| by a Student Accountant Expert
01 Jun 2000
Candidates studying for paper C3 ‘auditing practice and procedure’ are expected to be familiar with the use of analytical procedures. This article sets out the requirements of the relevant statements of auditing standards and explains the importance of analytical procedures in the context of the C3 Examination.
The relevant standards are ISA 520, Analytical Procedures and SAS 410, Analytical Procedures. There are no material differences between them. Both deal with:
Nature and purpose‘Analytical procedures’ concern not only analysis (of ratios, trends and relationships) but also the investigation of fluctuations.
The analysis usually considers both comparisons and relationships.
Financial information is compared, for example, with:
Typically, relationships are considered between:
Methods of analysis vary considerably, from simple comparisons to complex analyses using advanced statistical techniques. Analytical procedures may be applied to:
Application of analytical proceduresThe first standard in both ISA 520 and SAS 410 states that auditors “should apply analytical procedures at the planning and overall review stages of an audit”. Analytical procedures at these stages are therefore essential and are required (i.e., mandatory) in the conduct of any audit. Both ISA 520 and SAS 410 go on to state, that analytical procedures may be performed as substantive procedures (i.e., are optional).
At the planning stage
Analytical procedures at this stage (sometimes called ‘preliminary analytical review’) assist in:
Ratio analysis (i.e., the comparison of relationships between account balances and classes of transactions over several accounting periods) is particularly useful in identifying fluctuations for investigation. Because of the inter-dependency of many ratios, breaking them down and further refinement into specific components will identify the source of individual fluctuations.
For example, breaking down return on capital employed (ROCE) into gross profit on sales and asset turnover, then inventory turnover, average debt collection period, etc.
Importance of financial condition It is particularly important that the financial condition of a business and its ability to meet debts as they fall due is assessed at the planning stage. A deterioration in liquidity, gearing or profitability indicators potentially increases inherent risk as the risk of deliberate misstatement or manipulation is increased.
Financial information available at the planning stage may include:
Analysis of gross profit
Consider the following scenario:
Tivoli manufactures a small range of gardening tools and supplies them to wholesalers. Turnover for the year ended 31 December 1999 was approximately $2 million. The products of the company have not altered for many years, and turnover and profits have recently increased broadly in line with the rate of inflation.
As auditor, you attended the stocktake (i.e., physical inventory count) and undertook a direct confirmation of amounts due from customer for the year ended 31 December 1999 prior to the production of any management accounts for the year. On receipt of the draft management accounts for the year, your analytical procedures reveal that:
1 The gross profit percentage has increased from 32% to 36%.
2 Inventories at the end of the year represented 35% of the purchases during the year as compared with 25% for the previous year.
3 Purchases of materials show a gradually increasing trend each month throughout the year except for the last month which shows a decrease of 30% as compared with the previous month.
If you are asked something along the lines of “suggest possible reasons for the increase in the gross profit margin”:
For example, it is nonsense to suggest that the increase in gross profit percentage is due to inflation. If turnover and profits are increasing broadly in line with inflation then cost of sales must also be increasing at the same rate and the gross profit percentage will be unchanged. The scenario does not state what the rate of inflation is and it is unnecessary to speculate whether, for example, it is 2% or 20%.
Consider then, if sales have increased in line with inflation but the gross profit percentage has increased, cost of sales must have fallen. Now consider the components of cost of sales namely:
Clearly, cost of sales will have fallen if a cheaper unit cost of production has been achieved. This could have resulted from:
As auditor you would expect Tivoli’s management to be aware if cost reductions have been achieved during the year. You would also expect to be able to substantiate costs by reference to costing records. If however, management are not aware of such cost reductions, the possibility of error needs to be considered, for example:
Are these all equally likely? Think about each in turn bearing in mind that we are looking for causes of potential material error ((36% – 32%) x $2m = $80,000)
(a) Sales overstatement
If sales (credit entries) are overstated then either cash is overstated and/or trade accounts receivable (i.e., debtors) are overstated. Fictitious cash receipts would be picked up on monthly bank reconciliations. Any material overcharging of bona fide customers (whether in error or through fictitious sales invoices) will be brought to light by the direct confirmation of customers’ accounts. Thus, deliberate overstatement of sales seems unlikely.
Sales could also be overstated due to a cut-off error e.g., January 2000 sales being invoiced as December 1999. However, Tivoli is only generating $167,000 monthly revenue (on average) so a cut-off error of $80,000 would be obvious.
(b) Opening inventory understatement
Opening inventory was audited as last year’s closing inventory. If it was materially understated last year last year’s gross profit percentage would have been understated also. This would seem unlikely as the scenario does not suggest that last year’s auditors report was qualified in respect of the inventory valuation.
(c) Purchases understatement
Purchases could be understated if materials or components received before the year end have not been recorded until after the year end. Such an error might indicate a general lack of control over cut-off.
If purchase invoices are unrecorded (whether deliberately suppressed or omitted in error) liabilities as well as expenses will be understated. This would be brought to light by an examination of suppliers’ statement reconciliations.
(d) Closing inventory overstatement
Closing inventory could be overstated due to:
Suggest a valid business reason and a possible accounting error which could have contributed to findings 2 and 3 relating to Tivoli.
2 Increase in closing inventory/purchases ratio
3 Decreases in last month’s purchases
Substantive analytical proceduresAnalytical procedures at stages other than the planning and overall review stages are optional. Substantive analytical procedures (‘SAPs’) are based on the expectation that relationships which are known to exist may be expected to continue in the absence of clear evidence to the contrary. For example, the relationship between gross profit and sales revenue may be expected to remain constant unless there are changes in sales prices, sales mix and/or cost structure.
Extent of use
Factors determining the extent of use of substantive analytical procedures include:
The auditor is more likely to use analytical procedures for:
Extent of reliance
Factors determining the extent of reliance on substantive analytical procedures include:
Types of analytical procedure
Substantive analytical procedures include:
Trend analysis compares current data with prior periods and is particularly useful for analysing income and expenditure (e.g., monthly turnover). Methods include:
These techniques are not examinable in paper 6.
Useful ratios include:
Because ratios identify stable relationships they tend to be more relevant than absolute changes which could be influenced by many factors. Comparisons can be made with prior periods and against budgets and industry statistics.
Ratios may be used more in planning (see above) and review (see below) than in obtaining substantive evidence.
These provide an independent check on the total value of a population and are most useful for income and expenditure accounts. The mechanics are:
Such ‘proofs in total’ may remove the need for further substantive procedures (i.e., tests of detail). The following illustrations indicate how even simple models can be very effective.
For each category of asset calculate:
(Cost + additions – disposals) x straight-line % = charge for year
Alternatively, using reducing balance method, adjust accumulated depreciation for additions and disposals before calculating depreciation on the net amount.
Use information about the workforce: numbers of starters and leavers, wage rates, pay rises, productivity bonuses etc., to construct a model for the total payroll figure.
Last year’s audited expense (i.e., confirmed base data) ± starters/leavers adjusted for pay rises.
3 Hotel revenue
Calculate income for the year as:
Occupancy x Room rate.
Last year’s income (audited) x (1+i)% where i is the increase in room rate.
4 Fuel (petrol) costs
For each category of vehicle running on different grades of fuel (e.g., leaded, unleaded, diesel) calculate consumption as:
Mileage (per tacograph or mileometer)/consumption rate (e.g., miles per gallon or kilometres per litre)
Cost consumption at an average cost per litre or gallon to estimate the charge for the year.
Investigation of fluctuationsUnexpected trends or deviations should be discussed with relevant client’s staff and explanations obtained. For example, the production foreman may be more knowledgeable about problems with production scheduling than the finance officer.
Explanations must not be accepted at face value but corroborated either:
In the first instance explanations might be expected to be of a business nature, for example, a change in company policy about taking up discounts offered by suppliers or extending credit terms to customers. If the client is not aware of occurrences which could account for inconsistencies, the auditor must consider the types of material errors (e.g., due to cut-off) which could give rise to the fluctuations.
Reasons such as the deliberate concealment of errors, ‘window-dressing’, theft and fraud will usually only be considered as a last resort (unless the auditor has reason to suspect such irregularities).
Late adjustments to draft financial statements to correct cut-off and other errors may result in unusual fluctuations where previously none had been noted. Further explanation and corroboration will therefore be required.
At the overall review stageAnalytical review at this stage is required in forming an overall conclusion as to whether the financial statements as a whole are consistent with the auditor’s knowledge of the business. The review may also identify the need for further substantive procedures.
Ratio analysis is particularly useful in testing the consistency of the inter-relationships of amounts disclosed in the financial statements. It is usual to compare ratios calculated at this stage with those of the preliminary analytical review
ConclusionAs analytical procedures have applications covering three of the principal stages of an audit, it is highly likely that in any C3 examination you will have some opportunity to refer to them. However, such vague and general comments as “perform analytical procedures” are clearly unworthy of marks when another candidate writes, for example, “Schedule monthly payroll expenses and corroborate fluctuations by reference to starters/leavers and pay rises” or “Compare delivery vehicle running expenses to the number of vehicles with the prior year”.
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