ACC5218 Auditing Practice

Audit – ACC5218 Auditing Practice


Analytical Procedures – its importance

According to ASA – 520: Analytical Procedures: “Analytical procedures means evaluations of financial information made by a study of plausible relationships among both financial and non-financial data. Analytical procedures also encompass the investigation of identified fluctuations and relationships that are inconsistent with other relevant information or deviate significantly from predicted amounts” (Auditing and Assurance Standards Board-AASB, 2009).

Talking from the broader perspective, analytical procedures is one of the methods which helps auditors in collecting audit evidence. Below mentioned is a diagram which will help in understanding the tools auditors have to dig out evidences. These tools are used in combination with each other (Vijaya Swaminathan, 2012).

It is one of the mandatory duties of auditors to perform risk assessment for the assessment and identification of material misstatement risks at the assertion as well as financial statement level. Besides, it is recommended for auditors to use analytical procedures as a tool for risk assessment procedures. Auditors are needed to perform analytical procedures equally well near the ending of the audit exercises, the reason being it tests if the financial statements are in line with the overall understanding of business of auditor (AICPA, 2012).

Analytical procedures are usually used in assurance and non-audit engagements, like potential financial information review, and retrospective financial statements non-audit review. However, the way it should be used is not explicitly covered in the ASAs, though the rules in relation to its use are applicable (Charles Fung, 2010).

Throughout the entire exercise of audit, analytical procedures are used for three primary purposes:
  • Preliminary Analytical Review – Risk assessment

Analytical reviews at preliminary stage is performed to obtain the business understanding and environment in which it is working. For instance, financial performance is compared with previous years, along with relevant groups and industry, to assist in analyzing the material misstatement risk in order to recognize the timing, nature and extend of the audit procedures, i.e. to assist the auditor draft the firm audit strategy (Charles Fung, 2010).
  • Substantive Analytical Procedures

Analytical procedures are used as substantial analytical procedures when an auditor thinks that it is better to use analytical procedures instead of test of details in reducing the material misstatement risk at the assertion level to an adequately low level (Charles Fung, 2010).
  • Final Analytical Review

Final analytical review are exercised as financial statements review thoroughly at the conclusion of the audit to test if they are in line with the entity’s understanding of auditor. It is not done to secure the additional assurance though. In case any irregularity is unearthed, risk assessment should be exercised once again to consider if any additional audit procedures are needed (Charles Fung, 2010).

It is one of the objectives of ASA 520 is that targeted and credible audit evidence is collected when implementing substantial analytical procedures. The core idea behind the application of substantive analytical procedures is to attain guarantee, when it is used with other audit assessment techniques like test of details, and test of controls. Therefore, substantive analytical procedures are more focused on the large amount of data to get an idea.


What ratio means?Conclusions to DrawPotential Risks to be Investigated
-          Current Ratios:

Current ratio is a ratio which is used to understand the liquidity position of the organization. The components used in the calculation of current ratio are current assets and current liabilities. It helps in explaining if the company has enough short term assets to meet liabilities which are subject to fall due in less than a year’s period. Normally having current ratio of 1 means that company current assets of amount equal to current liabilities.

-                      The current ratio of 21st Century accessories in 2013 and 2014 is 2.24 and 1.89, respectively. Whereas the industry was having higher current ratio on average, however, the fall can be observed in both the cases from 2013 to 2014. In 2013, company had 2.24, it means that company had $1.89 assets on $1 liabilities, whereas industry was having $2.84 assets on $1 liabilities.-                      The potential risk is that company might not be estimating its current assets or current liabilities properly. Normally the major components of current assets are accounts receivables, and shot-term investments. In case of current liabilities, major portion can be trade payables, particularly.
-          Accounts Receivables Turnover:

Accounts receivables turnover represents the efficiency ratio, and it basically helps in explaining that how many times the business was able to recover its receivables. Its formula includes credit sales and average receivables. There is no doubt that the having higher turnover means business is having good liquidity position.
-                      Company’s account receivables is 7 and 6.3 in 2013 and 2014, respectively. Whereas the industry is sitting at lower turnover of 4.6 and 4.9, in 2013 and 2014, respectively. 6.3 turnover means that 6.3 times debtors paid off their invoices in the period of a year.-                      The potential risk is that company is not properly measuring its account receivables. To be specific it seems like it has understated the accounts receivables amount, or company has not properly accounted for provisions for bad debts.
-          Inventory Turnover Ratio:

It is again coming from the efficiency ratio family, and it explains that how many times inventory is sold and taken off the shelf in a certain period. It includes cost of sales and the average inventory.  The higher the turnover, better it is.

-                      Company’s inventory turnover is 5.5 and 5, in 2013 and 2014, respectively. Whereas the industry is sitting at 3.8 and 3.7, in 2013 and 2014, respectively. So, on average, company has managed to sell off its inventory more than industry average.-                      The potential risk is that company might have not properly accounted for COGS and inventory. The issue in inventory will not only impact inventory turnover, but it will equally well impact current ratio. So, taking care of this point is very important when designing audit strategy.
-          Return on asset

Return on asset helps in explaining about the profitability of the company. It explains about the return generated by the company with the help of its assets. It is calculated with the help of total assets and profit generated before interest and tax. Generally the return here is expressed in terms of %. So, higher the %, the better it is.
-                      Company’s ROA is 11% and 13%, in 2013 and 2014, respectively. Whereas the industry is earning ROA of 5%, 7%, in 2013 and 2014, respectively. It means that company is out performing industry in generating profits on assets.-                      The potential risk is that company is miscalculating its net revenues, expenses, or both. The gap is quite wide, so special consideration will be given to sales head. The way/point company is recognizing its sales at is worth taking a look at to check compliance with accounting standards. Besides, assets is another component worth taking a look at. Recognition of assets, depreciation, will be given a special care.
-          Profit Margin

Profit margin is one of the most important ratio which helps in measuring the ratio of net income to net sales. The higher the margin the better it is. Net income is driven out by deducting all the operation and non-operation expenses from net revenues. It is equally well expressed in % terms.

Company’s profit margin stayed at 4% in 2013 and 2014. Whereas the industry has recorded 6% margin in both the years. Company’s profit is lower than the profit generated by industry.-                      The potential risk is that company has not calculated its sales or net income. Any such related issues have been mentioned above so it seems like there is definitely a strong connection and risk lies here.
-          Gross profit %

Gross profit margin or percent is a measure of profitability. It helps in measuring the % of profit generated by the company after deducting all the direct expenses like cost of sales. It is the profit which company has earned before deducting all the operational expenses.
-                      Company has managed to earn a gross profit of 18%, and 20% in 2013 and 2014, respectively. Whereas the industry has observed 26% and 20%, in 2013 and 2014, respectively. It can be seen that industry wise the gross profit has dropped, but company has recorded increase in the gross profit.-                      The potential risk again lies in the income statement. So, auditors will have to take a deep look at the revenue and expenses figures.



WeaknessHow it leads to material misstatementManual Control
The most prominent weakness in the point 1 is that hiring and termination related papers are prepared by payroll officer, and s/he is the one who will record it in the system as well. Hence there is no segregation of duty or authentication process.The material misstatement exists due to the fact that payroll officer might be involved in a fraud of paying ghost employees. Hence there is a likelihood that wages and salaries appearing in the financial statements are overstated hence profit is understated.The process of authentication should have to be started. A senior must approve anything before it is recorded in the master file.
The most prominent weakness appears to be in point 2 is that the timesheets are processed and recorded by factory manager in factory, and the payment is made by the payroll department from head office, before any authentication or approval of seniors.The material misstatement exists here due to the consideration that there is a likelihood that salaries are not paid correctly. Hence the profit presented in the statement is not correct.The manual control can be that once the payroll department has prepared the payroll sheet, the factory general manager should review it, and sign it off to ensure the accuracy.