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The use of financial ratios assists the auditor in analyzing any unusual deviations form 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. 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 comparison 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 the 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. This reliance on the internal controls is stipulated in ISA 315 Understanding the entity and its environment and assessing the risks of material misstatement. This involves understanding all the five elements of internal control the control environment, the risk assessment process, the information system, control activities and the monitoring of the controls (IAASB, 2010).
The auditors should assess the adequacy and the effectiveness of the risk assessment policy. These would help in identifying the any possible risks of material misstatements. The auditor should asses the adequacy of the accounting system, identify any possible areas where misstatement could be material and come up with appropriate audit procedures.
After identifying the reliability of the internal control and taking the risk assessment, the auditor should test the controls to find out to what extent the controls can be relied upon. The tests include walk through tests on a sample of transactions and take tests of controls. This is meant to test if the transactions are recorded as anticipated. Any weakness found will be communicated to the management.
Implications of Domination by Paul Polishan for the company's independent auditors and how auditors should take this into consideration when planning for an audit
Paul Polishan dominated the accounting and financial report. He had strict instructions that he used to deter access and hence queries on the financial reports. Only his chosen and trusted junior staff could freely access any accounting information. This has an impact on the external auditor as there is a possibility that the auditors could not access all the records and documents that they wanted as evidence to the financial transactions. Again a CFO is a senior person and the audit staff may feel intimidated which would affect their independence in conducting the audit.
For the external auditor the existence of a dominating executive should be a sign on lack of a proper control environment. Control environment refers to the governance and the management functions and attitudes of those that have been given the responsibility of managing the internal control system. This includes the senior executives. If they do not follow the internal controls they should be guarding that means there are poor controls in the entity.
Segregation of duties assists in preventing of fraudulent transactions in accounting as this would have to involve a large number of people to collude. This is the kind of control that was missing at Leslie Fay. Segregation means that the people that are involved in the carrying out of the transactions are different from those doing the recording and those who are in the custody of the assets and those doing the reconciliations. This means there is more checks from different people at different. The auditor should take into consideration on how the accounting duties are segregated. According to Stone (2009), segregation of duties is one of the main ways to improve an entity's internal controls.
In planning for an audit where there is an executive dominating a department, the external auditor should check the authorizations of any large amounts by the executive. The auditor should get verify the procedures with the internal audit department and with other senior personnel in order to find out if the domineering CFO maybe doing things in a manner that is against the entity's set out policy.
How BDO's independence was jeopardized
The auditor's independence is very important as it makes the audit report to be reliable. The auditor should be impartial and independent of the management in giving a true and fair view of the financial statements. This is because the public and the stakeholders rely on the audit report and the need to disclose any important information on a public organization. The auditor's independence can be jeopardized by self interest, self review, advocacy, familiarity or intimidation. BOD Siedman's objectivity and independence may have been threatened by familiarity and possibly self interest. In addition to this the audit has a responsibility and a duty to give an opinion on the state of the financial statements. The opinion should be true and fair and in compliance with the laws and regulations. Thus BDO Siedman had a duty to the stockholders to verify the truth and fairness of the accounts and BDO failed in this duty, as such the stallholders rightfully included BDO Siedman in the lawsuit.
BDO Siedman had been the audit firm for too long. It had been the audit firm since the mid seventies, which would have led to a familiarity between the auditors and the accounting staff which jeopardized the independence of the audit firm. A familiarity threat occurs when an audit has had a close relationship with the client either after a long-term relationship or otherwise and where this relationship affects the auditor's objectivity and loss of professional skepticism. After being the auditors for over ten years, Polishan and the BDO Siedman's staff might have developed a familiarity and thus the auditors may have become sympathetic to Polishman and his staff. The risk of objectivity and independence reduces after an auditor has been engaged with a client for five years or more (Strohm, 2006).
Self-interest happens when the auditor has an interest in the profitability of the organization and where the fees paid to the firm are dependent on the results in the financial statements, (Strohm, 2006). The auditor is at the risk of being objective and this would have been the case for BDO Siedman. Self interest is in close relation with intimidation where the auditor can be intimidated by a possible loss for the chance to audit that particular entity in future. The fear of losing a major client can be a threat to the auditor's independence. There is a possibility that BDO Siedman were intimidated by Polishan which led to the auditors giving unqualified reports.