ANALYTICAL PROCEDURES SECTION 7

What Are Analytical Procedures? Evaluations of financial information made by a study of plausible relationships among financial and non-financial data Where used? Planning Substantive tests Overall review

Source of Expected Amount Analytical involve comparisons of recorded amounts or ratios to expected amounts Expected amounts developed from a variety of sources Source of Expected Amount Example Financial information from prior periods Anticipated results, such as budgets or forecasts Relationships of elements of financial information within the period Similar information regarding the industry in which the entity operates

Nature of Analytical Procedures Three common types: Trend analysis: The analysis of the change of an acount over time Ratio analysis: A comparison of relationships among financial statement accounts Reasonableness Tests: Computations usually involving non-financial data used to estimate an account balance

Trend Analysis Most common approach By analyzing changes in an account balance over past accounting periods The causal approach Requires auditor to develop expected results The diagnostic approach Compare the current amount to the trend to see if the current amount appears to be acceptable

Diagnostic Approach Example 200Y Change % Change Expected Explanation Sales 1,000,000 1,115,000 115,000 11.50 4.00 1 Cost of Sales 700,000 772,000 72,000 10.29 2 Depreciation 80,000 92,000 12,000 15.00 3 Sales commissions 50,000 66,000 16,000 32.00 4 Office Supplies 10,000 10,400 400 5 Advertising 8,000 8,320 320 Interest Expense 4,000 (66.70) 6 Utilities Expense 2,000 20.00 7 R & M Expense 3,000 3,100 100 3.30 Client bought new store on line in November Increased sales due to new store Client uses straight line. New store increased fixed asset base. Increase % of sales commissions OK Paid off debt Added store location

Simple Trend Analysis Involves determining an expected amount based on the account balance in prior periods E.g. A company may have an average annual increase in sales revenue of 10% What could be the cause if current years sales did not increase by 10%?

Regression Analysis Sales revenues can be affected by a variety of factors Can incorporate a number of variables Best fit technique

Job Order Costing Observation Direct Labour Hours Production Cost ($) 1 501 38,340 2 220 33,600 3 850 44,150 4 999 46,010 5 101 32,082 6 60 30,100 7 650 40,750 8 460 37,650 9 830 43,800 10 399 36,600 11 815 43,560 12 540 40,100

46,640 x 45,560 x x x 42,480 x 40,400 x 38,320 x x x 36,240 34,160 x 32,080 x x 30,000 200 400 600 800 1,000

What would be the expected job cost? From the graph Y = 30,000 + 16.64X Job # 876 uses 962 DLH What would be the expected job cost? But if Job # 876 only cost $42,000 Why?

Ratio Analysis Compares relationships among account balances Useful for both income and balance sheet Effective for income statement accounts because it typically compares the variations in operating activity

Time Series Analysis Ratios for an entity compared over time Cross-Sectional Analysis Ratios compared at a given point in time

Accounts Receivable Turnover Ratio Firm A Firm B Firm C Firm D Industry Average 1997 3.5 3.0 3.8 1998 3.4 2.9 3.9 3.6 1999 3.2 2000 3.3 2001 2002 3.7 2003 2004 3.1 Cross Sectional Analysis Time Series Analysis

Methods of Ratio Analysis Financial ratios and common size statements Analyzes relationships among account balances that the auditor expects to: Remain stable over time Be common across firms

Common-Size Statements In preparing common-size statement, the auditor converts the dollar amount of each account balance to a percentage of some relevant aggregate amount Time-series or cross-sectional Generally more useful for income statement accounts

Common-Size Income Statement 200B 200C 200D Revenues Sales 102.0 102.9 104.0 103.1 Sales returns 2.0 2.9 4.0 3.1 Net sales 100.0 10.0 Expenses Cost of sales 41.1 40.8 39.9 40.4 General, selling, and Admin. 21.3 22.4 23.4 23.3 Interest 18.1 18.8 19.4 20.0 Other 5.2 4.6 3.8 1.8 Tax 5.4 5.3 5.1 Income after tax 8.9 8.1 8.4 9.1

Use of Industry Ratios When performing cross-sectional analysis the auditor may use industry ratios Dun and Bradstreet 840 different classifications

Limitations in Using Ratio Analysis Different accounting principles can make financial ratios non-comparable Ratios may differ among entities depending upon individual differences Auditor should exercise caution when comparing the client with the industry

Reasonableness Tests Computations that calculate an expected amount by using operating data What could one use if trying to estimate passenger revenue for a bus company or an airline? How about total room revenue for a hotel?

One period model Reasonableness tests typically involve operating data which measures flow over time Can sometimes be excellent for the completeness assertion E.g. Expected revenues for an electrical utility

Timing of Analytical Procedures Three phases of an audit: Planning Fieldwork; and Final review The purpose of the analytical procedure depends on the audit phase

Planning Analytical procedures can draw attention to audit areas with significant potential for misstatement They can also enhance understanding of the client’s operations, transactions, and events The sophistication of the procedure can vary widely depending on the size and complexity of the client Determining risk

Fieldwork Used for substantive testing For a test of transactions an balances for inventory, what type of procedures can we use? How can an analytical procedures supply supporting or corroborating data for accounts receivable?

Final Review Analytical procedures are used in the overall or final review stage of the audit to assist the auditor in assessing The adequacy of substantive tests. The sufficiency of evidence The validity of conclusions reached Should be performed by a person with in-depth knowledge

Reliability of Data Used to Develop Expectations More reliable if From an independent source Maintained by people not in a position to manipulate relevant accounting records Derived from an adequate internal control structure Subjected to audit testing in a prior year