Unit 5

Question 1

What is financial statement analysis? (Our focus)

Answer 1

Involves the calculation of ratios and the examination of trends in financial statements to identify risks or inconsistencies.

• It is a part of risk assessment

Question 2

What is the purpose of financial statement analysis?

Answer 2

• Assists in risk analysis
• identify misstatement
• increase audit efficency by allowing auditors to look at FS as a whole.

Question 3

Whenb should the auditor perform a financial statement analysis?

Answer 3

At Planning stage to:

• identify risk
• determine which accounts to focus on

During audit:
- estimate account balances

At end of audit:
- identify any signifgant changes from expectations and ensure that these changes were addressed by audit work

Question 4

What do auditors use in the planning stage for analysis?

Answer 4

Use both trend and ratio analyis to:

• Highlight unusual fluctuations in accounts
• Aid in identification of risk
• Enhance understanding of client
• Identify accounts at risk of material misstatement
• Reduce audit risk by concentrating audit effort where risk of material misstatement is greatest

Question 5

What things related to data reliability should auditors consider when conducting analytical procedures?

Answer 5

• Has client data been audited? Is external data reliable?
• Poor controls signal higher risk in relying on analytical procedures
• Changes in accounting methods could distort data
• Auditor may have access to interim results only
• Reliability of budget setting process- is client continually missing budgeted targets?
• Are industry comparisons valid?

Question 6

What are the three main categories of ratios?

Answer 6

1. Liquidity ratios
2. Solvency Ratios
3. Profitability ratios

Question 7

What are liquidity ratios?

Answer 7

Liquidity ratios: measure the short term ability of a company to pay its maturing obligations and to meet unexpected needs for cash.

• Short term creditors such as suppliers would be the type of users who would be most interested in liquidity ratios.

Question 8

What are solvency ratios?

Answer 8

Solvency ratios: measure the ability of the company to survive over a long period of time and be able to pay off all its debt.

• Long term lenders such as banks, mortgage companies and leasing companies would be the most interested users of solvency ratios.

Question 9

What are profitability ratios?

Answer 9

Profitability ratios: measure the profit or operating success of a company for a specific period of time.

• Shareholders and potential investors would be most interested in profitability ratios.

Question 10

What are the financial statement analysis steps in the real world?

Answer 10

1. Develop expectations
2. Eye-ball F/S and identify ratios to calculate. Calculate the ratios for both current and prior period.
3. Eye-ball I/S and identify trends to analyze
4. Eye-ball B/S and identify trends to analyze
5. Document what happened in the ratio or trend
6. Document why the change may have occurred
7. Discuss what the potential financial statement error may be

Question 11

What steps should you use for financial statement analysis?

Answer 11

1. Ratio/Trend
2. What is happening?
3. Why might this be happening?
4. What is the potential financial statement error?

Example:
1. A/R Turnover
2. A/R is being collected slowly compared to prior year and to industry.
3. - May not being following up on receivables.
- Company may be extending credit to customers that cannot pay.
- Result is some receviables may not be colelctable.
4. Some receivables may not be collectible and should be written off.
Allowance for doubtful accounts and bad debt expense may be understated.