Chapter 0c - Analytical procedures Flashcards
What are analytical procedures? Why are they used at the planning stage?
Analytical procedures involve evaluating financial information by studying relationships between data, trends, and expected patterns to identify anomalies or inconsistencies.
Auditors will use these in the planning to understand the business and identify potential risks.
What are the key ratio types we look at in this course? State what aspect of financial statements they help the auditor assess
- Perfomance ratios - helps the auditor assess the company’s ability to generate profit.
- Liquidity ratios - help the auditor assess how easily a company can meet its obligations, and how the company manages its working capital
- Long term solvency ratios - Help the auditor assess the company’s ability to meet its long-term debt obligations
- Efficiency ratios - Help the auditor assess how effectively the company uses its assets and resources to generate revenue
Outline the perfomance ratios
- Gross profit margin
- Operating profit margin
- Operating cost percentage
- Return on capital employed
Define gross profit margin, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures the efficiency of a company in producing goods or services relative to its revenue.
Factors That Can Cause Changes Year to Year:
* Changes in Sales Prices – An increase or decrease in the price at which products are sold can directly impact gross profit.
* Cost of Goods Sold (COGS) Fluctuations – Variations in the cost of raw materials, labor, or manufacturing overhead can affect the margin.
* Product Mix Changes – A shift in the types of products or services sold, with different cost structures, can influence the gross margin.
* Economic Conditions– Inflation, supply chain disruptions, or changes in demand for goods can affect both revenue and COGS.
* Pricing Strategies – Discounts, promotions, or price adjustments can affect the margin.
Audit Risks Gross Profit Margin Can Help Identify:
* Revenue Recognition Issues – Significant fluctuations in gross profit margin could indicate improper revenue recognition or sales manipulation.
* Cut-off Issues - Improper cut-off of sales transactions may lead to revenue and costs being recorded in the wrong period, affecting gross profit.
* Inventory Valuation Problems – Changes in gross margin may highlight issues with inventory valuation methods (e.g., FIFO vs. LIFO) or unrecorded inventory adjustments.
* Cost Misstatements – Variations in gross profit margin might suggest that the COGS is not being accurately recorded, potentially leading to misstatements in financial statements.
* Fraud Risk – Unexplained or unusual changes in the margin could signal potential fraudulent activities, such as manipulation of sales or cost figures.
Define operating profit margin, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures a company’s ability to generate profit from its core business operations, excluding the impact of financing and tax expenses.
Factors That Can Cause Changes Year to Year:
* Changes in Revenue – Growth or decline in sales directly impacts operating profit margin.
* Operating Cost Fluctuations – Increases in administrative, selling, or distribution expenses reduce the margin.
* Operational Efficiency – Improvements or declines in cost control, production efficiency, or economies of scale affect the margin.
* One-Off Items – Exceptional items such as restructuring costs or gains/losses from asset sales can distort operating profit.
* Changes in Business Strategy – Shifts in focus (e.g., expansion, outsourcing) can lead to higher or lower operating expenses.
* Inflation or Wage Increases – Rising costs that aren’t matched by price increases can erode margins.
Audit Risks Operating Profit Margin Can Help Identify:
* Expense Misclassification – Misstating operating expenses (e.g., capitalising costs that should be expensed) inflates profit.
* Incomplete Expense Recognition – Omitting or deferring operating costs can falsely enhance margins.
* Revenue Recognition Issues – Recognising revenue too early or late may distort the margin.
* Management Bias or Manipulation – Pressure to meet profit targets may lead to aggressive accounting estimates or improper adjustments.
* Going Concern Issues – Declining margins may signal deteriorating performance, raising concerns about the company’s viability.
Define operating cost percentage, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures the proportion of revenue that is consumed by operating costs, indicating how efficiently a business controls its operating expenses.
Factors That Can Cause Changes Year to Year:
* Changes in Operating Costs – Increases in rent, wages, utilities, or other overheads will increase the percentage.
* Revenue Fluctuations – A decrease in revenue without a corresponding drop in operating costs will raise the percentage.
* Cost Control Measures – Implementation of cost-saving strategies or automation can reduce the percentage.
* Business Expansion – New locations, product launches, or market entry may initially increase costs faster than revenue.
* Inflation or Wage Pressures – General increases in prices or staff costs will raise the operating cost base.
* Outsourcing or Restructuring – Changes in business structure may shift or reduce certain operating costs.
Audit Risks Operating Cost Percentage Can Help Identify:
* Expense Understatement – A lower-than-expected percentage may indicate that some costs have been omitted or deferred.
* Classification Errors – Misclassification of expenses (e.g., capitalising operating costs) can distort the percentage.
* Revenue Recognition Issues – Inflated or prematurely recognised revenue lowers the percentage artificially.
* Inadequate Disclosure of One-Off Costs – Unusual or non-recurring costs not properly disclosed can skew the metric.
* Fraud Risk – Manipulation of costs to meet targets or conceal poor performance may be reflected in abnormal fluctuations.
Define return on capital employed, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures how efficiently a company is generating profit from the capital it has invested in the business. It’s a key indicator of profitability and capital efficiency.
Factors That Can Cause Changes Year to Year:
* Operating Profit Changes – Increases or decreases in profitability directly impact ROCE.
* Asset Base Fluctuations – Significant investments or disposals of assets affect capital employed.
* Financing Structure – Changes in long-term debt or equity can alter the capital employed figure.
* Depreciation Policies – Variations in depreciation methods or estimates can impact both operating profit and asset values.
* Efficiency Improvements – Better asset utilisation or cost control can boost operating profit relative to capital employed.
* Non-Recurring Items – One-off gains or losses can distort ROCE if not adjusted for.
Audit Risks Return on Capital Employed Can Help Identify:
* Overstatement of Profit – Inflated operating profit (e.g., via revenue misstatement or cost understatement) exaggerates ROCE.
* Incorrect Asset Valuation – Over- or understatement of non-current assets impacts capital employed and may distort the ratio.
* Misclassification of Liabilities – Errors in identifying current vs. non-current liabilities can misstate capital employed.
* Manipulation of Earnings – Pressure to improve ROCE may lead to aggressive accounting estimates or improper deferral of expenses.
* Going Concern Concerns – A declining ROCE may indicate weakening financial performance and raise concerns over long-term viability.
Outline the liquidity ratios
- Current ratio
- Quick ratio (acid test)
Define current ratio, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures a company’s ability to meet its short-term obligations using its short-term assets. It indicates liquidity and short-term financial health.
Factors That Can Cause Changes Year to Year:
* Changes in Working Capital – Increases or decreases in receivables, inventory, or payables will affect the ratio.
* Cash Flow Management – Strong or weak cash generation impacts current assets directly.
* Debt Repayment or Refinancing – Repaying short-term debt or refinancing it into long-term liabilities can improve the ratio.
* Inventory Fluctuations – Overstocking or selling off inventory can influence current assets.
* Credit Policies – Stricter or more lenient credit terms with customers or suppliers will affect receivables and payables.
* Seasonality – For some businesses, current asset and liability levels vary significantly at different points in the year.
Audit Risks Current Ratio Can Help Identify:
* Liquidity Risk – A declining current ratio may indicate potential going concern issues.
* Overstatement of Current Assets – Inflated receivables or obsolete inventory can falsely improve the ratio.
* Understatement of Liabilities – Omitting or misclassifying current liabilities can distort liquidity.
* Cut-off Errors – Misstated timing of transactions near year-end can affect both current assets and liabilities.
* Fraud or Window Dressing – Manipulation of working capital items to temporarily boost the ratio around reporting dates.
Define quick ratio, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures a company’s ability to meet its short-term liabilities using its most liquid assets, excluding inventory. It’s a stricter test of liquidity than the current ratio.
Factors That Can Cause Changes Year to Year:
* Changes in Receivables or Cash Balances – Increases or decreases in liquid assets directly impact the ratio.
* Inventory Levels – A rise in inventory has no effect on the quick ratio but may signal poor liquidity if liquid assets don’t increase alongside.
* Payment Practices – Changes in how quickly customers pay or how the business manages supplier payments affect the ratio.
* Short-Term Borrowings – New short-term loans or repayments alter current liabilities and influence the ratio.
* Cash Management Strategies – Decisions around holding cash vs. reinvesting can shift liquidity.
* Economic Conditions – Slow-paying customers or rising bad debts reduce receivables, impacting the ratio.
Audit Risks Quick Ratio Can Help Identify:
* Liquidity Risk – A declining quick ratio may indicate that the company is unable to cover short-term obligations, suggesting potential going concern issues.
* Overstated Receivables – Including uncollectible debts can falsely improve the ratio.
* Understated Liabilities – Failure to include all short-term obligations can overstate liquidity.
* Improper Cut-off – Timing issues with revenue or expenses around year-end can misstate both assets and liabilities.
* Fraud or Window Dressing – Inflating liquid assets (e.g., cash or receivables) to boost the quick ratio near year-end may signal manipulation.
Outline the long term solvency ratios
- Gearing ratio
- Interest cover ratio
Define gearing ratio, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures the proportion of a company’s capital that is financed through debt compared to equity. It indicates the financial risk and long-term solvency of the business.
Factors That Can Cause Changes Year to Year:
* New Borrowings or Loan Repayments – Taking on more debt increases gearing; repaying debt reduces it.
* Changes in Equity – Issuing new shares reduces gearing; buybacks or losses that reduce retained earnings increase it.
* Profitability – Strong profits increase retained earnings and equity, potentially reducing gearing.
* Dividend Policies – High dividends reduce retained earnings and equity, increasing gearing if debt remains unchanged.
* Business Expansion or Acquisition – May involve new financing that increases debt levels.
* Fair Value Adjustments – Revaluation of assets or liabilities can impact equity and thus affect the ratio.
Audit Risks Gearing Ratio Can Help Identify:
* Going Concern Issues – High gearing can indicate financial stress and reliance on debt financing.
* Misclassification of Liabilities – Classifying long-term debt as equity or vice versa can distort gearing.
* Incomplete Disclosure of Debt – Undisclosed or off-balance sheet financing will understate gearing.
* Manipulation of Equity Figures – Errors or bias in profit measurement, retained earnings, or reserves may misstate the ratio.
* Covenant Breaches – High gearing may suggest risk of breaching loan covenants, requiring auditor attention and disclosure.
Define interest cover ratio, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures how easily a company can pay its interest expenses from its operating profit. It indicates the company’s ability to service its debt obligations.
Factors That Can Cause Changes Year to Year:
* Changes in Operating Profit – Improved profitability increases cover; declining profits reduce the ratio.
* Fluctuations in Finance Costs – Interest rate changes or variations in debt levels directly impact the ratio.
* New Borrowings or Loan Repayments – Taking on more debt increases interest costs; repayments reduce them.
* One-Off Gains or Losses – Exceptional items affecting operating profit can distort the ratio if not adjusted.
* Foreign Exchange Movements – If debt is in foreign currency, exchange rate changes can affect interest expense.
* Capital Structure Changes – Shifts between debt and equity financing influence the ratio over time.
Audit Risks Interest Cover Ratio Can Help Identify:
* Going Concern Risk – A low or declining ratio may suggest the company is at risk of being unable to meet interest obligations.
* Overstatement of Profit – Inflated operating profit (e.g., via misstatement of revenue or expenses) can mask debt-servicing issues.
* Incomplete or Incorrect Finance Costs – Errors in recording interest expenses (e.g., missing accruals) may misstate the ratio.
* Undisclosed Borrowings – Off-balance sheet or improperly recorded debt can understate finance costs.
* Aggressive Capitalisation Policies – Capitalising interest instead of expensing it inflates the ratio and understates financing burden.
Outline the efficiency ratios
- Net asset turnover ratio
- Inventory period
- Inventory days
- Trade receivable period
- Trade payable period
Define net asset turnover ratio, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures how efficiently a company uses its net assets to generate revenue. It indicates asset utilisation and operational efficiency.
Factors That Can Cause Changes Year to Year:
* Changes in Revenue – Increases or decreases in sales directly impact the ratio.
* Asset Base Fluctuations – Investment in or disposal of assets will change the net assets figure.
* Profit Retention or Distribution – Retained profits increase net assets; dividends reduce them, affecting the ratio.
* Asset Impairments or Revaluations – Adjustments to asset values impact net assets and therefore the ratio.
* Business Restructuring or Expansion – Acquisitions, mergers, or operational changes can significantly alter both revenue and net assets.
* Depreciation and Amortisation – These reduce the net book value of assets over time, influencing the ratio.
Audit Risks Net Asset Turnover Ratio Can Help Identify:
* Revenue Recognition Errors – Overstated or understated revenue distorts the ratio and may mask inefficiencies.
* Incorrect Asset Valuation – Overstated assets from improper valuation inflate net assets, lowering the ratio artificially.
* Incomplete Liability Recording – Understated liabilities overstate net assets and distort turnover.
* Cut-off Issues – Improper recording of revenue or expenses around the year-end can impact both components of the ratio.
* Inefficient Use of Resources – A declining ratio may signal poor utilisation of assets, raising questions around asset management or impairment.
Define inventory period, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures the average number of days it takes a company to sell its inventory. It reflects inventory management efficiency and how quickly stock is converted into sales.
Factors That Can Cause Changes Year to Year:
* Inventory Management Practices – Improvements in stock control or supply chain efficiency reduce the period.
* Sales Volume Changes – Higher sales can reduce inventory levels and shorten the inventory period.
* Product Mix – A shift toward products with longer lead times or slower turnover can increase the period.
* Seasonality – Businesses may hold more stock during certain times of the year, affecting the average.
* Obsolete or Slow-Moving Stock – An accumulation of unsold or outdated items increases the inventory period.
* Changes in Cost of Sales – Rising or falling COGS without a corresponding inventory change will affect the ratio.
Audit Risks Inventory Period Can Help Identify:
* Obsolete or Overvalued Inventory – A long inventory period may indicate obsolete or unsellable stock not written down appropriately.
* Inventory Valuation Issues – Inconsistent application of valuation methods (e.g., FIFO, weighted average) may misstate inventory levels.
* Cut-off Errors – Inclusion of inventory purchases or sales in the wrong period can distort the calculation.
* Theft or Shrinkage – Discrepancies between recorded and actual stock can go unnoticed if turnover appears normal.
* Fraud Risk – Manipulation of inventory figures to inflate asset value and profitability may be masked by irregular inventory periods.
Define inventory turnover, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures how many times a company sells and replaces its inventory during a given period. It reflects inventory efficiency and how well stock is being managed relative to sales activity.
Factors That Can Cause Changes Year to Year:
* Sales Volume – Higher sales usually lead to more frequent inventory turnover.
* Inventory Management – Efficient procurement and demand forecasting improve turnover.
* Product Mix – Different products turn over at different rates depending on demand and shelf life.
* Stock Obsolescence – Unsellable or obsolete inventory reduces turnover.
* Seasonality – Seasonal fluctuations can cause temporary increases or decreases in turnover.
* Bulk Purchasing – Buying in large quantities may increase average inventory and reduce turnover temporarily.
Audit Risks Inventory Turnover Can Help Identify:
* Overstocking or Obsolete Inventory – A low turnover rate may signal slow-moving or obsolete stock, possibly requiring a write-down.
* Inventory Valuation Issues – Misstatements in costing methods (e.g., FIFO vs. weighted average) can distort the calculation.
* Cut-off Errors – Improper recognition of inventory purchases or sales near year-end may affect inventory and cost of sales.
* Misstated Cost of Sales – Errors in recording production or purchase costs will impact the ratio.
* Fraud Risk – Intentional manipulation of inventory balances or cost figures could be hidden by unusual turnover patterns.
Define trade payable period, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures the average number of days it takes a company to collect payment from its customers after a sale. It indicates the effectiveness of credit control and cash collection processes.
Factors That Can Cause Changes Year to Year:
* Credit Policy Changes – Offering longer or more flexible payment terms can increase the period.
* Collection Efficiency – Delays or improvements in collection processes directly affect the period.
* Customer Creditworthiness – A higher proportion of sales to risky or slow-paying customers can lengthen the period.
* Economic Conditions – In a downturn, customers may delay payments, increasing the receivable period.
* Sales Volume and Timing – Year-end sales spikes may temporarily inflate receivables.
* Bad Debts or Disputes – Higher levels of uncollectible debts can distort the average collection period.
Audit Risks Trade Receivable Period Can Help Identify:
* Revenue Recognition Issues – Inflated or premature recognition of revenue may artificially increase receivables.
* Bad Debt Provisioning – An unusually long collection period may indicate the need for higher bad debt provisions.
* Cut-off Errors – Invoices recorded in the wrong period may overstate receivables.
* Fictitious Sales – Fraudulent sales can inflate trade receivables and distort the period.
* Going Concern Risk – Increasing delays in customer payments may signal liquidity issues and risk to cash flow.
Define trade receivable period, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures the average number of days a company takes to pay its suppliers. It reflects how the business manages its cash flow and relationships with creditors.
Factors That Can Cause Changes Year to Year:
* Supplier Payment Terms – Renegotiation of terms can lengthen or shorten the period.
* Cash Flow Constraints – Companies may delay payments when under financial pressure, increasing the period.
* Purchase Volume Fluctuations – Large one-off purchases or changes in production levels can affect average payables.
* Supplier Relationships – A strong relationship may result in more favourable terms, affecting timing.
* System or Process Changes – New accounting systems or procedures may affect when liabilities are recognised.
* Economic Conditions – In times of uncertainty, businesses may hold onto cash longer and delay payments.
Audit Risks Trade Payable Period Can Help Identify:
* Understatement of Liabilities – A shorter-than-expected payable period may suggest missing or unrecorded payables.
* Cut-off Errors – Purchases recorded in the wrong period can distort the payables balance and the period.
* Cash Flow Risk – A very short payable period may indicate poor cash management or pressure from suppliers.
* Overreliance on Supplier Credit – A very long period could signal that the company is using supplier credit to cover liquidity issues.
* Fraud Risk – Deliberately omitting or deferring recognition of liabilities can artificially improve financial ratios and mislead users.
CARD ON HOW TO STRUCTURE ANSWERS TO ANALYTICAL PROCEDURE QUESTION
