusions may suggest some kind of error or other problem that needs to be investigated further by the internal auditor.

    Lynn

    #237980

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    Denny Benjamin
    Participant

    Thank you Lynn.

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