Analytical Procedures
Risk
assessment procedures are designed for obtaining an understanding of the entity
and its environment, including its internal control. This understanding should
be a continuous, dynamic process of gathering, updating and analyzing
information throughout the audit. Risk assessment procedures provide the audit
evidence necessary to support the assessment of risks at the financial
statement and assertion levels. However this evidence does not stand alone. At
the risk response phase of the audit the evidence obtained will be supplemented
by further audit procedures (that respond to the risks identified) such as
tests of controls and/or substantive procedures. Where efficient, further
procedures such as substantive procedures or tests of controls may be performed
concurrently with the risk assessment procedures.
There are three risk assessment procedures.
They are as follows:
1. Inspection;
2. Observation; and
3. Analytical Review
Each of
these procedures should be performed during the audit but not necessarily for
each aspect of the understanding required. In many situations the results from
performing one type procedure may lead to another. For example, the findings
from analytical review on preliminary operating results may trigger enquiries
of management. The answers to the enquiries may then lead to requests to
inspect certain documents or observe some activities.
Analytical procedures used as risk assessment
procedures help to identify matters that have financial statement and audit
implications. Some examples are unusual transactions or events, amounts, ratios
and trends. The procedures are not normally very detailed or complex. They
often use data aggregated at a high level, which means the results can only
provide a broad initial indication about whether a material misstatement may
exist. The steps involved in performing analytical procedures include the
following:
What to
do
|
How to
do it
|
Identify
relationships within the data
|
Identify plausible relationships
among the various types of information that could reasonably be expected to
exist.
The financial and non-financial
information could include:
·
Financial statements for comparable previous
periods;
·
Budgets, forecasts and extrapolations,
including extrapolations from interim or annual data; and
·
Information regarding the industry in which
the entity operates and current economic condition,
|
Compare
|
Evaluate the results.
Where unusual or unexpected relationships
are found, consider potential risks of material misstatement.
|
Evaluate
results
|
Where unusual or unexpected
relationships are found, consider potential risks of material misstatement.
|
Obtaining
an understanding of the nature of the entity and its environment, including
internal control, has a number of benefits, as outlined below:
-
Developing
expectations needed for performing analytical procedures.
-
Case
Study – Acer Computer Repairs
Extract:
Acer keeps
an inventory holding of more commonly needed parts. Acer has mentioned that his ideal level of
inventory should represent about a month’s worth of sales. There are obviously
numerous suppliers that Acer makes use of, and although there are some that
insist on C.O.D, the majority of them allow Acer a 30 day term to settle.
Income is
recognized on completion of a job. This is justified on the basis that if
customers never collect their goods, the selling price of those goods will
always be enough to cover the invoice price of the repair. If the goods are not
collected within 30 days of the advised date of completion of the job (which is
specified on the original sales order – a copy of which is given to the
customer) they are sold to Cash Converters and the full proceeds are then
recorded as income.
When
customers pay COD for the repairs, a receipt is made out if the customer asks
for it. Monthly statements are sent to the customers who have 30 day terms.
Acer
expects gross margins of 70%.
Ratio
|
2011
|
2010
|
Current Ratio
|
3
|
1
|
Acid Test Ratio
|
1
|
1/2
|
Receivables Turnover
|
25
times
|
36 times
|
Days sales in receivables
|
14
days
|
10 days
|
Inventory Turnover
|
10
times
|
9 times
|
Days cost of sales in inventory
|
38
days
|
41 days
|
Days purchases in creditors
|
24
days
|
34 days
|
Gross Profit Margin – Total
|
55%
|
54%
|
Return on operating assets
|
12%
|
8%
|
Conclusion on Risk Assessment Analytical Review
The ratios
show that the company has had a solid year. Liquidity is sturdy which does not
imply that Acer’s has a going concern problem. Profitability has improved.
Currently the company effectively manages the working capital. Accounts
receivable days and accounts payable days are in line with the standard 30 days
payment terms. The return on assets and current ratio illustrate that the
company performs strongly. Management utilizes the Company’s assets to generate
profits. The gross profit margin is well below Acer’s expectations. There are
the following issues that need further investigation:
1.
The days cost of sales in inventory is
significantly higher than the 20 days Acer would like. This indicates a
potential overstatement which would lead to a reduction in cost of sales and
hence greater operating profit.
2.
The decrease in the number of day’s purchases
in creditors may indicate a potential under recording of expenses and/or
purchases and creditors.
Case Study - Dagga Stompies (Pty) Limited
During the planning of the 2011 audit of Dagga
Stompies (Pty) Limited a company owned by the financial director of ZCA, you
performed the certain analytical procedures. The following particulars came to
your attention:
Details
|
2011
|
2010
|
2009
|
2008
|
2007
|
Commission
paid
|
R38 000
|
R29 800
|
R27 200
|
R25 000
|
R22 500
|
Stock
turnover
|
2.1
|
2.53
|
2.81
|
3.34
|
3.36
|
Stock as
%age of current assets
|
57%
|
53%
|
51%
|
49%
|
48%
|
Debtors
collection period – days
|
78
|
72
|
67
|
62
|
60
|
Provision
for bad debts as a %age of debtors
|
11%
|
12.5%
|
14%
|
15.1%
|
16%
|
According to the company’s policy, commission
is calculated at 10% of sales.
1. You are required to evaluate the trend during
the past 5 years in respect of each of the above items and to arrive at the
appropriate conclusions based on such evaluations.
2. To describe the audit procedures that you as
auditor would perform as a result of your evaluations.
SUGGESTED SOLUTION
1.
Although commissions paid reflect a constant
increase during the past 5 years, it increased by 27.5% from 2010 to 2011, (9.5%
from 2009 to 2010, 8.8% from 2008 to 2009 and 11.1% from 2007 to 2008) which is
not consistent with the increases in previous years. This might be an
indication that sales and or commissions paid are overstated in the financial
statements
2.
The stock turnover rate has decreased
gradually over the last 5 years and this is inconsistent with the possibility
that sales may be overstated as an decreased stock turnover gives an indication
that turnover has decreased due stock been sold less often. This could indicate
a problem in cost of sales or in the valuation of stock. There might be
obsolete stock in the value.
3.
Stock as a percentage of current assets has
increased over the past 5 years. This indicates deterioration in the quick
ratio which has an impact on the going concern abilities of the company.
4.
The debtor’s collection period has
deteriorated over the past 5 years. This indicates that debtors are paying at a
slow rate or there has been an extension of credit terms. Provision for
doubtful debts must be reviewed.
5.
The provision for doubtful debts has decreased
as a percentage of debtors over the past 5 years. This is conflict with the
information obtained in 4. Debtors are paying slower; credit has been extended
hence the provision for doubtful debts should be increasing. Provision for
doubtful debts are understated hence debtors are overstated.
AUDIT PROCEDURES
1.
Calculate 10% of sales and compare the
calculated figure with actual commission paid.
2.
If the above calculation indicates the current
year is out of line – select invoices and trace them to orders and delivery
notes in order to ensure that all sales are valid – this test must be extended
3.
Investigate an extended sample of high value
stock items for their ability to be sold and compare cost prices to selling
prices.
4.
Establish whether if a provision for
obsolescence is necessary.
5.
Carry out extended valuation tests on the cost
of stock.
6.
Follow through payments on an extended number
of high value debtors subsequent to year end.
7.
If there were no subsequent payments determine
the ability of the debtor to pay by discussions with management and history of
payments.
8.
Discuss with management the provision for
doubtful debts and consider the possibility of increasing the amount. The
debtor’s age analysis must be used in this process.
There are two other major purposes for which
analytic al procedures can be used.
1.
As the
primary source of evidence for a financial statement assertion. This would be a
substantive analytical procedure which are procedures designed to substantiate
a financial statement amount by using predictable relationships among both
financial and non-financial data. They are mostly applicable to large volumes
of transactions that tend to be predictable over time.
2.
To perform an overall review of the financial
statements at or near the end of the audit.
Most
analytical procedures are not very detailed or complex. They often use data
aggregated at a high level, which means the results can only provide a broad
initial indication about whether a material misstatement may exist.
The results of these analytical procedures
should be considered along with other information gathered to:
·
Identify
the risks of material misstatement related to assertions embodied in
significant financial statement items; and
·
Assist in
designing the nature, timing, and extent of further audit procedures.
Some
smaller entities may not be able to provide the auditor with current financial
information such as interim or monthly financial information for performing
analytical procedures. In these circumstances, some information may be obtained
through inquiry, but detailed inquiries may need to wait until an early draft
of the entity’s financial statements is available.
Audit Procedures
1. Obtain a copy of the most recent operating
results and identify plausible relationships among the various types of
information available. Consider both financial and nonfinancial information.
2. Compare expectations with recorded amounts or
ratios developed from recorded amounts and last year’s files.
3. Identify unusual or unexpected relationships.
Obtain an explanation from management and assess the resulting risk of material
misstatement.
Substantive Analytical Procedures
Substantive
analytical procedures involve a comparison of amounts or relationships in the
financial statements with an expectation developed from information obtained
from understanding the entity, and other audit evidence. If the inherent risks
are low for a class of transactions, substantive analytical procedures alone
may provide sufficient appropriate audit evidence. However, if the assessed
risk is low because of related internal controls, the auditor would also
perform tests of those controls. Consequently for significant risks identified,
analytical procedures would always be used in combination with other
substantive tests or tests of control.
To use an
analytical procedure as a substantive procedure, the auditor should design the
procedure to reduce the risk of not detecting a material misstatement in the
relevant assertion to an acceptably low level. This means that the expectation
of what the recorded amount should be is precise enough to indicate the
possibility of a material misstatement, either individually or in the
aggregate.
The use of
substantive analytical procedures by themselves is not considered an
appropriate response to address a significant risk. When the approach to
significant risks consists only of substantive procedures, the audit procedures
can consist of:
-
Tests of details alone; or
-
A combination of tests of details and
substantive analytical procedures.
For
audit-planning purposes, substantive analytical procedures may be grouped into
three distinct levels based on the level of assurance obtained. These are
described below:
Impact
on Reducing Audit Risk
|
Description
|
Highly Effective (Low Level of Risk
that the Recorded Amount is
Misstated)
|
Procedure is intended to be the
primary source of evidence regarding a financial statement assertion. It
“effectively” proves the recorded amount. However, if the risk involved is
significant, it would be supplemented by other relevant procedures.
|
Moderately Effective
|
Procedure is only intended to corroborate
evidence obtained from other procedures. A moderate level of assurance is
obtained.
|
Limited
|
Basic procedures, such as comparing
an amount in the current period to a previous period, are useful but only
provide a limited level of assurance.
|
Techniques
There are
a number of possible techniques that can be used to perform the analytical
procedures. The objective is to select the most appropriate technique to
provide the intended levels of assurance and precision. Techniques include:
·
Ratio analysis;
·
Trend analysis;
·
Break-even analysis;
·
Pattern analysis; and
·
Regression analysis.
Each
technique has its particular strengths and weaknesses that the auditor needs to
consider when designing the analytical procedures. A complex technique such as
regression analysis may provide statistically reliable conclusions about a
recorded amount. However, a simple technique such as multiplying the number of
apartments by the approved rental rates (per leases) and adjusting the result
for actual vacancies may provide a reliable and precise estimate of the rental
revenue.
Factors to Consider
Designing
Substantive Analytical Procedures
|
Suitability given the nature of the
assertions.
|
Reliability of the data (internal or
external) from which the expectation of recorded amounts or ratios is
developed. This will require tests on the accuracy, existence, and
completeness of the underlying information such as tests of controls or
performing other specific audit procedures, possibly including the use of
computer-assisted audit techniques (CAATs).
|
|
Whether the expectation is sufficiently
precise to identify a material misstatement at the desired level of
assurance.
|
|
Amount of any difference in recorded
amounts from expected values that would be acceptable.
|
Questions to Address
Establishing
Meaningful Relationships Between Information
|
Are the relationships developed from
a stable environment?
·
Reliable and precise expectations may not be
possible in a dynamic or unstable environment.
|
Are the relationships considered at
a detailed level?
·
Disaggregation of amounts can provide more
reliable and precise expectations than an aggregated level.
|
|
Are there off-setting factors or complexity
among highly summarized components that could obscure a material
misstatement?
|
|
Do the relationships involve items
subject to management discretion?
·
If so, they may provide less reliable or
less precise expectations.
|
The degree
of reliability of data used to develop expectations needs to be consistent with
the levels of assurance and precision intended to be derived from the
analytical procedure. Other substantive procedures may also be required to determine
whether the underlying data is sufficiently reliable. Tests of controls may
also be considered to address other assertions such as the data’s completeness,
existence, and accuracy. Internal control over non-financial information can
often be tested in conjunction with other tests of controls.
Is the
Data Sufficiently Reliable for Achieving the Audit Objective?
|
Is the data obtained from sources
within the entity, or from independent sources outside the entity?
·
The reliability of audit evidence is increased
(with some exceptions) when it is obtained from independent sources outside
the entity.
|
Is data from sources within the
entity developed by persons not directly responsible for its accuracy?
·
If so, consider further procedures to check
accuracy.
|
|
Was the data developed under a reliable
system with adequate internal control?
|
|
Is broad industry data available for
comparison with the entity’s data?
|
|
Was the data subject to audit testing in the
current or prior periods?
|
|
Were the auditor’s expectations
regarding recorded amounts developed from a
variety of sources?
|
To avoid
unwarranted reliance on a source of data used, the auditor would perform
substantive tests of the underlying data to determine whether it is sufficiently
reliable, or test whether internal controls over the data’s completeness,
existence, and accuracy are operating effectively.
In some
cases, non-financial data (for example, quantities and types of items produced)
will be used in performing analytical procedures. Accordingly, the auditor
needs an appropriate basis for determining whether the non-financial data is
sufficiently reliable for the purposes of performing the analytical procedures.
Differences from Expectations
When differences
are identified between recorded amounts and the auditor’s expectations, the
auditor would consider the level of assurance that the procedures are intended
to provide and the auditor’s performance materiality. The amount of the
acceptable difference without investigation would, in any event, need to be
less than performance materiality.
Procedures
used for the investigation could include:
·
Reconsidering the methods and factors used in
forming the expectation;
·
Making inquiries of management regarding the
causes of differences from the auditor’s expectations and assessing
management’s responses, taking into account the auditor’s understanding of the
business obtained during the course of the audit; and
·
Performing other audit procedures to
corroborate management’s explanations.
As a result of this investigation, the auditor
may conclude that:
·
Differences between the auditor’s expectations
and recorded amounts do not represent misstatements; or
·
Differences may represent misstatements, and
further audit procedures need to be performed to obtain sufficient appropriate
audit evidence as to whether a material misstatement does or does not exist.
Examples of Effective Substantive Analytical
Procedures
Financial Statement Amount
|
Relationship
and Procedure
|
Sales
|
Selling price applied to the quantities
shipped.
|
Amortization Expenses
|
Amortization rate applied to capital asset
balances, allowing for effect of additions
and disposals.
|
Overhead Element of Inventory
|
Relating actual overheads to actual
direct labor or production volumes.
|
Payroll Expense
|
Pay rates applied to number of employees.
|
Commission Expense
|
Commission rate applied to sales.
|
Payroll Accruals
|
Daily payroll applied to number of days
accrued.
|
Other Analytical Procedures
Analysis can take the form of:
·
Detailed comparisons of current financial
statement or financial data with that of prior periods or with current
operating budgets.
·
An increase in accounts receivable with no
corresponding increase in sales could indicate that a problem exists in the
collectability of accounts receivable. An increase in the number of employees
in a professional organization would lead the auditor to expect an increase in
salary expense and a corresponding increase in professional fee revenue.
·
Comparative data on the various types of
products sold or types of customers. This could help explain month-to-month or
period-to-period fluctuations in sales.
·
Ratio analysis.
·
Ratios can provide support for the current
financial statements (e.g., comparable to industry norms or prior periods’ results)
or raise points for discussion. Certain institutions, such as banks and trade
associations, produce financial statistics on an industry-wide basis. Such
statistics can be useful when compared to those of an entity’s operation, and
inquiries made where differences from industry trends occur.
·
Graphs.
·
Finally, consider the use of graphs to portray
the results of procedures. Graphs visually highlight significant differences
from month to month or period to period.
Use of Analytical Procedures in Forming an
Opinion
Upon substantial completion of the audit, the
auditor is required to use analytical procedures to assist in evaluating the
overall financial statement presentation.
The purpose of using analytical procedures at
or near the end of the audit is to determine whether the financial statements
as a whole are consistent with the auditor’s understanding of the entity.
These procedures would address questions such
as:
·
Do the
conclusions drawn from such procedures corroborate the conclusions formed
during the audit of individual components or elements of the financial
statements?
Analytical
procedures may reveal that certain financial statement items differ from
expectations formed by the auditor based on knowledge of the entity’s business
and other information accumulated during the audit. Such differences would need
to be investigated using procedures such as those described above. This
investigation may indicate the need for changes in presentation or disclosure
in the financial statements.
·
Is there a
risk of material misstatement that has not been previously recognized?
If
additional risks are identified, the auditor may need to re-evaluate the
planned audit procedures to respond appropriately.
Example of a Substantive Analytical Procedure
Questions
|
Response
|
||
Describe
the procedure to be performed and the expected outcome.
|
Multiply the rent charges per unit
with the number of rental units to predict the revenue from apartments, and
then compare result with the revenue recorded in the entity’s accounting
records.
|
||
What is
the value of the recorded amount or ratio?
|
R278,000
|
||
What
assertions will be addressed?
|
Completeness, existence, and
accuracy
|
||
What
performance materiality will be used?
|
R10,000
|
||
What
amount of difference (between recorded amounts and expected values) is
acceptable?
|
1%
|
||
Remaining
risk of material misstatement after procedure performed (i.e., moderate or
low).
|
Low
|
||
Describe details of each data
element used in calculating the expected outcome (i.e., financial and
non-financial).
|
Describe
the procedures performed to evaluate the reliability of each data element
used (consider source, comparability, nature, relevance, and controls over
preparation).
|
W/P
Ref
|
|
Rental
units
|
We reviewed the floor plans and physically
inspected the building for major changes.
|
||
Rent per unit
|
We reviewed a sample of lease
contracts to determine the rent payable.
|
||
Provide details of the calculation,
the expected outcome, and results of the comparison to the recorded amount or
ratio:
Number of
rental units = 26 Rent per unit = R12,000 per year
Calculation
= 26 X 12,000 = R312000. The difference to the recorded amount is R34,000
|
|||
Where the difference (between
recorded amounts and expected values) exceeds the acceptable value, explain
what investigation was performed and the results (i.e., inquiries of
management, obtaining additional evidence and performing other audit
procedures).
We
inquired about the difference and verified that, on average, 2 units were
vacant (not the same ones) each month during the year, and one unit was not
rented and used for meeting purposes and as an occasional accommodation for
visitors. This accounts for R36,000 of the difference leaving R2,000
unexplained. This is below the acceptable level described above.
|
|||
Conclusion:
Test was successfully completed.
|
|||
CONSIDER POINT
The use of
“non-financial” data in a substantive analytical procedure can often enhance
the result. Nonfinancial data could include information such as head counts,
square footage for a retail store, or the number of specific products shipped.
When performing analytical procedures, it is imperative to set expectations
(e.g., relationship with related balances, changes from prior period, etc.) and
then compare those expectations to the financial statement information. Avoid
the opposite approach of starting with the financial information and then
attempting to explain variances using knowledge of the client and its
environment. Analytical procedures are much stronger when they are created by
expectations based on an understanding of the entity and its environment.
However, the reliability of any “non-financial data” used needs to be
established before its use in a substantive analytical procedure.
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