Analytical Procedures ISA 520

Question 1

ISA 520

Answer 1

Analytical procedures are a key part of the auditing process, defined by ISA 520 as evaluations of financial information through analysis of plausible relationships among both financial and non-financial data. These procedures help auditors identify any significant fluctuations or relationships that are inconsistent with other relevant information or expected values.

1. Comparison:
   
   • The core of analytical procedures is comparison. Auditors compare key relationships between figures (both financial and non-financial) to identify any anomalies.

1. Comparison with Prior Accounting Periods:
   
   • Explanation: Establish patterns and trends, and look for unusual fluctuations in the current financial year that seem inconsistent with previous periods.
   • Example: Comparing this year’s sales revenue with last year’s to identify any significant increases or decreases.
2. Comparison with Expected Results:
   
   • Explanation: Compare actual results with budgeted results, forecasts, or results that the auditor was expecting.
   • Example: Comparing actual expenses with the budgeted amounts to identify any significant variances.
3. Comparison with Industry Average Results:
   
   • Explanation: Obtain comparable information for other entities in the industry or individual entities in the same industry.
   • Example: Comparing the company’s profit margins with the industry average to assess performance.
4. Comparison with Comparable Parts of the Same Entity:
   
   • Explanation: Compare results of different branches or divisions within the same entity.
   • Example: Comparing the performance of different store locations within a retail chain.

In an exam, you might be asked to carry out analytical procedures for an entity described in a case study. The purpose is to test your ability to:

1. Identify Unusual Features:
   
   • Example: Spotting a substantial increase in sales revenue but a substantial decrease in the cost of sales.
2. Investigate Unusual Figures:
   
   • Example: Suggesting further investigation into why administrative expenses have significantly increased.
3. Provide Possible Explanations:
   
   • Example: Explaining a significant change in the gross profit margin due to changes in pricing strategy or cost of goods sold.

• A substantial increase in sales revenue but a substantial decrease in the cost of sales.
• A significant change in the gross profit margin.
• A significant change in administrative expenses.
• A significant change in selling and distribution expenditure.
• A significant change in interest costs or investment income.
• A significant change in the net profit margin.

By using these comparisons and identifying unusual items, auditors can focus their efforts on areas that may require further investigation, ensuring the accuracy and reliability of financial statements.

If you have any more questions or need further clarification, feel free to ask!

Analytical procedures are essential in auditing, especially for substantive testing. They help auditors evaluate financial information by analyzing plausible relationships among both financial and non-financial data. Here’s a breakdown of how auditors use these procedures, as guided by ISA 520.

1. Suitability of Analytical Procedures:
   
   • Explanation: Determine if the analytical procedures are appropriate for the given assertions, considering the assessed risks of material misstatement and the effectiveness of these procedures in detecting specific types of material misstatements.
   • Example: If the risk of misstatement in revenue recognition is high, the auditor might use trend analysis to compare current period revenue with prior periods.
2. Developing Expectations:
   
   • Explanation: Develop an expectation of recorded amounts or ratios and evaluate whether this expectation is precise enough to identify a misstatement.
   • Factors to Consider:
     
     • Accuracy of Predictions: How accurately can amounts be predicted?
     • Disaggregation of Information: Can information be broken down into detailed components (e.g., sales by product line)?
     • Availability of Information: Is the necessary information readily available?
   • Example: Predicting sales revenue based on historical trends and market conditions.
3. Evaluating Data Reliability:
   
   • Explanation: Assess the reliability of the data used to develop expectations. Unreliable data will not be useful.
   • Factors to Consider:
     
     • Source of Information: Is the source credible?
     • Comparability: Is the information comparable to the entity being audited?
     • Nature and Relevance: Is the information relevant and prepared with realistic expectations?
     • Controls Over Data Preparation: Are there strong controls over how the data is prepared?
   • Example: Using industry averages to compare a company’s performance, ensuring the industry data is relevant and comparable.
4. Determining Acceptable Differences:
   
   • Explanation: Establish what level of difference from expected amounts is acceptable without further investigation, linking this to materiality.
   • Example: Setting a threshold for acceptable variance in expense accounts, beyond which further investigation is required.

If the auditor identifies fluctuations or relationships that are inconsistent with other information or show unacceptable differences from expected amounts, ISA 520 requires the auditor to:

1. Make Enquiries of Management:
   
   • Explanation: Ask management for explanations and verify their responses.
   • Example: If there is an unexpected increase in administrative expenses, the auditor might ask management for reasons and supporting documentation.
2. Perform Other Audit Procedures:
   
   • Explanation: Conduct additional audit procedures if management’s explanations are inadequate or if further evidence is needed.
   • Example: If management cannot explain a significant drop in gross profit margin, the auditor might perform detailed testing of sales and cost of goods sold.

Scenario: An auditor is reviewing the financial statements of DEF Corporation and notices a significant increase in sales revenue but a substantial decrease in the cost of sales.

Steps the Auditor Might Take:

1. Develop an Expectation:
   
   • Based on historical data, the auditor expects sales revenue and cost of sales to move in tandem.
2. Evaluate Data Reliability:
   
   • Verify the source of sales and cost data, ensuring it is reliable and comparable.
3. Investigate Fluctuations:
   
   • Ask management to explain the unusual relationship between sales revenue and cost of sales.
   • Perform additional procedures, such as detailed testing of sales transactions and cost allocations, to verify the accuracy of the reported figures.

By following these steps, the auditor can effectively use analytical procedures to identify and investigate potential misstatements in the financial statements.

If you have any more questions or need further clarification, feel free to ask!

Sure, let’s go through a practical example that applies each step of analytical procedures in substantive testing.

Scenario: An auditor is reviewing the financial statements of XYZ Corporation for the fiscal year 2024. The auditor notices a significant increase in sales revenue but a substantial decrease in the cost of sales.

1. Suitability of Analytical Procedures:
   
   • Concept: Determine if the analytical procedures are appropriate for the given assertions, considering the assessed risks of material misstatement.
   • Example: The auditor decides to use trend analysis to compare current period revenue with prior periods to identify any unusual spikes or drops. Given the high risk of misstatement in revenue recognition, this method is suitable.
2. Developing Expectations:
   
   • Concept: Develop an expectation of recorded amounts or ratios and evaluate whether this expectation is precise enough to identify a misstatement.
   • Example: Based on historical data, the auditor expects sales revenue to increase by 5% annually. The auditor also expects the cost of sales to increase proportionally. This expectation is developed using past financial statements and market conditions.
3. Evaluating Data Reliability:
   
   • Concept: Assess the reliability of the data used to develop expectations. Unreliable data will not be useful.
   • Example: The auditor verifies that the sales data comes from a reliable sales system and the cost data is accurately recorded in the inventory system. The auditor also checks that the industry data used for comparison is relevant and comparable.
4. Determining Acceptable Differences:
   
   • Concept: Establish what level of difference from expected amounts is acceptable without further investigation, linking this to materiality.
   • Example: The auditor sets a threshold for acceptable variance in sales revenue and cost of sales at 5%. Any variance beyond this threshold will require further investigation.
5. Investigating Fluctuations and Relationships:
   
   • Concept: If fluctuations or relationships are inconsistent with other information or show unacceptable differences from expected amounts, the auditor must investigate.
   • Example: The auditor notices that sales revenue increased by 15%, but the cost of sales decreased by 10%. This is inconsistent with the expectation that both should increase proportionally. The auditor asks management for explanations and supporting documentation.

1. Make Enquiries of Management:
   
   • Concept: Ask management for explanations and verify their responses.
   • Example: Management explains that the increase in sales revenue is due to a successful marketing campaign, and the decrease in cost of sales is due to a new supplier offering lower prices. The auditor requests supporting documents such as marketing reports and supplier contracts.
2. Perform Other Audit Procedures:
   
   • Concept: Conduct additional audit procedures if management’s explanations are inadequate or if further evidence is needed.
   • Example: The auditor performs detailed testing of sales transactions and cost allocations. This includes reviewing sales invoices, purchase orders, and supplier invoices to confirm the accuracy of the reported figures.

By following these steps, the auditor can effectively use analytical procedures to identify and investigate potential misstatements in XYZ Corporation’s financial statements. This ensures that the financial statements are reliable and provide a true representation of the company’s financial performance and position.

I hope this practical example helps clarify the concepts. If you have any more questions or need further details, feel free to ask!

Let’s break down these common financial ratios with practical examples to help you understand each concept clearly.

1. Net Profit Ratio:
   
   • Formula: $$\text{Net Profit Ratio} = \frac{\text{Net Profit}}{\text{Sales}} \times 100\%$$
   • Example: If XYZ Corporation has a net profit of $50,000 and sales of $500,000, the net profit ratio is:
     $$\text{Net Profit Ratio} = \frac{50,000}{500,000} \times 100\% = 10\%$$
2. Gross Profit Ratio:
   
   • Formula: $$\text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Sales}} \times 100\%$$
   • Example: If XYZ Corporation has a gross profit of $150,000 and sales of $500,000, the gross profit ratio is:
     $$\text{Gross Profit Ratio} = \frac{150,000}{500,000} \times 100\% = 30\%$$

1. Asset Turnover Ratio:
   
   • Formula: $$\text{Asset Turnover Ratio} = \frac{\text{Sales}}{\text{Total Assets}}$$
   • Example: If XYZ Corporation has sales of $500,000 and total assets of $1,000,000, the asset turnover ratio is:
     $$\text{Asset Turnover Ratio} = \frac{500,000}{1,000,000} = 0.5$$
2. Inventory Turnover Ratio:
   
   • Formula: $$\text{Inventory Turnover Ratio} = \frac{\text{Cost of Sales}}{\text{Average Inventory}}$$
   • Example: If XYZ Corporation has a cost of sales of $300,000 and an average inventory of $50,000, the inventory turnover ratio is:
     $$\text{Inventory Turnover Ratio} = \frac{300,000}{50,000} = 6$$

1. Current Ratio:
   
   • Formula: $$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$
   • Example: If XYZ Corporation has current assets of $200,000 and current liabilities of $100,000, the current ratio is:
     $$\text{Current Ratio} = \frac{200,000}{100,000} = 2$$
2. Quick Ratio:
   
   • Formula: $$\text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}$$
   • Example: If XYZ Corporation has current assets of $200,000, inventory of $50,000, and current liabilities of $100,000, the quick ratio is:
     $$\text{Quick Ratio} = \frac{200,000 - 50,000}{100,000} = 1.5$$

1. Gearing Ratio:
   
   • Formula: $$\text{Gearing Ratio} = \frac{\text{Long-term Debt}}{\text{Share Capital and Reserves}} \times 100\%$$
   • Example: If XYZ Corporation has long-term debt of $300,000 and share capital and reserves of $700,000, the gearing ratio is:
     $$\text{Gearing Ratio} = \frac{300,000}{700,000} \times 100\% = 42.86\%$$
2. Interest Cover Ratio:
   
   • Formula: $$\text{Interest Cover Ratio} = \frac{\text{Profit Before Interest and Tax}}{\text{Interest Charges}}$$
   • Example: If XYZ Corporation has a profit before interest and tax of $100,000 and interest charges of $20,000, the interest cover ratio is:
     $$\text{Interest Cover Ratio} = \frac{100,000}{20,000} = 5$$

1. Earnings Per Share (EPS):
   
   • Formula: $$\text{EPS} = \frac{\text{Profits Attributable to Ordinary Shareholders}}{\text{Number of Shares}}$$
   • Example: If XYZ Corporation has profits attributable to ordinary shareholders of $50,000 and 10,000 shares, the EPS is:
     $$\text{EPS} = \frac{50,000}{10,000} = $5$$
2. Price/Earnings (P/E) Ratio:
   
   • Formula: $$\text{P/E Ratio} = \frac{\text{Current Market Price per Share}}{\text{Earnings per Share}}$$
   • Example: If the current market price per share of XYZ Corporation is $50 and the EPS is $5, the P/E ratio is:
     $$\text{P/E Ratio} = \frac{50}{5} = 10$$
3. Dividend Yield:
   
   • Formula: $$\text{Dividend Yield} = \frac{\text{Dividend per Share}}{\text{Current Market Price per Share}} \times 100\%$$
   • Example: If XYZ Corporation pays a dividend of $2 per share and the current market price per share is $50, the dividend yield is:
     $$\text{Dividend Yield} = \frac{2}{50} \times 100\% = 4\%$$
4. Dividend Cover:
   
   • Formula: $$\text{Dividend Cover} = \frac{\text{Earnings per Share}}{\text{Dividend per Share}}$$
   • Example: If the EPS of XYZ Corporation is $5 and the dividend per share is $2, the dividend cover is:
     $$\text{Dividend Cover} = \frac{5}{2} = 2.5$$

By understanding and calculating these ratios, auditors and investors can gain valuable insights into a company’s financial health, operational efficiency, and investment potential¹²³.