Planning and Auditing Risk - Report Example

Planning and Auditing Risk Acceptable level of audit risk depends upon the aggregation level and misstatements in the financial statements acceptable to the auditor.1 One should observe difference between the audit risk achievable and the audit risk acceptable. The audit risk that was achievable generally depend upon the constituents of AR. The risks will be of three types: inherent, control and detection risks. The audit risk accepted may change from one level to another level. It depends upon the details audited at every stage. Ratio analysis is comparing the financial details of the company with previous yerars, competitors and other areas of industry. In this paper the ratio analysis of chemeq limited is done by comparing the 2005 financial draft with 2004 annual report. There are different ratios to analyse the financial status and auditing risk of the company. Some of the ratios are mentioned below and they are analysed according to the annual report and financial statements of 2004 and 2005 regarding Chemeq limited. Average rate of interest = Interest expense – Accounts payable Liabilities (Adopted from: http://www.investopedia.com/university/ratios/averageinterestrate.asp) = 10000-2380/3005 = 2.55 (for 2005) Average rate of interest = 11,000- 00 = 4.6 (2004) 2380 The above results imply that the interest rate is more in 2004 than in 2005. This implies that the rate of interest payable decreased from previous year, which is an indication of good credit receiving. The decrease of interest payables is capable of showing increase in profit. The above result will show negative result when the rate of increase in borrowing is more than the rate of decrease in interest. But the financial statements did not denote that thing. So as per the interest rate is concerned there is no audit risk. Cash flow to assets: Cash from operations/total assets =937947/7554842 = 0.124 for 2004 and 22933/74388 = 0.3 for 2005. Though the cash flow from assets was less than the minimum required (0.2) in 2004 it developed reasonably to a safe level of 0.3 in 2005. The rate of development in cash flow and the current cash flow is safe for the company’s needs of cash. Common size analysis: Entity/Total entity = cogs/total sales = 9954762/12785000 =0.779 for 2004 (entity is taken as sales) For 2005 cogs/total sales =60670/62894 = 0.965 Here the ratio for the year 2005 is more than the ratio of 2004. This implies that the rate of decrease of cogs is less than rate decrease of sales. This is not a healthy development as this erodes profit percentage. This means that the profit is decreasing and the ratio of cash flow to assets calculated is positive due to disposal of assets, which is not recommendable. This may cause the audit risk. Dividend pay out ration: Yearly dividend per share/earnings per share =12784953/9954089 = 1.284 for 2004 For 2005 62894/60670 =1.03 The decrease in ration tells us that the company is giving less dividend to the share holders. This generally is an healthy process because the capital remained due to decrease in paying of dividend is used in investing for future projects, which increases future profitability. But here in the previous ratios it was established that the trend in cost of sales is not satisfactory and the cash flow is due to the dissolution of assets. This background of the company will not allow to treat the decrease in dividend pay out ratio as a healthy trend. Asset turnover = Revenue/total assets = 905177/75824147 = 0.011 for 2004 For 2005 = Revenue/total assets = 60670/74388 = 0.815 The increase in asset turnover ratio indicates the decrease in rate of profit (profitability). In the previous ratios we got the ratio regarding the analysis of cash satisfactory. This implies assets were eroded to attain cash, which is non available due to less profitability. This cannot be considered as acceptable audit risk. Collection Ratio: Accounts receivable/Revenue = 38864/1116 = 34.82 for 2004 Accounts receivable/revenue = 616101/ 2116 = 29.11 for 2005 The above results of collection ratio imply that the collection of revenues from the customers was quickened in 2005 than in 2004. This can be considered as a healthy development as the returns are in short time. But this result shows that the credit sales was decreased, which may cause negative effect on turnover. This may not cause audit risk but if this trend is continued it shows derogative effect on turnover. Inventory turnover = Cost of goods sold/average or current period of inventory = 1122794/197512 = 5.68 for 2004 cost of goods sold/ average or current period of inventory = 1940/672 = 2.88 for 2005 The above result shows that the ratio is less and it decreased from previous year to present year (2005). This shows that inventory increased faster than the increase of sales if any. Though the sales was increased the increase observed in inventory is not recommendable. The increase in inventory more than the deserved rate will show negative effects in future as the products of the company are subjected to expire. If the sales of the products in the inventory decrease and the demand for other products increase the present goods will spoil increasing the production costs or increase in loss. This may affect profitability. So this is not only a un acceptable audit risk, but also not recommended as an activity of business. Return on Equity: Net Income/share holder’s equity = 13273/88822422 = 0.0001 for 2004 No net gain was reported and the company was compelled to pay for the share holders from the cash generated from pledging the assets or shareholders may not receive any income from their investment. Even in 2004 the income for share holders is one rupee for one lakh rupees. This can be considered as capable of having deteriorating effect on the capability of raising capital and the company may face the loss of assets and cash crunch when the profit did not appear before the assets disappear. But here the company is paying off debts and this can result in more profitability in next year as there will be less debts and less interest to pay. It can be considered as acceptable audit risk because the company spent the amount on clearing debts and releasing the pledged assets. Return on assets = Net income + interest expense Total assets = As net income is not reported and net loss per share (11.7) was reported. This implies there is no real return from the assets and the company is managing from the cash generated by pledging of assets and from the income got in the form of royalty from patents and licenses. This type of income needs time to grow as more patents and licenses should be acquired by the company. This is a long term process and continuing it without support from profit generated by sales activities is suicidal. This is not only an audit risk but also needs careful handling to come out of the losses in the coming years. Working Capital Ratio: Current assets/current liabilities = 75824147/11845009 = 6.401 for 2004 For 2005 Current assets/current liabilities =74388/43029 = 1.7 The above result shows that in the year 2004 there is excess of working capital by the cash generated from assets. It was not invested in proper manner in 2004. But the ratio 1.7 in 2005 denotes that the excess cash broughtover from 2004 was invested or used to pay the debts in 2005. This was reflected as the value of ratio is 1.7 in 2005 which can be considered as safe and satisfactory. The ratio between 1.2 and 2 is considered as the result for maintenance of balanced working capital. Debt Asset Ratio: Total liabilities/total assets = 11,845,009/75,824,147 = 0.15 for 2004 For 2005 Total liabilities/Total assets = 43,029/74,388 = 0.5 In 2004 and 2005 the debt asset ration is fairly low, that is lesser than 1. But it was to observed that the ration increased from 0.2 to 0.5 which tells that the company is slowly turning towards a path of maintaining asset by debt rather than equity. This is capable of causing a major audit risk. Profit Margin: Net Income/Revenue = 8858/9955 = 0.88 for 2004 which denotes that the returns are very high. This much hightest (88%) returns are possible in chemeq by disposing assets and due to high pricing. Both the cases are not dependable for future pruposes. When the competition rises and a need for cost efficiency arises the disposing of assets and high pricing strategy will not work. For 2005 22933/60670 = 0.37 The decrease of ratio indicates the change in pricing strategy and decrease of disposal of assets. Still the profit margin is high due to disposal of assets only. The real net profit ration can be obtained if the company stops disposing assets and gains income solely depending on sales of products and not assets. As the company is having high net profit due to sale of assets, it amounts to a high audit risk. Acid Test Ratio = Cash + Accounts Receivable + short term investments Current liabilities = 67957+695+1055/2380 = 29.2 for 2005 and for 2004 52357+616+453/11302 = 4.7 In 2005 the company had very high acid test ratio. Actually a high acid test ratio denotes the capability of the company efficiently paying liabilities. But the capability of paying liabilities is got by selling assets, which amounts to audit and business risks. The ratios used in the above analysis were adopted from http://www.investopedia.com/university/ratios/ 2 &3 Business risk analysis The results from the financial statement and annual report of 2004 provide the information for business risk analysis. The ratio analysis, which was done in the first part exhibited various audit risk areas as well as business risk areas. While doing the ratio analysis it was observed that there was loss in earnings per share and the company is not capable of enabling the investors to get reasonable return on their investment. This can be considered as a major business risk as the company cannot gather capital from public issue if it wants capital for further ventures. This compels company to borrow the amount required for future capital needs and present working capital. This needs the pledging of assets and if they were not released in time the net assets will be lost and the company’s net worth will be disturbed creating business risk and eroding the credit rating. The increase of production costs is reasonable if there is increase in profitability more than the rate of increase of production. But it is not happening in the case of Chemeq. This affects profitability and if it continues for five years the company may face severe consequences that are not reversible. Cash flowing from investing activities is almost more than half the cash generated from the operating activities. Investing the excess of cash is reasonable but the investment from the cash generated should not effect the regular activities of the company. This already resulted as loss per share of the company. If it continued to do so, the other cash related activities such as payment of salaries and payment for the raw material or other services may also be affected. This results in generating cash from assets and if the investment does not yield the expected income in reasonable time, then it will be difficult to cope up with the operations of the company. This can be termed as a major business risk. To avoid this the investment of the company in 2004 and 2005 must yield returns in less than five years as the assets that are generating cash for the company can support the firm for less then five years only if the statistics of the performance was taken into consideration. The revenue from operating activities is far less than the revenue from non operational activities. This means that the revenue generated for the company is not by the sales but by disposal of the assets of the company. This type of revenue cannot be generated every year as the assets erode. If this continues for more than 2 or three years the company may face another serious business risk. The expense of borrowing is more than the revenue generated from both operational and non operational activities. The profit from these activities will be the amount remained after subtracting the cost of production and other activities. This means that the profit is still more lesser than the expense of borrowing. The company is borrowing more than it can pay. This amounts to both audit and business risks. Both are not acceptable. 4 Materiality: From the above analysis the it was observed that interest decreased from 2004 to 2005. Actually this amounts to good credit rating but the decrease of interest payments is due to disposal of assets that reduced the debt. This amounts to less production in the company and if this continues for more than two years it may cause severe dilution in capital and results in loss of equity and the decrease in profits. Very less returns on assets and equity will damage the infrastructure and capital rising capacity of the company. While calculating the acid test ratio, profit margin and debt ratio it was observed that every capability of the company is obtained by dissolving the assets. In some instances the dissolving is less in 2005 and the management is stating that after the initiation of pharmacy unit the production and sales will increase, thus increasing the profitability. But if that not occurs in time, the company have to face serious audit and business risks. If the audit and business risks mentioned in the 1,2&3 were to be nullified the production capacity must increase. Till now the sales was less despite good quality of the products and the reputation earned in a short period. This increase of production is possible according to the words of CEO that ‘Active Pharmaceutical ingredient plant’ will produce the necessary goods that is capable of increasing sales. The increase of sales can be assured as there is demand for the company’s products and the loss is just due to the lack of production. If this is the case and if aforesaid unit starts production in reasonable time and produces well, the company can recover from the audit and business risks mentioned in the above analyses. Chemeq is spending more on the construction and research as it is eying the markets globally. It should take into consideration the climates and needs of different countries and regions. This requires more research and investment and according to the strategies of the management it is ready to increase both its production and sales in the coming two to three years and the assets contained by the company are enough to support company till that time. So if the strategies regarding construction, research and production work out well the company can eliminate both the business and audit risks in two to three years. The company is also disposing the unnecessary units for its production and investing them in the future research and for future infrastructure required for the increase of production. The increase of production will be a result of success in research work. So the research, construction and production are interrelated. But by this time the company is doing well with the proposed initiation of pharma unit mentioned above. So if that starts working company can have enough cash from operational activities and it can be used to protect assets and to pay for the shareholders. This in turn increases the capacity to rise the capital required and increases the credit rating. So the chance of nullifying the business and audit risks lie in the success and timely initiation of the pharmacy unit mentioned above. References: The references were given in the following format Name of the author, year, title, name of the publisher/.sponsor, edition information, type of media, date retrieved, website address. The information in the above mentioned format is given based on availability. If it is not available a gap was left or the non availability was mentioned. 1.Auditing and assurance standard board, 2006, Auditing Standard ASA 520 Analytical procedures, Australian Government, ,electronic, 4-10-06, http://www.auasb.gov.au/docs/AUASB_Standards/ASA_520_28-04-06.pdf#search=%22AUS%20512%20%2F%20ASA%20520%20ratio%20analysis%22 2. Author’s name not mentioned, 2006, Activity based risk analysis model of auditing, ABREMA, ,electronic, 4-10-06, http://www.abrema.net/abrema/acceptable_g.html 3.Author’s name not mentioned, 2006, Ratio analysis, Investopedia.com, ,electronic, 4-10-06, http://www.investopedia.com/university/ratios/ Read More