QUESTIONS AND ANSWERS Auditing Help

You are due to commence the final audit of ABC Ltd. a manufacturing company for the year ended June 30, 20×8 and have been presented with a draft set of financial statements for the year which have been prepared by management. Your interim audit was conducted earlier in the year and you came to the conclusion at that stage that systems were unsatisfactory. The main objective of your audit is to enable you to express an opinion on whether the financial statements give a true and fair view and you wish to examine the draft financial statements to assist you in your audit planning by identifying significant audit areas and potential audit problems at the start of the assignment.

The financial statements together with typical ratios for a similar industry are as follows:

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Note: closing stock and Accounts receivable at June 30, 20×6 were Rs. 25,000 and Rs.17,000 respectively.

PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED JUNE 30, 20×8

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Typical ratios for a similar industry

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Required
Review the above financial statements and industries averages and list the main features therein, which require’ most attention during your forthcoming final audit. Give your reasons.

With regard to those areas which may cause you some concern, outline the main matters which you would need to investigate (a detailed audit program is not required)

a ) Matters requiring attention

  1. Although gross profit to sales is almost in line with industry ratio, the net profit margin is considerably lower.
  2. Administrative expenses have reduced by Rs. 3,000 compared to last year
  3. Excessive amount is blocked in Inventories.
  4. Assets turnover is reduced from 1.69 to 1.49 in 20×9. It is slightly lower than Industry average too.

( b ) Matters which need investigation

  1. Check that directors’ personal expenses are not charged to business, a possible reason for reduced net margins.
  2. Check that accrued payroll and other accrued expenses of June 20×8 have been accrued for Omission of certain accruals may be the cause for reduced administrative expenses.
  3. Check that inventories have not been overstated, particularly check adequacy for allowance for obsolescence. Overstatement of inventory may be the reason for decline  in inventory turnover
  4. Consider adequacy of provision for depreciation. this could be the cause for decrease in assets turnover.

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Following are abridged accounts of Northern Plastics. The company has been doing well in the past but during 20×8, due to loss of certain major customers the performance was deteriorated.

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What matters will you consider in planning the audit?

  1. Increase in gearing is alarming. Increase in long term loan might have been made to finance fixed assets for anticipated expansion. The expansion could not take place because of recession.
  2. Increase in overdraft appears to be the result of over stocking in anticipation of increased turnover, which could not take place.
  3. Fall in payable turnover may be the indication that certain suppliers might have restricted credit sales to the company and could be insisting for cash payments.
  4. It seems that dividends have been paid by arranging increase in overdraft which is not sound policy.
  5. The management and auditors should be alert of going concern problem because:

a) Gearing of more than 100% is not acceptable scenario in most of the cases. Further borrowings are almost out of question and even if funds are available the interest rate will be exorbitant.

b) Overdraft limit has not been given but it is obvious that the bank may withdraw the facilities due to fall in interest cover.

c) A further slight decrease in sales or margins may result in future losses.

d) Liquidity position has significantly deteriorated.

e) Refusal of certain suppliers to grant further credit is evident from the payable ratio.

What are the uses and limitations of analytical procedures

Uses

1. Analytical procedures assist auditors in identifying potential problems and important areas of audit.

2. Assist in assessing risk of material misstatements

3. Analytical procedures may be used as substantive procedures in the circumstances where they are more efficient and effective than tests of details, to detect material misstatements (for example in testing completeness assertion)

4. At the final review stage, analytical procedures assist in evaluation whether the amounts in financial statements are reasonable and consistent with the auditor’s knowledge of the business.

Limitations of Ratio Analysis

1. Conclusions drawn from a comparison of ratios of one entity with others even in the same industry may be misleading because of adoption of diverse policies in numerous areas of accounting. Although the International Accounting Standards have narrowed down the options to a large extent, still there is no single set of accepted accounting principles, which the users may refer. The adoption of diverse accounting policies allowed by International
Accounting Standards and also by local regulations may produce financial statements, which are different in material respect.

Examples of areas where different accounting policies are being used include allocation of costs to inventories, depreciation expense, research and development, employee end of service benefits, investments and intangibles.

2. Comparison of ratios of two entities may also be misleading if one
entity records the transactions and events in accordance with legal form and the other entity recognizes the principle of substance over form.

3. The ability to interpret financial data is affected by the manner in which the data is presented. For example, if adequate disclosures
have not been made, misleading conclusions may be drawn.

4. Manipulation of the financial statements due to pressures on management to produce predetermined results will obviously distort the ratios. For example the management may be under pressure declare a certain percentage of dividends. Also, due to bank. convents, the management may be influenced to produce financial statements, which will meet the minimum ratios required by bank e.g., restriction of debt ratio to a predetermined limit.

5. Sometimes the accounts are not intentionally distorted but the financial statements may not be reliable due to inherent difficulties of making some complex estimates. Such estimates are sometimes quite material and pervasive. For instance estimated cost of completion of uncompleted contracts.

6. The usual requirements of reporting information on a timely basis and maintaining balance between costs and benefits may impair reliability of the financial statements on which ratios are based.

7. In isolation, ratios could be of limited value. These should be considered in relation to other ratios.

8. Where business is diversified, a change III the sales mix would distort ratios.

9. Ratios which are computed from data which is not ordinarily related may be misleading. For example, a comparison of sales to research and development expenses or sales to advertisement does not make much sense. Research and development costs depend upon management discretion and will not have relationship with sales. Likewise, if advertisement expense is incurred in one year, full benefits of such expense may not accrue in the same accounting year.

10. If price level changes are not considered, ratios of two entities which are set up in different years are not comparable. For example, Company A was established in 1980 and Company B was established in 1997. Depreciation charge on plant and machinery in case of Company A will be substantially lower than that of Company B.

11. Ratio analysis is based on the expectation that relationship among data exists and expected results can be predicted. However, events which cannot be measured in monetary terms are not reflected in the financial statements, (for example, changes in management of the company). Such events may have far reaching effect on future performance of the entity.

12. No two companies, even in the same industry are exactly similar. It is possible that both the companies have similar capacity, same suppliers and customers, but one has leased major assets and another owns the assets.

13. In most of the cases, when ratios reflect unusual fluctuations. additional investigation is required to ascertain causes of such fluctuations.

14. Analytical procedures performed without obtaining understanding the business may be misleading

15. Inquiry from management alone on unusual fluctuations as indicated by analytical procedures, may be insufficient or misleading.

16. Ratio analysis may be misleading if the data on which ratios computed is incomplete or inaccurate.

Cole Limited is engage in trading of building materials. Major products are cement, marble and timber

Total sales for year ended December 31, 20×8 amounted to Rs. 12 million, around 5,500 sales invoices were issued during year

Your risk assessment procedures reflect that the design of controls are appropriate. However, the management has informed you that some unrecorded cement sales are suspected

Discuss matters that would you consider in applying analytical procedures as substantive tests, to detect material misstatement in sales revenues.

Following matters will be considered in applying analytical procedures as substantive procedures in Cole Limited

1. Suitability of using substantive analytical procedures for given assertions:

– Analytical procedures are more efficient and effective in verifying completeness assertion, that is detecting unrecorded sales. In verification of understatement of cement sales, therefore, analytical procedures are quite useful.

– Since the internal controls are not weak, analytical procedures are appropriate

– Analytical procedures in this case are useful along with tests of details

2. Reliability of data

– External source of information might include trade journals and newspapers indicating business trends and selling prices

– Comparability of data is possible through financial analysts reports

– Budgets will be more reliable if they are considered attainable

– Analytical procedures will include comparison of financial and non financial data. For example, number of cement bags sold with sales revenue. Here the auditor will verify controls over processing of units purchased and sold.

3. Whether the expectation is sufficiently precise

– There is an expectation, that higher the sales volume, the higher should be sale revenue. Comparison of gross margins will also be useful.

– The more the information is dis aggregated, the great reliance can be placed on analytical procedures. If separate data is available for sales and cost of sales of cement, marble and timber, analytical procedures will be more reliable.

Mr. Mubarak is the auditor on the audit of Sky Blue Limited. While comparing the draft financial statements with the previous year, he noted many unusual fluctuations. Briefly explain the procedures he should follow in the above situation.

The procedures to investigate unusual differences are:

(a) Making inquiries from management

(b) Corroborating management responses by:

c) Consideration of the need to perform other audit procedures if management is unable to provide adequate·explanation.

While applying analytical procedures on an audit, the auditor has predicted direct material consumption of Rs. 1,500 million. The actual cost of direct material consumed as per accounts is Rs. 1,570 million. The auditor has emphasized on production volume and increase in material price, in arriving at the said estimation. The management believes that general increase in material prices is the reason for such deviation.

Describe the course of action the auditor should take in dealing with his situation.

The auditor should determine the amount of acceptable difference by considering the following:

– materiality level
– required degree of assurance
– aggregate differences in other account balances
– expected degree of accuracy

Many of the above are dependent on the nature of the company’s business, about which no information has been given in the question.

Analytical procedures may sometimes be more effective than test of
details in detecting material misstatement. Give two examples.

1. Completeness assertion of salesmen commission: Substantial decrease in salesmen commission expense compared to auditor’s expectation based on sales and commission percentage, may reveal that December accrued commission payable in January has not been provided in the accounts. The error may be more difficult to detect even if 100% commission expense as recorded, is verified.

2. Substantial increase in traveling expense compared to last year may indicate unauthorized traveling.

The analytical procedures which are carried out near the end of the audit usually assist the auditor in forming an overall conclusion on the financial statements.

Required

a) State the objectives which an auditor expects to achieve while applying analytical procedures at the end of an audit.
b) Discuss the course of action an auditor should adopt when results of analytical procedures identify inconsistent relationships or differ from expected values by significant amounts.

The auditor should apply analytical procedures at or near the end of
the audit in order to:

(i) Form an overall conclusion as to whether the financial statements as a whole are consistent with the auditor’s understanding of the entity.

(ii) Corroborate the conclusions formed through other procedures performed during the audit of individual components or elements of the financial statements.

(iii) Identify previously unrecognized risk of material misstatement.
In such circumstances, the auditor may:

  1. Revise the auditor’s assessment of the risk of material misstatement; and
  2. Modify the further planned audit procedures accordingly.

(b) When analytical procedures identify significant fluctuations or relationships, the auditor shall investigate such differences. Fluctuations can be investigated in the following manner:

(i) Inquiring of management and obtaining appropriate audit evidence relevant to management responses. These audit evidence may be obtained by taking into account:

  1. The auditor’s understanding of the entity and its environment; and
  2. With other audit evidence obtained during the course of the audit.

(ii) Performing other audit procedures when:

  1. Management is unable to provide an explanation, or
  2. The explanation together with the audit evidence obtained is not considered adequate.

Set out possible error / fraud conditions and responses to risk if he analytical procedures reveal:

1. Increase in current ratio
2. Decrease in current ratio
3. Increase in inventory turnover
4. Decrease in inventory turnover
5. Increase in receivable turnover
6. Decrease in receivable turnover
7. Increase in gearing ratio
8. Decrease in gearing ratio
9. Increase in gross margin
10. Increase in gross margin but decrease in net profit margin.

Possible error / fraud conditions and responses to risks are as under:

1. Increase in current ratio

(a) Overstatement of receivable

(i) Fictitious receivable:

– Verify customer purchase order
– Match sales invoices with dispatch notes
– Verify subsequent collections.

(ii) Inadequate allowance for doubtful debts:

– Review age analysis
– Check subsequent collections
– Inspect correspondence with customers that are considered doubtful
– Consider legal proceedings against customers.

(b) Overstatement of inventories

(i) Erroneous valuation:

– Verify reliability of cost of inventories
– Review GRNs issued during first week of next accounting period to see that none have been included in inventories.
– Recount major inventory items and work back to year end count.

ii) Inadequate allowance for obsolete inventories:

– Check subsequent selling prices
– Review age analysis of inventories
– At the time of physical observation note rusty, dusty, Damaged and broken goods.

(c) Understatement of accounts payable and accruals

– Check subsequent payments
– Match GRNs issued near year end with suppliers invoices to ensure that goods received before year end have also been entered in purchases day book.
– Verify computations for tax provision
– Evaluate reasonableness of estimated provision for warrantees.

2. Decrease in current ratio

a) Understatement of closing inventory

– Check physical inventory with quantity on count sheets
– Check inventory pricing
– Consider that allowance for obsolescence is not overstated.

(b) Overstatement of accounts payable and accruals

-Check subsequent payments
-Check suppliers invoices with GRNs

3. Increase in inventory turnover
– Understatement of closing inventory

4. Decrease in inventory turnover
– Overstatement of closing inventory

5. Increase in receivable turnover
– Understatement of receivable

6. Decrease in receivable turnover
– Overstatement of receivable

7. Increase in gearing ratio
– Further financing may not be available and could lead to going concern problem. Consider management plans to improve the
situation.

8. Decrease in gearing ratio

Finance lease treated as operating lease
– Inspect the lease
– Apply criteria f or lease classification

9. Increase in gross margin

– Overstatement of closing inventory
– Understatement of cost of sales.

10. Increase in gross margin but decrease in operating margin

– Costs may have been omitted or erroneously classified as operating expenses.

IAS 520, Analytical procedures states that analytical procedures may be applied to consolidated financial statements, components and individual elements of information. Discuss limitations of analytical procedures to be applied on consolidated financial statements.

Analytical procedures are more useful if the data can be dis aggregated.

Application of analytical procedures on group financial statements may be misleading if:

a) Accounting policies of the group are not uniform.

b) Business activities of the components are diversified.

c) Some components produce specialized products.

d) Comparison of actual data with budgeted data may be meaningless if budgetary controls of some of the components are inadequate. .

e) A comparison of financial information with non financial information will carry little meanings if controls over non financial information of some components are not effective.

What are the limitations of using analytical procedures as risk assessment procedures? 

IAS 315 requires performance of analytical procedures as risk assessment procedures. The limitation are:

a) Analytical procedures at risk assessment procedures generally performed before year end, on the basis of interim financial statements. If, for example, the year end is December, and the analytical procedures are applied on the data September 30, it is difficult to project the year end figures, particularly in case of seasonal business.

b) Certain adjustments are generally recorded only at end of year, for example revaluation, impairment losses, deferred taxes.

c) Interim financial statements are generally not subject to close review by management in the same way as year end financial
statements.

d) Consisting accounting policies may not be followed for interim financial statements.

Discuss type of information that you would require to carry out analytical procedures.

1. Month – to – month data:
Monthly comparisons may be more useful in detecting immaterial misstatement than comparison on annual basis.

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2. Prior period data:

Prior period data is required to predict current year giving consideration to known changes

3. Budget

The client’s prepared budgets for the current period may be useful for anticipated results. ..

4. Industry data:

Common size-percentages- nirlos ,,-and trends data for the companies in file ‘same industry” are available from financial analysis.

5. Relevant non financial information:

on financial data such as the number of employees, square footage of selling space, and number of units produced may be useful in estimating related account balances such as wages and salaries, sales and cost of production..

Substantive procedures are of two types

a) Test of details
b) Substantive analytical procedures

Give examples of test of details.

Tests of details are of two types

(i) Tests of details of transactions
(ii) Tests of details of account balances

Tests of details of account balances

Test of details involve tracing from source documents such as sales
invoices to financial statements.

Example of test of details of sales transactions are

1. Test validity and accuracy of sales invoices:

           (a) Check arithmetical accuracy of sales invoices
(b) Verify selling prices from price list
(c) Compare quantities billed with dispatch notes

2. Trace sales invoices to sales day book

3. Check total of sales day book

4. Trace monthly totals of sales-day.book to general ledger

5. Select dispatch notes issued during last week of accounting period and compare with sales invoices.

6.Verify compliance of revenue recognition policy in accordance
with IAS 18

Tests of details of transactions are general more time consuming than substantive analytical procedures. An example of substantive analytical procedure to verify sales is to multiply number of units sold with standard selling price.

Tests of details of account balances

In. Order to test details of account balances, the auditor directly obtains evidence about an account balance rather than individual debits and credits comprising the balance.

For example, the auditor may verify balance in accounts receivable by external confirmation, or observe physical inventory count.

Enumerate matters are to be considered in using analytical procedures as substantive procedures?

Following matters are to be considered in using analytical procedures as substantive procedures:

1. Suitability of analytical procedures
Analytical procedures are more suitable where:

(a) Data constitutes large volume and individual amounts are small.
(b) Data is predictable because relationship between data exists.
(c) Effectiveness of internal controls. If controls are weak, test of details are preferable rather than analytical procedures.
d) If test of details have already been performed on an assertions, performance of analytical procedures will provide increased confidence.

2. Reliability of data

(a) Information used for analytical procedures is more reliable if such information is obtained from third part, for example, independent financial analysts.
(b) Comparability of data, for example comparison of client’s data with other companies in the same industry and same segment.
c) Relevance of information, for example if compared with budget, the auditor should consider whether the budget is realistic.
d) If the auditor compares, financial data with non-financial data, the auditor should evaluate controls over completeness and accuracy of such data.

3. Develop expectations of significant account balances and ratios

The auditor develops expectations based on the understanding of the entity and its environment.

(a) Consider accuracy with which data can be predicted.
(b) Consider to what extent the data can be broken down by departments or products, or geographical locations.

4. Set out amount of differences from anticipated and actual data that the auditor will accept without further investigation.

Insignificant variances between anticipated and actual data may be accepted without further investigation. The determined is affected by:

(a) Materiality
(b) Desired level of assurance
(c) Assessed risk of material misstatement.

Posted on November 3, 2015 in Analytical Procedures

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