Chapter 7

Question 1

Analytical procedures - Planning stage

Answer 1

Analytical procedures MUST be used as a part of risk assessment at the planning stage under ISA 315.

Question 2

Analytical procedures - Evidence gathering stage

Answer 2

They may be used as substantive procedures.

In practical terms, the use of substantive analytical procedures involves four distinct steps:
1. Firstly, formulate expectations
2. Secondly, compare expected value with actual recorded amount
3. Thirdly, obtain possible reasons for variance between excepted value and recorded amount
4. Fourthly, evaluate impact of any unresolved differences.

Question 3

Analytical procedures - Review stage

Answer 3

Analytical procedures must be used at review stage.

Considerations will include:
- Whether the financial statements adequately reflect the information and explanations previously obtained and conclusions previously reached

• Whether the procedures reveal any new factors which may affect presentation or disclosures in financial statements
• Whether the procedures produce results which are consistent with the auditor’s knowledge
• The potential impact of uncorrected misstatements identified during the course of the audit.

Question 4

Performance ratio - Return on Capital employed

Answer 4

Profit before interest and tax /
equity plus net debt

• where net debt is all borrowings less cash owned

Question 5

Return on Capital employed - Potential causes

Answer 5

• Changes in return
• Age of plant
• Revaluations of non-current assets
• New loans/overdraft

Question 6

Return on Capital employed - Audit risks

Answer 6

• Misstated profit
• Unrecorded liabilities
• Overstated cash
• Change in accounting policy

Question 7

Performance ratio - Return on shareholder funds

Answer 7

Net profit for the year /
share capital + reserves

Question 8

Performance ratio - Gross profit margin

Answer 8

Gross profit x 100 /
Revenue

Question 9

Performance ratio - Cost of sales percentage

Answer 9

Cost of sales x 100 /
Revenue

Question 10

Performance ratio - Operating cost percentage

Answer 10

Operating costs x 100 /
Revenue

Question 11

Performance ratio - Operating profit margin

Answer 11

Profit before interest and tax x 100 /
Revenue

Question 12

Gross profit margin - Potential causes

Answer 12

Revenue
- Consistent with price changes?
- Has sales volume been a factor?
- Has the sales mix changed?
- Have new products been launched?
- Effects of currency translation?

Cost of sales
- Impact of raw material price change?
- Foreign currency changes
- Labour changes - rates or quantity?
- Changes in overhead costs

Question 13

Gross profit margin - Audit risks

Answer 13

Revenue
- Early recognition of revenue
- Cut off issues
- Mistranslation of overseas sales

Cost of sales
- Fraud overstating an expense
- Mistranslation of overseas purchases
- Misclassified costs distorting
- Misstated closing inventory
- Deferring costs into next period
- Change in given cost or estimation (depreciation)

Question 14

Liquidity ratio - Current ratio

Answer 14

Current Assets /
Current Liabilities

Question 15

Liquidity ratio - Quick ratio

Answer 15

Current Assets - Inventory /
Current Liabilities

Question 16

Current and Quick ratio - Potential causes

Answer 16

If low - highlights liquidity problems
if high - poor use of shareholder funds

Potential causes:
- Inventory/ receivables/ payable misstated
- Manipulation ie repayment of liabilities just prior to YE`

Question 17

Long term solvency ratio - Gearing

Answer 17

Net debt /
Equity x 100

• where net debt is all borrowings less cash owned

Question 18

Long term solvency ratio - Interest cover

Answer 18

Profit before interest payable /
interest payable

Question 19

Gearing - Potential causes

Answer 19

• Decrease by upward revaluation of NCA
• Increase by large impairment
• Increase by new finance
• Increase by large cash purchase

Question 20

Gearing - Audit risks

Answer 20

• Going concern
• Understated liabilities
• Overstated cash
• Misclassified preference shares

Question 21

Efficiency ratio - Net asset turnover

Answer 21

Revenue /
Capital Employed

Question 22

Efficiency ratio - Inventory period

Answer 22

Inventories * 365 /
cost of sales

if high - potential obsolescence problems
if low - run risk of running out of inventory

Question 23

Efficiency ratio - Trade receivable period

Answer 23

Trade Receivables * 365 /
Revenue

A change in this ratio may indicate:
- Bad debt collection problems
- Change in customer base
- Change in terms

Question 24

Efficiency ratio - Trade payable period

Answer 24

Trade payable * 365 /
Cost of sales

if high - may indicate liquidity problems, risk of supplier ceasing supply, enforcing liquidation