Observations on DIPL’s Financial Statements

While performing the task of audit, an auditor’s job is to determine the quality of the financial statements prepared by the management of the client. The auditor is to determine the audit procedures on the basis of his understanding of the entity, nature & business operations of the entity, timing & extent of procedures adopted, etc. Every procedure must be justified with what assertion is being tested and the reason for adopting this procedure. Auditor’s job is to obtain sufficient appropriate audit evidence on the basis of audit procedures. Such procedures include Inspection, observation, confirmation, reperformance, recalculation, and analytical procedures which are often applied in some combination (Basu, 2009).

Analytical procedures are an important part of audit process as it helps an auditor to understand the nature & operations of the business and to observe the key changes in the business. It helps an auditor to identify the potential areas of risk where the auditor can further proceed with other audit procedures.

As per the given case study of DIPL, various key ratios have been calculated to identify the changes in the business and to analyze its financial position(Blank, 2014). The study of ratios makes the financial statements comparable with that of its prior results, budgeted results as well as other company’s financial statements in the industry. The following observations are seen while calculating ratios of previous three years of DIPL: 

The company is under an obligation that it is to maintain at least 1.50 as current ratio and less than 1 as debt-equity ratio otherwise the loan given to it will be recalled. The company is do abiding by it but it can be the case that to maintain this conditions, it has shown its shareholders equity amount high which is because of drastic change in the retained earnings inspire of incurring heavy expenditure in 2015, for example, new adoption of IT system, takeover of a new company, heavy purchase of plant and equipment, etc. Also, it shows a tax amount of Rs. 87116 on the profit of Rs. 3059299, which goes against the tax slab calculations (Boynton & Johnson, 2006). Thus, the company might have manipulated its profits to show required ratios. 

The cash ratio is being calculated instead of quick ratio as quick ratio excludes only inventory while cash ratio also excludes depreciation which is actually a non-cash expense thus, determining the ready cash available within the company. DIPL’s cash ratio was 0.89 in 2013 but it showed an improvement in 2014 by having 1.00 which means that the company had enough cash available to pay its short term obligations (Cahill & Kane, 2011). However, in the current year, the cash ratio reduced by almost 8% showing that the company’s cash in hand reduced instantly and that the short term obligations cannot be paid so frequently if in case it has to be paid. 

The return on assets ratio measures how efficiently a company is using its assets to convert it into profits and revenues. It is important for both the management &  investors to know the return the company is earning as the major investments of a company are in its assets. However, in this case, the return on assets is decreasing every year,that is, from 18.25% &  14.41% to 11.37% in 2015. Also, in the current year, % change in assets is more than the double of % change in net earnings which is not a good sign. 

Analyzing Key Ratios

Proprietary ratio is an indication of financial stability of the company, that is, whether the company has sufficient equity balance to support its operations or not. It indicates whether the investment made in the company is being properly capitalized or not. In the following case, the ratio has drastically reduced from 0.71 (2013) & 0.68 (2014) to 0.47 in 2015 meaning that the company is unable to capitalize its equity investment or it is making more use of its additional debts, which is not a good sign. 

The interest coverage ratio has reduced drastically from 40.94 (2013) &  40.13 (2014) to 4.79 in 2015 indicating that  the paying ability  of the company is getting weak to bear its interest expenses. Also, there is a heavy burden of interest expenses on the company. 

The net profit of the company is almost consistent in all the three years ranging between 6-7%. However, every previous ratio indicates suspicions. So, net profit remains in doubt and therefore, calls for a serious in depth study of financial statements (GUPTA., 2016).

Risk of material misstatement refers to the risk that the financial statements are misstated and posses a material change. The auditor is to trace the risk of material misstatement at two levels:

At the financial level : Here, the risk identified is relatable to the financial statements as a whole as it covers the risk such as inefficient control system, lack of required capital to continue the business, unusual pressure, unusual transactions, hasty decisions, etc (Horngren, 2017).

At the Assertion level : Here, the two types of risk involved are – Inherent risk which refers to the risk which is due to errors or frauds that are materially misstated either individually or in aggregate and have a material effect other than the failure of controls. Control risk refers to the risk that indicates a material misstatement exists in the books as it couldn’t be detached or prevented to enter into the business’s books of accounts by the internal control system, thereby indicating the risk due to failure of controls in the firm.

As per the given question, the two identified inherent risk in DIPL can be stated in the following two points:

Valuation of Inventory: The Company follows the valuation of raw material as per weighted average method. Now, the valuation of inventory has a direct impact on the profits of the company as wrong valuations leads to overstatement or understatement of closing stock thereby showing more or less profits. For example, the closing stock is 20 units, opening stock is 100 units of Rs. 1000 and purchases are 200 units of Rs. 3000. Following the average method, the stock valuation comes out to be Rs. 13.34 per unit, that is, the closing stock values Rs. 267 but in actual, this 20 units are from the purchases where one unit cost Rs. 15 and therefore, the closing stock should have been valued at Rs. 300. Thus, by following average method, less closing stock value will be shown leading to decrease in overall profits (Griffin, 2009). However, in the board meeting in June 2015, the company decided to change its valuation method to FIFO basis which signifies towards the matters that it might be trying to hide its money earned out of wrong valuation of inventory. Also, by doing so, the inventory value shows an increment of 56% approximately in comparison to 2014 data indicating towards higher closing stock value thereby, higher profits and thereby, showing a better & strong position of the company so as to enjoy future funding smoothly or to win the investor’s confidence or to satisfy the loan giver that the company has enough generation of earnings.

Identified Inherent Risks

Unusual Pressure within the entity: There are allot of factors within the entity that signifies that there is an unusual pressure or a certain kind of error or fraud that the company is trying to hide (Hooks, 2011). Such pressures can be enumerated in the following points :

The company appointed a new internal audit team in January, 2015 while it closes its books in June. This is suspicious as enquiries are to be made for such a step in the middle of the year because it might have been adopted to identify the fraudulent activities that the management already has an intuition about. Also, it changed its CEO too in the same month. Thus, further enquiries are to made with the previous CEO as well as the management for such a change.

The company took a loan of Rs. 7.5 million from BDO Finance. It did make a heavy expenditure on the assets but at the same time, it adopted a complete new IT System in the entity and even took over another company called Nuclear Publishing Limited inspite of the fact that the purchase price of plant and equipment already exceeds the loan amount. Thus, the purpose of loan and the expenditures made by the company aren’t justified. Also, it signifies towards an unusual pressure that some fraud risk factor do exists.

It is auditor’s responsibility to perform its duties in such a way so as to obtain reasonable assurance whether the financial statements show a true & fair view or not and that the information reflected in the statements are free of material misstatements caused by error & fraud. Fraud is a legal determination theory and the auditor is expected to not have enough expertise to make such a legal determination(Knechel, Salterio & Ballou, 2017). Instead, auditors are considered with determination of misstatements that arises usually out of two things: firstly, from fraudulent financial reporting and secondly, from misappropriation of assets (Messier, 2016).

Fraud risk factors are the conditions that exist usually where a fraud takes place. These conditions are:

1. Management or the workers have an incentive or are under pressure ;
2. Situations are favorable enough to provide an opportunity to commit fraud ; and
3. Fraudsters involved are able to rationalize for the fraudulent activity carried out.

As per the given case study of DIPL, the two identified fraud risk factors arising out of fraudulent financial reporting, to which the company is susceptible to, and its affect on the performance of the audit are as follow (Ramaswamy, 2015):

Recognition of storage fees from ‘E-book facilities’: The company used to charge the publishers an annual “storage fees” for keeping their e-books on its website. However, these storage fees were payable 12 months in advance and were recognized in full in the month of its invoice notwithstanding the fact that they are being recognized in advance, thus, misapplication of accounting principle. The revenue recognition concept states that the revenue is to be recognized only when it is being earned, that is, either the goods have been provided or the services have been performed (Khan and Jain, 2013). Thus, without actually providing the servicing or without actually completing the service period, the revenue for such months shall not be recognized and treated as ‘advance from publishers’ under current liabilities. However, the board meeting did arrive at the conclusion of recognizing the revenue only when the transaction is completed. However, such a change came up due to the internal audit team and it might be taking place to cover up for the previous wrong recognitions because of which more revenue has been showed in the books so as to show a strong position in the market.

Adoption of New IT System: The Company put an excessive pressure on the IT department to install the new computerized system in the month of June, 2015 itself when it closes its accounts (Whittington & Pany, 2016). It didn’t care about the fact that whether the staffs are being properly trained about its working or whether the new system has been first tested properly or not. It just wanted to replace its existing system because of which when the transactions were being transferred, a number of transactions were lost in this process (PAVAN, 2014). This action of management indicates towards the existence of fraud risky factors as if some fraudulent activity has been undertaken and with the fear of internal audit team who would be definitely able to rectify it, the management thought of replacing the entire system so as to hide the transactions and claim it to transactions lost due to less knowledge or inefficiency of the accounting & IT department. Also, the same action serves as an opportunity to the employees or the other members who may take an advantage of messed up accounts and thereby, misappropriate the cash balances or conduct any such activity that would lead to personal earnings on account of the organization and later on, blame the department for being so careless regarding the transfer of accounts (Pitt, 2014).

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