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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

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AUDITING

ACCOUNTING STANDARDS AND FINANCIAL RATIOS

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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
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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.
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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
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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.
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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.
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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.
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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
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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
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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.
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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.
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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).