Audit Working Papers 1

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.