University of the West Indies

Internal Auditing
Course Work Assignment

Name:
Student ID#:
Course: Internal Auditing - Financial Accounting

Program/Type:
Question #1
 Mr. Chai 's Trial Balance for year ended April 30th, 2010

DR CR

$ $

Capital 83,887

Sales 259,870

Trade Creditors 19,840

Returns Outwards (Purchase Returns) 13,407

Provision for Bad Debts 512

Discounts Allowed 2,306

Discounts Received 1,750

Purchases 135,680

Returns Inwards (Sales Returns) 5,624

Carriage Outwards 4,562

Drawings 18,440

Carriage Inwards 11,830

Rent, Rates & Insurance 25,973

Heating & Lighting 11,010

Postage, Stationery & Telephone 2,410

Advertising 5,980

Salaries & Wages 38,521

Bad Debts 2,008

Cash in Hand 534

Cash at Bank 4,440

Stock as at May 2009 15,654

Trade Debtors 24,500

Fixtures & Fittings at cost 120,740

Provision for Depreciation - Fixtures & Fittings as at 30th April 2010 63,020

Depreciation 12,074

442,286 442,286

Question #2
 Mr Chai's Trading and Profit and Loss Account for the year ended 30th April, 2010
$ $
Sales 259,870
Less Return Inwards (Sales Returns) (5,624)
Sales Turnover for the period 254,246

Opening Stock
Add Purchases 15,654
135,680
Less Returns Outwards (Purchase Returns) 151,334
(13,407)
Add Carriage Inwards 137,927
11,830
Less Closing Stock 149,757
(17,750)
Less Cost of Goods Sold 132,007
Gross Profit 122,239
Add Trade Discounts Received (non-operating income received) 1,750
123,989

Less EXPENSES
Carriage Outwards 4,562
Discounts Allowed 2,306
Rent, Rates & Insurance 25,973
Less Prepaid - Rates (5,435)
Less Prepaid - Insurance (1,120) 19,418

Heating & Lighting 11,010

Add Accruals - Heating & Lighting 1,360 12,370

Postage, Stationery & Telephone 2,410

Advertising 5,980
Salaries & Wages 38,521
Bad Debts 2,008
Provision for Bad Debts
Adjusted Provision for Bad Debts (3% of Trade Debtors) 223

Adjustment is to make the provision 3% of Trade Debtors - ($24 500 x 3% =

$735). $510 was already provided for thus this would represent an increase
in the provision from ($510 - $735), therefore the additional $223 is the
expense.
Depreciation 12,074
Total expenses 99,872

Net Profit 24,117

Question #2…cont'd
 Mr. Chai's Balance Sheet for the year ended April 30th, 2010
$ $ $ $
Provision for
Depreciation
(Accumulated
Depreciation)
- Fixtures and
Fittings as at
30th April Net Book
Fixed Assets Cost 2010 Value Financed by:

Fixtures and Fittings 120,740 63,020 57,720 Capital 83,887

Add Net Profit 24,117

108,004

Current Assets Less Drawings 18,440

Stock 17,750 89,564

Debtors
Less Adjusted Provision for Bad
Debts ($24 500 - $735 = $23 765) 23,765

Cash in Hand 534

Cash at Bank 4,440

Prepaid Rates 5,435

Prepaid Insurance 1,120

Total Current Assets 53,044

Current Liabilities

Trade Creditors 19,840

Accruals - Heating & Lighting 1,360

Total Current Liabilities 21,200

Working Capital 31,844

89,564 89,564
Question #3
State whether Mr. Chai is able to meet his short term obligations.
Using the Current Ratio which is mainly used to get an idea of the company's ability to pay back its short-term
liabilities using its short-term assets such as cash and stock. The higher the current ratio, the more capable Mr.
Chai would be able to meet his obligations. If Mr. Chai’s current ratio works out to less than 1 this would mean
that he would be unable to pay off his obligations if demanded at this point. Current Assets should be at least
twice the value of the Current Liabilities. The ideal liquidity position is 2:1, this ratio is usually considered to
be an adequate liquidity for most businesses, if not then its cause for concern. The higher the current ratio the
better for his business.

If his current ratio computes to be less than one, this does not mean that his wine business is not in good
financial health and will go bankrupt immediately. He can also turn to the Bank for assistance in the form of a
loan or seek Investors to bail him out. However this is not the best way to go and will not be a good sign for his
business.
The current ratio also measures the level of efficiency of Mr. Chai’s operations or how effective his
Management is able to sell his wine products for cash. If his Stock is not fast moving or if his receivable days
are above the arrangement his business can experience liquidity problems.

Using the Current Ratio or Liquidity Ratio

Current Assets = $ 53,044 = 2.50

Current Liabilities $ 21,200 thus a ratio of 2.5:1

Client's liquidity position is 2.5, thus ratio is 2.5:1 or 2:1. Based on the Current Ratio computation Mr. Chai’s
business can meet its short term obligations. Mr. Chai is in a position to service/meet his Short Term Debts and
still be able to continue to operate on a day to day basis.

The current ratio though a popular means of testing liquidity can be misleading and should not be relied on to
be the sole indicator of liquidity.

Using the Acid Test or Quick Ratio

The acid test ratio though very similar to the current ratio does not use/take into consideration the Stock or
Inventory (wine on stock) to measure Client’s liquidity. This ratio takes into account that the Stock on Hand
may be slow moving and Client not having control over the level with which it will be turned over. It measures
the amount of the most liquid current assets it has to cover liabilities; Stock has to first be sold to reflect a true
picture. The ideal acid test ratio should work out to be at least 1:1.
Current Assets - Stock = $53,044 - $17,750 = 1.66
Current Liabilities $21,200
= 1.7
thus a ratio of 1.7:1

This is a very good sign for Mr. Chai as his acid test ratio is greater than the acceptable 1:1, although the stock
was eliminated from the computation. Thus Mr. Chai would be able to meet his short term obligations even if
his current stock is not sold

Question #4
Comment on the business profitability and liquidity position.

Profitability Position – Mr. Chai

To measure profitability of business profitability ratios are used to assess a business's ability to
generate income compared to its expenses and other relevant costs over a determined period. The ratios
by themselves have no meaning, except when compared with another period to measure how the
business is doing or against a similar type business to gauge trends.

Two such profitability ratios are the Gross Profit Margin ratio or the Net Profit Margin ratios. As
explained, the effectiveness of the ratios most effective when they are compared with another period.

The Gross Profit Margin is the percentage of total sales earned which Mr. Chai will retain after all his
direct costs which are associated with producing his wine. The greater the percentage works out to be
the more Mr. Chai will retain on each dollar of sales to service the other associated costs and expenses.

Computing Mr. Chai’s Gross Profit Margin (GPM) below:

Gross Profit x 100 = $122,239 x 100 = 47.04

Net Sales $259,870
% = 47

To produce 47% Mr. Chai needs to spend 53%, thus this is not a feasible option. It cannot be profitable
to spend so much to produce so little since his Cost of Sales is alarming at 53%. Mr. Chai may want to
re-examine his Current Assets to ensure that his assets are being adequately employed. This could
mean he is holding on to too much of his Current Assets, in his case the Stock and Provision for Bad
Debts. He may want to re-look at the quantity of Stock, which is appears to be slow moving (could be
attributed to the nature of his Stock (wine) which has a higher value the older it cures). As a result he
may want to look at other areas such as:
• Increasing his number of reliable Vendors to reduce his receivables which is also high at
$19K.
• Distributing the price of his Stock according to the maturity
• Re-look at his suppliers and the cost of his Carriages at $11K.
• Growing his own grapes instead of purchasing thus reducing his carriages and returns.
• Approaching a Bank for a loan to construct his own premises since rental is way too high at
$25K. He may also consider purchasing and for a vineyard.

Let’s look at his Net Profit Margin (NPM) computation:

Net Profit x 100 = $24,117 x 100 = 9.28

Net Sales $259,870

% = 9
Again this does not reflect sound profitability; the NPM is low at 9%. Mr. Chai has to examine his
resource optimization, to ensure that they are being adequately employed and evenly distributed. Take
for instance his total expenses which are very high at $99K. The high contributory factors being Rent,
Rates and Insurance at $25K, Heating and Lighting at $11K and the most alarming being Salaries and
Wages at $38K.
It is imperative that he seeks to reduce his total expenses so as to derive higher profitability because
both his Gross and Net Profit margins needs to be improved.

Liquidity Position - Mr. Chai

Based on the Client's liquidity position of 2.5:1 the business can meet its short term expenses. Mr.
Chai is in a good position to service/meet his Short Term Debts and still have additional for
investments and to operate on a day to day basis.

Using the Current Ratio

Current Assets = $ 53,044 = 2.50
Current Liabilities $ 21,200 thus a ratio of 2.5:1
However though both the Current and Quick ratios reflect that the business will be able to cover its
short term obligations both with the high stock and without the stock as in the quick ratios, we saw
where both the Gross and Net Profit Margins reflected that a not so good financial situation and clearly
Mr. Chai will have to re-look at his resource optimization to be able to show a higher profitability in
the next financial year.

Question #5
Is the business asset being optimized? Give reasons for your answer.
Using the Test to determine how much of the Asset contributed to Sales and Net Profit.

Sales x 100 = $ 259,870 x 100 = 215 %

Fixed Asset at Cost $ 120,740

259,5
To test this rationale $ 120,740 x 215% = 91
This proves asset optimization because the resultant figure is very close to Sales and thus his asset is
being used effectively used towards sales.

Using the Test to determine how much of the Asset contributed to Net Profit. and Fixed Assets

Net Profit x
100 = $ 24,117 x 100 = 20 %
Fixed Asset at Cost $ 120,740

To test this rationale $ 120,740 x 20% = 24,148

Fixtures & Fittings is contributing 20% towards the Net Profit. Thus to prove this rationale, it is reflected that
the asset is contributing optimally towards the Net Profit as well.

It is therefore safe to say that Mr. Chai’s Fixtures and Fittings are effectively employed and this can
also result in a reduction in expenses like overtime and increase in the profitability capacity of his
business.

Question #6
Determine the Return on Investment to Mr. Chai.
To measure Mr. Chai’s efficient use of his investment or his Return on Investment we can determine
the cost benefit or return on his investment as a percentage or a ratio as shown below:

Net Profit x 100 = $24,117 x 100 = 29%

Capital $83,887
Mr. Chai’s Percentage Return on Capital Invested in Business = 29%

Mr. Chai's Net Profit is only 29% of Sales, though not so bad he should still try to increase his Net
Profit by reducing some of his expenses, such as Salaries which is very high at $38,520. As Sole
Trader salaries is not justified at such a high figure. Salaries account for more that % of the Total
Expenses.

Its noted that his Rental is also more than his Net Profit, so he may want to try looking for a cheaper
place to rent for his business or purchasing his own property.

He may also want to check the interest rate being offered at his bank to ensure there is not a wide
disparity in the rates and this percentage.

The higher the return on investment the better the business choice is seen. By itself it only shows how
the returns are related to the cost of production. The risk of the investment is not seen here, thus like
the other ratios used in this assignment should not be used in isolation but rather together to give a
holistic view of performance of the business.

References: Internet Readings - Solution Matrix • Cost-Benefit-Analysis

Class Lectures - Financial Accounting