A Procedural Approach to Auditing Principles - Example

Running header: Auditing Student’s name: Instructor’s name: Subject code: Date of submission: I)Preliminary analytic review of balances and ratios Computation of ratios a) Debt-Equity ratio Debt-equity ratio= total liabilities/shareholders equity 2010 debt –equity ratio 2009 debt –equity ratio =$7024000/$14713500 = 0.4774 =$6909000/$15255500=0.4529 b) Interest expense coverage Interest coverage =net income before interest and taxes /interest expense 2010 interest coverage 2009 interest coverage =$215000/$264000 =0.8144 times $1509000/$286000= 5.2762 times c) Current ratio Current ratio = current assets /current liabilities 2010 current ratio 2009 current ratio =$8827500/$2992000 =2.9504 =$9315500/$2509000 =3.7128 d) Quick ratio Quick ratio = (total current assets –inventory)/ total current liabilities 2010 quick ratio 2009 quick ratio =$5274500/$2992000 =1.7629 =$6250500/$2509000 =2.4912 e) Inventory turnover ratio Inventory turnover ratio =cost of goods sold/inventory 2010 inventory turnover ratio 2009 inventory turnover ratio = $18503000/3553000 =5.2077 times =$18324000/3065000 =5.9785 times f) Accounts payable to sales ratio Accounts payable to sales ratio =accounts payables/net sales 2010 accounts payable to sales ratio 2009 accounts payable to sales ratio =$1279000/$21643000=5.9095% =$1104000/$24019000= 4.5963% g) Return on assets Return on assets = net profit/total assets 2010 return on assets 2009 return on assets = ($49000)/$21737500= -0.2254% =$1795000/$22164500= 8.0985% h) Return on equity Return on equity =net profit/owners equity 2010 return on equity 2009 return on equity =($49000)/$ 14713500=-0.3333% $1795000/15255500=11.7662% i) Debtors collection period Debtors collection period= debtors/average daily sales 2010 debtors collection period 2009 debtors collection period =$1465000/($21643000/365)= 24.7066 =$2327000/(24019000/365)= 35.3618 The analytical review report to the management The company’s performance Judging from the financial statements provided, the company’s performance generally deteriorated during the year ended June 30 2010 as compared to the previous year. The poor performance can be attributed to the decrease in the amount of sales while the costs of doing business (expenses/cost of goods sold) actually increased. This resulted to a loss in the company’s net profit, a situation that needs to be rectified. The company ought to intensify its sales efforts and come up with ways of reducing costs so that it can operate profitably. The poor performance can be seen in the company’s low inventory turnover ratio. The company’s inventory was turned over 5.2 times in 2010 as opposed to 6 times in 2009 resulting to lower sales. This needs to be investigated. However, the company performance as far as debt collection is concerned is satisfactory at 245 days in 2010 as opposed to 35 days in 2009 implying improved efficiency as far as debt collection is concerned. The company’s liquidity/ ability to meet its short term and long-term obligation are acceptable as it is above the industry average. However, there was a reduction in the company’s liquidity ratios during the year ended 30 June 2010 as compared to the previous year. The company’s current ratio stood at 3.0 in 2010 as opposed to 3.7 in 2009 while the company’s quick ratio stood at 1.8 and 2.5 respectively. However, this level is acceptable as it is far much above the industry average. The company has also been able to maintain a debt equity ratio of 2:1 as per the loan contract agreement since the ratio is 0.48 in 2010 and 0.45 in 2009. Therefore, the company has not faulted this condition on debt equity ratio. However, the company’s ability to meet its interest’s obligation is wanting owing to the low amount of profit before interest. The company’s interest expense coverage ratio is 0.8 times which has greatly reduced from 5 times in 2009. If this trend is to continue, the company may not be able to meet its interest obligations in future. The company’s performance as far as profitability is concerned is very poor especially as compared to the year 2009. It is also below the industry average. This can be attributed to the net loss realized in 2010.the company had a return on assets ratio of 0.2 and return on equity ratio of 0.3 during the year ended June 30 2010 which was a great decline from the previous year’s figures. In conclusion, the company’s performance during the year ended 30th June 2010 greatly declined as opposed to its performance during the previous year. The company’s cash flow statement also showed a negative balance implying that the company may soon be in a financial crisis. The management therefore needs to come up with ways of bettering the company’s performance and profitability so that it can be able to meet its financial obligations and r4emain in the market in future. II)Areas that the auditor need to pay special attention to during the audit of the year ended 30 June 2010 As earlier stated, the company’s performance during the year ended 30th June 2010 greatly declined as compared to the previous year performance. Furthermore, this is the first audit that the auditor is carrying out in this company. Therefore, the auditor needs to be careful in his approach to this audit. Some of the areas to pay attention on include; a) The auditor needs to gather as much information as possible regarding the company and the environment in which it operates so as to determine the major audit risks associated with the audit. b) Internal control testing – the auditor needs to asses the operating effectiveness of internal controls within the company so as to determine the amount of substantive procedures and tests to carry out during the audit. c) Substantive procedures- the auditor needs to carry out substantive procedures so as to ascertain that the management assertions regarding financial statements are reliable. As such, the auditor needs to pay special attention to the following issues, i) Sales The auditor needs to look at the sales figures during the year ended 30 June 2010 and compare them with those of the previous year. There seems to be a very big decline from the previous year’s figure. This discrepancy need to be investigated so as to establish the cause. This is because it could be an understatement or a pointer to a fraud. The auditor needs to establish whether there were circumstances that could have led to the decline in sales. This should also be compared with the industry average to establish whether this was the trend in the industry or it was just an isolated case. ii) Profitability With the decline in sales, it is expected that cost of goods sold will also decrease proportionately. However, the cost of sales increased to surpass those of the previous year. This had the effect of greatly reducing the company’s profit. The auditor needs to investigate the reasons that could have led to this since it could be an overstatement. The declining trend in profitability need to be explained. iii) return on capital employed- this will determine whether the company is making good use of shareholders investments. Any unusual discrepancies from the previous year’s figures should be investigated. iv) Retained profits- the auditor needs to consider what is retained as compared to what the company distributes to the shareholders. v) Cash - cash is the most liquid asset that a business possesses and as such, it has the highest risk of fraud as such, the auditor needs to pay special attention to cash to ensure that the decline in cash is not as a result of fraud. vi) inventory- the auditor needs to pay special attention to stock since it carries a risk of being stolen. Furthermore, he should examine whether the use of two methods of valuation i.e. LIFO and FIFO results in material misstatement of inventory and hence profits. III) The following are the internal controls that may be expected in inventory recording and valuation system at Triple Steel Corporation; i) Inventory should always be stated at the lower of cost or market price so as to avoid overstatement of cost and hence reporting the wrong figure of profits. ii) Only one method of valuation should be applied to valuation of stock. If the company decides to use the first-in-first-out method of inventory valuation, then it should be applied throughout the inventory valuation process (Marianne 56). This prevents over/undervaluation of inventory and hence giving the wrong figures of profit. iii) There should be proper documentation of every purchase of stock. As such, all items of stock recorded in the company’s ledger should bear their support documents. Furthermore, the company should either use cycle counts or annual inventory counts to ensure that the actual amount of inventory on hand is the actual amount recorded in the company’s accounting ledgers. IV) Comment on the dividend payment for the year 2010 of triple Steel Corporation During the year ended 30th June 2010, the company made a net loss after tax of $49000 implying that there were no funds available for payment of dividends for the year. However, the management went on to pay a dividend of $500000. Previously, this would have been a breach of the corporations act but with the amendments made on the act; the situation has changed. Effective from 28thjune 2010, section 254t(1) (a) of the corporations act 2001 regarding payment of dividends was altered to imply that dividends can be paid out of retained earnings provided the company’s assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for dividend payment. Furthermore, the dividend was paid out of past profits and hence this is deemed right according to law provided the company’s ability to meet its financial obligation is not tampered with. This can be seen in a case where the Tatts group paid dividends even when it had made a loss owing to the fact that it had sufficient retained earnings during the previous periods. Work cited: Marianne, Staden. A procedural approach to auditing principles, New York, Oxford University Press, 2010 Read More