8 Analytical Procedures C a s es inc lu de d in t his Se ction 8.1 Laramie Wire Manufacturing 245 Developing Expectations for Analytical Procedures 8.3 Burlingham Bees 239 Using Analytical Procedures in Audit Planning 8.2 Northwest Bank 251 Using Analytical Procedures as Substantive Tests Ot he r c ase s t h at discuss topics rel ated to this section 1.1 Ocean Manufacturing, Inc The New Client Acceptance Decision 2.3 Flash Technologies, Inc Risk Analysis and Resolution of Client Issues Instructor Resource Manual — Do Not Copy or Redistribute 39 Instructor Resource Manual — Do Not Copy or Redistribute Laramie Wire Manufacturing C a s e 8.1 Using Analytical Procedures in Audit Planning Mark S Beasley · Frank A Buckless · Steven M Glover · Douglas F Prawitt INS TRUCTIONAL Ob je c t ive s [1] To help students understand the three audit stages when analytical procedures are typically used [2] To illustrate, using an example based on an actual situation, how powerful “planning analytics” can be in helping the auditor identify risks and potential problem areas requiring further substantive test in the audit To develop students’ understanding of the use of analytical procedures in the audit planning stage [4] To illustrate the potential usefulness and importance of considering non-financial information when conducting analytical procedures in the planning stage [3] KEY FACTS The auditor is required to use analytics in the planning and final review stages of an audit, and is encouraged—though not required—to use analytics as substantive tests in the evidence gathering stage In the planning stage, analytics are used to help the auditor gain an overall understanding of the client and its business environment and to help the auditor identify potential risks and problem areas that will require more extensive substantive testing during the evidence gathering stage Laramie Wire Manufacturing Co manufactures a wide range of insulated copper wiring products using the basic raw materials of plastics and copper rod The company devotes 25% of its 500,000 square feet of floor space to the storage of raw materials and finished inventories Each pallet of copper rod uses 36 square feet of floor space and holds 1,500 pounds of copper The pallets are not stackable From the case materials, students can calculate the number of pallets of copper rod the company claims to have, the number of barrels containing plastic material, and the number of spools of finished wire (see suggested solutions, below) The amount of space the company has to store inventories is insufficient to contain the amount of inventory the company claims to possess The price of plastics dropped from $.19 in 2007 to $.12 per pound in 2008, raising a valuation issue The case contains other information that is useful for planning the audit but that is not particularly useful for calculating or interpreting planning analytical procedures USE OF CASE This case vividly illustrates the important role of analytical procedures, and especially the use of non-financial information, in assisting the auditor to identify risks and potential problems in the planning stage of the audit The general concepts and circumstances underlying this case are loosely based on an actual company named Laribee Wire Mfg Co The numbers in this case are fabricated, The case was prepared by Mark S Beasley, Ph.D and Frank A Buckless, Ph.D of North Carolina State University and Steven M Glover, Ph.D and Douglas F Prawitt, Ph.D of Brigham Young University, as a basis for class discussion It is not intended to illustrate either effective or ineffective handling of an administrative situation Copyright © 2009 by Pearson Education, Inc., Upper Saddle River, NJ 07458 239 Section 8: Analytical Procedures but many of the concepts illustrated are very similar to the actual case Excerpts from a 1992 Wall Street Journal describing the Laribee Wire situation are included in these teaching notes to provide the instructor a lively way to wrap-up the case discussion This case is ideal for use as an in-class group exercise that promotes active learning Used in conjunction with the WSJ article excerpts (below), this case provides an excellent alternative to lecturing on the use of planning analytics that students find quite memorable Alternatively, the case can be prepared as a moderately-short out-of-class written assignment Either way, however, an in-class discussion of the issues is critical in bringing out the vivid lessons this case has to offer For example, the WSJ excerpts add several interesting and important lessons to the case, including such insights as specific methods Laribee Wire used to inflate inventories (e.g., “lapping” inventory shipments between plants, etc.) If the case is going to be used for an in-class discussion, we recommend having students read the case and perform analytical procedures prior to the in-class discussion In class, students can meet in pairs or small groups to discuss and compare the analytical procedures they performed and identify the risks that the procedures suggest Once all students have had an opportunity to state their ideas and arrive at a group consensus, the instructor can randomly call on individual students to share their group’s answers with the class Randomly calling on individual students to share their group’s answers with the class helps to ensure that all students take responsibility for learning the material Excerpts from the WSJ article on Laribee Wire can be read or provided to the students after they have had an opportunity to share their answers with the class If the case is going to be used as an out-of-class writing assignment, we recommend discussing the case requirements with the students prior to having them complete the assignment In class, the instructor can call on students to share their answer with the class and discuss excerpts from the WSJ article PROFESSIONAL STANDARDS Relevant professional standards for this assignment are AU Section 311 “Planning and Supervision” and AU Section 329 “Analytical Procedures.” SU G G E S TED S OLUTION [1] Perform analytical procedures to help you identify relatively risky areas that indicate the need for further attention during the audit, if any Below is a list of some of the analytical procedures that can be performed with the data given in this case Some of the procedures produce results that suggest further attention, while others produce results that would not be out of line with expectations Some additional analytical procedures highlighting the problems seeded in the case are included in the answer to question #2 Average Days Sales in Receivables – This ratio increased 16% from 2007 to 2008 while sales increased only 4% during the same time period The auditor would want to find out why the ratio increased—whether it was due to a change in collection policies or patterns or possibly to inflated sales Percentage Change in Cost of Goods Sold – The cost of goods sold account increased 3% from the previous year compared to an increase in sales of 4% Percentage Change in Inventories – The dollar value of the plastics inventory increased 23% over the previous year, while copper inventory increased 59%, and finished goods inventory increased 41% These large increases in inventory would necessitate further attention Inventory as a Percent of Sales – In 2007 inventory was 37% of sales and in 2008 it 240 Instructor Resource Manual — Do Not Copy or Redistribute Case 8.1: Laramie Wire Manufacturing jumped to 53% of sales This large difference in inventory as a percentage of sales would clearly necessitate further audit attention Percentage Change in Accounts Payable – accounts payable increased 6% from the previous year This is a relatively small change given the percentage change in inventory This change in conjunction with the change in inventory should alert the auditor to investigate further the balances in the inventory accounts Expected Value of Copper Rod Inventory – Multiplying the inventory quantity on hand by the market price for copper rod inventory yields an expected amount of $2,832,000 This estimated amount is greater than the reported account balance of $2,625,000, and thus appears to be consistent with inventory being carried at the lower of cost or market Expected Value of Plastic Inventory – Multiplying the inventory quantity on hand for plastic inventory by the market price yields an expected value of $132,000 This estimated amount is significantly less than the reported account balance of $224,500 and thus does not appear to be consistent with inventory being carried at the lower of cost or market This variance should alert the auditor of an area needing further attention Average Square Feet of Warehouse Space Used by Copper Rod Inventory – Copper rod is the only inventory for which the auditor can calculate the average space occupied This calculation shows that the inventory on hand would be about 3,933 pallets With each pallet occupying 36 square feet, the total amount of warehouse space occupied by the copper rod inventory would be 141,600 square feet This amount is greater than the 125,000 square feet of warehouse space allocated to inventory, without even considering the other types of items held in inventory This non-financial measure is an indicator of possible problems that the auditor would want to follow-up on All of the above analytical procedures relate to both the Existence/Occurrence and Valuation management assertions With the Existence/Occurrence assertions, the auditor is concerned with whether or not the transactions and items included in the account balances are valid and actually exist The Valuation assertion is concerned with the proper valuation being placed on individual inventory, accounts receivable, and accounts payable accounts [2] Focus specifically on each of the following balance-related management assertions for the inventory account: existence, completeness, valuation, and rights and obligations Link any risks you identified for this account in question to the related management assertion Briefly explain identified risks or issues for the inventory account that require further attention, if any Students should notice several potential issues with Laramie’s inventory through the results of their analytical procedures They are listed below Inventories went from under 40% to over 50% of sales from 2007 to 2008 The increases are mostly in finished good and copper rod inventories Also, inventory turnover went from just over 2.0 to just under 1.4 from 2007 to 2008 These ratios point to potential concerns relating to the valuation and existence assertions The plastics inventory appears to be carried above market on the 2007 balance sheet, rather than the lower of cost or market The market price drop from $.19 to $.12 from 2007 to 2008 should attract attention to this problem Plastics inventory at the end of 2008 is 1.1 million lbs Multiplying this by $.12/lb equals a market value of $132,000 The inventory is carried at $224,500, or about $.20 per pound This comparison points to a possible concern relating to the valuation assertion Whether there is a misstatement cannot be determined until the net realizable value of plastics inventory is calculated The space that the inventory should take is greater than the space available in the company’s warehouse The copper rod alone is more than can fit in the inventory area of the facility Laramie’s financial statements assert that the company has about 5.9 million pounds of copper rod at the end of 2008 Each pallet can hold 1,500 pounds of copper Instructor Resource Manual — Do Not Copy or Redistribute 241 Section 8: Analytical Procedures rod Thus, there must be about 3,933 pallets Each pallet is 6x6, or 36 square feet 3,933 times 36 square feet equals approximately 141,600 square feet of required floor space The pallets are not stackable, as indicated in the case information The inventory area of the facility has only 125,000 square feet (500,000 x 25%), and this area has to hold not only copper rod but also plastics and finished goods This raises a potential concern relating to the existence assertion Students may generate other concerns, but the above three are the ones that may have been apparent to Laribee’s auditors had they performed the “right” analytical procedures to detect the problems Be sure to point out that auditing is always easier with hindsight, but that juries always hear cases “after the fact.” Also point out that the large accounting firms all provide high-quality audits, but they all make occasional mistakes Make it clear to the students that the purpose of this case is not to “pick on” any single auditing firm, but rather to learn from the past In addition, point out that this short case of necessity greatly simplifies the actual situation The issues brought out here were probably not as clear in the actual situation, even in the presence of hindsight A discussion on how to handle a situation when possible problems are found will also be instructive and interesting to the students Balancing the need for professional skepticism with the importance of not overreacting is a professional skill new auditors need to develop early on in their careers After having the students bring out their concerns and discussing the three concerns listed above, read to them the following excerpts on Laribee Wire Mfg Co from the WSJ in 1992 Making a PowerPoint slide with the article so the students can read along is also helpful 242 Instructor Resource Manual — Do Not Copy or Redistribute Case 8.1: Laramie Wire Manufacturing WALL S TREET JOURNAL EXCERPTS—LARIBEE WIRE MF G “How an audit can misfire is illustrated by the way Deloitte & Touche, the auditors of Laribee Wire Mfg Co., failed to realize that the New York copper-wire maker was buoying a sinking ship by creating fictitious inventories Laribee was plagued by huge debt almost seven times its equity generated by a major acquisition in 1988 Meanwhile, its sales to the troubled construction industry, its major customer for copper wire, were declining In 1990, Laribee borrowed $130 million from six banks The banks say they relied on the clean opinion that D&T gave Laribee’s financial statements for 1989, when the company reported $3,000,000 in net income A major portion of the loan collateral consisted of Laribee’s inventories of the copper rod used to draw wire at its six U.S factories But after Laribee filed for bankruptcy-court protection in early 1991, a court-ordered investigation by other accountants, attorneys and bankruptcy specialists showed that much of Laribee’s inventory didn’t exist Some was on the books at bloated values Certain wire-product stocks carried at $2.20 a pound were selling at only $1.70 to $1.75 a pound Shipments between plants were recorded as stocks located at both plants Some shipments never left the first plant, and documentation supposedly showing they were being transferred to the second plant “appeared to be largely fictitious,” the report to the court found And 4.5 million pounds of copper rod, supposedly worth more than $5 million, that Laribee said it was keeping in two warehouses in upstate New York would have required three times the capacity of the buildings, the report said “It was one of the biggest inventory overstatements I’ve ever seen,” says John Turbidy, the court-appointed trustee He estimates that inventory fraud contributed $5.5 million before taxes to Laribee’s 1989 results Absent this fraud and other accounting shenanigans, Laribee would have reported a $6.5 million loss instead of the profit, he adds Laribee’s previous top management declines to comment Banks and other creditors sued D&T in state courts in Texas, Illinois, North Carolina, and New York earlier this year for unspecified damages, charging it with malpractice and gross negligence in failing to spot the accounting manipulations at Laribee A suit filed by Asarco Inc., a copper producer and Laribee creditor, accuses Mel Dobrichovsky, the Deloitte partner who oversaw Laribee’s audit, of fraud in missing the inventory scam and other improper audit practices “The auditor was either taken in or missed the obvious,” Mr Turbidy says “Giving the auditors the benefit of the doubt, I assume that it was inexperience on their part because some who showed up at Laribee’s plants were fresh out of college Otherwise, how could they have overlooked such blatant manipulations?” James T Simmons, Laribee’s former vice president for operations, says a firm later merged into Deloitte sent “three to five auditors with three years or less experience to the plants to check inventory.” He recalls: “The faces kept changing and there was little continuity.” According to several Laribee employees, a standing joke at the plants was that the next outside auditor “would be fresh out of high school.” Mr Simmons adds that Mr Dobrichovsky “never showed up at the plants” during annual inventory counts Mr Dobrichovsky, who left D&T at the end of 1990, declines to comment Deloitte denies any wrongdoing and says the audits “were done in accordance with professional standards.” 1 Berton, Lee, “Convenient Fiction: Inventory Chicanery Tempts More Firms, Fools More Auditors - A Quick Way to Pad Profits, It Is Often Revealed Only When Concern Collapses - A Barrel Full of Sweepings,” The Wall Street Journal, December 14, 1992, p A1 Instructor Resource Manual — Do Not Copy or Redistribute 243 Instructor Resource Manual — Do Not Copy or Redistribute Northwest Bank C a s e 8.2 Developing Expectations for Analytical Procedures Mark S Beasley · Frank A Buckless · Steven M Glover · Douglas F Prawitt I ns tr uc t ional Ob je c t ive s [1] To illustrate how analytical procedures can be used as substantive tests [2] To provide students a hands-on experience in developing expectations based on both aggregated and disaggregated information To illustrate the importance of expectation precision and how the level of aggregation can impact precision [4] To illustrate how auditors might over rely on weak analytical procedures [3] KEY FACTS Northwest Bank (NWB), headquartered in Walla Walla, Washington has operations in 35 communities in the states of Washington, Oregon, and Idaho NWB’s loan portfolio consists primarily of agricultural loans, commercial loans, real estate loans, and loans to individuals NWB has been an audit client for three years Controls over bank loans are excellent; as such, the audit team places high reliance on controls The primary substantive procedure used to test the reasonableness of loan interest income is substantive analytical procedures Only if the analytical procedure identifies a significant difference will other substantive audit procedures be performed to test interest income In the prior year, the engagement team performed a very high-level analytical procedure based on average aggregate loan balances and interest rates Students first perform an analytical procedure to test interest income based on high-level aggregated information The high-level analytic suggests interest income is fairly stated Then students perform an analytical procedure for using disaggregated information (quarterly loan balances and interest rates by loan portfolio) The analytic based on disaggregated information suggests interest income is materially misstated USE OF CASE We use this case as an in-class individual exercise Students only need about 10 minutes to complete both parts of the case The case directly addresses a concern included in the report issued by the Public Oversight Board’s (POB) Panel on Audit Effectiveness The Panel examined actual audits performed by eight different firms One of the findings reported by the Panel is that when analytics are used as the sole or primary test, 20% of the time the analytical procedures used were insufficient to provide the necessary level of assurance The report went on to say that generally the insufficient procedures related to income statement accounts This case demonstrates how an auditor might over rely when a weak procedure produces a “positive” result The case also demonstrates how the precision (quality) of an analytical procedure is enhanced by using disaggregated information The case was prepared by Mark S Beasley, Ph.D and Frank A Buckless, Ph.D of North Carolina State University and Steven M Glover, Ph.D and Douglas F Prawitt, Ph.D of Brigham Young University, as a basis for class discussion It was adapted from an article authored by S Glover, D Prawitt, and J Wilks appearing in the 25th Anniversary edition of Auditing : A Journal of Practice and Theory (2005) Northwest Bank is a fictitious company All characters and names represented are fictitious; any similarity to existing companies or persons is purely coincidental Copyright © 2009 by Pearson Education, Inc., Upper Saddle River, NJ 07458 245 Section 8: Analytical Procedures We have all students complete the first part of the exercise (the analytical procedure based on high-level aggregated data and related questions) before asking them to complete Part B We usually discuss both parts after students complete Part B PROFESSIONAL STANDARDS Relevant professional standards for this assignment are AU Section 329, “Analytical Procedures,” and AU 326, “Audit Evidence.” Q u es ti o n s and Su gg e st e d Solu tion s – PART A [1] As part of the year-end audit and using the analytical-procedure approach similar to last year’s audit (average loan volume multiplied by weighted-average interest rate), determine if Northwest Bank’s interest income from loans reported at December 31, 2008 appears fairly stated Do the results of the analytical procedure indicate that you accept 2008 interest income as reported? Yes No Please briefly explain your answer Yes, using last year’s approach, loan interest income appears fairly stated because the difference ($154,000) is less than materiality ($525,000) NWB’s Loan Interest Analytics 2008 (in thousands) Average loan volume ($388,110 + 383,860)/2 multiplied by Weighted Average Annual Interest Rate Computed Interest Income per Audit 2008 Interest Income per NWB Difference is immaterial $385,985 9.115% 35,183 35,337 154 Students may be interested to know the responses from 20 practicing auditors completing a similar case For question all auditors accepted the balance as fairly stated [2] Based on the results of the analytical procedure, how likely is it that 2008 interest income is materially misstated? 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Definitely not Definitely Misstated Misstated Student responses will vary The actual assessment is not as interesting as the difference between this assessment and a similar assessment made in Part B Students may be interested to know that the average response from 20 practicing auditors completing a similar case was about 9% for question 246 Instructor Resource Manual — Do Not Copy or Redistribute Case 8.2: Northwest Bank [3] Please indicate on the scale below your assessment of the strength (quality and sufficiency) of evidence provided by the interest income analytical procedure: Extremely Weak/ Extremely Strong/ Useless Evidence Removes all Doubt Student responses will vary The actual assessment is not as interesting as the difference between this assessment and a similar assessment made in Part B Students may be interested to know that the average response from 20 practicing auditors completing a similar case was 3.9 for question Q u es ti ons and Su gg e st e d Sol ution s – PART B [1] Given the additional information provided in Part B (i.e., quarterly information by loan type), please determine if Northwest Bank’s interest income from loans reported at December 31, 2008 appears fairly stated Can you accept 2008 interest income as reported? Yes No Please briefly explain your answer No, using the disaggregated information provided in Part B, loan interest income does not appear fairly stated because the difference ($815,000) is significantly greater than tolerable error or materiality for interest income ($525,000) NWB’s Loan Interest Analytics 2008 (in thousands) Expected Annual Interest Expense for 2008 per Audit ($22,644 + 9,363 + 2,515 = $34,522) 2008 Loan Interest Income per NWB Difference $34,522 35,337 $815 Note: A copy of the information included in the case is provided on the next page Instructor Resource Manual — Do Not Copy or Redistribute 247 Section 8: Analytical Procedures Commercial and Real Estate Agricultural Loans Loans For the Year 2008 (balances in thousands) First Quarter Average Loan Volume (or Balance) × Weighted Average Interest Rate (Qrtly) Expected Interest Income, First Quarter Second Quarter Average Loan Volume × Weighted Average Interest Rate (Qrtly) Expected Interest Income, Second Quarter Third Quarter Average Loan Volume × Weighted Average Interest Rate (Qrtly) Expected Interest Income, Third Quarter Fourth Quarter Average Loan Volume × Weighted Average Interest Rate (Qrtly) Expected Interest Income, Fourth Quarter Individual and Other Loans $ 99,998 2.40% 2,400 See Info Below* $ 267,003 2.15% 5,741 101,200 2.35% 2,378 See Info Below* 263,868 2.08% 5,488 95,608 2.35% 2,247 See Info Below* 264,400 2.13% 5,632 $ 96,200 2.43% 2,338 See Info Below* $ 266,510 2.17% 5,783 $ 22,644 $ 9,363 Annual Expected Interest Income by Loan Type based on Quarterly Data + + + Computed Total Interest Income per Audit $ 2,515* $ 34,522 ($22,644 + $9,363 + $2,515, in thousands) 2008 Loan Interest Income per NWB Difference (in thousands) *Computation of Individual and Other Loans 12/31/07 12/31/08 Average Annual Loan Volume $ 21,109 $ 21,152 11.7% 12.1% × Weighted Average Interest Rate Annual Expected Interest, Individual and Other (in thousands) $ 35,337 $ 815 Average $ 21,131 11.9% $ 2,515 It is important for the instructor to remind students that the aggregated data used to make the assessment in question of Part A are based on the disaggregated information provided in Part B Ask students to look back at the case to determine what caused the difference between Parts A and B (the underlying data are the same, the differences is cause by lower interest rates and balances in the 2nd and 3rd quarters) Students may be interested to know that 15 of the 20 practicing auditors would not accept the balance as fairly stated based on the information in Part B (These are the same 20 auditors whose responses are reported for questions 1-3 in Part A Those accepting the balance as fairly stated may have made a mathematical error (the auditor’s case required them to complete more computations) or have some other basis for believing the balance is fairly stated 248 Instructor Resource Manual — Do Not Copy or Redistribute Case 8.2: Northwest Bank [2] Based on the results of the analytical procedure preformed in Part B, how likely you think it is that 2008 interest income is materially misstated? 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Definitely not Definitely Misstated Misstated Student responses will vary The actual assessment is not as interesting as the difference between this assessment and a similar assessment made for question in Part A Student’s assessments should be much higher in Part B Students may ask what the next step for the auditor would be The auditor will not propose an adjustment to the financial statements based on the analytical procedure Given the yearly average and the quarterly analysis, a logical next step would be to look at monthly loan data Other steps might include inquiry of the client and detail testing of interest income Students may be interested to know that the average response from 20 practicing auditors completing a similar case was 44.8% for question of Part B Thus, the auditors’ likelihood assessment increased approximately 36% between Parts A and B [3] Please indicate on the scale below your assessment of the strength (quality and sufficiency) of evidence provided by the interest income analytical procedure: Extremely Weak/ Extremely Strong/ Useless Evidence Removes all Doubt Student responses will vary The actual assessment is not as interesting as the difference between this assessment and a similar assessment made for question Student’s assessments should be higher in Part B The comparison between question in Part A and Part B leads to a good discussion on how disaggregated information improves the precision of an expectation and thus the quality of the analytical procedure Other factors influencing the precision of an expectation include: • Type of analytical procedure Regression analysis and reasonableness tests (like the one in this case) generally produce more precise expectations than ratio or trend analyses • Predictability of the relationship The more predictable the relationship the more precise the expectation Generally, income statement accounts are more predictable than balance sheet accounts • Reliability of the source data The more reliable (i.e., valid, objective) the source data, the more precise the expectation While it is easy to talk with students about ways to improve the quality of analytical procedures, this case really drives home the point It is also important to discuss the cost/benefit analysis that must go into the decision on the level of disaggregation desirable More disaggregation is not always better In considering the appropriate level of disaggregation we should pursue (i.e., how detailed Instructor Resource Manual — Do Not Copy or Redistribute 249 Section 8: Analytical Procedures the input data should be in for the analytical procedure) we should consider the costs and benefits associated with: • Data collection (more disaggregated data is generally more costly to collect) • Data analysis (more disaggregated data is generally more costly to analyze) • How much corroborating evidence is available for the input data We must be able to effectively and efficiently corroborate the input data If we cannot corroborate the input data, the analytical review results are of little value The costs of gathering and analyzing daily information in an audit like NWB would most assuredly exceed the benefits In this case, a more precise expectation is probably not too costly and would likely be the preferred choice Students may be interested to know that the average response from 20 practicing auditors completing a similar case was 3.8 for question in Part B This response is similar to the response for question in Part A, but it is higher than the auditors’ revised assessment of the strength of the aggregate-level analytical procedure captured in question in Part B [4] Now reevaluate the first analytical procedure you performed (i.e., based only on average aggregate loan and interest averages) Using hindsight, please indicate on the scale below your assessment of the strength (quality and sufficiency) of evidence provided by that high-level interest income analytical procedure: Extremely Weak/ Extremely Strong/ Useless Evidence Removes all Doubt Student responses will vary The actual assessment is not as interesting as the difference between this assessment and a similar assessment made for question in Part A Here students are re-evaluating a previous judgment they made with the benefit of hindsight Student’s assessments are typically lower in Part B The comparison between responses to question in Part A and question in Part B leads to a good discussion about the potential danger of over reliance on weak analytical procedures based on high-level aggregate information In Part A the analytical procedure based on simple averages yielded an immaterial difference, which may lead to overconfidence in the strength of the procedure (if a weak procedure yields an unacceptable results the auditors would pursue alternative audit approaches) With the benefit of hindsight, students can see the obvious limitations of the analytical procedure based on simple averages The POB Panel on audit effectiveness examined actual audits and reported that when analytical procedures were used for the primary substantive test, as was the case for Northwest Bank, the procedures were not sufficiently precise to produce adequate assurance Students may be interested to know that the average response from 20 practicing auditors completing a similar case was 2.9 for question of Part B Thus, with the benefit of hindsight, when auditors’ reevaluated the assurance obtained from the aggregate analytical procedure, they reduced their assessment from 3.9 on question of Part A, to 2.9 in Part B 250 Instructor Resource Manual — Do Not Copy or Redistribute Instructor Resource Manual — Do Not Copy or Redistribute Burlingham Bees C a s e 8.3 Using Analytical Procedures as Substantive Tests Mark S Beasley · Frank A Buckless · Steven M Glover · Douglas F Prawitt I ns tr uc t ional Ob je c t ive s [1] To illustrate how analytical procedures can be used as substantive tests [2] To illustrate how audit plans will differ when analytical procedures are used to gain assurance [3] To provide students a hands-on experience in developing a somewhat complex revenue expectation To illustrate the importance of expectation precision and how the level of aggregation can impact precision [5] To illustrate the audit planning and other judgments associated with using analytical procedures as substantive tests [4] KEY FACTS The Burlingham Bees franchise is a minor league baseball team The audit firm of Hickman and Snowden has relied primarily on tests of details to gain assurance that reported ticket revenues are fairly stated The new audit manager, Michelle Kramme, believes analytical procedures may be used effectively as substantive tests related to ticket revenue Tickets R Us is an independent company hired to operate ticket gates and report total tickets collected Revenue, attendance and ticket prices have increased from prior year Attendance at weekend games is 25% higher than at weekday games Attendance increases by 10% when the Bees host a promotional event USE OF CASE We find that students often think of analytical procedures as only a risk-identification technique utilizing simple trends or financial ratios This case is designed to demonstrate how analytical procedures can be used as effective and efficient substantive tests This case is based loosely on an actual audit engagement of a major league baseball franchise Obviously, the names and facts have been changed and simplified In the actual case the senior auditor developed substantive analytical procedures, which proved to be extremely powerful and effective The analytical procedures replaced a significant amount of other detail testing while maintaining the level of achieved audit risk The reduction in audit hours dramatically improved the audit’s profitability The senior received high praise and was promoted to manager earlier largely as a result of her performance on the audit of the baseball franchise The case was prepared by Mark S Beasley, Ph.D and Frank A Buckless, Ph.D of North Carolina State University and Steven M Glover, Ph.D and Douglas F Prawitt, Ph.D of Brigham Young University, as a basis for class discussion Burlingham Bees is a fictitious team All characters and names represented are fictitious; any similarity to existing teams, companies or persons is purely coincidental Copyright © 2009 by Pearson Education, Inc., Upper Saddle River, NJ 07458 251 Section 8: Analytical Procedures We have had students complete this case either outside of class or as an in-class exercise We usually permit students to work in small groups when completing this assignment We typically use this case when the students are studying the concepts associated with substantive testing and/or the audit of the sales and collection cycle If the case is used outside of class, instructors may want to ask students to utilize computer software technology (e.g., spreadsheet) to compute the expectation The most difficult step in developing an expectation for ticket revenue in this case is the initial problem set-up If the case is used as an in-class exercise instructors may want to mingle among the groups to assess progress so that hints can be provided to students who appear to be “stuck.” One hint the instructor might consider providing to students to set up an algebraic equation with total attendance on the left-hand side and solving for the unknown variable “x”, which is average attendance for a typical weekday game (see solution to requirement #2 below) The development of financial-performance expectations requires an understanding of significant factors that influence a balance or assertion This case requires students to use nonfinancial data to develop an expectation The initial problem set-up requires students to model the relationship of various factors and numbers As noted above, some students may experience frustration at first However, the case will help demonstrate the thought that must be invested in the development of expectations designed to provide audit assurance PROFESSIONAL STANDARDS Relevant professional standards for this assignment are AU Section 329, “Analytical Procedures,” and AU 326, “Audit Evidence.” Q UE S TION S AND SUGG ESTED SOLUTION S [1] Research professional standards (AU 329) and list the requirements related to developing an expectation and conducting analytical procedures when those procedures are intended to provide substantive evidence What are the advantages of developing an expectation at a detailed level (i.e., using disaggregated data) rather than at an overall or aggregated level? Some particularly relevant excerpts from AU329 are provided below: “A basic premise underlying the application of analytical procedures is that plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary.” (Paragraph 2) “Analytical procedures involve comparisons of recorded amounts, or ratios developed from recorded amounts, to expectations developed by the auditor The auditor develops such expectations by identifying and using plausible relationships that are reasonably expected to exist based on the auditor’s understanding of the client and of the industry in which the client operates.” (Paragraph 5, emphasis added, the standards require the auditor to develop an expectation) “The expected effectiveness and efficiency of an analytical procedure in identifying potential misstatements depends on, among other things, (a) the nature of the assertion, (b) the plausibility and predictability of the relationship, (c) the availability and reliability of the data used to develop the expectation, and (d) the precision of the expectation.” (Paragraph 11) The following factors influence the auditor’s consideration of the reliability of data for purposes of achieving audit objectives: • Whether the data was obtained from independent sources outside the entity or from sources within the entity 252 Instructor Resource Manual — Do Not Copy or Redistribute Case 8.3: Burlingham Bees Whether sources within the entity were independent of those who are responsible for the amount being audited • Whether the data was developed under a reliable system with adequate controls • Whether the data was subjected to audit testing in the current or prior year • Whether the expectations were developed using data from a variety of sources (Paragraph 16) • “Expectations developed at a detailed level generally have a greater chance of detecting misstatement of a given amount than broad comparisons Monthly amounts will generally be more effective than annual amounts and comparisons by location or line of business usually will be more effective than company-wide comparisons The level of detail that is appropriate will be influenced by the nature of the client, its size and its complexity Generally, the risk that material misstatement could be obscured by offsetting factors increases as a client’s operations become more complex and more diversified Disaggregation helps reduce this risk.”(Paragraph 19) Generally, the more disaggregated the data the more precise the expectation Precision is the auditor’s measure of the potential effectiveness of an analytical procedure, and therefore the degree of reliance that can be placed on the procedure and the assurance derived from it Effectiveness refers to the procedure’s ability to identify accounts with and without misstatements The AICPA Auditing Practice Release, “Analytical Procedures,” indicates that other factors that can influence the degree of precision of an expectation include reliability of the input data, predictability of the account, and the method used to form an expectation (e.g., simple comparison analysis versus multiple regression analysis) Thus, the primary advantages associated with a disaggregated or precise expectation is the quality of the expectation and the level of audit assurance provided by the procedure The more precise the expectation the closer the auditor’s independent expectation should be to the “correct” amount Significant differences between a precise expectation and the reported client balance, the more likely the difference relates to a misstatement Because precision is associated with the quality of the evidence, the more precise the expectation the more assurance provided [2] Using the information provided, please develop a precise expectation (i.e., using the detailed or disaggregated data provided) for ticket revenues for the 2008 fiscal year Student approaches will vary, however, in our experience most students develop an expectation that is very close (within $1,000) to the one provided below The approach illustrated below is one method to develop a precise expectation Step — First compute the average attendance for a typical weekday game (i.e., no promotion) Weekends increase attendance 25% and promotions increase attendance 10% There were 43 weekday and 29 weekend games Promotions were held on weekdays and 10 weekends 434,348 = (43 - 7)X + 7(1.1X) + (29 – 10)(1.25X) + 10(1.25(1.1X)) promo weekday promotional weekend 434,348 = 36X + 7.7X + 23.75X + 13.75X 434,348 = 81.2X X = 5,349.1 Average attendance for a typical weekday game Instructor Resource Manual — Do Not Copy or Redistribute 253 Section 8: Analytical Procedures Step — Compute average attendance for other game categories Typical weekend game 6,686.4 = 1.25(5,349.1) Promotional weekday game 5,884 = 1.1(5,349.1) Promotional weekend game 7,355 = 1.1(6,686.4) Step — Compute average ticket prices for weekday and weekend games using ticket price and sales mix data Average ticket price for weekday games $6.20 = $10(30%) + $6(35%) + $4(20%) + $2(15%) Average ticket price for weekend games $5.70 = $10(25%) + $6(30%) + $4(25%) + $2(20%) Step — Compute expected 2008 ticket revenue by multiplying average ticket price by average attendance figures by the number of games Game Category Typical weekday Typical weekend Promotional weekday Promotional weekend Average Average Average Number Game Ticket Game of Ticket Attendance Price Revenue Games Revenues (A) (B) (C)=(A)x(B) (D) (E)=(C)x(D) 5,349.1 $6.20 $33,164.42 36 $1,193,919.12 6,686.4 $5.70 38,112.48 19 724,137.12 5,884.0 $6.20 36,480.80 255,365.60 419,235.00 7,355.0 $5.70 41,923.50 10 Total Expected 2008 Ticket Revenue $2,592,657 Observed Audit Difference (12,237) Reported 2008 Ticket Revenue $2,580,420 The instructor will want to point out the fact that the information or data used to develop an expectation cannot simply be accepted from management It is important to consider the source of the information and the information’s reliability In many cases, some assurance that the input factors are fairly stated is necessary The students’ case materials indicate that the total attendance figure came from an independent outside source (Tickets R Us) and that sales mix percentages, average attendance increases on weekends and for promotional events were all based on prior Bees audits (additional assurance on these inputs may be necessary in future years) No information is provided regarding the source of the number of games, the number of promotional events or the ticket prices Presumably these data would not be hard to obtain from sources independent of those who are responsible for amounts being audited (e.g., league schedule, ticket agencies, advertisements, or other operational sources within the organization) The question asks students to compute a precise (i.e., based on disaggregated or detail-level data) However, the case also asks the students to consider the advantages of computing a precise expectation over an imprecise expectation Two examples of imprecise or highly aggregated analytical procedures are provided on the next page 254 Instructor Resource Manual — Do Not Copy or Redistribute Case 8.3: Burlingham Bees Aggregated Analytical Procedures Example 2007 Year revenue Multiply by increase in attendance Multiply by increase in ticket price 2008 Expected revenue Observed difference 2008 Reported revenue Example 2007 Year revenue Divide by approximate 2007 attendance 2007 average ticket price Multiply by increase in ticket price Expected 2008 average ticket price Multiply by 2008 attendance Expected 2008 ticket revenue Observed difference 2008 Reported revenue $2,200,000 x 1.10 x 1.10 $2,662,000 (81,580) $2,580,420 $2,200,000 394,000* $5.58 x 1.10 $6.14 434,348 $2,666,897 (86,477) $2,580,420 *The case indicates 2008 attendance was more than 10% higher than 2007 (434,348/1.1 = 394,862, use 394,000) We discuss the observed differences between the 2008 reported revenue and the various expectations in the suggested solution to the next question However, it should be made clear that even if a low quality, aggregated procedure produces an expectation that is near the reported value, the procedure likely does not provide sufficient competent evidence that revenue is fairly stated In other words, if the expectation is of low quality, so is the evidence no matter what the outcome of the procedure For an excellent discussion of how outcome may lead practicing auditors to over-rely on weak analytical procedures see “Why Do Auditors Over-Rely on Weak Analytical Procedures? The Role of Outcome and Precision,” by S Glover, D Prawitt, and J Wilks appearing in the 25th Anniversary edition of Auditing: A Journal of Practice and Theory (2005) [3] (a) How close does the Bees’ reported ticket revenue for 2008 have to be to your expectation for you to consider reported ticket revenue reasonable or fairly stated? (b) If reported ticket revenues were outside your “reasonableness range,” what could explain the difference? [a] For substantive analytical procedures, the tolerable difference can be no greater than overall materiality The case provides pre-tax net income and if we apply the typical rule of thumb of 5% of pre-tax net income to compute materiality we obtain $24,000 The size of materiality raises a number of important points that should be discussed: Materiality as a percentage of total revenue is less than 1% This is common for accounts on both the income statement and balance sheet and it highlights why it is impractical in most cases to audit aggregate account balances Rather, auditors will typically need to examine revenue components (i.e., by product, location, subsidiary, division) separately The disaggregated expectation yielded a difference of $12,237 To the extent the inputs to the auditor’s expectation are reliable (i.e., audited, from third parties) the analytical procedure appears to provide strong evidence that revenue is fairly stated Students may ask if it is common for auditors in practice to be able to derive such precise and effective revenue analytical procedures The answer is that yes it is rather common for certain revenue components For example interest revenue for financial institutions, Instructor Resource Manual — Do Not Copy or Redistribute 255 Section 8: Analytical Procedures room revenue for hotels, natural gas revenue for residential customers (as a function of weather or “heating degree days”), and cable TV revenue The aggregated procedures yield differences that are greater than materiality Differences larger than materiality are investigated and frequently lead the auditor to develop more precise expectations However, as noted in the suggested solution to question 1, even if the aggregated procedures yielded differences less than materiality, the auditor should take little comfort in the evidence because the expectations are of low quality [b] [4] If the reported ticket revenue is outside the reasonableness range it could be explained by a number of reasons such as: Revenues are misstated The auditor’s expectation failed to incorporate important factors In the Bees case it could be information about season ticket packages, group packages, games played in poor weather, changing sales mix, mid-season price changes, free ticket give-a-ways, etc Auditor error There may be a mathematical error or the model used to develop the expectation may be incorrectly specified The total attendance figure is wrong (a) What are the advantages of using analytical procedures as substantive tests? (b) If the engagement team decides to use analytical procedures for the Bees’ audit, how will the audit plan differ from prior years? (c) Discuss whether you believe analytical procedures should be used as substantive tests for the Bees 2008 audit? [a] Auditors are continuously assessing the effectiveness and efficiency of audit procedures Analytical procedures are generally much more efficient than tests of details Obviously, the auditor does not wish to sacrifice effectiveness Fortunately, analytical procedures can also be very effective tests In some instances analytical procedures can even be more effective than tests of details AU 329.12 provides the following example: “Comparisons of aggregate salaries paid with the number of personnel may indicate unauthorized payments that may not be apparent from testing individual transactions.” Thus analytical procedures, if designed properly and if based on reliable data, can be both efficient and effective substantive tests As noted earlier, this case is based loosely on an actual audit engagement of a major league baseball franchise In the actual case the senior auditor developed substantive analytical procedures, which proved to be extremely powerful and effective The analytical procedures replaced a significant amount of other detail testing while maintaining the level of achieved audit risk The reduction in audit hours dramatically improved the audit’s profitability The senior received high praise and was promoted to manager early largely as a result of her performance on the audit of the baseball engagement 256 [b] The nature, timing and extent of audit testing would change if the auditors decided to use analytical procedures as substantive tests Obviously, the audit plan will specify the use of analytical procedures In addition, the audit plan will likely include fewer, less extensive, and/or different tests of details The actual effect on the audit plan will depend on the results Based on the difference between the recorded and expected balance and considering the precision with which the expectation was developed, the auditor would determine the desired nature, timing, and extent of further audit testing [c] Most students believe analytical procedures should be used as a substantive test for the Bees audit Instructor Resource Manual — Do Not Copy or Redistribute ... 99,9 98 2.40% 2,400 See Info Below* $ 267,003 2.15% 5,741 101,200 2.35% 2,3 78 See Info Below* 263 ,86 8 2. 08% 5, 488 95,6 08 2.35% 2,247 See Info Below* 264,400 2.13% 5,632 $ 96,200 2.43% 2,3 38 See... $6.20 $33,164.42 36 $1,193,919.12 6, 686 .4 $5.70 38, 112. 48 19 724,137.12 5 ,88 4.0 $6.20 36, 480 .80 255,365.60 419,235.00 7,355.0 $5.70 41,923.50 10 Total Expected 20 08 Ticket Revenue $2,592,657 Observed... $2,200,000 394,000* $5. 58 x 1.10 $6.14 434,3 48 $2,666 ,89 7 (86 ,477) $2, 580 ,420 *The case indicates 20 08 attendance was more than 10% higher than 2007 (434,3 48/ 1.1 = 394 ,86 2, use 394,000) We discuss