Financial Ratios And Audit Procedures: A Case Study Of DIPL Ltd.

Financial Ratios Computed for DIPL Ltd.

Each time a publisher wants to add a book to DIPL’s ‘digital library’ (a server storing all of the publisher’s books in a digital format, ready to print), it emails the book to DIPL in PDF format. The digital library is backed up at the close of business every day, with the backup tapes kept off site. Once the book is stored in the digital library, the publishers can order copies to be printed as required.

When the publishers confirm the order, the accounting system automatically retrieves details of the publisher’s credit record and stops any orders from publishers that have exceeded their credit terms and limits. A printout of the transactions history of the publishers is generated and must be signed by both Helena keng, the head of publishing, and Jane Roger, the head of accounts at DIPL, before the order can continue, after the transaction history has been signed and dated, accounts receivable staff file it.

If there are no credit problems with the order, it is processed and printed by casual staff in the relevant warehouse, who then load the books onto pallets for shipping. When printing is finished, the sales clerk, Brown Pall, prepares an invoice and dispatch docket and forwards them to the accounts receivable department. The accounts receivable clerk Gay Chan, checks the prices and arithmetic accuracy of the invoices and signs the invoice as evidence of her check. Gay records the sales both the accounts receivables subsidiary ledger and the general ledger and books are shipped to the publisher’s nominated destination (or the publisher will arrange pick up at the warehouse if has its own distributors). The client accepts liability for the goods when they are received in accordance with the purchase order, and signs the
dispatch docket as proof of delivery.

The proceeds from each e-book sale are paid to the publisher’s net of a 5% commission.Proceeds are sent to publishers automatically upon download (the commission is withheld by DIPL). Revenue from the commission is recognised when is withheld from payment to the publishers.DIPL also charge publishers an annual “storage fee” payable 12 months in advance, for keeping the e-book on DIPL’s website. Publishers are invoiced on the date the first download.of a title occurs. As new books are downloaded on an ongoing basis, the storage fee isinvoiced at different times of the year. Revenue from storage fees has been recognised in the month the fees are invoiced, notwithstanding the fact that the fees are charged 12 months in advance.

In September 2014, DIPL acquired Nuclear Publishing Ltd (NPL). The main rationale behind the lay in the value of the copyright NPL held over a large range of specialised medical textbooks. Although the potential print run for the textbook was not large, each textbook had a high profit margin and had been used in universities across the world for many years. DIPL acquired the business operation of NPL (not the shares), paying net assets (including the right
to the copyright). However, in June 2015 an article was published in a medical journal about a new theory that could result in NPL’s medical textbooks becoming obsolete. If the new theory is valid, the textbooks are unlikely to be reprinted or used as textbooks at universities in the future, effectively making them unviable as e-books.

Some Payments from accounts receivables are received by cheque through the mail, and the cashier, Judy Bones, record these in an inwards remittance register when the mail is opened. She then banks the cheques and forwards the payment advices to Gay Chan for posting ton the accounts receivable ledger. Most payments, however, are received by electronic funds transfer (EFT). Each day, Judy downloaded the previous day’s receipts from online banking and provides a copy to Gary for posting. Judy then reconciles the total of the batch postings to accounts receivable to the amount banked for the day. The assistant accountant, Boby Roger, prepares a bank reconciliation at the end of each month.

Since DIPL’s incorporation, depreciation on assets has been calculated using the straight-line method to allocate their cost over their estimated useful lives, as follows:
• Printing presses up to 20 years
• Other production equipment up to 15 years
• Other equipment up to 10 years.

Audit is an independent examination of the financial statement performed by the auditors in order to give an unbiased opinion about it. The auditing procedure is broadly classified into two categories- substantive procedures and analytical procedures. The analytical procedures deal with the calculation of the significant accounting ratios that enables to analyse the performance and position of the company and compare the current status with that of the past periods (Basu, 2009). This helps the auditor to understand the financial statement in a more better and precise manner. The auditor sets up an enquiry if he finds that there are certain manipulations done in the financial statements. He extends the nature and timing of carrying out his audit procedures.

According to the case study of DIPL Ltd. , following are the few financial ratios calculated to evaluate the performance of the company for the year ended:

1. Current ratio

Current ratio can be calculated by dividing current assets by current liabilities. This ratio is classified as liquidity ratio as it evaluates the capability of the company to meet it short term liabilities with the help of short term assets of the company. As we can see in the above table, the current ratio is growing over the years. This is a positive sign for liquidity as the company has a strong financial health to meet its current liabilities.

2. Debt to Equity ratio.

Debt appears on the liability side of the balance sheet and there is always a burden on the company to pay off in the future. In this case study, we can find that there was no debt in the initial two years but subsequently in the third year the company had to raise debt which increased the debt equity ratio from 0 to 0.61. Although the ratio is not very high but when compared to previous years it does not reflect a good financial health(Blank, 2014).

3. Net profit margin

Net profit margin shows the financial performance of the company at the year end. However, we can also compare the net profit of the company over the years. It is clearly visible to us in the above graph that in the year to 2014 there was a fall in the net profit which reflects the inefficiency in the working of the management. The net profit of the year 2015 is slightly lower than the year 2013 which shows that the company needs to be more efficient towards its workings Boynton & Johnson, 2006)..

4. Interest Coverage Ratio.

The method of calculating interest coverage ratio is to divide the net income of the company by earnings before interest and tax expenses (EBIT). The interest coverage ratio is calculated to see whether the company earns sufficient profits to pay interest on the amount of the debt borrowed by the company. It is adverse for the company if the ratio falls which is clearly seen in the graph above (Cahill & Kane, 2011).

5. Return on assets.

Return to asset is calculated by dividing net income by the total assets. This asset helps in the determination whether the company is making optimum utilisation of its assets or not. If the company is using the assets efficiently then the graph will be upwards which is favourable whereas if the company is not being able to make full utilisation of the assets that are present in the company then the graph will slope downwards. A downward sloping graph is not considered good (GUPTA., 2016).

6. Proprietory ratio.

Audit Procedures Performed for DIPL Ltd.

A company calculates the proprietary ratio by dividing the total of shareholders fund by the total assets of the company. It helps in determining the capitalisation done in order to manage and support the business. As we know, it is not possible to carry on business without assets. So, the proprietary ratio helps to know the proportion of shareholders fund that has been invested in the assets of the company (Horngren, 2017)..

While performing the audit procedure the auditor always faces risk at two levels which will be discussed further below. These risks are basically relating to any material changes or any misstatements that may be involved in the preparation of the financial statements. The two levels at which risk is observed are- financial level and assertion level.

First- Financial level risk is the one which is related to the financial statements of the company. Such risk may include shortage in the required resources, inefficient management and control system of the company, unusual transactions and difficulty in taking situations

Second- Assertion level risk further involves two types of risk- inherent risk and control risk. Control risk is the errors or frauds that couldn’t be handled by the management. In simpler language, if there occurs such error in the financial statement which cannot be separated then such risk is known as control risk (Griffin, 2009). Assertion risk refers to presence of errors in the financial statements either by an individual or a group of individuals which has a material impact on the financial information of the company.

As per the case study of DIPL ltd, the two major inherent risk are described below:

1. Inventory valuation- There are various methods to do valuation of the inventory. The method of valuation of inventory followed by DIPL ltd is weighted average method. Inventory valuation has a great importance as it indirectly affects the profits of the company. The wrong valuation of the inventory may overstate or understate the closing stock of the company which may give a inappropriate information about the financial performance of the company (Hooks, 2011). Suppose, if the closing inventory is 20 units, purchases made during the year is 200 units of Rs.3000 and the opening inventory of 100 units is Rs.1000. If we follow average method then the value of stock per unit comes out to be Rs.13.34, so the total closing stock will be Rs. 267 but actually the 20 units left is left from the purchases made at Rs.15 per unit. Hence, the conclusion is that the closing stock should be valued at Rs. 300. Now we know that if the closing stock is understated then the profits for the year will also be less than the actual profit of the company (Knechel, Salterio & Ballou, 2017). The company proposed to change its method of valuation from weighted average to FIFO in June, 2015. It decided to do so in order to hide the extra profits earned behing the valuation of closing stock which is wrong. If the company does this then there will be  a rise in the closing stock of the company, it is expected to be 56% more than what it was in the year 2014 which will result in showing higher profits. Such higher profits will mislead the investors as it would make them feel that the company is in a good financial health. The creditors or the lenders may also get misled and provide them funds which could be resulting of loss in the future (Messier, 2016).
2. Unusual pressure within the entity- We may say after reading the case study that there are certain factors that force us to believe that there is a presence of some kind of unusual pressure or a certain kind of error of fraud that is happening in the company which it is trying to hide.  The following points describe the unusual pressure that are identified:

• A new internal audit team was set up in the middle of the year also it is seen that the company closes its book in the month of June which is a kind of unusual activity. This has created a doubt in the management whether there are some fraudulent activities going on in the company (Ramaswamy, 2015). Also, it is observed that a new CEO has been appointed. Therefore, enquiries have to be done to the previous CEO as it is important to know the reason for the change.
• A loan of 7.5 million was taken by the company. The lender of the loan was BDO finance. The company invested a huge amount of funds in the assets as well as it also spent money on installing the IT system. Apart from this it also made one huge expense that was taking over another company whose name was nuclear publishing limited. It was a matter of concern when it was identified that the purchase value of the plant and equipment exceeded the loan amount. So, it is clear that the expenses and the funds borrowed are not justifiable (Khan and Jain, 2013)..

The responsibility of the auditor is to provide an unbiased opinion of the financial statement and to identify if there are any major misstatements in them which could have a material impact. However, the opinion of the auditor is not the assurance if the future viability (Whittington & Pany, 2016). It is the duty of the auditor to identify the misstatements caused due to inefficiency in financial reporting and if the company has made any manipulation with the figures of the assets of the company. It is not the duty of the auditor to extend its audit procedures to find out if there is any fraud happening because it requires the skill of legal determination theory which is obviously not the expertise of the auditor.

Fraud risk factors are present only if there is a presence of fraud in the company. The conditions are as follows:

1. The workers or the management are not provided the proper working conditions which may create a pressure on them.
2. There are many opportunities available to them in order to commit fraud.
3. The fraudulent activities are being rationalised by the persons committing it.

As per the given case study of DIPL ltd, the following are the two risk factors that has been identified (PAVAN, 2014):

1. Set up of new IT system- The Company introduced a new IT system in the month of June itself. It advised the department to make the accounting system fully computerised. It was not concerned whether the necessary training was provided to the workers or not, it just wanted to install the system without even testing it. When the new IT system was introduced all the accounts had to be transferred which created a huge mess in IT department. This mess also gave advantage to some who were involved in doing some fraud as they could cover it up.
2. Recognition of storage fees from 'E-book facilities- A storage fees was charged from the publishers to keep their e-books on the website. However, the proper accounting principle was not followed while recording such fees transactions. The fees were received in advance for a year, the recognition for which was done in the month of invoice outstanding (Pitt, 2014).. As we know, this is a violation of the accounting principle as this should not be treated as revenue but should rather be treated as a current liability in the books. This board accepted the fact that the transaction can be recorded only after providing the service. However, this change took place because of the newly set up internal audit team.

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