Financial Statement Analysis & Red Flags

This assignment delves into the analysis of financial statements to pinpoint potential red flags indicative of fraudulent activities or mismanagement. The focus is on identifying signs of earnings manipulation due to pressure, issues with inventory size compared to sales turnover, and recurring negative cash flows from operations. The assignment stresses the importance of scrutinizing accounting practices and recognizing warning signals that may suggest a need for further investigation.

Running head: AUDITING
Auditing
Name of the Student:
Name of the University:
Author’s Note:
Course ID:

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Table of Contents
Answer to Question 1:................................................................................................................2
Introduction:...........................................................................................................................2
Discussion:.............................................................................................................................2
Conclusion:............................................................................................................................3
Answer to Question 2:................................................................................................................3
Introduction:...........................................................................................................................3
Discussion:.............................................................................................................................3
Conclusion:............................................................................................................................4
Answer to Question 3:................................................................................................................5
Introduction:...........................................................................................................................5
Discussion:.............................................................................................................................5
Conclusion:............................................................................................................................6
References:.................................................................................................................................7

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Answer to Question 1:
Introduction:
The external auditors conduct their responsibilities based on the quantum of
information that their clients have supplied to them. However, it is the accountability of the
external auditors to determine the accuracy and use it as a basis for developing the audit
opinion (Abernathy et al. 2014). As a result, if a third party depend on such support and
suffer serious losses, the liability should fall on the external auditors, if they intentionally
connive in falsifying the reports for favouring their clients. In opposition, they must not be
held accountable, which is a sound cause that they include disclaimers in the reports
expressly.
Discussion:
The applications of the law of tort in the profession of auditing and the method
through which the auditors are planning to minimise their exposure to the ensuing liabilities
have been shaped through certain recent landmark cases. The most significant case chosen is
“Caparo Industries Plc (Caparo) v Dickman (1990)”. In this case, Caparo pursued Touche
Ross following a group of share purchases of an organisation, Fidelity Plc. According to the
allegations of Caparo, the purchase decisions have been based on incorrect accounts, which
overvalued the organisation (Doxey et al. 2016). In addition, another claim has been made
that Touche Ross owed a duty of care to the potential investors as auditors of fidelity.
However, the claim has been unsuccessful, since the court has inferred that the preparation of
accounts have been made for the existing shareholders to exercise their class rights. In
addition, the auditors had no prior knowledge that Caparo would put the accounts for
purchase (Earley et al. 2016). This case provides evidence of the duty of care between an
auditor and a third party. According to this ruling, this takes place when

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 The encountered loss is a foreseeable consequence of the conduct of the defendant
 There is adequate proximity of association between the pursuer and the defendant
 It is just, fair and reasonable in imposing a liability on the defendant
Conclusion:
From the above discussion, it has been found that there is rising trend of litigation
costing the audit profession billions of money. They could minimise their exposure to
litigation; however, the audit profession has borne the force of penalties for misdemeanours
conducted on the part of the other culpable parties. Such penalties are restrictive to
competition, which might damage the capital markets largely.
Answer to Question 2:
Introduction:
The distressed banks in the current credit crunch obtain unqualified audit reports from
the auditors. Such crunch had brought daily news of corporate collapse and bailouts
plundering the pockets of the taxpayers at an unprecedented scale (Glover and Prawitt 2014).
Each collapse has detected that the highly paid directors possessed little idea about the value
of the organisation, liabilities, assets, income, costs, financial health and profits. This is
because of the silence of the auditors, since they received large fee amounts along with
dishing out health bills.
Discussion:
Several cases of auditor independence have been evident during the credit crunch.
There is partial nationalisation of Bradford & Bingley. The accounts of 2007 received a clean
health bill from KPMG, the audit firm. The auditors had received fees of £1.4 million that
includes £0.7 million for consultancy services. However, there have been errors in the

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preparation of financial statements and they provided consultancy services to the
organisation, which have affected their independence (Knechel 2013).
The distressed HBOS is being swallowed on the part of Llyods TSB. In this case,
KPMG has provided a clean health bill in its 2007 accounts. The auditors obtained £11.4
million in fees, which includes £2.4 million for consultancy services. Wachovia, which is the
fourth biggest bank-holding organisation in US, has been negotiating a rescue with Wells
Fargo. The 2007 accounts of the bank had received an unqualified audit report from KPMG,
in which the latter had received $33.3 million in the form of fees. It constitutes of $4.1
million for consultancy related to tax matters (Glover, Taylor and Wu 2016).
The US government has closed down the US government and it is sold subsequently
to JP Morgan. The 2007 accounts of the bank has clean heath bill from its auditors Deloitte
and Touche, in which the latter had obtained $15.08 million in fees including $2.26 million
for consultancy services (Humphrey, Loft and Samsonova-Taddei 2014). There is bailing out
of Fortis on the part of the Dutch government. Its 2007 accounts had clean health bill from
Deloitte and Touche and PWC, its joint auditors. The auditors have obtained €37 million as
fees, which include €11 million for consultancy.
Conclusion:
Thus, based on the above cases, it could be evaluated that the auditors have
compromised their independence for safeguarding the interests of the organisation in
exchange of money. They need to be more responsible and careful while publishing the audit
reports for their client organisations.

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Answer to Question 3:
Introduction:
Royal Bank of Scotland had shifted to Ernst & Young from Deloitte to audit its
accounts from 2016. This is because Deloitte has failed to respond effectively to the critical
factors of audit risk (Simunic, Ye and Zhang 2015). Deloitte had failed to qualify the 2007
RBS account, as it had received $17 million in audit fees and $14.2 million in non-audit fees.
Discussion:
According to the provided case, the major audit risks that Deloitte had failed to
indentify while auditing the accounts of RBS include the following:
 The importance laid on earnings and integrity of the management
 The size of inventory is large, while the turnover rate of the bank is extremely low
 Monthly income and confirmations of assets
 Negative cash flows from operations for several months
 Raised inventory and raised accounts payable (William Jr, Glover and Prawitt 2016)
Deloitte has not placed emphasis on the integrity of the management, which could be
questioned because of the amount of reliance laid on earnings due to management pressure.
Another reason for the concern is the size of inventory. Depending on the rate of turnover, the
size of inventory is much higher in contrast to the requirement, which indicates the drop in
sales. In addition, there is an indication of fraud occurrence due to non-standard
confirmations of accounts receivable and negative cash flows from operations happening
over several months (Ye and Simunic 2013). Another fraud indication is the rise in accounts
payable and rise in inventory, in which there is already abnormally bigger inventory. This
would provide reason to ask why additional stick is purchased on credit, if there is additional

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inventory in-house in contrast to being sold. All of these items together would depict that the
internal controls in place are ineffective largely and the management is inefficient.
Conclusion:
From the above discussion, it has been found that Deloitte has failed to respond
effectively to the critical factors of audit risk. Deloitte had failed to qualify the 2007 RBS
account, as it had received $17 million in audit fees and $14.2 million in non-audit fees.
Deloitte has not placed emphasis on the integrity of the management, which could be
questioned because of the amount of reliance laid on earnings due to management pressure.
Another reason for the concern is the size of inventory. Depending on the rate of turnover, the
size of inventory is much higher in contrast to the requirement, which indicates the drop in
sales. In addition, there is an indication of fraud occurrence due to non-standard
confirmations of accounts receivable and negative cash flows from operations happening
over several months

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References:
Abernathy, J.L., Hackenbrack, K., Joe, J.R., Pevzner, M. and Wu, Y.J., 2014. Comments of
the Standards Committee of the Auditing Section of the American Accounting Association on
PCAOB Staff Consultation Paper Auditing Accounting Estimates and Fair Value
Measurements.
Doxey, M.M., Fuller, S.H., Geiger, M.A., Gist, W.E., Hackenbrack, K.E., Janvrin, D.J.,
Pitman, M.K. and Roush, P.B., 2016. Comments by the Auditing Standards Committee of the
Auditing Section of the American Accounting Association on PCAOB Release No. 2016-
003, Proposed Auditing Standard—The Auditor's Report on an Audit of Financial Statements
when the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB
Standards. Current Issues in Auditing, 11(1), pp.C26-C40.
Earley, C.E., Hooks, K.L., Joe, J.R., Polinski, P.W., Rezaee, Z., Roush, P.B., Sanderson,
K.A. and Wu, Y.J., 2016. The Auditing Standards Committee of the Auditing Section of the
American Accounting Association's Response to the International Auditing and Assurance
Standard's Board's Invitation to Comment: Enhancing Audit Quality in the Public
Interest. Current Issues in Auditing, 11(1), pp.C1-C25.
Glover, S.M. and Prawitt, D.F., 2014. Enhancing auditor professional skepticism: The
professional skepticism continuum. Current Issues in Auditing, 8(2), pp.P1-P10.
Glover, S.M., Taylor, M.H. and Wu, Y.J., 2016. Current practices and challenges in auditing
fair value measurements and complex estimates: Implications for auditing standards and the
academy. Auditing: A Journal of Practice & Theory, 36(1), pp.63-84.
Humphrey, C., Loft, A. and Samsonova-Taddei, A., 2014. The rise of international standards
on auditing. The Routledge Companion to Auditing, p.161.

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Knechel, W.R., 2013. Do auditing standards matter?. Current Issues in Auditing, 7(2), pp.A1-
A16.
Simunic, D.A., Ye, M. and Zhang, P., 2015. Audit Quality, Auditing Standards, and Legal
Regimes: Implications for International Auditing Standards. Journal of International
Accounting Research, 14(2), pp.221-234.
William Jr, M., Glover, S. and Prawitt, D., 2016. Auditing and assurance services: A
systematic approach. McGraw-Hill Education.
Ye, M. and Simunic, D.A., 2013. The economics of setting auditing standards. Contemporary
Accounting Research, 30(3), pp.1191-1215.