Managing Financial Principles and Techniques Conducting Operational Audits

The financial statements are prepared for the purpose of presenting a periodical review or report of the progress made by the concern. It shows the Aµstatus of the investment in the business and result achieved during the accounting period.

"Financial Statements" refer to at least two statements which the accountant prepares at the end of a given period. These statements are Profit and Loss Account (Income Statement) and Balance Sheet (Position Statements).The purpose of Profit and Loss Account is to ascertain the net result of the training activities (i.e. profit or loss).Balance Sheet is prepared to show the financial position of the business as on a particular date.

Definitions

According to John N Mayer, The Financial Statements provide a summary of the accounts of a business enterprise, the Balance Sheet reflecting the assets and liabilities and the income statement showing the results of the operations during a certain period.

According to Smith and Ashburne, Financial as the end product of financial accounting is a set of financial statements, that purport to reveal the financial position of the enterprise, the result of its recent activities, and an analysis of what has been done with earningsA´.

As per the definition financial statements are the outcome of preparing financial accounts and these statements reveal financial position and profitability of the concern and the utilization of retained earnings. Thus, financial statements include:

• Profit and Loss Account
• Balance Sheet
• Statement of Retained Earnings
• Fund Flow Statements
• Cash Flow Statement
• Certain Schedules

Nature of Financial Statements

The financial statements are prepared on the basis of recorded facts. The facts are recorded in monitory terms. The statements are prepared for a particular period and the transactions are recorded in a chronological order. The American Institute of Certified Public Accountants states the nature of financial statements as, A³Financial statements are prepared for the purpose of presenting a periodical review of report on progress by the management and deal with the status of investment in the business and the result achieved during the period under review. They reflect a combination of recorded facts, accounting principles and personal judgments.

The following points explain clearly the nature of financial statements:

Recorded Facts

This refers to the data taken out from the accounting records. The original cost or historical cost is the basis of recording various transactions. The financial statements do not disclose such facts as are not recorded in the accounting books whether or not such facts are material.

Accounting Conventions

While preparing financial statements certain accounting conventions are followed. E.g. Stock is valued at cost price or market price is lower, valuing fixed asset at cost less depreciation, etc.

Personal Judgment

Although concepts and conventions provide a good guideline to the accountant for arriving at a decision as to how much should be charged to the Profit and Loss Account of the year and how much should be carried forward to the next year as unexpired costs, the applications of these concepts and conventions depend on the personal judgment of the accountant.

Postulates

The accountant makes certain assumptions while making accounting records. One of these assumptions is that enterprise is treated as a going concern; similarly, he has to use other postulates like business entity concept, money measurement concept etc.

ANALYSIS OF FINANCIAL STATEMENT

The financial statements provide rich information about the operational result of a business unit and much can be learnt from a careful examination of these statements. Financial statements are prepared primarily for decision making. The statements are not an end in them, but are useful in decision making. Financial analysis is the process of determining the significant operating and financial characteristics of a firm from accounting data. The profit and loss account and balance sheet are indicators of significant factors-Profitability and Financial soundness.

DEFINITIONS

Metcalf and Titard: Analysis of financial statements is a process of evaluating the relationship between component part of a financial statement to obtain a better understanding of a firm's position and performance. Myers: Analysis of financial statements is largely a sound of relationships among the various financial factors in a business as disclosed by single set of statements, and a study off the trend of these factors as shown in a series of statementsA´. OBJECTIVES OF FINANCIAL ANALYSIS The following are the main objectives of the financial analysis of financial statements: 1. 2. 3. 4. 5. 6. 7. 8. To estimate the earning capacity of the firm. To gauge the financial position and financial performance of the firm. To determine the long term liquidity of the funds. To judge the solvency of the firm. To determine the debt capacity of the firm. To decide about the future prospects of the firm. To know the progress of the firm. To measure the efficiency of operations.

TYPE OF FINANCIAL ANALYSIS Distinction between the different types of financial analysis can be made either on the basis of material used for the same

or according to the modus operandi of the analysis or the object of the analysis. The following chart will give a snap-shot view of it.

TYPE OF FINANCIAL ANALYSIS

• According to Material used
• According to modus operandi
• According to objectives of analysis
• External Analysis
• Internal Analysis
• Horizontal Analysis
• Vertical Analysis
• long term Analysis
• Short term Analysis

1. External Analysis

External Analysis of financial statements is made by those who do not have access to the detailed accounting records of the company, i.e. banks, creditors and general public.

2. Internal Analysis

Such analysis is made by the finance and accounting department to help the top management. These people have direct approach to the relevant financial records. 3.

3. Horizontal Analysis

When the financial statements for a number of years are reviewed and analyzed, the analysis is called A³horizontal analysisA´.

4. Vertical Analysis

When ratios are calculated from the balance sheet of one year, it is called vertical analysis

5. Long term Analysis

In long term analysis the fixed assets, long term debt structure and the ownership interest is analyzed.

6. Short term Analysis

It is mainly concerned with the working capital analysis. The current assets and current liabilities are analyzed and cash position of the concern is determined.

What Does Performance Audit Mean?

An audit performed on an asset manager by an outside accounting firm to verify that the performance figures shown to the public on marketing materials represent the true aggregate results of the firm's clientele.

Appraisal of how a particular activity is carrying out the company's policies and procedures. Such review may cover any activity within a department, division, or local area. A performance audit can be a review of a program to assure that it is satisfying its objectives. The program may apply to management and accounting procedures, guidelines, or policies. The performance audit may take into account the anticipated benefits of a program relative to the actual performance. Also relevant may be the costs and time associated with the activity. A report of management's abilities is typically prepared to meet particular goals. Included in the report are measures of the effectiveness of internal controls and efficiency of procedures and processes. The performance audit may be initiated by the organization or by external interested parties. However, the performance audit is not performed as a means to attest to the financial records and statements of the company. An example of a performance audit is how certain work routines are being conducted.

Performance auditing: a powerful management practice to enhance performance in your organization

"Because we are in a dynamic environment, we have got new people, new technology, a new marketplace, new competitors and new regulations, we need to be very vigilant about the fundamentals of this business. And that is a role performance auditing plays; the ability to collect information and impart that knowledge on processes and to do it constantly through all of this change "

(Duane Ackerman, CEO, BellSouth Corporation; source IIA wesbite)

What is performance auditing?

Performance audits are short term assignments, usually two or three week long, sometimes more - conducted internally within the organization in order to address key issues that may impact performance as well as recommend solutions. Experts usually describe "performance auditing" - also called operational auditing - as a management tool to provide managers with reasonable assurance that their organization will achieve its objectives.

Although they represent a valuable service to managers in an increasingly complex environment, performance auditing is a delicate process which should be conducted carefully in cooperation with employees at various levels of the organization if it wants to really achieve a value adding contribution to the organization.

Performance auditing also reflects the commitment of management to maintain a good "internal governance" system of the firm to the benefit of its stakeholders. It is extensively used by large companies as a common practice to tackle with the increasing complexity of their worldwide operations and necessary decentralized organizational models.

If you are asked to conduct a performance audit within your organization you will need to:

• develop a proactive communication in order to install a good climate for cooperation,
• carefully define the scope and objectives of the assignment;
• develop a top-down approach for understanding risks and processes,
• find an appropriate level for gathering evidence and documenting your work in order to support your findings
• communicate findings in a proactive manner in order to enhance empowerment of employees

For this you will need to rely on methodologies and tools; this workshop will provide you with the necessary skills and deliverable templates to carry out performance audits successfully; it will give you the opportunity to share experience with professionals who have led operational audits and experienced the many "pitfalls" you will need to avoid.

• Introducing performance auditing in organizations: benefits and challenges

How do organizations react to problems and find solutions

Measuring performance and monitoring: fundamentals

Latest trends and developments in the practice of operational auditing

Performance auditing in the social market economy in China

Conducting Operational Audits

Step 1: Communication

- Developing a positive mindset around the audit

- Understanding expectations from the commissioner of the audit

- Defining your role and "game rules"

Step 2: Planning

- Defining the scope and objectives

- Recruiting the team

- Carrying out the preparation works

Step 3: Building the performance audit framework

- What the successful approach to auditing?

- Understanding the activities to be audited

- Identifying objectives, processes and controls

- Risk scoring

- Defining the key priority areas for the audit

Step 4: Fieldwork

- Collecting information

- Conducting interviews

- Testing

- How to deal with IT controls?

Step 5: Communicating audit findings

- Writing audit reports

- Oral communication

- The auditor's behaviour

- Long-term perspective: continuous auditing and knowledge management in the modern firm

- Enhancing a risk culture within your organization

- Internal governance a competitive advantage

- Role of internal audit

Financial Ratio Analysis:

"In order to make detailed financial analysis it is necessary to consider the trends in key figures over a number of years. Most important and interesting trends are: Sales, profit, Net assets and dividends. Most of the information on which the financial analysis is based is provided in the organisation's Income statement and balance sheet." (Barry Elliott & Jamie, august 2007).

Methods of Ratio Analysis:

Time Series analysis

Cross-sectional analysis

Time Series Analysis:

Time-Series analysis evaluates performance over time.

It allows to analyse trends over a number of years and to examine the way in which performance may have changed over time.

For instance time series analysis can make by comparing any company's performance for two or more than two years i.e. 2007 and 2008.

Cross-Sectional Analysis:

Cross sectional analysis allows for comparison with the industry average or with competitors at a single point in time.

This comparison allows a judgement to be made about the firm's position within the industry.

For instance to make a comparison of any company's performance against its rival (competitor) for the same year.

E.g. Shall Company's ratios are compared with British Petroleum Company. (Both are in same industry and same business).

Types of Financial Ratios:

Following are the different types of financial ratios

Liquidity Ratios

Profitability Ratios

Activity Ratios

Solvency/Coverage Ratios

Liquidity Ratios:

Liquidity ratios assess company's ability to pay off itsA short-terms debts obligations.A 

Generally, the higher the value of the ratio, theA larger the margin of safetyA thatA the company possesses to cover short-term debts.

AA company'sA ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment.

Bankruptcy analysts and mortgage originators frequently use theA liquidity ratios to determineA whether a company will be able to continue as a going concern.

The current ratio of the company shows that company have enough current assets to repay its all the current liabilities which shows that company is in good condition but not enough good as it was in 2007

The absolute liquid ratio shows that company has 34.26% highly liquid assets to repay its current liabilities. This shows bad impact of the company. Although company has more liquid assets in 2007 to clear its liabilities this shows that company's performance is going worse day by day.

The quick ratio shows that company have enough funds available to repay its current liabilities. This is good sign for investors. But as we compare it with ratios of previous two years it shows that it is also decreasing. Company has not enough funds available as they were available in 2007.

The GP margin ratio shows that our gross profit is 34.26% of total sales. This is increasing with the increase of sales. As we compare GP margin ratio of last three years, we see that GP margin is in very good in 2008. This attracts the investors.

The NP to Net Sales ratio shows that the margin of net profit of total sales is 9.8% is quiet low as compared to previous two years. This shows that company has increased it administrative and marketing expenses this year.

The share holders of the company are not getting enough earning this year as much as they have earned in previous years. This makes investors to withdraw their investment from business. And business goes down without having investment.

The Debts to total assets shows that the company has 2 assets to repay its 1 Liability or debts. The company is in good position to clear its debts. As we compare it with past two years the company was in better condition. Company increased it debts this year.

The debtor turnover ratio shows that we have made 4.91 times credit sales than avg. debtors. In past years company made more credit sales than this year. It means company prefer to make more cash sales.

The avg. collection period shows that company recovers debts from customers in 74.33 days. As we compare this with last two years than we come to know that company recovered its debts in fewer periods than this. It means company made soft debts recovery policies.

The inventory conversion period shows that company converts it stock/inventory into sales in 29.62 days. But in previous years company took 23.9 days and 21.19 days to convert its stock into sales. This year company took more time for conversion into sales. This means that company policies need urgent attention.

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