SAMPLE NOTES FROM OUR ACCOUNTANCY ANSWERED ASSURANCE GUIDE:
ENGAGEMENTS: ANALYTICAL PROCEDURES
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ENGAGEMENTS ANALYTICAL PROCEDURES
Analytical procedures are a method used by auditors to understand their client’s business and any changes in that business through the comparison of financial data. This comparison can be against forecasted or budgeted results, results from previous periods, or industry averages. ISA 520: Analytical procedures sets out the auditor’s responsibility to perform analytical procedures. A four-step approach is used when performing analytical procedures:
UNDERSTAND THE BUSINESS
COMPARE THIS TO ACTUALS
DEVELOP AN EXPECTATION
INVESTIGATE ANOMALIES
Analytical procedures must be used at both the planning and the overall review phase, as per the ISAs. They can also be used as part of substantive testing during the gathering of evidence. ANALYTICAL PROCEDURES (ISA 520) PLANNING (ISA 310)
EVIDENCE (ISA 500)
OVERALL REVIEW
Must be part of the risk assessment process.
Can be used as a form of substantive procedure.
Must be used to assist forming an overall conclusion.
Whilst analytical procedures are commonly used throughout the audit process, it is imperative that the user understands their limitations, and the methods used to ensure that any analysis is verified. The limitations of analytical procedures include that: 1) In order to be effective, a good understanding of the entity is required. This may be limited in the first year of testing. 2) They are quite complex – more junior staff may struggle to appreciate the subtleties of analysis. 3) Results are much more useful if they can be compared against the results of previous periods or similar businesses; comparability is reliant on having appropriate, accurate information available. 4) The quality of the analysis is dependent upon the quality of the source data. Accurate analysis requires reliable, relevant, complete and accurate source data. 5) By using an ‘overview’ approach, inconsistencies may be hidden. It may require the subdivision of data to ensure more comprehensive analysis.
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ANALYTICAL PROCEDURES
There are a number of common ratios which are often used as part of the analytical procedures. The ratios which you will need to know and be able to calculate for your Assurance exam are as follows: EFFICIENCY The trade receivables collection period is the average number of days it takes for cash to be collected from credit customers.
TRADE RECEIVABLES COLLECTION PERIOD (Days) Trade Receivables Revenue
This can be compared to the customer credit terms to ensure that the trade receivables collection period is shorter than this value. A high value suggests poor controls over cash collection and high levels of bad debts.
x 365
TRADE PAYABLES PAYMENT PERIOD (Days) Trade Payables
x 365
Purchases
A high value indicates an inability of the company to pay off its debts, indicating poor cash flows.
INVENTORY HOLDING PERIOD / INVENTORY TURNOVER (Days)
Inventory Cost of Sales
The trade payables collection period is the average number of days it takes for the company to pay its suppliers.
x 365
The inventory holding period, or inventory turnover, is the average number of days that inventory is held before it is sold. A large value may suggest that too much stock is being held, and could mean that closing inventories are overvalued as older stock could lose its value.
ANALYTICAL PROCEDURES (EFFECIENCY) - WORKED EXAMPLE
Q:
ABC Ltd. offers its credit customers a payment period of 60 days on all purchases, however, all purchases from its suppliers must be paid within 30 days. Revenue
£635,750
Cost of Sales
£456,500
Trade Receivables
£95,800
Trade Payables
£40,025
From the above information, calculate the trade receivables collection period and the trade payables payment period and comment on whether ABC Ltd. is making and collecting payments efficiently. (continued overleaf)
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ANALYTICAL PROCEDURES
A:
Trade Receivables Collection Period à Using the equation from above: Trade Receivables Collection Period = = =
Trade Receivables Revenue £95,800 £635,750 55 days
x 365 x 365
The trade receivables collection period is 55 days, less than the 60 days offered to credit customers. This indicates that ABC Ltd. generally receives payments in a timely manner from customers.
Trade Payables Payment Period à Using the equation from above: Trade Payables Payment Period = = =
Trade Payables Purchases £40,025 £456,500 32 days
x 365 x 365
The trade payables payment period is 32 days, more than the 30 days offered by ABC Ltd.’s main suppliers. This indicates that ABC Ltd. generally makes late payments, which could be an indication of cash flow problems or poor controls around payments.
LONG-TERM SOLVENCY
GEARING RATIO Net Debt Equity
x 100%
The gearing ratio assesses the reliance of the business on external finance (debt). A high gearing ratio indicates that the company has a large proportion of debt compared to equity. In most cases, a lower gearing ratio means greater financial stability.
INTEREST COVER Profit before Interest Payable Interest Payable
The interest cover ratio assesses the company’s ability to pay its interest costs. Put simply, the interest cover is the number of times that a company can pay off its interest costs for the year. For example, an interest cover of 10 would mean that the company could pay off its interest cost ten times over before it started to make a loss. A large number indicates that it can easily pay off its interest costs. Interest cover of less than one suggests that a company is unlikely to be able to pay off its current interest liability easily.
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ANALYTICAL PROCEDURES
SHORT-TERM LIQUIDITY The current ratio shows a company’s ability to pay its current liabilities from its current assets.
CURRENT RATIO
Current Assets Current Liabilities
If the current ratio < 1 then the company has more liabilities than assets, suggesting that it may struggle to pay off its short-term debts. This could indicate potential cash flow problems. If the current ratio > 1 then current assets are greater than current liabilities – this suggests a strong financial position, but could also indicate that the company may be sitting on short term assets rather than investing them. An increase in the current ratio could indicate the shifting of debt from short-term debt to long term debt.
QUICK RATIO Current Assets - Inventory Current Liabilities
The quick ratio is very similar to the current ratio, but only includes a company’s very liquid assets (i.e. assets which can easily be turned into cash). A large cash investment would reduce the quick ratio.
PERFORMANCE Gross profit margin is a way to assess profitability before any overheads are taken into account.
Gross profit = Revenue – Cost of Sales (Purchases)
GROSS PROFIT MARGIN (%)
Gross Profit Revenue
x 100%
A gross profit of 45% would mean that for every £100 worth of sales, the profit before overheads is £45. A change in the mix of products sold will often have an effect on the gross profit margin. An increase could suggest a more efficient production technique or a reduction in the cost of raw materials, which has not been reflected in the sales price. A decrease may suggest price cuts.
OPERATING PROFIT MARGIN (%) Operating Profit Revenue
Operating profit margin (or net margin) is a way to assess profitability after taking overheads into account. Operating profit = Gross Profit – All Overheads
x 100%
A gross profit of 20% would mean that for every £100 worth of sales, the profit after overheads is £20.
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ANALYTICAL PROCEDURES
RETURN ON CAPITAL EMPLOYED (“ROCE”) (%) Operating Profit Equity + Net Debt
x 100%
The Return on Capital Employed gives a measure of how effectively resources are being used to generate profit. A company is generally financed through a combination of equity and net debt, so a ratio of 30% would indicate that £30 profit is produced for every £100 worth of investment.
The profit on an item can be calculated based on the mark-up or margin. The mark-up is calculated on cost; the margin on selling price. For an item which costs £100, using a percentage of 20% (cost = £100, X = 20%): MARGIN
MARK-UP
Margins are based on the SALES price
Margins are based on the COST
Sales Cost GP
% 100 (100 – X) X
% 100 80 20
£ 125 100 25
Sales Cost GP
% 100 + X (100) X
% 120 (100) 20
Sales Price
£ 120 (100) 20
= £100 / 0.8 (80%) = £125
Sales Price
= £100 x 1.2 (120%) = £120
QUESTION BANK
ICAEW Question Bank, Chapter 3: Process of assurance: planning the assignment Questions: 3, 12, 18, 23 – 25 ICAEW Question Bank, Chapter 11: Evidence and sampling Questions: 3, 4, 20, 21 ICAEW Question Bank, Chapter 13: Substantive procedures – key financial statement figures Questions: 12
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ANALYTICAL PROCEDURES
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REVISION CHECKLIST
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