The Role of Financial Ratios in Auditing Analysis

The use of financial ratios assists the auditor in analyzing any unusual deviations from the expected results, (Gupta, 2004). The financial ratios are then compared with the entity's ratios for prior periods as well as with ratios for other businesses in the same industry. A comparison with the industry ratios would have warned BDO of some irregularities in Leslie Fay's financial statements. BDO Seidman should have been interested some important ratios that would help in determining the accuracy of the financial statements that had been prepared by Polishan and his staff.

The important ratios include the liquidity ratios, the profitability ratios and the operating ratios, the leveraging ratios and the solvency ratios. Of higher importance should have been the profitability apart from the gross profitability ratio. An example would be the assets turnover ratio which provides information on the efficiency on how the assets that have been purchased are being utilized.

The liquidity ratios would have assisted in knowing if and how the entity was going to repay its liabilities especially in the short term.

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An important ratio to investors and one that BDO Seidman should have considered is the price/cash flow ratio. This indicates the relationship between the stock price and the operating cash flow. This is considered as the best way to determine the entity's profits. The capital turnover ratio is an important ratio to compare the sales and the capital employed. A change in the capital turnover ratio would mean a manipulation of sales or one or more of the elements that make part of the capital employed, that is, fixed assets, cash, debtors or inventory.

The use of ratios by the auditors is an important but it requires skills and experience in order to get the correct analytical results. Other financial information required during the audit

The auditors should have done more testing in the controls of the financial process by a plan to audit other important financial statements such as the cash flow statement and the bank reconciliation statement. The auditors should have also followed the financial transactions that had resulted to the balances in Leslie Fay's balance sheets and the income statement. This would include conducting tests of control in the transaction cycle. The auditors should have audited Leslie Fay's sales system, the purchases system, the inventory system, the cash system and the payroll system. In addition to this the auditor should have asked questions about ant subsequent events. Subsequent events are those events that occur in the period between the financial period closing date and the date that the auditors conduct the auditor, both the adjusting and the non-adjusting events. In addition to the balance sheet, the income statement and the ratios, the auditor should have also asked for the period's cash flow statement.

The cash flow statement is an important tool to investors and the management as it assists them in knowing the financial health of the organization. It is a statement that supports the income statements as there must be a connection between cash sales and credit sales especially if they have not been paid by the end of the financial period. Huge sales in the income statement without corresponding huge cash flow from the organizations operations should raise questions and should be explained by reconciliation. It has a link with the balance sheet as it records ay new cash sales and purchases and other payments. The cash and bank balances can then be verified by a physical cash count for the cash balances and confirmation by the bank through a bank letter that is sent by the auditor. The auditor should also request for the bank reconciliations and explanations for all the cheque shown in the bank reconciliation. A comparison of the ratios by the competing firms would have been important to the auditor in discovering the irregular variances.

The auditor would have asked for an explanation for the variance as well as the evidence for the explanation figures. A qualified auditor should make wise judgment when planning an audit. The auditor should be inquisitive and should be quick to notice some irregularity in the financial statements. This inquisitiveness should have guided the auditor to understand why Leslie Fay sales increasing while sales in the overall garment industry had been going down. This would have led to the querying by the auditors as to how Leslie Fay was the only garment industry that had not suffered a decline in sales during the late 1980s and early 1990s recessionary period. This in turn would have led to a need to plan an audit on the revenue cycle and tests on the internal controls in relation to the revenue cycle. The auditor should have verified the accuracy and the existence of the figures that were appearing in the income statement as revenue.

The verification of the sales system should include authorization of the sales and the accounts recording of these sales (Rittenbergm Et al., 2009). An audit on the sale systems involves ensuring that there is proper authorization of the sales orders, proper matching of customers to these orders, payments and the invoices and the records of goods outwards. An audit plan on revenue and sales system should include verification of any sales figure that appears at the end of the financial period as in most cases, there is a possible risk of fraud or wrong adjustment of figures. It would also include an audit on the sales ledger control account. The sales revenue cycle would involve verification of the discounts to the customers. Had these measures been taken by the BDO Seidman audit firm, the fraud by Kenia would have been discovered earlier. The auditor should have planned to audit the inventory of the organization. Inventory audit is important as it may form substantial and material amounts in the financial statements. This was the case at Leslie Fay where inventory was more than 30% of total assets in all the years within 1987 to 1991.

A plan for inventory audit should emphasize on the existence of the inventory, accuracy and proper disclosure. This should include verifying the cut off whereby the inventory is recorded in the correct financial period. An auditor should plan to attend the client's inventory physical count which provides the auditor with reliable audit evidence about the existence of this inventory. When planning for the attendance, the auditor should take into consideration the previous year's physical count procedures, the value of the inventory in comprison with the total assets, and the procedures involved during the counting process. An attendance by BDO Siedman auditors during the inventory physical count at Leslie Fay would have revealed a shortage in the physical count as compared to the recorded figures.

The physical count would have detected the irregularities that had been created when Kenia and his colleagues forged inventory tags. Physical inventory counting includes a comparison and recording of the purchase orders, good received notes and delivery notes. This ensures that the goods that are recorded as sales have actually been sold. Regarding the goods in transit, the auditor should plan to get third party confirmation that these goods are in existence and that they are in their premises. The inventory counting should be taken by conducted by personnel who are not daily involved in the inventory. In obtaining the payroll system the auditor would have identified how the remunerations for the executives at Leslie Fay were being calculated.

A verification of the payroll system includes the documentation and authorization of the salary changes, the calculation of the salaries and deductions, the payments. The payments should be compared with the cash sent to the bank and money debited to Leslie Fay's bank accounts. This would have led to the auditors query on the high incentives by the executives. Another important area that should have been audited is the purchases system. This should emphasize on the authorization of the buying process, the custody and existence of the received goods and the recording of these transactions in the accounting books. Close to the purchases system is the accrual control account. To audit the accruals the auditor should have asked for after closing date invoices. This would ensure that all goods received have been recorded properly.

Non-financial variables or factors that an auditor should consider when planning an audit and their audit implications.

When preparing for an audit, there are some factors that an auditor should take into consideration. This should include the nature of the business, the timing of the audit, and the extent of the risk assessment procedures which is adequate for identifying the risk of material misstatement. After the appointment the auditor should get to know the operations of the client's business that is being audited. This includes the business operations, the investments and financing, and the financial reporting dates and methods. The auditor should assess the client's internal controls, the control procedures as well as taking a risk assessment tests.

The initial planning should start with the strength and reliability of the internal controls that are in existence. Internal controls assist in the safeguarding of the company assets and investors investments, prevention and detection of fraud. Internal controls are meant to improve efficiency in running a business as risks are identified. The internal controls also do help in ensuring the accuracy and reliability of the annual reports as the control systems ensure that the reporting is in compliance with the existing regulations. In assessing the reliability of the internal controls, the auditor will be able to determine the amount of testing that should be taken on the financial statements.

Paul Polishan apparently dominated Leslie Fay’s accounting and financial reporting functions and the individuals who were his subordinates. What implications do such circumstances pose for a company’s independent auditors? How should auditors take such circumstances into consideration when planning an audit? A company in which one person is dominating all the accounting and financial reporting would imply that the company may have weak internal controls. When one person is essentially in charge of all the transactions in two departments, it would definitely indicate a set of weak internal controls. Weak internal controls can lead to employees perpetrating fraud, as it did in the Leslie Fay case. Management of the company, not the auditors, are responsible for internal controls. Section 404 of Sarbanes-Oxley requires that all public companies issue a report on internal control containing: 1) a statement that they are responsible for establishing and maintaining the controls and 2) an assessment of the effectiveness of those controls.

Recall also that the second GAAS fieldwork standard states that “The auditor must obtain a sufficient understanding of the entity and its environment, including its internal controls…” the internal control framework followed by most U.S. companies is the Committee of Sponsoring Organizations of the Treadway Commission (COSO). More specific to this case, the audit team would have to assume that these circumstances would imply a weak internal control over classes of transactions. Auditors often are more concerned with the transactions rather than the account balances because the transactions will weigh heavily into the correctness of the account balances. The third component of internal control under COSO is control activities. There are several relevant factors under this component. For starters, there was probably not adequate separation of duties. It was said that Polishan ruled the accounting and finance departments. The person whom is responsible for putting out the financial statements and showing the public the financial position of the company should not be the one booking entries.

Also, was there proper authorization of transactions and activities? Every transaction had to be run through Paul Polishan, the CFO. This sounds like adequate controls; the problem was that Polishan’s word was final on everything. No one else had any say because of Mr. Polishan’s total authority. Mr. Polishan also had near total authority on financial reporting. The real problem here is when someone has total control over both these functions, opportunities for fraud start to appear. With no one willing to question his positions, he was free to authorize transactions that made the books look better but obviously did not reflect economic actuality. Another aspect is independent checks. Basically, this is reviewing the other areas of control activities.

There were likely no checks done in the case of Leslie Fay because Polishan had the final say on all transactions. Even if checks were in place, they were likely done by Polishan. The person responsible for performing the checks should be independent of the person originally responsible for performing the data. Obviously Polishan cannot be independent of himself. It was also mentioned that Mr. Polishan’s overall compensation was tied to the financial performance of the company. He had the motive, ability and means to cover up his fraudulent activity. Another key factor leading to weak internal control was the fact that Polishan’s department was in an entirely different physical location. A lot of the major accounting and financial decisions for this company were being made at a separate building, far away from other key management personal. Now how should auditors take into consideration these circumstances when planning the audit? The audit team will need to obtain and document their understanding of the company’s internal controls. This can be done using a narrative, flowchart, or questionnaire.

A narrative seems it would be best if applied here because it will help identify the separation of duties factor. The auditors may then want to perform a walkthrough to make sure what has been written down in the narrative is actually what is performed. In a walkthrough, the auditor selects a few documents and traces them from beginning to end. This way, the auditor can see the entire process involved in every transaction. This type of control may have helped the auditor see just how much influence Polishan had over the accounting area. It could have easily, however, been covered up. However, having the understanding that he had significant influence over finance, and that he oversaw all accounting matters should have raised a red flag. It would be very easy for someone to commit fraud in accounting knowing that they also controlled finance. It seems that the fraud perpetrated in this case would be hard for an auditor to uncover.

One person had control over two key departments. He himself never “got his hands dirty”, yet, always instructed subordinates to follow his instructions. After obtaining proper understanding of internal controls, the auditors must then assess control risk. This involves identifying audit objectives, identifying existing controls, associating controls with related audit objectives and, evaluating control deficiencies, significant deficiencies and material weaknesses. A control deficiency exists if the design or operation of controls does not allow a company to prevent or detect fraud on time. When a control is well designed yet is not carried out well, an operational deficiency exists. In this case, the controls would appear to be in place. All transactions are done at the appropriate level, and are vouched for by the CFO.

However, the CFO (Polishan) was forcing incorrect and fraudulent entries. Polishan would force his subordinate Donald Kenia to make then erroneous entries. The process would appear to be appropriate, but in this case fraud was committed at top levels. In general, the independent auditors should see this multi-tiered level of control and it should raise a red flag. They should set some type of testing, such as the walkthrough or narratives to better determine if there is potential for fraud. So much being done and controlled by one man is a red flag. The fact that Leslie Fay was able to maintain high sales and profits while others in the industry struggled was another red flag. These were all key factors that point to poor internal control and potential fraud.