AUDITING ACCOUNTING STANDARDS AND FINANCIAL RATIOS
I. ACCOUNTING STANDARDS – INTRODUCTION AND OBJECTIVES • Written documents, consisting authoritative pronouncements, issued by Government or Regulatory body • Standardize diverse accounting policies • Add reliability to the Financial Statements • Facilitate intra – company and inter company comparisons • Eradicate baffling variation in treatment of accounting aspects
II. ESSENCE AND METHOD OF ACCOUNTING: • UNIVERSAL ACCOUNTING PRINCIPLES: • Double Entry Accounting (Debits (+) = Credits (-)) • Assets = Liabilities + Equity • Change in Equity is a result of Revenues and Expenses (Profit or Loss) • CHARACTERISTICS OF FINANCIAL ACCOUNTING: - Accounting identifies, measures and communicates financial information • This information is about economic entities • Information is communicated to interested parties such as investors, creditors, unions and governmental agencies.
III. INTERNATIONAL ACCOUNTING STANDARDS – WHY NEEDED • Accounting principles and procedures vary widely from country to country • Multinational companies incur additional costs of preparing different reports for use in different countries • Accounting reports lack consistency • Financial analysis is more costly and less efficient • Lack of comparability causes the credibility of accounting to suffer • It does not make economic sense for every country to incur the enormous cost of developing its own national standards
IV. DISTINCTION BETWEEN ACCOUNTING AND AUDITING • Accounting is the recording, classifying, and summarizing of economic events for the purpose of providing financial information used in decision making. • Auditing is determining whether recorded information properly reflects the economic events that occurred during the accounting period.
V. TYPES OF AUDITS • Operational Audit: • Involves evaluation of any part of an organization’s operating efficiency and effectiveness. • Not limited to accounting areas • Compliance Audit: - Determine whether the auditee has complied with specific procedures, rules, or regulations set by some higher authority. • Financial Statement Audit: • Determine whether overall financial statements are stated in accordance with specified criteria. • Generally accepted accounting principles are normally the criteria, although other basis of accounting are at times used.
VI. TYPES OF AUDITORS • External or Independent Auditors – CPAs are the only group permitted to provide financial statement audits. Such audits are required of all publicly traded companies. • General Accounting Office Auditor – works for the Comptroller General who reports to and is solely responsible to Congress. They audit various governmental bodies. • Internal Revenue Agents – evaluate taxpayer compliance with tax laws. • Internal auditors – Auditors who are employees of the companies they audit.
VI. AUDIT REPORT • The standard audit report consists of 7 parts: • Report title – Must include the word independent • Audit report address – Customary to address to board of directors and stockholders to demonstrate independence • Introductory paragraph – States that an audit has been performed; identifies the financial statements and appropriate dates; states that the financial statements are the responsibility of the entity’s management. • Scope paragraph – States that auditor followed GAAS or PCAOB standards and indicates that the audit only provides reasonable assurance. • Opinion paragraph – Communicates the results of the audit. • Name of CPA firm or practitioner. • Audit report date showing last day of field work. Auditor is held accountable only through this date
VIII. FINANCIAL RATIOS – DEFINITION AND PURPOSE • The relationship between two accounting figures expressed mathematically is known as financial ratio • What is the purpose of analysis of financial ratios: – It is for a meaningful study of information in the financial statements – Ascertaining overall financial position of a business organization • Interpretation of key information in the financial statements • Objectives: • Assess credit risk profile of the borrower • Establish sound well defined credit granting criteria • Assess utilization of credit facility • Ensure safety of bank funds
IX. LIQUIDITY RATIOS • Current Ratio = Current Assets/Current liabilities. A liquidity ratio that measures a company's ability to pay short-term obligations. The ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point • Quick ratio = (Current assets – Inventories)/Current liabilities. Also known as the "acid-test ratio" or the "quick assets ratio". An indicator of a company's short-term liquidity. The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio, the better the position of the company.
X. EFFICIENCY RATIOS • Profit margin = Net income/Revenues. It measures how much out of every dollar of sales a company actually keeps in earnings. Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. • Return on Equity = Net profit/Shareholder`s equity. The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. Does not include preferred stocks. • Return on Assets = Net Income/Total assets. An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings.
XI. OTHER RATIOS • Interest cover – shows whether funds are available to repay expenses on company`s debt. • Debt/Equity ratio is a.k.a. gearing (UK) or leverage (US). Compares the amount of debt to company`s own capital. • Earnings per share (EPS) = (Net income – Dividends on preferred)/ Average number of outstanding shares. The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability. • Price/Earnings (P/E) ratio = Market value per share / Earnings per share. A valuation ratio of a company's current share price compared to its per-share earnings. EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E).