Precourse work Flashcards
What are the different ways that a board of directors could manipulate the profit and loss account? (5)
Recognising revenue too early
Recognising revenue that doesn’t exist e.g. fraud fake sales invoice
Delaying the recognition of costs until next year
Overstating the value of closing inventory by either pretending you have more units at the year end or valuing the inventory at a higher price
Classifying expenditure differently than the previous year, could make current year numbers appear higher or lower than they should be
What are the different ways that a board of directors could manipulate the statement of financial statement? (6)
Recognising a non-current asset that should have been expensed
Failure to depreciate a non-current asset correctly
Overvaluing inventory to boost current assets
Recognising a sale on credit that didn’t take place e.g. fraud overstating trade rec
Failure to write off a bad debt
Failure to recognise a liability for a cost that did take place e.g. understate TP and understate COS
What is analytics procedures in audit?
It is where we look at trends, patterns and relationships to help direct our audit efforts
The most common analytical procedure is to compare the current year to the prior year using ratio analysis.
Gross Profit Margin Formula
Gross Profit Margin = Gross Profit / Revenue
Want this to be HIGH
- Usually does not change dramatically from one period to the next, unless the company changes its sales mix (sales mix e.g. new product introduced which has a higher profit margin)
- Increased margin may be due to decreasing costs or increased sales prices
-Changes could result from Improved / reduced purchasing power (economies of scale) e.g. f you buy more from your supplier they will likely give you a better deal. - And increase in GP% could be due to overstated revenue, understated purchases or overstated inventories
Operating Profit Margin Formula
Operating Profit Margin = Profit before interest and tax (PBIT) / Revenue
- want this to be HIGH
- Can reflect how efficiently a business is being run, i.e. through controlled overheads
- How well business is operating its core activities and controlling its costs
- A sharp increase or decrease in this ratio is probably due to changes in administrative expenses, e.g. bad debts, restructuring costs, salary increases.
- Note: you need to be careful when calculating PBIT. Most statements of profit or loss only give PBT so you will need to add back the interest charge to arrive at PBIT.
Return On Capital Employed (ROCE) Formula
Return on capital employed (ROCE) = Profit before interest and tax/ Capital employed
Capital employed = TALCL OR Equity (sc+sp+re) + NCL
TALCL = total assets LESS current liabilities
- Measures how much profit is generated for every £ of assets employed
- Indicates how efficiently the company uses its assets
Want this to be HIGH (depends on industry, age of assets, whether co revalues its PPE etc) e.g. Unilever (manufacture) ~20% but PWC (Services) ~50%
Current Ratio Formula
Current ratio = Current assets / Current liabilities
- CA = (Inventory + Receivables + Cash + Prepayments)
- CL = (Payables + Overdraft)
- How easily business can afford to pay its current liabilities out of its current assets
- Measures how easily a company can meet its current obligations.
- Less than 1 means CL > CA and could be a cause for concern, e.g. how will company pay its creditors?
- “Correct” level depends on the industry:
– Too high indicates too much cash tied up in working capital
– Too low and we cannot meet obligations as they fall due
Ideally ≥ 1 but depends on industry (e.g. supermarkets typically < 1)
Too low = liquidity probs; Too high = holding costs/poor return on assets
Quick Ratio / Acid Test Formula
Quick ratio = Current assets – Inventory / Current liabilities
- How easily business can afford to pay its current liabilities out of its most liquid current assets
- In times of crisis, businesses struggle to sell inventory quickly. What can be turned into cash quickly.
- Quick ratio (or acid test) sometimes seen as better test of liquidity as excludes inventory.
- Value depends on industry
Receivables Collection Period Formula
Receivables collection period = (Trade receivables / Revenue) × 365 days
- Shows how quickly customers settle their debts
- Depends on credit policy and credit controls
- Increase may be indicative of recognition of fake sales/trade receivable
- Compare to business’s credit terms
- if considerably higher than credit terms = risk of bad debt
- if lower = great, efficient, cash flow
Payables Payment Period Formula
Payables Payment Period = (Trade payables / Purchases (or COS)) × 365 days
- Shows how quickly a business pays its suppliers
- A significant decrease could be indicative of unrecorded credit purchases at the year end
Company to supplier’s credit terms - want to take advantage of full credit term (free credit) But if too high, risk of losing supplier’s goodwill & supplier could refuse to supply
Inventory Days Formula
Inventory Days = (Inventory/COS) x 365 days
- Shows how long a business takes to sell its inventory
- If increasing there could be a risk of obsolete inventory - we would need to write down cost to NRV
Too low - risk running out of inventory
Too high - high inventory holding costs
Gearing Ratio Formula
Gearing ratio = Net debt / Equity
Amount of lending/investment that is tied up in debt as a proportion of the investment from the shareholders (equity)
Net debt = Loan - Cash = Risky Investment
Equity = SC + SP + RE + Other Reserves = Unrisky Investment
- Debt is riskier than equity due to interest having to be paid and risk assets will be seized if repayments are not made
- Composition of business’s long-term finance (money borrowed from lenders versus money sourced from shareholders)
- Can be increased/decreased by: significant asset purchases; repayment of debt, issue of new debt
- Loan agreements (covenants) may require a company not to exceed a particular level of gearing.
- Higher the number the worser the company is to invest in
Too high - risk company won’t be able to service its finance (pay interest & repay capital)
Too low - not taking advantage of cheaper debt finance (interest is tax-deductible & lower risk to investor
Interest Cover Formula
Interest cover = Profit before interest and tax (PBIT) / Interest payable expense
- Profit before interest and tax (PBIT) = Operating cost
- Interest payable expense = Finance Costs
- This ratio shows how many times the interest expense can be covered by profits. In simple terms, the higher this figure is, the easier the company will find it to pay its interest expense.
Ideally ≥ 1 (bank loan covenants typically require interest cover of around 2.5 - 3.5)
Net Asset Turnover Formula
Net asset turnover = Revenue / Capital employed
Capital employed = TALCL OR Equity (sc+sp+re) + NCL
TALCL = total assets LESS current liabilities
- How efficiently business uses its long-term finance to generate revenue
- Measures how much sales revenue is generated for every £ of assets employed
- A significant decrease can be caused by new assets being purchased close to the year end
- An increase could be caused by the purchase of more efficient assets
- Want this to be HIGH (depends on industry, age of assets, whether co revalues its PPE etc)
Which ethical codes do we follow in the UK?
ICAEW Code and FRC (Financial Reporting Council) Ethical Standards
