Question

Module 9 Prompt: What is forensic Auditing? What is Internal auditing?

Module 10 Prompt: Compare and contrast a horizontal analysis and vertical analysis Identify and Explain factors that affect quality of earnings Identify what each type of ratio measures liquidity ratios Solvency ratios Profitability ratios

Answer 1

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What is forensic Auditing?

A forensic audit is an examination and evaluation of a firm's or individual's financial information for use as evidence in court. A forensic audit can be conducted in order to prosecute a party for fraud, embezzlement or other financial claims. In addition, an audit may be conducted to determine negligence or even to determine how much spousal or child support an individual will have to pay.

Forensic auditing is a specialization within the field of accounting and forensic auditors often provide expert testimony during trial proceedings. Most large accounting firms have a forensic auditing department.

The audit covers a wide range of investigative activities performed by accountants. The process may also include serving as an expert witness in a fraud trial. A forensic audit could also cover situations that do not involve fraud or embezzlement, such as disputes related to a bankruptcy, business closures, and divorces.

The investigation process follows a similar path as a regular audit of financial statements. The steps can include planning, review and a report. If the investigation was undertaken to discover the presence of fraud, evidence is presented to uncover or disprove the fraud and determine the amount of the damages suffered. The findings are presented to the client — and possibly the court should the case go that far.

During the planning stage, the forensic auditing team establishes objectives, such as identifying if fraud has been committed, how long it has been going on, the parties involved, quantifying the financial loss and providing fraud prevention measures. While gathering evidence, the team collects evidence in the proper manner in order for it to be used in a court case. There are various techniques used to gather evidence. A report is produced for the client with the findings. Lastly, those involved in the forensic audit may be asked to present their findings to the court.

What is Internal auditing?

Internal audits evaluate a company’s internal controls, including its corporate governance and accounting processes. They ensure compliance with laws and regulations and accurate and timely financial reporting and data collection, as well as helping to maintain operational efficiency by identifying problems and correcting lapses before they are discovered in an external audit.

Internal audits play a critical role in a company’s operations and corporate governance, now that the Sarbanes-Oxley Act of 2002 has made managers legally responsible for the accuracy of its financial statements. Besides making sure that a company is complying with laws and regulations, internal audits monitor operating results and verify the accuracy of its accounting and audit trails. They also safeguard against potential fraud, waste or abuse, and seek to identify breakdowns in internal controls. Internal audits provide management and the board of directors with value-added advice, suggesting improvements to current processes and practices which may include information technology systems as well as supply-chain management if they are not functioning as intended.

Internal audits may take place on a daily, weekly, monthly or annual basis. Some departments may be audited more frequently than others. For example, a manufacturing process may be audited on a daily basis for quality control, while the human resources department might only be audited once a year. Audits may be scheduled, to give managers time to prepare the required documents and information, or they may be a surprise, if unethical or illegal activity is suspected.

Compare and contrast a horizontal analysis and vertical analysis:

The main difference here has to do with the time frame that each method of analysis looks at. A horizontal analysis typically looks at a number of years. By contrast, a vertical analysis looks only at one year.

A horizontal analysis compares financial information for one company with the same types of financial income for the same company in one or more previous years. For example, you could look at the company's inventory and determine the percent change for its inventory over each of the last three years

By contrast, a vertical analysis is more of a snapshot. It shows all of the firm's financial information for a particular year. Each item on the statement is typically expressed a percentage of some particular statistic. In other words, you might express everything as a percentage of the firm's total assets. This form of analysis allows a firm to compare itself quite easily to other firms in its industry.

Horizontal analysis of financial statements is also known as trend analysis. It involves a financial analyst observing comparisons between line items or ratios in financial statements over the course of two or more specific time frames. In horizontal analysis, the earliest period being analyzed is referred to as the base period. As the name implies, this technique is useful for analyzing trends in financial statements. Usually, the changes noted will be depicted both in dollar values and as percentages.

A vertical analysis, on the other hand, involves analyzing every line on a financial statement as a percentage of another line. On an income statement, in other words, one could conduct a vertical analysis by converting each line on the statement into a percentage of your gross revenue.

Identify and Explain factors that affect quality of earnings:

Quality of Earnings analysis helps to judge the congruence between the economic earnings of the firm and the integrity of its balance sheet and enables an investor to arrive at more reliable numbers and keep behavioral biases in check. The financial statement of a company does not always give an accurate picture, however QoE analysis gives a clear picture of the management practices of a business. That is: Do they act in the best interest of the minority shareholders? Whether they follow good corporate governance practices? Do they have prudent capital allocation policies?

Quality of Earnings are affected by the following

Recognizing Revenues too early and Expenses too Late: Companies follow different revenue recognition policies and largely comes under the ambit of the management to decide how soon / late to recognize revenues and expenses in the books. Faulty revenue recognition also includes recording bogus revenue, which ends up with large sales return at a later period. Case in point is Valeant Pharmaceuticals, which recognized revenues at the wholesaler level not factoring in eventual sales return at a later stage. Recognizing revenues early leads to higher contribution and also gives false confidence of a growing to line as well as bottom line.

Extraordinary Charges and Gains: Quality of earnings can also deteriorate by booking frequent material extraordinary charges and gains. The incentives could be multiple, but companies engage in large number of transactions to push down the unwanted expenses from the Proforma earnings to the one time charges which Wall street will generally ignore. These charges include restructuring charges, employee severance costs, impairment of assets, impairment of Goodwill etc. Companies may also account for a large number of expenses in a single bad year so that future years’ profits look good.

Increasing Inventories and Receivables: Not only do increasing inventories and receivables reflect higher investment in working capital, but they also indicate the following - a. In order to increase sales, company has started offering lenient credit terms its debtors and is also pushing its inventory through the sales channel. b. Higher inventories inflate the gross margins and also carry a major risk of inventory write downs in the future.

Liquidity Ratios:

Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital. Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio, and operating cash flow ratio.

Current liabilities are analyzed in relation to liquid assets to evaluate the coverage of short-term debts in an emergency.

Solvency ratios:

The solvency ratio is a key metric used to measure an enterprise’s ability to meet its debt obligations and is used often by prospective business lenders. The solvency ratio indicates whether a company’s cash flow is sufficient to meet its short-and long-term liabilities. The lower a company's solvency ratio, the greater the probability that it will default on its debt obligations.

Profitability ratios:

Profitability ratios are a class of financial metrics that are used to assess a business's ability to generate earnings relative to its revenue, operating costs, balance sheet assets, and shareholders' equity over time, using data from a specific point in time. Profitability ratios consist of a group of metrics that assess a company's ability to generate revenue relative to its revenue, operating costs, balance sheet assets, and shareholders' equity. Profitability ratios also show how well companies use their existing assets to generate profit and value for shareholders. Higher ratio results are often more favorable, but ratios provide much more information when compared to results from other, similar companies, the company's own historical performance, or the industry average.