Just For Feet Inc.
Q1. Prepare common-sized balance sheets and income statements and compute key ratios for 1997-1998. What were the high-risk financial statement items for the 1998 audit?
* Common-sized financial statements:
* Key ratio analysis:
Liquidity and solvency:| 1999| 1998| 1997|
Current ratio| 3.387 | 1.998 | 2.142 |
Debt to equity| 1.117 | 0.672 | 0.720 |
Times interest earned| 6.376 | 24.665 | 28.286 |
Activity| | | |
AR turnover| 44.641 | 42.749 | 39.127 |
Inventory turnover| 1.493 | 1.649 | 1.107 |
Profitability ratios| | | |
Operating margin| 6.61%| 7.17%| 8.12%|
Net margin| 3.44%| 4.47%| 5.43%|
Return on assets| 3.87%| 4.77%| 3.70%|
Return on equity| 8.18%| 7.98%| 6.37%|
According to the data computed above, Just For Feet did relatively well in liquidity since the current ratio and debt to equity were similar to companies in the same industry. Besides, JFF had a typical AR turnover rate as others in the retail businesses, and the operating margin and net margin also looked fine. But turn to inventory turnover rate, the number was quite terrible for a retail company. Compare to average number of the industry which is around 2.8-3.2, JFF’s faced a serious difficulty on inventory turnover, which led to a potential risk in generating profit. Also the return on assets and equity were below the competitors in the market, and the time interest earned declined very fast during 1996-1998, means that the quality of financing activities was poor.
* High-risk financial statement items:
For 1998 audit, there were several factors should be carefully concerned. The first was the number of inventory. JFF’s inventory in 1998 consisting more than half of the company’s total assets, which was a high risk factor and need more efforts on physical confirmation and valuation. The second audit red flag was the negative cash flow. The common cash flow for a retail company should be positive and this is especially true for those large, well established ones. So JFF’s situation made it stand out in the industry, and the audit process should focus on this abnormal fact. Moreover, the dramatic increases in debt and the rising of accounts payable should also be considered and require extra audit attention.
Q2. Identify internal control risks common to large, high-volume retail. How should these risks affect the audit planning decisions for such a client?
Generally speaking, the most possible internal control risk to large, high-volume retail stores is that about inventory. How to count it and value it accurately is always the issue that auditors should concern most. The audit team should examine the company’s period physical count records and perform year-end inventory count by themselves to ensure the accuracy of inventory number. Also, another very important risk area that auditors should pay attention to is the cash accounts. The audit procedures designed to examine whether the financial figures are fairly stated should adjust to adapt to the specific company base on its overall business environment and operating characteristics.
In addition, retail companies always adopt cost leadership strategy which minimizes operating expenses. This will result in inconsistency in policies because of decentralization and high employer turnover rate because of low human resource expense, and both these factors will accordingly increase risk of accounting errors or frauds. In order to issue opinion properly for a retail company, auditors should plan appropriate audit test focus on these high risk areas.
Q3. Identify inherent risk factors common to businesses facing such competitive conditions. How should these risks affect the audit planning decisions for such a client?
Intensively competitive business environment will increase the management’s pressure and thus increase the inherent audit risk of the company. In...