Review of cash flow statement: operating activities, investing activities, financing activities

In cash flow statement prepared on an indirect method, the preparer is required to assess the cash flow activities belongs to which categories: operating, investing or financing activities. It is important to have a clear mind and exercise cautious in reviewing the "classification" of cash flow activities.

To illustrate, during the year, a Company ABC received non-current funding from its holding company. It is the intention of the Company to borrow the fund from its holding company to run the opeartions. As such, the fund received from the holding company need to be disclosed as "financing activities" instead of "opearting activities". This will assist the financial statement user to understand the nature of fund received from holding company.

We also want to highlight the following items where the financial statement preparer may mess up:
Dividend received: this is part of investing activities, as it represents the return on investment the Company made
Dividend paid: this is part of financing activities, as it represents the return given to the shareholder - who had invested in the Company's shares
Acquisition of property, plant and equipment: investing activities- as this represent the company's investment in asset to generate return

In short, we propose the auditor to review the classification of cash flow activities cautiously to assess the reasonableness of the disclosure.

How to identify provision for warranty / goods returned - credit notes review

During the course of your audit, you may note that there is high % of goods returned or customer utilised the warranty provision. Goods returned / utilisation of warranty could be quite common in certain industry, e.g. retail / electornic / mass production industry. What will be the implication to our audit?

In this instance, we should request our audit client to perform a retrospective review of the history of goods returned and determine how many % of total goods sold had been returned to the Company in the past. A provision for goods returned or warranty should be recorded on a monthly basis. This is because, based on historical experience, the Company will not be able to earn 100% of its goods sold / delivered.

A good way for auditor to test / review the goods returned history is to check the credit note issued during the year and check the nature of the credit note. If there is high volume of credit notes being issued for goods returned, then it is important for us to emphasize to client to accrue for provision for gooods returned.

Auditing technique - experience of an audit manager/ executive: talking to audit clients

We would like to share with you on one of the useful / fruitful auditing techniques for jounior / senior auditors / executive / managers - talking to audit clients.

What we noted recently in the auditing industry is we noted that auditors have been spending time in digging out documents / reviewing documents / checking sales invoices, suppliers' statement of accounts, goods- received notes etc etc. No doubtul that test check to supporting documents is an important element of our audit. However, it is also important to talk to our audit clients.

By talking to our audit clients ( or rather chatting), we will understand that significant business developments, potential changes to the business, significant accounting and auditing issues - all these may help us to identify issues. Identifying accounting and auditing issues allow us to address the issues and resolve the issues earlier.

Certain changes may not be easily identifiable/ visibly obsivous from the financial results. A discussion with audit client may make you become aware of the impact of certain changes / events/ matters. As a result, we emphasize to all auditors on the importance and the need of talking to our audit clients frequently. Maintaining a good relationship with audit clients allow you to execute the audit smoothly.

Review of management's assessment for compliance with debt covenant

It is common that debt covenants are imposed on loans extended by bankers to their own customers, including: financial covenants based on year-to-date financial performance/ financial position of our audit client.

It is important to remind our audit client to read the clauses carefully and understand that term completely. For instance, a banker required an audit client to maintain consolidated net worth of US$60 million at all times. The definition of interpretation will be clearly defined in the clause the bank facility letter. This need to be reviewed carefully to ensure that breach of debt covenant is identified on a timely basis.

To illustrate, our audit client XYZ may have a consolidated net worth of US$62million, including foreign currency translation reserve of S$5million. Certain banks may exclude foreign currency translation reserve in computing the net worth- this will lead to the breach of debt covenant if the requiement is US$60million.

In short, it is important for auditor to understand the bank facility letter and review management's assessment cautiously.

Important notes while using debtors' turnover (days) analysis

In analyzing debtors' balance, it is common for us to compute debtors' turnover (days) in our analytical review procedures to assist us in understanding the fluctuation of debtors' balance. The formula of debtors' turnover (days) is as follows:

Debtors turnver (days) = Average Trade Debtors balance / Sales for the year x 365 days

Generally, in the audit industry, we will compare current year debtors' turnover (day) with preceding period and identify any movement. Nevertheless, it is important to note that debtors' turnover day is the result of a computation based on the formula above. The result may not represent the actual events.

For instance, by using the formula above, an auditor note that the debtors' turnover day has improved 60 days in prior year to 30 days in current year. It is dangerous to conclude that the debtors' turnover day has improved. It is important for us to understand further from management on the reason for the decrease in debtors' turnover day. This is because, assuming that there is no significant changes to the pool of customers, it is unlikely for a customers to pay faster than prior period. Unless, there is special incentive (e.g. discount on early settlement) given to customer in current year to settle outstanding debts promptly.

As a result, we should not solely rely on the result of a formula. We should always match the data computed against actual business scenario to ensure that we understand the business and cross- check the data.