ATC F8 materials FF8 AA (Int)Session16 j08

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OVERVIEW

Objective

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To describe the role of analytical procedures in the audit process and the use of substantive analysis.

WHEN USED

OVERALL REVIEW STAGE PLANNING

STAGE

¾ Stages in the audit

¾ Purposes

¾ Need for

¾ Based on

¾ Financial condition

FLUCTUATIONS SUBSTANTIVE

PROCEDURES MEANING AND

NATURE

¾ Sufficiency

¾ Financial statement assertions

¾ Extent of use

¾ Types of test

¾ Proof in total

¾ Extent of reliance

¾ Need for

¾ Examples

¾ Meaning

¾ Comparison

¾ Relationships

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1

MEANING AND NATURE

1.1

Meaning

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The analysis of significant ratios and trends including the resulting investigation of fluctuations and relationships:

that are inconsistent with other relevant information; or which deviate from predicted amounts.

1.2

Comparisons of financial information

With Examples

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prior periods

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anticipated results (from budgets and forecasts)

   

2007 2007 2006 Actual Budget Actual

Turnover ($) 11,900 12,000 10,000

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predictive estimates Depreciation for year ≈ 15% × year end cost

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similar industry

information. Receivables turnover vs industry average

1.3

Consideration of relationships

Between

Examples

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Elements of financial information expected

to conform to a predicted pattern. Gross profit % to sales

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Financial information and relevant

non-financial information. Payroll costs to number of employees

1.4

Methods

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Range from simple comparisons to intricate analyses using advanced statistical techniques. May be applied to:

consolidated financial statements;

components (e.g. subsidiaries, divisions, segments);

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2

WHEN USED

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Analytical procedures are required to be undertaken at the planning and overall review stages. They may also be used at other stages, as a procedure for obtaining audit evidence, ie substantive analytical procedures.

To assist in planning nature, timing and extent of other audit procedures.

As substantive procedures at the detailed testing stage – when more effective or efficient than tests of detail.

As an overall review, to conclude whether financial statements as a whole are consistent with auditors’ knowledge of the business.

3

PLANNING STAGE

3.1

Need for

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Analytical procedures should be applied to help: understand the business; and

identify areas of potential risk.

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“Preliminary” analytical procedures are used to: assess financial condition (see 3.3 below);

increase knowledge of the business (see Session 9) through the accumulation of information on trends in key relationships;

plan the nature, timing and extent of other audit procedures.

3.2

Based on

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Interim financial and non-financial information

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Budgets/forecasts and management accounts

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Draft financial statements

3.3

Financial condition

3.3.1

Importance

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Deterioration potentially increases inherent risk as deliberate misstatement/manipulation is more likely.

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3.3.2

How assessed

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Short-term – liquidity indicators such as the current ratio.

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Long-term – gearing and profitability indicators, e.g.:

debt/equity ratio

return on capital employed (ROCE) gross profit (GP)%

earnings per share (EPS).

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Loans and borrowings – defaults in and renegotiation of repayments.

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Cash flow projections – receipts from operations less than maturing debt.

4

SUBSTANTIVE ANALYTICAL PROCEDURES

4.1

Sufficiency

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Analytical procedures can themselves provide sufficient audit evidence where an item can be verified directly by reference to another (valid) item (e.g. commission on sales, bank interest, rental expense, depreciation). (See proof in total below.)

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Analytical procedures may be effective in testing for understatement (i.e. completeness). For example, in predicting sales from purchases and known margins.

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Where sufficient substantive evidence is not obtained by analytical procedures alone, some tests of detail will also be required.

Illustration 1

Payroll

(assertions)

Analytical procedures

Tests of detail (ideas in

outline)

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Completeness

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Compare cost with budget/prior period(s) – month on month and for year

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“Proof in total” (eg that the number of employees on the payroll can be verified to independent control totals – say in HR)

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Postings from payroll to general ledger

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Payroll

(assertions)

outline)

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Occurrence

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Compare cost with budget/prior period(s) and similar organisation/ industry

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Ratio analysis e.g. average cost per employee by department and comparing with prior periods, other

departments

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Cash book/bank payments and transfers

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Starters and leavers , eg agreeing that all leavers in a period have been excluded from the payroll for that period and all joiners included

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Measurement (amount and in correct period)

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Compare accruals (e.g. statutory deductions, holiday pay, etc) with prior period(s)

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Labour turnover (should decrease with increasing remuneration)

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Postings from payroll to general ledger

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Sample of payroll

transactions (accuracy, etc) and cut-off testing at period end

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Presentation

and disclosure

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Compare disclosure with prior year financial statements

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Ratios e.g. payroll to cost of sales, average pay per employee

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Disclosure checklist

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Postings from general

ledger to payroll

4.2

Financial statement assertions

Example 1

(a) For each of the following financial statement assertions relevant to sales revenue suggest a suitable analytical procedure.

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Solution

Revenue

(assertions)

outline)

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Completeness

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Occurrence

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4.3

Extent of use

4.3.1

Factors to consider

4.3.2

Impact on use

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Audit objectives (see assertions

above) and extent of reliance See extent of reliance (below)

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Degree of disaggregation of

available information Procedures are more effective when applied to components

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Availability of financial and

non-financial data Independently prepared non-financial data should result in more effective procedures.

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Reliability of information

available Budgets prepared with sufficient care will facilitate more effective procedures.

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Relevance of information Budgets based on expectation are more useful than goals to be achieved.

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Sources of information Independent sources are more reliable

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Comparability of information Broad industry data may not be relevant to specialized products.

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Knowledge gained previously

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Nature of enterprise and its

operations. Steady trends develop in some businesses therefore easier to know what to expect and identify variations.

Example 2

Albatross Ltd had 100 employees last year with total wages of $840,000 and 100 employees this year with a wage bill of $950,000, an increase of 13% The annual pay rise was 6% and the level of business has remained approximately constant.

Required:

(a) Suggest reasons other than error or irregularity which could account for the greater than expected increase.

(b) In the absence of a satisfactory reason for the increase, suggest how the payroll could have been inflated by error or irregularity.

Solution

(a)

Business reasons

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(b)

Possible error or irregularity

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4.4

Types of test

Trend analysis (graphical

time series or regression

analysis)

Ratio analysis

Reasonable test

= “proof in total”

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“Scattergraph” relies on visual inspection

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Time-series analysis can be cumbersome

Examples

receivables collection period

inventory turnover asset turnover

payables payment period

Examples (see later) on payroll depreciation investment income rental income

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Statistical regression (using computer program) is most objective

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Ratios identify stable relationships therefore more relevant than absolute changes

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“Models” can be very precise, even simple models can be very effective

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Useful for income and expenditure a/c analysis.

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Useful for both statement of financial position and income and

expenditure a/c analysis.

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Most useful for income and expenditure a/c analysis.

Illustration 2

Testing petrol costs in a taxi firm

Steps

Application

1 Identify factors likely to influence

the amount to be tested Petrol costs determined by kilometres driven 2 Clarify relationship and confirm it

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3 Predict likely range of values Kms

driven price per Average litre ($)

Expected petrol cost

($)

Jan 2,387 1.59 825 – 716 Feb

etc 2,954 1.61 1034 – 897 4 Compare predictions with actual Prediction ($) Actual ($)

Jan 716 – 825 755

Feb 897 – 1034 1200

5 Investigate variances and

corroborate explanations January is within range, February is not

4.5

Proofs in total

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An independent check on the total value of a population

4.5.1

Mechanics

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Calculate the expected value of a population. The base data must be independent of the population being tested or otherwise confirmed to be materially correct.

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Compare with recorded value.

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Difference should not be material.

4.5.2

Examples

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Depreciation – for each category of asset:

(Cost + Additions – Disposals) × straight-line % = Charge for year

Alternatively, using reducing balance method, adjust accumulated depreciation for additions and disposals also and calculate depreciation on net amount.

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Payroll – use information about workforce, numbers of starters and leavers, wage rates, pay rises, productivity bonuses etc to construct a model for the total payroll figure. For example:

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Hotel revenue – income for year

Occupancy × Room rate; or

Last year’s income (audited) × (1+i) where i is the percentage increase in room rate

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Fuel (petrol) costs – for each category of vehicle running on different grades of fuel (e.g.

leaded, unleaded, diesel) calculate consumption. For example, as:

Mileage (per tacograph or mile-meter) ÷ consumption rate (e.g. miles per gallon or kilometres per litre)

4.6

Extent of reliance

4.6.1

Factor

4.6.2

Impact on reliance — Examples

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Materiality of items

involved Cannot rely only on analytical procedures for material inventory balances, but may rely solely for immaterial income and expense items.

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Other procedures Reviewing subsequent cash receipts might confirm or dispel queries raised by analytical procedures on an ageing of customers’ accounts.

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Accuracy of

predictions Greater consistency expected in comparing gross profit margins from one period to another than in comparing discretionary expenses (e.g. research or advertising).

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Risk assessments

(IR and CR) If internal control over sales order processing is weak (i.e. CR is high) more reliance on tests of details in drawing conclusions on receivables may be required.

4.6.3

Greatest use

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Existing well-established client

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Well-known, stable industry

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Predictive information available (budgets, cash flow forecasts)

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Effective accounting and internal control systems.

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OVERALL REVIEW STAGE

5.1

Need for

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5.2

Examples

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Comparison of current year results with previous year(s).

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Review of significant trends and ratios to identify emerging patterns or changes in known patterns e.g. if liquidity ratios deteriorating.

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Recalculation of key ratios and trends to reflect adjustments to the financial statements.

6

INVESTIGATION OF FLUCTUATIONS

Significant fluctuations, inconsistent relationships or deviations from predicted amounts should be investigated and adequate explanations and appropriate corroborative evidence obtained.

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Unexpected trends or deviations should be discussed with management in the first instance.

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Explanations must be substantiated (e.g. by reference to existing knowledge and audit evidence already obtained).

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If management’s explanation in inadequate, further audit procedures may be necessary.

FOCUS

You should now be able to:

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describe and explain the nature and purpose of analytical procedures in planning;

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compute and interpret key ratios used in analytical procedures;

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EXAMPLE SOLUTION

Solution 1 — Sales revenue assertions

Revenue

(assertions)

outline)

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Completeness

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Comparison with budget, prior period(s) etc

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Review of gross profit %(s)

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Reasonableness test (where

margins known)

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Cut-off tests (goods despatch)

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Postings from sales day book

to general ledger

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Sales orders to despatch notes and invoices

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Occurrence

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Ratio of sales returns to sales

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Average number or value of

credit notes per month

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Sales invoices to customer orders

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Post year-end credit notes

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Sales returns and allowances

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Direct confirmation

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As for completeness

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Ratio of discounts to credit

sales

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Postings from sales day book to general ledger

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Cutoff tests (goods despatch)

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Sample of invoices (prices, etc)

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Direct confirmation

Solution 2 — Total wages

(a)

Business reasons

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There may have been a change in sales mix with previously bought-in goods being replaced by goods manufactured in-house, resulting in substantial authorized overtime.

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There could have been a switch to more skilled (therefore more expensive) labour.

(b)

Possible error or irregularity

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Misposting in the general (nominal) ledger

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“Dummy” employees on the payroll

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Unauthorized overtime being paid