PART # 1

A financial statement or financial report is a formal record of the financial activities of a business, person or other entity. For a business enterprise, all the relevant financial information, presented in a structured manner and in a form easy to understand, is called the financial statement. It is prepared to meet external reporting obligation sand also for decision making purposes. It typically includes four basic statements, accompanied by a management discussion and analysis-

1. Income statement 2. Cash flow statement 3. Owner's equity statement 4. Balance sheet Role of these Statements in evaluating companies Performance and Financial Position:

Role of Balance Sheet (B/S) In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. It shows assets, liabilities and equity of specific date usually at the end of financial year. A balance sheet is often described as a Snapshot of a companys financial condition

A BALANCE SHEET is the financial statement that reports a firms financial condition at a specific time. It shows a balance between a companys assets and its liabilities and owners equity. Assets include productive, tangible items that help generate income, as well as intangibles of value. Cash in hand and bank indicates how amount of liquid asset is available for the company.

More amount of current liabilities , and account receivable in the balance sheet indicate that , the company will need cash money to pay those. The value of what stockholders own in a firm (minus liabilities) is called STOCKHOLDERS EQUITY (or SHAREHOLDERS EQUITY.) The formula for OWNERS EQUITY is assets minus liabilities. For corporations, the OWNERS EQUITY account records the owners claims to funds they have invested in the firm plus earnings kept in the business and not paid out. How does B/S help in evaluation? The Balance Sheet Tells the Rest of the Story The Balance Sheet will help you understand your financial storys setting and characters and how they work together to achieve the storys endprofitability. The Balance Sheet identifies the means available to make those profits repeat and grow in future years. Using this years Balance Sheet, you will have a better idea of how to plot next years profitability story and what your future business wealth will be. To use this tool effectively and improve your financial performance, you need to evaluate the major Balance Sheet components Assets, Liabilities, and Equity.

Role of Income Statement (I/S)

INCOME STATEMENT is the financial statement that shows a firms profit after costs, expenses, and taxes. It summarizes all of the resources that have come into the firm (revenue), all the resources that have left the firm, and the resulting net income or loss. The income statement reports the results of operations over a particular period of time.

Gross profit (also called gross margin) is the difference between sales and cost of goods sold. It indicates the extent to which a company is able to cover costs of its production. Earnings from operations refer to the difference between sales and all operation costs and expenses. Earnings from continuing operations is the income from a companys continuing business after interest and taxes. Positive value of it refers a good financial position. How does I/S help in evaluation?

Are the revenues and profits growing over time? Are they moving in a smooth and consistent fashion, or erratically up and down? Investors value predictability, and prefer more consistent movements to large swings. For each of the key expense components on the income statement, calculate it as a percentage of sales for each year. For example, calculate the percent of cost of goods sold over sales, general and administrative expenses over sales, and research and development over sales. Also, determine whether the spending trends support the companys strategies. For example, increased emphasis on new products and innovation will probably be reflected by an increased proportion of spending on research and development. Look for non-recurring or non-operating items. These are "unusual" expenses not directly related to ongoing operations. However, some companies have such items on almost an annual basis. How do these reflect on the earnings quality? If one finds anything that looks very suspicious, research the information you have about the company to find out why.

Role of Statement of Stockholders Equity:(also known as the Statement of retained earnings, statement of shareholders investment or statement of changes in shareholders equity) It shows the balance in retained earnings after making adjustments for current profits and current dividend. It is one of the basic financial statements as per Generally Accepted Accounting Principles, and it explains the changes affecting the account, such as profits or losses from operations, dividend paid and any other items charged or credited retained earnings. It also shows information on treasury stock, any new shares issued, the impact of exercised options, preferred stock details and additional paid-in-capital.

Role of Cash flow Statement (C/F) The STATEMENT OF CASH FLOWS reports cash receipts and disbursement related to the firms major activities: 1. OPERATIONS - Cash transactions associated with running the business. 2. INVESTMENTS - Cash used in or provided by the firms investment activities. 3. FINANCING - Cash raised from the issuance of new debt or equity capital or cash used to pay business expenses, past debts, or company dividends.

Balance sheet shows various assets. But it does not show how the additions were financed or paid for. Income statement shows net income. But it does not indicate the amount of cash generated by operating activities. The statement of changes in stockholders equity shows cash dividends declared but not the cash dividend paid during the year. To know those are important for evaluating a companys performance.The number one financial cause of small-business failure today is INADEQUATE CASH FLOW. Businesses often get into cash flow problems when they are growing quickly, borrowing heavily, and receiving payment from customers slowly. They are selling their goods and services, but arent getting paid in time to turn around and pay their own bills.

How does C/F help in evaluation? The CASH FLOW ANSWERS QUESTIONS such as: > How much cash came into the business from current operations? > Was cash used to buy stocks, bonds, or other investments? > Were some investments sold that brought in cash? > How much money came in from issues stock?

PART # 2

Objective of Audit of Financial Statements

The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an identified financial reporting framework. The phrases used to express the auditors opinion are give a true and fair view or present fairly, in all material respects, which are equivalent terms.

Although the auditors opinion enhances the credibility of the financial statements, the user cannot assume that the opinion is an assurance as to the future viability of the entity nor the efficiency or effectiveness with which management has conducted the affairs of the entity.

Steps to develop Audit objectives :

1.Understand objectives and responsibilities for Audit 2. Divide Financial Statements into Cycles

3. Know Management assertions about financial statements 4. Know general audit objectives for classes of transactions, accounts and disclosures 5. Know specific audit objectives for classes of transactions, accounts and disclosures

While the auditor is responsible for forming and expressing an opinion on the financial statements, the responsibility for preparing and fairly presenting the financial statements in accordance with the applicable financial reporting framework is that of the management of the entity, with oversight from those charged with governance. The audit of the financial statements does not relieve management or those charged with governance of their responsibilities.

The objective of the ordinary audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which they present fairly, in all material respects, financial position, results of operations, and cash flows in conformity with generally accepted accounting principles.

Types of Audit Reports

It is important to note that auditor's reports on financial statements are neither evaluations nor any other similar determination used to evaluate entities in order to make a decision. The report is only an opinion on whether the information presented is correct and free from material misstatements, whereas all other determinations are left for the user to decide. There are four common types of auditors reports as follows: 1. Unqualified Opinion An opinion is said to be unqualified when the Auditor concludes that the Financial Statements give a true and fair view in accordance with the financial reporting framework used for the preparation and presentation of the Financial Statements. An Auditor gives a Clean opinion of Unqualified Opinion when he or she does not have any significant reservation in respect of matters contained in the Financial Statements. The most frequent type of report is referred to as the Unqualified Opinion, and is regarded by many as the equivalent of a clean bill of health to a patient,which has led many to call it the Clean Opinion, but in reality it is not a clean bill of health.This type of report is issued by an auditor when the financial statements presented are free of material misstatements and are represented fairly in accordance with the Generally Accepted Accounting Principles (GAAP), which in other words means that the companys financial condition, position, and operations are fairly presented in the financial statements. It is the best type of report an auditee may receive from an external auditor. An Unqualified Opinion indicates the following -(1) The Financial Statements have been prepared using the Generally Accepted Accounting Principles which have been consistently applied; (2) The Financial Statements comply with relevant statutory requirements and regulations; (3) There is adequate disclosure of all material matters relevant to the proper presentation of the financial information subject to statutory requirements, where applicable; (4) Any changes in the accounting principles or in the method of their application and the effects thereof have been properly determined and disclosed in the Financial Statements.

2. Qualified Opinion report A Qualified Opinion report is issued when the auditor encountered one of two types of situations which do not comply with generally accepted accounting principles, however the rest of the financial statements are fairly presented. This type of opinion is very similar to an unqualified or clean opinion, but the report states that the financial statements are fairly

presented with a certain exception which is otherwise misstated. The two types of situations which would cause an auditor to issue this opinion over the Unqualified opinion are:

Single deviation from GAAP this type of qualification occurs when one or more areas of the financial statements do not conform with GAAP (e.g. are misstated), but do not affect the rest of the financial statements from being fairly presented when taken as a whole. Examples of this include a company dedicated to a retail business that did not correctly calculate the depreciation expense of its building. Even if this expense is considered material, since the rest of the financial statements do conform with GAAP, then the auditor qualifies the opinion by describing the depreciation misstatement in the report and continues to issue a clean opinion on the rest of the financial statements. Limitation of scope - this type of qualification occurs when the auditor could not audit one or more areas of the financial statements, and although they could not be verified, the rest of the financial statements were audited and they conform GAAP. Examples of this include an auditor not being able to observe and test a companys inventory of goods. If the auditor audited the rest of the financial statements and is reasonably sure that they conform with GAAP, then the auditor simply states that the financial statements are fairly presented, with the exception of the inventory which could not be audited.

3. Adverse Opinion report An Adverse Opinion is issued when the auditor determines that the financial statements of an auditee are materially misstated and, when considered as a whole, do not conform with GAAP. It is considered the opposite of an unqualified or clean opinion, essentially stating that the information contained is materially incorrect, unreliable, and inaccurate in order to assess the auditees financial position and results of operations. Investors, lending institutions, and governments very rarely accept an auditees financial statements if the auditor issued an adverse opinion, and usually request the auditee to correct the financial statements and obtain another audit report. 4. Disclaimer of Opinion report A Disclaimer of Opinion, commonly referred to simply as a Disclaimer, is issued when the auditor could not form, and consequently refuses to present, an opinion on the financial statements. This type of report is issued when the auditor tried to audit an entity but could not complete the work due to various reasons and does not issue an opinion. Although this type of opinion is rarely used,the most common examples where disclaimers are issued include audits where the auditee willfully hides or refuses to provide evidence and information to the auditor in significant areas of the financial statements, where the auditee is facing significant legal and litigation issues in which the outcome is uncertain (usually government investigations), and where the auditee has going concern issues (the auditee may not continue operating in the near future).Investors, lending institutions, and governments typically reject an auditees financial statements if the auditor disclaimed an opinion, and will request the auditee to correct the situations the auditor mentioned and obtain another audit report.

Importance of Effective Internal Control

Internal control is a process designed to provide reasonable assurance regarding the achievement of objectives in the following categories: Effectiveness and efficiency of operations Reliability of financial reporting Compliance with applicable laws and regulations

Several key points should be made about the importance of effective internal control:

1. People at every level of an organization affect internal control. Internal control is, to some degree, everyone's responsibility. Within the University of California, administrative employees at the department-level are primarily responsible for internal control in their departments.

2. Effective internal control helps an organization achieve its operations, financial reporting, and compliance objectives. Effective internal control is a built-in part of the management process (i.e., plan, organize, direct, and control). Internal control keeps an organization on course toward its objectives and the achievement of its mission, and minimizes surprises along the way. Internal control promotes effectiveness and efficiency of operations, reduces the risk of asset loss, and helps to ensure compliance with laws and regulations. Internal control also ensures the reliability of financial reporting (i.e., all transactions are recorded and that all recorded transactions are real, properly valued, recorded on a timely basis, properly classified,

and correctly summarized and posted).

3. Internal control can provide only reasonable assurance - not absolute assurance regarding the achievement of an organization's objectives. Effective internal control helps an organization achieve its objectives; it does not ensure success. There are several reasons why internal control cannot provide absolute assurance that objectives will be achieved: cost/benefit realities, collusion among employees, and external events beyond an organization's control.

An effective control system provides reasonable, but not absolute assurance for the safeguarding of assets, the reliability of financial information, and the compliance with laws and regulations. Reasonable assurance is a concept that acknowledges that control systems should be developed and implemented to provide management with the appropriate balance between risk of a certain business practice and the level of control required to ensure business objectives are met. The cost of a control should not exceed the benefit to be derived from it.

The degree of control employed is a matter of good business judgment. When business controls are found to contain weaknesses, we must choose among the following alternatives: Increase supervision and monitoring; Institute additional or compensating controls; and/or Accept the risk inherent with the control weakness (assuming management approval).