MAKING FINANCIAL DECISIONS
MAKING FINANCIAL DECISIONS
There are different types of accounting records and such records are important in any organization. One of the common account records is the income statement. An income statement provides one with an accurate description of the company’s profitability over a set period of time. An income statement could be described as an accounting statement that matches a company’s revenues with its expenses over a given period of time usually a quarter or a year. An income statement is composed of several items including sales, costs, increase and decrease in intangible value, taxes, and outstanding shares. Another key accounting record is the balance sheet. A balance sheet categorizes a company’s resources such as assets, liabilities and owner’s equity. According to Pandey (2002, p.67) the components of a balance sheet are divided into current and long-term categories. Pandey (2002, p.68) further observes that these components are listed in order of liquidity. Beside a balance sheet and income of statement, a statement of cash flows is also very important in a business. Cash flow statement provides one with information about a company’s cash receipts and cash payments. According to Khan and Jain (2003, p.56) a cash flow statement has several objectives. Firstly, it is effective in predicting the amounts of timing and ascertaining of future cash flows. Secondly, it indicates how cash is used and generated. It also helps the creditors, stockholders and customers to determine the flow of cash in a business. Thirdly, it helps an entrepreneur to understand the differences between net income and net cash flow from operating activities. Finally, it helps an entrepreneur to examine a company’s investing activities and financing transactions.
Needless to say, it is important for an entrepreneur to understand different accounting concepts the common of which are business entity, matching concept, money measurement, going concern, accounting period, cost concept, realization concept and accrual concept. To understand the importance of each of these concepts it is instructive to examine their roles. To start with, a business entity treats a business and an owner as two different entities. In other words, a business entity is the very basis of accounting concepts, conventions and principles. The money measurement concept allows an entrepreneur to distinguish between transactions that can be expressed in terms of money and those that cannot. The going concern concept assumes a business entity can carry out its activities for an indefinite period of time. This concept is important as it facilitates the preparation of financial statements. The accounting period concept is important in calculating tax, predicting future prospects of a business and helping an entrepreneur to procure credit from financial institutions. The accounting cost concept requires all assets to be recorded in the books of account at their purchase price. This requirement is helpful in the sense that it allows an entrepreneur to calculate depreciation of fixed assets. Another key concept is the dual aspect concept which allows an entrepreneur to detect errors and the realization concept which makes accounting information more objective. Equally important is the accrual concept which helps an entrepreneur to know the actual expenses and income during a particular period of time. Using this concept an entrepreneur should be able to calculate the net profit of his or her business. Finally there is the matching concept which states that revenue and expenses should be recorded in the same accounting period. This concept should help an entrepreneur to ascertain the exact amount of profit or loss of the business.
In order to effectively run a business it is also important for an entrepreneur to understand the factors that influence the structure of accounting system. One of factors is the company’s need for accounting information. Accounting information that is generated in a company could be useful not only to the investors but also the creditors and the management. It is also worth noting that accounting systems are influenced by the nature of the business and the operations of that business. Other factors that come into play include the perception of the employees and the management, the level of training accorded to the users, the nature of implementation and the implementation partners, and the resources available for the operation of the system.
Risk in any business could affect both primary and supporting assets.
Failing to manage risk can lead to litigation. Litigation can end being costly as businesses are forced to incur a number of injurious costs including attorney fees, out-of-pocket expenses, and foregone revenues. Failure to manage risk could also lead to sanctions from private and public regulatory bodies such as the Securities and Exchange Commission. It could also lead to impaired professional reputation as a result of adverse publicity.
In any organization there is a possibility of risk occurring. Fraud in an organization manifests itself in many ways. For instance, fraudulent financial reporting could occur due to improper revenue recognition, overstatement of assets and understatement of liabilities. Other actions that are fraudulent include misappropriation of assets, revenues or assets, conflict of interests, discrimination, antitrust practices and environmental violations.
In an organization, fraud and risk can be prevented and detected through a number of ways. Firstly, fraud and risk can be managed through auditing and monitoring. However, according to Prasanna (2006, p.71) it is not possible to audit every fraud and misconduct risk and so it becomes necessary to perform a risk assessment before hand. For this method to work, it is imperative to have competent employees who should have a comprehensive understanding of what fraud is and what its red flags are.
Beside auditing and monitoring, fraud and risk can be prevented and detected through proactive data analysis. Proactive data analysis has been found to be effective in identification of suspicious transactions, assessing the effectiveness of internal controls and monitoring fraud threats and vulnerabilities. Organizations could choose to either use continuous transaction monitoring or retrospective based analysis. The former allows organizations to continuously monitor areas that pose strong risks while the later allows organizations to analyze transactions in one or two-year increments.
Another prominent way of fraud prevention and detection is the use of process controls. According to Prasanna (2006, p.71) process controls are effective in detecting fraudulent activities. In his view Pandey (2002, p.81) observes that to effectively manage risk and fraud in an organization, the management should put in place internal controls. But what are internal controls? According to Charles, Gary and John (2009, p.80) internal controls refer to the procedures and policies that are adopted by the management to ensure a business entity operates in an efficient and profitable manner. Internal controls safeguards both physical and un-physical assets. This is achieved by conducting reliable and safe back-up procedures, clearing assignment of duties and controlling operating environments. It is also worth noting that one of the other roles of an internal control system is producing accurate and complete accounting records and timely preparation of financial reports. Most importantly, a control system is composed different component. The first component is maintenance of a control environment. In order to avoid risk and fraud it is important for all the stakeholders to understand, be aware and commit themselves to the policies and procedures established. A strong control environment should be implemented using tight budgetary controls and effective internal audit functions. The second component is risk assessment which is the act of identifying, prioritizing and implementing risk management strategies, policies and procedures. The third component is control activities which include accounting systems and specific control policies and procedures. In this regard, setting up an accounting and portfolio tracking system could be helpful play an important role in the process of data preparation, data entry, and transaction processing and document generation. Control procedures could include activities such as performing independent checks, separation of duties, authorization and approval of transactions and activities, use of adequate documents and records, and maintaining physical control over assets and records. The fourth component is information and communication. In this regard, internal audit reports, monitoring and evaluation reports need to be shared among the stakeholders. Finally, internal control cannot be effective without continuous monitoring and supervision. This can be achieved by strengthening the internal audit functions.
Factors to consider when planning for an audit
In this scenario audit risk is high because the company’s financial statements are likely to be misstated. It is also highly possible that the auditor will fail to detect such material misstatements. Given these possibilities, the auditor is likely to issue an inappropriate opinion on the financial statements. To effectively conduct the audit it will imperative for the audit to keep the audit risk at low levels.
Given the prevailing circumstances it will be important for the auditor to ascertain the degree to which users will rely on the client’s financial statements. Using incomplete or erroneous documents could prove injurious to the users and the auditor. It is also worth noting that some businesses have high levels of inherent risk. To deal with this problem, the auditor is required to identify inherently risky areas and gather appropriate evidence regarding those areas. Inherent risk is also determined by the integrity of the management, results of pervious audits and client motivation to misstate the financial statements. Another important component of audit risk is detection risk. In this scenario detection risk is high and as such the auditor will be required to select proper audit procedures.
Another important concept in the auditing process is materiality. In this regard, the auditor should determine whether the misstatements will distort the view given by the financial statements and influence the understanding and economic decisions of the users. The scope of audit is also very important and it should help the auditor all areas of concern. In order to improve the accuracy of the audit report it will important for the auditor to get an assurance from the client as to whether the information contained in the accounting records is reliable and sufficient. Most importantly, the auditor will be required to apply the compliance test and substance test examine the validity of the information contained in the financial records.
Audit tests will play an important role in detecting any misstatements in the financial statements. According to there are several types of tests that can be used during the auditing process and they include: risk assessment procedures, test of controls, substantive tests of transactions, analytical procedures, and tests of details of balances. The risk assessment procedures can be used by the auditor to assess the risk of material misstatement in the financial statements. In this case, analytical procedures will also be important for preliminary analytical review. Given that conducting a detailed audit may be difficult, analytical procedures will give the auditors an accurate view of the level of material misstatements.
Purpose of an audit report
Auditing plays a pivotal role in providing the internal and external parties with financial information about particular information. The information generated by an audit could be helpful to the employees, the management, shareholders, lending institutions, regulatory agencies and security market. According to Prasanna (2006, p.81) auditing is an important social control mechanism for promoting accountability. There are four types of audit reports, each of which is discussed below.
Types of audit report
A qualified opinion is issued when a report fails to conform to generally accepted principles of accounting. A qualified opinion is also expressed when there no sufficient audit evidence. A qualified opinion contains an explanatory paragraph contains a paragraphs where the auditor highlights the reasons why the audit report is not unqualified
It states that the financial statements were prepared were prepared in accordance with the generally accepted accounting principles and is presented when auditor ascertains that each of financial records is free of any misrepresentations. This kind of report is repaired by an unbiased third party and its titles contain the word “independent.”
In Charles, Gary and John’s (2009, p.80) view this is the worst type of an audit report that a business entity can receive. This report does not conform to generally accepted accounting principles and indicates that the financial records provided by the business have been grossly misinterpreted. When a auditor expresses an adverse opinion he or she is required to include an explanatory paragraph that should contain all the reasons for his or her adverse opinion.
Disclaimer of opinion
A disclaimer of opinion is expressed when the auditor is unable to make an informed opinion as to the fairness of presentation of the financial statements in conformity with GAAP. It is also appropriate if the auditor is unable to perform a sufficient audit. When this happens, the auditor is required to issue a disclaimer explaining the issues why the opinion of the firm’s financial status could not be determined.
Constituents of an audit report
An audit report should have a title indicative of the word “independent.” The title is followed by an address and an introductory paragraph. The introductory paragraph indicates the responsibility of the external auditor, and the management. It also contains the company’s financial statements including the balance sheet, statement of income, and statement of cash flows. An audit report also has a scope paragraph indicating the purpose, the nature and the scope of the audit. In any report, there must also be an opinion paragraph which indicates the auditor’s assessment of corporate risks and controls. An opinion paragraph is followed by an explanatory paragraph. A sample of an auditor report is detailed below.
AN INDEPENDENT AUDITOR’S REPORT_____________________
The Board of Directors,
We have audited the accompanying balance sheet of the Upton Company which comprise of the balance sheet as of 31st December 2012 and other financial statements for the year(s) ended then.
The audit was conducted according to the generally acceptable accounting principles. The prevailing standards requires the auditors to examine whether financial statements are free from material assessment, to examine evidence supporting the amounts and disclosures in the financial statements, and evaluate the principles used.
In our opinion, the financial statements give a true view of the financial position of Upton Company as of 31st December 2012, and of the results of its operations for the year ended in accordance with GAAP.
Stratton and Briggs limited
24th December, 2012_____________________________________________________________
Purpose and contents of a management letter
A letter of management is written by the auditor towards the end of the audit. It contains information on weaknesses that have been identified by the auditor and recommendations of how they can be mitigated. The letter of management serves several purposes. Firstly, it enables an auditor to give his or her comments regarding accounting records, systems and controls. Secondly, it highlights any materials errors and ways through which they can be rectified. Thirdly, it offers the management constructive advice and improves the quality of the evidence gathering process. A letter of management starts off with an opening paragraph, after which any matters arising from the audit are listed. A raft of weaknesses and recommendations are then listed. The letter ends with a concluding paragraph. An example of a management letter is show below.
__________________ MANAGEMENT LETTER___________________________
Stratton and Briggs limited
Certified accountants and registered auditors
Audit for the year ended 31st December 2012
We are writing to you regarding the matter arising from the audit for the year ended 31st December 2012. Our responsibilities are guided by the relevant regulations and in accordance with generally acceptable accounting principles. This report has been prepared for the use by the management and others within the organization and none of its contents may be disclosed to external parties. The matters detailed in this report reflect matters coming to our attention during the auditing process.
Appropriate forecasting procedures are not undertaken and this problem can be attributed to the significant turnover in the finance management directorate.
The management does not receive reliable information for the decision-making process.
A strong financial management framework should be put in place.
We would be pleased to discuss the above issues at your own convenience.
Stratton and Briggs limited________________________________________________________
Charles T. H., Gary L. S., and John A. E. (2009). Introduction to
Financial Accounting. Pearson Education
Khan, M. Y. & Jain, P. K. (2003). Financial Management – Text and Problems.
New Delhi: McGraw Hill Publishing Company Limited, New Delhi
Pandey, I. M. (2002). Financial Management. Vikas Publishing House Pvt.
Prasanna, C. (2006). Financial Management – Theory and Practice. New Delhi:
Hill Publishing Company Limited,
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