CHAPTER FIVE - Planning Engagements

Current Ratio =

Current Assets/Current Liabilities

Quick Ratio =

Current Assets - Inventory/ Current Liabilities

Current Ratio should be greater than

1

Quick Ratio chooses to

remove inventory from current assets as it is seen as illiquid

Quick Ratio can be seen as

more cautious and more prudent

If the Current Ratio increases YoY, either

• current assets have increased

• current liabilities have decreased

Potential Causes of Increased Current Ratio

• New Long Term Loans

• Disposal of a NCA for cash

• Unusually large sale at YE

PPE is classed as a

non current asset - therefore, not in the current ratio

Inventory will always be

smaller than trade receivables, as trade receivables sell inventory at a profit.

Risks of Misstatement with the Eario

• Misstated Trade Receivables - irrecoverable debts

• Misstated Inventory - Wrong Price/Unit

• Misstated Trade Payables - Wrong Year

Long Term Solvency is

a company’s ability to meet its long term financial obligations

• e.g. debt repayment

Gearing Ratio =

Net Debt/Equity x 100

Gearing Ratio - Net Debt

Borrowings - Cash Owned

• any interest bearing debt

• overdrafts

• long/short term loans

Gearing Ratio - Equity

• total equity

• share capital

• share premium

• retained earnings

• revaluation surplus

Gearing Ratio Increases

• Debt = increased

• Equity = decreased

Gearing Ratio Increased - Potential Causes:

• Changed by Impairment on NCA (equity will go down)

• Changed by a large dividend being paid

• Changed by new finance

• Changed by large cash purchase

Gearing Ratio Decrease - Potential Causes:

• Changed by Revaluation

• Changed by share issue

Gearing Ratio - Risks of Misstatement:

• Going Concern

• Existence of Covenants - motive to understated liabilities/overstate cash/overstate equity

• Inappropriate revaluation of NCA

Long Term Solvency Ratios:

• Gearing

• Interest Cover

Interest Cover Equation =

Profit before Interest Payable/Interest Cost

Interest Cover is

• often linked to debt covenants

• better if the number is higher!

Interest Cover - Motive for Manipulation

• Interest can be understated

• Profit can be overstated and recognised too early

Efficiency Ratios

• Inventory Period

• Trade Receivable Period

• Trade Payables Period

Inventory Period =

Inventories x 365 / COS

Increase in the Inventory Period - Potential Causes

• Increase in stock due to a big sale in the next year

• Change in how Inventory is valued (AVCO to FIFO)

If prices are rising during the year, FIFO is more likely to

give you a higher value for the inventory

Increase Inventory Period - Risk of Misstatement

• Overvalued Inventory

• Inclusion of non-existent inventory

• Inappropriate change in cost estimation

Trade Receivable Period =

Trade Receivables/Revenue x 365

Trade Receivables Increase - Potential Causes

• Collection Problems

• Large Sale at the YE on credit

• Change in customer base/terms

Trade Receivables Increase - Risk of Misstatement

• Omitted Bad Debt Expense

• Errors in Revenue Recognition

• Errors in Revenue Cut Off

• Non-Existent Trade Receivables recognised at YE

Trade Payables Period =

Trade Payables/ COS or Credit Purchases x 365

Trade Payables - Decrease Potential Causes

• Suppliers have changed their terms

• Large payment made just before the YE

Trade Payables - Decrease Risks of Misstatement

• Recognition of Invoices in the Wrong Year

• Missing/Incomplete Trade Payables at YE

PLANNING - Benefits of Analytical Procedures

• Material/Risk areas can be identified

• Items which look odd can be considered further

• Highlight Errors not picked up before

• Uses Information outside of the Accounting records

• Assists in understanding the client’s business

PLANNING - Limitations of Analytical Procedures

• Good knowledge of the business is required to understand results

• Consistency of results may conceal a material error

• Tendency to carry out procedures mechanically, without professional scepticism

• An experienced member of staff to complete

• Reliable data may not be available