- 30 Marks
AA – L2 – Q23 – Analytical Procedures
Question
You have been presented with the following draft financial information about Fresca Solutions, a very successful company that develops and licenses specialist computer software and hardware. Its non-current assets mainly consist of property, computer hardware and investments, and there have been additions to these during the year. The company is experiencing increasing competition from rival companies, most of which specialise in hardware or software, but not both. There is pressure to advertise and cut prices.
You are the audit manager. You are planning the audit and are conducting a preliminary analytical review and associated risk analysis for this client for the year ended 31 May 20X8. You have been provided with a summarised draft statement of comprehensive income which has been produced very quickly and certain accounting ratios and percentages. You have been informed that the company accounts for research and development costs in accordance with IAS 38 Intangible Assets.
Statement of comprehensive income
| Year ended 31 May | ||
|---|---|---|
| 20X7 | 20X8 | |
| €’000 | €’000 | |
| Revenue | 15,206 | 13,524 |
| Cost of sales | 3,009 | 3,007 |
| Gross profit | 12,197 | 10,517 |
| Distribution costs | 3,006 | 1,996 |
| Administration expenses | 994 | 1,768 |
| Selling expenses | 3,002 | 274 |
| Profit from operations | 5,195 | 6,479 |
| Net interest receivable | 995 | 395 |
| Profit before tax | 6,190 | 6,874 |
| Income tax expense | 3,104 | 1,452 |
| Net profit | 3,086 | 5,422 |
| Retained profits | 1,617 | 3,983 |
| Dividends paid | €1,469,000 | €1,439,000 |
Accounting ratios and percentages
| Year ended 31 May | ||
|---|---|---|
| 20X7 | 20X8 | |
| Earnings per share | 0.43 | 1.04 |
| Performance ratios include the following: | ||
| Gross margin | 0.80 | 0.78 |
| Expenses as a percentage of revenue: | ||
| Distribution costs | 0.20 | 0.15 |
| Administrative expenses | 0.07 | 0.13 |
| Selling expenses | 0.20 | 0.02 |
| Operating profit | 0.34 | 0.48 |
Required
(a) In accordance with ISA 520 Analytical Procedures explain when analytical procedures shall or may be carried out and the nature of such procedures.
(b) Using the information above, comment briefly on the performance of the company for the two years.
(c) Use your answer for part (b) to identify the areas that are subject to increased audit risk and describe the further audit work you would perform in response to those risks.
Answer
(a) When analytical procedures shall or may be carried out
ISA 520 requires the auditor to apply analytical procedures at the overall review stage of the audit in order to assess the reasonableness of the reported figures.
In addition, the auditor may also use analytical procedures as a substantive audit testing procedure, if it is an effective method of testing for that particular area/circumstances.
(ISA 315 also requires the auditor to apply analytical procedures at the planning stage, in order to identify areas of high audit risk.)
The nature of analytical procedures
Analytical procedures are defined by ISA 520 as “evaluations of financial information through analysis of plausible relationships among both financial and non-financial data”. Much of the analysis consists of measuring ratios, and comparing the ratios obtained from the current year’s financial results with:
- expected ratios; and
- ratios from previous financial periods.
If key ratios are close to what they are expected to be, the auditor may take this as evidence that the relevant balances or transaction amounts are reliable and ‘accurate’. If a ratio is very different from what is expected, the auditor should investigate the reason for the variation. There may be a good reason why a ratio differs from its expected value. On the other hand, a ratio might have an unusual value because there is a misstatement in the financial statements.
(b) The company has increased its revenues by 12% and its gross profit by 16% which in a competitive market is very good (if not entirely credible) however, increased operating expenses have resulted in a reduction in operating profits of 20%.
The gross margin is very high; this is not abnormal in this section, especially for software (although the margin is high for hardware), but it may also be the result of errors, because the information has been produced very quickly. This is also true of the other figures.
Total expenses as a percentage of revenue have increased substantially with the result that operating profit as a percentage of revenue has reduced by around a third.
The increase in the selling expenses as a percentage of revenue may reflect the need for the company to spend more on advertising.
The increase in the distribution costs as a percentage of revenue may reflect inefficiencies in the method of distribution in an industry that separates these functions.
The administrative expenses as a percentage of revenue have halved although they do not represent a significant amount in absolute terms.
The reduction in operating profits has been partially offset by increased net interest receivable but profit before tax is still down 10%.
The reduction in profit before tax and the increased tax charge have resulted in a reduction in profit after tax of over 40%.
Total dividends have been increased, despite the lower profits.
The reduction in earnings per share is partly due to the reduction in profits but there is insufficient information to state whether it is also attributable to an increase in the number of shares, although this seems likely.
(c) Gross margin and operating expenses
I would obtain a detailed schedule of revenue and cost of sales showing the opening and closing inventory figures for both software and hardware and I would perform a detailed review of changes on, say, a monthly, quarterly and half-yearly basis.
I would ascertain the accounting policies for revenue recognition for both software and hardware and ensure that they were in accordance with relevant International Accounting Standards. I would then test the application of these policies to individual transactions. IAS 38 Intangible Assets requires that certain development costs be capitalised in the statement of financial position and that research costs and costs that do not meet the criteria for capitalisation be expensed.
I would seek to establish why all three categories of operating expenses have changed so dramatically, by inquiry and by obtaining a schedule of operating expenses and a breakdown of the cost of sales figure.
I would perform detailed analytical procedures on operating expenses and cost of sales/gross margins, on a quarterly and monthly basis and I would also perform detailed testing of transactions in these areas in order to ensure that misclassifications have not occurred.
Audit evidence provided by work on the inventory figure in the statement of financial position (such as analytical procedures performed on the inventory levels and attendance at the inventory count) will also provide evidence in relation to cost of sales.
It is possible that some reclassifications or even misstatements have been made – some costs appearing as operating expenses might properly belong in cost of sales. It certainly seems odd that whilst revenue has increased by 12%, the cost of sales figure has hardly increased at all. The reduction in administrative expenses should also be investigated.
I would obtain schedules relating to non-current assets and establish the extent to which these had contributed to an increase in depreciation costs. I would enquire as to the nature of the additions and their purpose. Additional non-current assets would also be expected to contribute to revenues. If the change in the earnings per share figure is (partly) a result of a new issue of shares, it may be that the cash generated has been used for investment in non-current assets.
Because of the possibility of misstatements, I would increase my sample sizes during tests of controls over the recording, processing and posting of transactions that are posted to revenue, cost of sales and operating expense accounts.
I would perform detailed substantive testing on samples of transactions in these areas from source documentation (such as licensing documentation, payroll records, purchase invoices for components etc.) through to the daybooks, ledgers and schedules supporting the statement of comprehensive income (for completeness) and vice versa.
The extent of substantive procedures will depend on the extent to which controls are shown to be effective and I would be particularly careful to follow up any misstatements discovered in both tests of controls and substantive testing. I would also pay particular attention to any unauthorised, substantial or late adjustments.
Interest receivable
I would ask for a breakdown of, and explanation for, the increase in net interest receivable. I would perform further analytical procedures on the interest costs and income and ensure that these are in line with current interest rates and the types of investments held by the company.
Taxation
It seems strange that the tax figure has increased so dramatically. I would ask for copies of the tax calculations for detailed review, and to corroborate explanations provided by management.
Dividends and earnings per share
I would enquire as to why dividends had increased, despite the lower profits, and establish whether this trend can be maintained in the face of falling profits. I would also enquire as to whether the company has any plans to restructure in line with trends in the industry, what the company intends to do about the competition, and whether there is any possibility of a take-over.
I would establish whether there had been any share issue during the year that had affected the calculation of the earnings per share and, if there had been, what the purpose of the share issue was.
- Topic: Audit Evidence
- Uploader: Samuel Duah