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Analytical procedures in auditing

Kim Smith

THIS article sets out the requirements of the relevant statements of auditing standards and explains the importance of analytical procedures.

Auditing standards

The relevant standard is ISA 520, Analytical Procedures (SAP 14 with respect to ICAI). It deals with: i) the nature and purpose of analytical procedures; ii) the application of analytical procedures _ at the planning stage, as substantive procedures, and at the overall review stage; iii) extent of reliance; and iv) investigating significant fluctuations.

Nature and purpose

`Analytical procedures' concern not only analysis (of ratios, trends and relationships) but also the investigation of fluctuations.

The analysis usually considers both comparisons and relationships.

Comparisons: Financial information is compared, for example, with: i) prior periods (historical data); ii) budgets and forecasts (future-oriented data); iii) predictive estimates (for example, of the annual depreciation charge); and iv) industry averages .

It is common practice for the auditor to prepare a schedule of account balances for the current year (unaudited) with comparatives (audited) with +/- difference columns expressed in both absolute (that is, $) and relative (percentage) terms.

Relationships: Typically, relationships are considered between:

a) elements of financial information which are expected to adhere to a predicted pattern (for example, gross profit percentages); b) financial and non-financial information (for example, hotel revenue to room occupancy).

Methods used: Methods of analysis vary considerably, from simple comparisons to complex analyses using advanced statistical techniques. Analytical procedures may be applied to: consolidated financial statements; components (for example, subsidiaries, div isions and segments); and individual elements of financial information (account balances, for instance).

Purposes: i) To assist in planning the nature, timing and extent of other audit procedures;

ii) As substantive procedures, when their use is more effective or efficient than tests of detail; and

iii) As an overall review, to conclude whether financial statements as a whole are consistent with auditors' knowledge of the business.

Application of

analytical procedures

The standard states that auditors ``should apply analytical procedures at the planning and overall review stages of an audit''. Analytical procedures at these stages are, therefore, essential and are required (that is, mandatory) in the conduct of any au dit. It goes on to state that analytical procedures may be performed as substantive procedures (that is, are optional).

At the planning stage: Analytical procedures at this stage (sometimes called `preliminary analytical review') assist in:

i) increasing knowledge and understanding of the business through the accumulation of information on trends in key relationships;

ii) identifying areas of potential risk (relating to the enterprise's financial condition, for instance); and

iii) determining the nature, timing and extent of other audit procedures (that is, audit strategy) by directing tests to areas of potentially material misstatement.

Ratio analysis (that is, the comparison of relationships between account balances and classes of transactions over several accounting periods) is particularly useful in identifying fluctuations for investigation. Because of the inter-dependency of many r atios, breaking them down and further refinement into specific components will identify the source of individual fluctuations.

For example, breaking down return on capital employed (ROCE) into gross profit on sales and asset turnover, then inventory turnover, average debt collection period, and so on.

Importance of financial condition: It is particularly important that the financial condition of a business and its ability to meet debts as they fall due is assessed at the planning stage. A deterioration in liquidity, gearing or profitability indicators potentially increases inherent risk as the risk of deliberate misstatement/manipulation is increased.

Information availability: Financial information available at the planning stage may include: interim financial information; budgets or forecasts; management accounts;

a `trial balance' (that is, a list of balances extracted from the general ledger); and draft financial statements.

Analysis of gross profit: Consider the following scenario:

Tivoli manufactures a small range of gardening tools and supplies them to wholesalers. Its turnover for the year ended December 31, 1999, was approximately $2 millions. The products of the company have not altered for many years, and turnover and profits have recently increased broadly in line with the rate of inflation.

As auditor, you attended the stock-take (that is, physical inventory count) and undertook a direct confirmation of amounts due from customer for the year ended December 31, 1999, prior to the production of any management accounts for the year. On receip t of the draft management accounts for the year, your analytical procedures reveal that:

i) The gross profit percentage has increased from 32 to 36;

ii) Inventories at the end of the year represented 35 per cent of the purchases during the year compared with 25 per cent for the previous year; and

iii) Purchases of materials show a gradually increasing trend each month throughout the year except for the last month which shows a decrease of 30 per cent compared with the previous month.

If you are asked something along the lines of ``suggest possible reasons for the increase in the gross profit margin'': think rather than guess; and seek valid, business reasons and possible errors rather than speculating on improbable frauds and irregul arity.

For example, it is nonsense to suggest that the increase in gross profit percentage is due to inflation. If turnover and profits are increasing broadly in line with inflation, then cost of sales must also be increasing at the same rate and the gross prof it percentage will be unchanged. The scenario does not state what the rate of inflation is and it is unnecessary to speculate whether it is, say, two or 20 per cent.

Suppose sales have increased in line with inflation but the gross profit percentage has increased, then the cost of sales must have fallen. Now consider the components of cost of sales, namely: opening inventory; add: cost of production (raw materials co nsumed + conversion costs); and less: closing inventory.

Clearly, the cost of sales will have fallen if a cheaper unit cost of production had been achieved. This could have resulted from: more efficient production methods; and/or

cost savings on materials, direct labour wage rates, and production overheads.

As auditor, you would expect Tivoli's management to be aware if cost reductions have been achieved during the year. You would also expect to be able to substantiate costs by reference to costing records. If, however, the management is not aware of such c ost reductions, the possibility of error needs to be considered. For example, a) sales may be overstated; b) opening inventory may be understated; c) purchases (or other components of manufacturing cost) may be understated; and d) closing inventory may b e overstated.

Are these all equally likely? Think about each in turn bearing in mind that we are looking for causes of potential material error ((36 per cent - 32 per cent) x $2m = $80,000).

a) Sales overstatement: If sales (credit entries) are overstated, then either cash is overstated and/or trade accounts receivable (that is, debtors) are overstated. Fictitious cash receipts would be picked up on monthly bank reconciliations. Any material overcharging of bona-fide customers (whether in error or through fictitious sales invoices) will be brought to light by the direct confirmation of customers' accounts. Thus, deliberate overstatement of sales seems unlikely.

Sales could also be overstated due to cut-off error, for example, January 2000 sales being invoiced as December 1999. However, Tivoli is only generating $167,000 monthly revenue (on average), so a cut-off error of $80,000 would be obvious.

b) Opening inventory understatement: Opening inventory was audited as last year's closing inventory. If it was materially understated last year, last year's gross profit percentage would have been understated also. This would seem unlikely as the scenari o does not suggest that last year's auditors report was qualified in respect of the inventory valuation.

c) Purchases understatement: Purchases could be understated if materials/components received before the year end have not been recorded until after the year end. Such an error might indicate a general lack of control over cut-off.

If purchase invoices are unrecorded (whether deliberately suppressed or omitted in error) liabilities as well as expenses will be understated. This would be brought to light by an examination of suppliers' statement reconciliations.

d) Closing inventory overstatement: Closing inventory could be overstated due to: an error in the physical count (for example, double counting); and errors in pricing (work-in-progress being costed to reflect too high a degree of completion, thereby over -allocating labour and overhead).

Exercise

Suggest a valid business reason and a possible accounting error which could have contributed to findings (ii) and (iii) relating to Tivoli.

Suggested solution: Increase in closing inventory/purchases ratio (item (ii)).

Business reasons:

A Substantial year-end purchases of materials or components may have been made in anticipation of price increases;

A Lax inventory control could have lead to a build-up of raw materials stocks;

A Lack of customer demand or unsaleability may have resulted in slower-moving finished goods; and

A A change in the `mix' of goods held (for example, more WIP and finished goods compared to raw materials).

Accounting errors:

A Overstatement of closing inventory quantities or prices (see (d) above);

A Understatement of purchases (see (c) above);

A As the fluctuations noted are based on draft management accounts, it is possible that Tivoli has not yet processed certain routine year-end adjustments (for example, to achieve an accurate purchase cut-off);

A Inadequate provisions against slow-moving products, or a reduction in general provision compared to the previous year;

A A change in accounting policy for inventory, for example: to FIFO valuation (previously LIFO); to include additional categories of overhead; and using different bases of apportionment/absorption.

Decreases in last month's purchases (item (iii)):

Business reasons:

A Management could have deliberately cut back on purchases in the last month having realised that stock levels were increasing. (The substantial purchase in (ii) above would need to have been made prior to December 1999 for both fluctuations to be explai ned.)

A Alternatively, a regular monthly purchase may have been delayed from December 1999 to January 2000, perhaps for cash flow reasons (seasonal factors are unlikely to significantly influence sales or purchases).

Accounting errors:

A Understatement of purchases and liabilities due to inaccurate cut-off (see (c) above).

(To be concluded)

(Edited extracts from the January 2000 issue of Students' Newsletter. A publication of the Association of Chartered Certified Accountants, London.)

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