ATC f8 materials FF8 AA (int)session16 j08

SESSION 16 – ANALYTICAL PROCEDURES OVERVIEW Objective To describe the role of analytical procedures in the audit process and the use of substantive analysis MEANING AND NATURE WHEN USED PLANNING STAGE Need for Based on Financial condition SUBSTANTIVE PROCEDURES Sufficiency Financial statement assertions Extent of use Types of test Proof in total Extent of reliance Meaning Comparison Relationships Methods Stages in the audit Purposes OVERALL REVIEW STAGE Need for Examples FLUCTUATIONS 1601 SESSION 16 – ANALYTICAL PROCEDURES MEANING AND NATURE 1.1 Meaning 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 prior periods anticipated results (from budgets and forecasts)     2007 Actual 2007 Budget 2006 Actual Turnover ($) 11,900 12,000 10,000 predictive estimates Depreciation for year ≈ 15% × year end cost similar industry information Receivables turnover vs industry average 1.3 Consideration of relationships Between Examples Elements of financial information expected to conform to a predicted pattern Gross profit % to sales Financial information and relevant nonfinancial information Payroll costs to number of employees 1.4 Methods Range from simple comparisons to intricate analyses using advanced statistical techniques May be applied to: consolidated financial statements; components (e.g subsidiaries, divisions, segments); individual elements of financial information (e.g account balances) 1602 SESSION 16 – ANALYTICAL PROCEDURES WHEN USED 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 PLANNING STAGE 3.1 Need for Analytical procedures should be applied to help: understand the business; and identify areas of potential risk “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 Interim financial and non-financial information Budgets/forecasts and management accounts Draft financial statements 3.3 Financial condition 3.3.1 Importance Deterioration potentially increases inherent risk as deliberate misstatement/manipulation is more likely Ability to meet debts as they fall due underlies the going concern basis of preparation of financial statements 1603 SESSION 16 – ANALYTICAL PROCEDURES 3.3.2 How assessed Short-term – liquidity indicators such as the current ratio Long-term – gearing and profitability indicators, e.g.: debt/equity ratio return on capital employed (ROCE) gross profit (GP)% earnings per share (EPS) Loans and borrowings – defaults in and renegotiation of repayments Cash flow projections – receipts from operations less than maturing debt SUBSTANTIVE ANALYTICAL PROCEDURES 4.1 Sufficiency 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.) Analytical procedures may be effective in testing for understatement (i.e completeness) For example, in predicting sales from purchases and known margins Where sufficient substantive evidence is not obtained by analytical procedures alone, some tests of detail will also be required Illustration Payroll (assertions) Completeness Analytical procedures Compare cost with budget/prior period(s) – month on month and for year “Proof in total” (eg that the number of employees on the payroll can be verified to independent control totals – say in HR) 1604 Tests of detail (ideas in outline) Postings from payroll to general ledger Agreeing existence of employees (eg either by physical verification and/or agreement to personnel records SESSION 16 – ANALYTICAL PROCEDURES Payroll (assertions) Occurrence Analytical procedures Compare cost with budget/prior period(s) and similar organisation/ industry Ratio analysis e.g average cost per employee by department and comparing with prior periods, other departments Measurement (amount and in correct period) Compare accruals (e.g statutory deductions, holiday pay, etc) with prior period(s) Labour turnover (should decrease with increasing remuneration) Presentation and disclosure Compare disclosure with prior year financial statements Ratios e.g payroll to cost of sales, average pay per employee 4.2 Tests of detail (ideas in outline) Cash book/bank payments and transfers Starters and leavers , eg agreeing that all leavers in a period have been excluded from the payroll for that period and all joiners included Postings from payroll to general ledger Sample of payroll transactions (accuracy, etc) and cut-off testing at period end Disclosure checklist Postings from general ledger to payroll Financial statement assertions Example (a) For each of the following financial statement assertions relevant to sales revenue suggest a suitable analytical procedure (b) Where analytical procedures may not be applicable or insufficient, suggest a test of detail 1605 SESSION 16 – ANALYTICAL PROCEDURES Solution Revenue (assertions) Analytical procedures Tests of detail (ideas in outline) Completeness Occurrence Measurement (amount and in correct period) 4.3 Extent of use 4.3.1 Factors to consider 4.3.2 Impact on use Audit objectives (see assertions above) and extent of reliance See extent of reliance (below) Degree of disaggregation of available information Procedures are more effective when applied to components Availability of financial and non-financial data Independently prepared non-financial data should result in more effective procedures Reliability of information available Budgets prepared with sufficient care will facilitate more effective procedures Relevance of information Budgets based on expectation are more useful than goals to be achieved Sources of information Independent sources are more reliable Comparability of information Broad industry data may not be relevant to specialized products Knowledge gained previously (“cake”) Effective procedures are based on recognizing unusual/unexpected variations If knowledge is limited, it is difficult to know what to expect 1606 SESSION 16 – ANALYTICAL PROCEDURES Nature of enterprise and its operations Steady trends develop in some businesses therefore easier to know what to expect and identify variations Example Albatross Ltd had 100 employees last year with total wages of $840,000 and 100 employees this year with a wage bill of $950,000, an increase of 13% The annual pay rise was 6% and the level of business has remained approximately constant Required: (a) Suggest reasons other than error or irregularity which could account for the greater than expected increase (b) In the absence of a satisfactory reason for the increase, suggest how the payroll could have been inflated by error or irregularity Solution (a) Business reasons (b) Possible error or irregularity 1607 SESSION 16 – ANALYTICAL PROCEDURES 4.4 Types of test Trend analysis (graphical time series or regression analysis) “Scattergraph” relies on visual inspection Ratio analysis Examples (see later) Examples Time-series analysis can be cumbersome Reasonable test = “proof in total” receivables collection period inventory turnover asset turnover payables payment period on payroll depreciation investment income rental income Statistical regression (using computer program) is most objective Ratios identify stable relationships therefore more relevant than absolute changes “Models” can be very precise, even simple models can be very effective Useful for income and expenditure a/c analysis Useful for both statement of financial position and income and expenditure a/c analysis Most useful for income and expenditure a/c analysis Illustration Testing petrol costs in a taxi firm Steps Application Identify factors likely to influence the amount to be tested Petrol costs determined by kilometres driven Clarify relationship and confirm it is credible and relevant Kilometres per litre range from 4.6 – 5.3 1608 SESSION 16 – ANALYTICAL PROCEDURES Predict likely range of values Jan Feb etc Compare predictions with actual Jan Feb Investigate variances and corroborate explanations 4.5 Kms driven Average price per litre ($) Expected petrol cost ($) 2,387 2,954 1.59 1.61 825 – 716 1034 – 897 Prediction ($) Actual ($) 716 – 825 897 – 1034 755 1200 January is within range, February is not Proofs in total An independent check on the total value of a population 4.5.1 Mechanics 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 Compare with recorded value Difference should not be material 4.5.2 Examples 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 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: (Last year’s audited expense (confirmed base data) ± starters/leavers) × (1+i) where i is the average percentage pay rises Investment income – apply known interest rates to nominal value of investments (audited) 1609 SESSION 16 – ANALYTICAL PROCEDURES 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 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 Materiality of items involved Cannot rely only on analytical procedures for material inventory balances, but may rely solely for immaterial income and expense items Other procedures Reviewing subsequent cash receipts might confirm or dispel queries raised by analytical procedures on an ageing of customers’ accounts 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) 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 Existing well-established client Well-known, stable industry Predictive information available (budgets, cash flow forecasts) Effective accounting and internal control systems OVERALL REVIEW STAGE 5.1 Need for In completing the audit, analytical procedures should be performed in drawing an overall conclusion on the consistency of the financial statements as a whole with knowledge of the business 1610 SESSION 16 – ANALYTICAL PROCEDURES 5.2 Examples Comparison of current year results with previous year(s) Review of significant trends and ratios to identify emerging patterns or changes in known patterns e.g if liquidity ratios deteriorating Recalculation of key ratios and trends to reflect adjustments to the financial statements INVESTIGATION OF FLUCTUATIONS Significant fluctuations, inconsistent relationships or deviations from predicted amounts should be investigated and adequate explanations and appropriate corroborative evidence obtained Unexpected trends or deviations should be discussed with management in the first instance Explanations must be substantiated (e.g by reference to existing knowledge and audit evidence already obtained) If management’s explanation in inadequate, further audit procedures may be necessary FOCUS You should now be able to: describe and explain the nature and purpose of analytical procedures in planning; compute and interpret key ratios used in analytical procedures; discuss and provide examples of how analytical procedures are used as substantive procedures 1611 SESSION 16 – ANALYTICAL PROCEDURES EXAMPLE SOLUTION Solution — Sales revenue assertions Revenue (assertions) Analytical procedures Completeness Occurrence Comparison with budget, prior period(s) etc Tests of detail (ideas in outline) Cut-off tests (goods despatch) Review of gross profit %(s) Postings from sales day book to general ledger Reasonableness test (where margins known) Sales orders to despatch notes and invoices Ratio of sales returns to sales Sales invoices to customer orders Average number or value of credit notes per month Post year-end credit notes Sales returns and allowances Direct confirmation Measurement (amount and in correct period) As for completeness Ratio of discounts to credit sales Postings from sales day book to general ledger Cutoff tests (goods despatch) Sample of invoices (prices, etc) Direct confirmation Solution — Total wages (a) Business reasons 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 There could have been a switch to more skilled (therefore more expensive) labour (b) Possible error or irregularity Misposting in the general (nominal) ledger “Dummy” employees on the payroll Unauthorized overtime being paid Employees being paid at higher rate of pay than authorized 1612 ... Cut-off tests (goods despatch) Review of gross profit %(s) Postings from sales day book to general ledger Reasonableness test (where margins known) Sales orders to despatch notes and invoices... discounts to credit sales Postings from sales day book to general ledger Cutoff tests (goods despatch) Sample of invoices (prices, etc) Direct confirmation Solution — Total wages (a) Business reasons