Substantive Procedures: Methods Followed By Auditors For Analyzing Financial Statements

Introduction to Substantive Procedures

The various methods followed by an auditor for the well being of the account balances and many other major transactions in the company at a substantive level is collectively known as Substantive procedures. These methods if strictly followed by the auditor provide the organizations with an opportunity to plan the future strategies. The evidence collected during the period can also be helpful in eliminating any material misstatements that may have existed in the financial statements.

If a financial statement is legal and totally valid then it is easy for the auditors to present a clear view of the state of affairs of the company. Thus for achieving the above-explained goals, the auditor must put pressure for following the substantive methods. But it is necessary to analyze all the current situations before following any methods (Heeler, 2009). In the case of DIPL Ltd also, the auditor must analyze all the current situations before following any substantive measures. This procedure has proved to be a boon to for the auditors by which they can easily detect any flaw in the financial statements. But it is important to take into account valid evidence before applying substantive procedures (Gay & Simnet, 2015).    

 Financial Statements records of the company clearly show that the company has strong foundations. On the basis of the records, analysis can be made with the help of ratio analysis, the pattern of trend and scanning of the financial records. The trend factor in the financial statements is very crucial, as it depicts the performance of the company over a limited mentioned period of time. The previous records are always helpful in deciding the future performance (Elder et. al, 2010). Another procedure for the evaluation of the ratios can be useful in determining the yearly performance and can be a decision making a factor. The third factor that is the evaluation of the financial records can be taken into account for depicting the relationship between different variables (Reding et. al, 2015). So the three factors can be given the title of the decision making factors and are important for carrying out an audit.   

In order to start a well mannered and to determine the financial performance, the following computation of three years for DIPL Ltd is presented below. The profitability ratio depicts the way in which the business functions, the liquidity ratio represents the potential of the company to credit the obligations and lastly the solvency ratio determines the position of the company (Heeler, 2009).  

Analyzing Financial Statements using Ratios

Gross profit aligned with net profit ratio depicts the profitability ratio. The performance of a company in its respective fields is denoted by the gross profit ratio; which in this case saw a trivial downfall in a span of 3 years. The net profit ration also denotes the performance; which in this case had been stable for the year term depicting that the company had performed equally in all the three years and has worked hard to maintain the desired results (Guerard, 2013).   

Liquidity Ratio

It is the topic that current ration aligned with the quick ratio is evaluated together. A healthy current ratio depicts that the company has a hard liquidity base; in this case, the ratio is 1:1 which is very positive for the company as it increased in all the three years. Also, the quick ratio is a first-class indicator of liquidity. This ratio does not consider the stock and hence is a better indicator as compared to the current ratio (Guerard, 2013). Records show that the quick ratio also has seen a positive deflection. This also shows that the liquidity is in a good state.  

Solvency Ratio

It is crystal clear that the debt and equity gather together to form the debt equity ratio. Records show that the debts of the company increased highly in the year 2015. It is also seen that the debt equity ratio stands to cross 1 which is fatal for the company. Due to this reason the company will be exposed to a higher interest rate thus unable to obtain extra loans (Libby et.al, 2011).

Thus it is clear from the overall view that the finances of the company are not at all stable right now due to drop in cash position in three past three years. This situation simultaneously calls for the liquidity problem. Also, a cut off in funds is visible from the accounting receivables which depict the loss of potential in the realization system. The major factor of increase in the bad debts is the improper concept of the stock evaluation. The debt proportion has increased considerably leading to a surge in the debt capacity of the company (Johnstone et.al, 2014). It needs to be noted that if the debts increase in major proportion then the company faces several risks like unavailability of the loan, higher interest rate payment, etc. Moreover, the ability of the company is highly doubted if debt proportion enhances beyond the limit.

Liquidity Ratio and Current Ratio

Going through the financial statement of the company of DPIL it can be observed that it had distinctive risks observed from its business operations. Even though the company operates through proper internal control over all its operations, there are certain risks still prevailing in the financial report of the company. An inherent risk is the one that is present in the company and is difficult to be eliminated. Such risks need to be faced with the strong internal control mechanism and cannot be removed in totality (Gay & Simnet, 2015). The risks observed from its system of business operations are as follows:

1. A person having a financial interest in the company assigned to vital appointments.

In case of the company DPIL Ltd, it is observed from the information available that a new CEO is appointed who pursues a financial interest with the organization. The Chief Executive Officer appointed has been granted with a benefit wherein he will be given a ten percent share in the profit of the company if the business growth exceeds more than ten percent revenue growth. In addition to this, the CEO has appointed a team of an internal auditor under his command and work under him. The risk prevailing in this case that the CEO is in a position that he might use unethical ways and means to enhance the revenues of the company by manipulating the books of accounts. The team of the internal auditor that has a link with the CEO might be influenced to hide the manipulations and hence, the financial statements might project a different scenario. It is vital to be noted that the CEO should have a financial pecuniary in the company as it will lead to biased decision making (Matthew, 2015). Henceforth, this is a fundamental risk for the company that can play a vital role in the decision-making process. If the board of directors would have undertaken such decisions in appointing the internal auditors, such risks would have been avoided.

1. Migrating to the new information technology system from the old information technology system.

A decision has been taken by the board of DPIL Ltd to implement a new information technology system for a transparent and better accounting process. Though, the decision to adopt a new system for a better accounting method, yet the new technology has not been implemented properly into the system in place of the old system. Further, the company has neither taken care of in providing proper training facilities to its existing personal or they hire fully trained persons that are required to work on new technology implemented into the system (Church et. al, 2008). Furthermore, all the employees have been allowed to access the new system has given rise to the inherent risk to the company. In respect to this, dealing with the new technology system, only the senior executives and accountants must be given permission to access the new technology system that are in turn answerable to the management and auditors of the organization. As because, of incomplete footstep taken by the company prior to implementing the new technology into the system, might have adversely impacted the financial report thereby impacting the image of the company.

Solvency Ratio and Debt Equity Ratio

Taking into consideration of the observations and the two obvious risks implies a bigger threat for DPIL Ltd., and punitive measures must be swiftly taken for a smooth, effective and transparent functioning of the company to improve the financial performance and overall business environment.

There are two types of fraud risks owing to the business nature of DIPL Ltd are as follows:

• As a result of the vague analysis of the new It system, improper details got introduces into the system and thereby creating flaws in the accounting figures of the financial statements. In such cases,the major dejection is formed by the misstatements of the accounting balances. Also because of the potentially weak methods of evaluation, it is easy for the accountants to impact the financial statements in a style by which they come under no allegation (Gilbert et. al, 2005). For example, an accountant may settle some transaction outside the boundaries and may display it as outstanding amounts for self-benefits. Thus it can be computed that the new IT system has loopholes in the form of inability to record correct data.
• It is to be seen thatthe company records receipts through mailing facilities. This process can easily be tampered with by the accountants for fraudulent activities as the bank certification is unavailable in most cases. Thus in these cases, it becomes necessary to gain bank verification by the bank statements so as to help the accountants to pass on any amount that requires substantiation. In some cases, it is also seen that the bank itself is conducting some wicked internal control processes. Taking the advantage of the above situation the accountants can cleverly transfer the assets of the company to an off beam person or themselves can take advantages from it because of the flaw (Carcello, 2012). All this not only degrades the financial position but also the assets of DIPL Ltd. It is thus demanded that to have a potentially strong reconciliation system in the bank. Thus, it is the duty of the managing body to analyze minor details as well to gain control over the information being put up in the financial statements.      

The words of the auditor can fail to make an impact if the management itself has taken to fraudulent ways. The major factor behind such massive conspiracies can be the immense power installed in the hands of the management to change the financial statements as per their needs, which is a mere task for them. Also, the changes made by the managing body in the financial statements are tough to get detected by the auditor (Geoffrey et. al, 2016). Thus, it is the duty of the auditor to adopt such measures that will not only highlight but also eliminate such manipulations in the financial statements. In order to eliminate those documents like tax challans, ledgers, etc must be taken into account. Untimed entry of the assets of the bank may not get recorded in the financial statements and thus may show the auditor’s work in a negative way while showing the cash position of the company as weak (Black, 2010).  Improper financials made by the managing body can result in an unhealthy audit. It is also necessary that the auditor is in compliance with the latest IT system, but due to the ineffective entry of the transaction in the earlier stage, the audit can have a degraded quality. Poor checking of the systems may impact the audit can are enough to set up loopholes for both the auditor and the company. This poor checking of the system can also result in piracy, data breach, and many more fatal malfunctions. All these factors may cause the decision of the auditor to be against the company. Thus, it is necessary for the auditor to be in compliance with the new IT system. This will save the time that would have been required for the auditor to get ready as per the system which would have otherwise resulted in mismanagement and would have resulted in a negative decision on the company’s part.

References

Black, W. K 2010, Epidemics of “Control Fraud” lead to Recurrent, Intensifying Bubbles and Crises, Working paper, University of Missouri-Kansas City.

Carcello, J 2012, ‘What do investors want from the standard audit report?’, CPA Journal vol.82, no. 1, pp. 7-12

Church, B, Davis, S & McCracken, S 2008, ‘The auditor’s reporting model: A literature overview and research synthesis’, Accounting Horizons vol. 22, no. 1, pp. 69-90.

Elder, J. R, Beasley S. M.& Arens A. A 2010,  Auditing and Assurance Services, Person Education, New Jersey: USA

Gay, G & Simnet, R 2015, Auditing and Assurance Services, McGraw Hill

Geoffrey D. B, Joleen K, K. Kelli S & David A. W 2016,  ‘Attracting Applicants for In-House and Outsourced Internal Audit Positions: Views from External Auditors’,  Accounting Horizons, vol.  30, no. 1, pp. 143-156. 

Gilbert, W. Joseph J & Terry J. E., 2005, ‘The Use of Control Self-Assessment by Independent Auditors’,  The CPA Journal, vol. 3,  pp. 66-92

Guerard, J. 2013, Introduction to financial forecasting in investment analysis, New York, NY: Springer, pp. 78-81

Heeler, D 2009, Audit Principles, Risk Assessment & Effective Reporting. Pearson Press

Johnstone, K,  Gramling, A &  Rittenberg, L.E 2014, Auditing: A Risk Based-Approach to Conducting a Quality Audit, 10th Edition, Cengage Learning

Libby, R., Libby, P. & Short, D 2011,  Financial accounting, New York: McGraw-Hill/Irwin.

Matthew S. E 2015, ‘ Does Internal Audit Function Quality Deter Management Misconduct?’, The Accounting Review, vol. 90, no. 2, pp. 495-527

Reding, H.R,  Sobel, P.J,  Anderson, U.L,   Head,M.J,  Ramamoorti, S, Salamasick,M &  Riddle, C 2015,  Internal Auditing: Assurance & Advisory Services, 3^rd Edition, The Institute of Internal Auditor Research Foundation.

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