|
|
|
Chapter 4, 38-40 4-38.
(Sources of Information for Audit Planning) The
client is a continuing audit client; thus, the firm's audit file on the client
and reports to the SEC or other users should serve as a major source of
information to be used in planning the audit.
The primary sources of information the audit should consult include
these: 1.
Prior year working papers, including the permanent file, to obtain
information about o
Planning materiality. o
Audit adjustments and difficulties
encountered during the audit, o
Audit budget and actual time on
various parts of the audit. o
Matters of continuing audit
importance, such as loan agreements and key personnel. o
Engagement letter and constraints
affecting current years audit. o
Audit staff personnel assigned o
Industry accounting or auditing
pronouncements as they may affect the client and any actions the client took in
previous years to implement the pronouncements. o
Identification of risk factors. o
Previous reports. o
Partner and supervisory memos
assessing important audit areas. o
Account assessments of continuing
importance such as allowance accounts, warranty estimates, or loan loss
reserves. o
Comments by the prior year auditors
about changes they recommend for the current year audit. 2.
Reports to regulatory agencies or other special purpose reports: o
Identification of important
reporting items. o
Current reporting requirements. 3.
Review of regulatory correspondence: o
Potential risks for client. o
Potential implications for current
year reports. 4.
Review of business periodicals: o
Current business news about the
client. o
Introduction of new products. o
Overview of current economic
developments, competitor actions, and other competitive developments affecting
the client. 5.
Review of industry databases: o
Comparison of company developments
and financial results with industry averages and trends. 6.
Interview with top management: o
Operating plans such as new
construction, new product developments, or major financial plans such as
mergers, acquisitions, or new plant developments. o
Management's assessment of the
company's prospects, risks and so on. o
The concerns management wishes to
have addressed during the audit. 7.
Review of internal audit reports: o
Problem areas identified during
their audits. o
Actions taken by the auditees,
management, and audit committees. o
Potential planning for cooperation
with external auditor in performing the year-end audit. o
Competence and coverage of audit
work. 8.
Review of audit committee meetings: o
Special concerns. o
Previous topics and disposition. 9.
Discussion with audit partner: o
Time budget and personnel
assignment preferences. o
Preliminary assessment of risk
factors. o
Timing for the audit. o
Due date and type of audit reports
or other reports to be issued. 4-39.
(Using Electronic Information in Performing Risk Analysis) This
is a project that can be assigned for the semester to apply the risk analysis
approach to an audit. The
assignment has proven to be extremely valuable and has been used extensively by
both authors as well as colleagues at our schools.
We usually have students make preliminary reports to the instructor as
well as a final report that may go to either the instructor or the whole class. We find that the project helps the students synthesize the
risk analysis approach and its relationship to the conduct of the audit. 4-40.
(Risk Analysis: Linkage to Direct Testing)
a. The
debate is a meaningful one. Eventually,
every audit gets involved in direct testing of account balances to determine
whether there is a material misstatement in the account balance or the financial
statements as a whole. However, as
the research pointed out in the chapter, the major audit failures of the last
decade tended to occur because auditors had developed a habit of testing the
accounts and looking for technical compliance with GAAP while not understanding
the underlying economics of the company and its transactions.
The auditor must not only analyze technical requirements, but is called
upon increasingly to comment on the overall fairness of presentation – at
least to the audit committee. Finally,
we need to emphasize that there are many areas of financial statement audits
where simply technical auditing will not work.
For example, the auditor needs to understand strategies, the economy,
competition, and so forth to make estimates of inventory obsolescence,
collectibility of receivables, or product warranty liabilities.
For the reasons identified above, most of the firms have determined that
auditor 2’s analysis is the better analysis.
Analytical review and a business risk analysis are not designed to
replace “old fashioned audit testing”, but it brings a fuller perspective to
the audit tests. It also allows the
auditor to focus on accounts most likely to contain a material misstatement. b.
The SEC concerns are well-founded. Whenever
auditors fall into the trap of “mindlessly” following procedures and not
analyzing the implications of their findings, they can fall into an audit
approach that will likely miss material misstatements.
Analytical review is not the only procedure that is performed, nor is
analytical review only compared with previous company results.
The full business risk approach will analyze company results and compare
it to industry trends and current economic trends affecting the company.
Thus, while the current results may be consistent with previous years,
they might not be consistent with other economic trends or with competitor
trends. The auditor needs to
investigate both and reach a judgment about material misstatement.
For example, if the company results were consistent with previous years,
but there have been major changes in the economy such as a major interest rate
change, a downturn in the economy, a slowdown in housing, new competitors, and
so forth, it should heighten the auditor’s skepticism towards the correctness
of the client’s account balance. The
key is that business risk analysis is much more than analytical review. c.
There are three ways in which risk analysis is linked to test of details. 1.
Knowledge of economic trends, competitor actions, and industry
developments will assist the auditor in making judgments about complex account
balances such as inventory obsolescence, collectibility of receivables, warranty
expense and liability, and pension expense and the related reliability. The auditor needs this knowledge to make the estimates.
Simply projecting last year’s balance, or trends in balances, forward
to this year is not an acceptable audit approach. 2.
Preliminary analytical review focusing on comparison with previous year
financial balances can highlight account balances that are out of line with
expectations. The account balances
that are out of line with expectations should be signaled for greater detailed
examination. 3.
Further, the knowledge the auditor has gained about the company can help
identify areas the auditor needs to investigate.
In other words, the company results may be consistent with previous
year’s financial results, but may be inconsistent with industry trends or
industry averages. It is the cumulative knowledge gained from the
three steps above that helps the auditor plan the audit to be both more
efficient and more effective. 4-41.
(Analytical Review in Planning an Audit) a.
Advantages o
Identify significant divergences in trends, earnings components, asset
and liability structure, and so on. o
Identify the effect of management policy decisions on the company in
comparison with industry average (may be good or bad or simply may raise
questions). o
Identify potential problem areas (e.g., why this company is so much
different than the industry as a whole). What
assumptions would be required to justify such differences? Limitations o
The client may have operations that are significantly different (at least
in some portion) than the industry as a whole. o
The client may have a different operating philosophy (e.g., financing or
operating leverage, which may distort all important ratios and other
comparisons). On the other hand,
the potential downside of such policies may also be identified through
comparison with industry data. o
The client may use accounting principles that are different from those of
other companies in the industry. For
example, the client may use LIFO and many of the other companies may use FIFO.
Such differences will cause company and industry data to lack
comparability. b.
Identification of risk areas for Jones Manufacturing: Potential
Risk Indicator
Risk Analysis Inventory
increase
There is a substantial increase in inventory, both in dollar terms and as
a percentage of sales, which could indicate potential problems with new
products, with obsolescence, or with competitiveness with other products.
It may indicate an increase of inventory just before year-end in
anticipation of rise in cost, a strike, or unusually heavy demand.
Inventory may be overstated due to misstatements of quantities or prices.
This could also affect the following change. Cost
of goods sold decrease COGS has
decreased to 55 percent of sales at the same time inventory has increased.
One explanation is that COGS has not been booked for some significant
sales. There may also be a change
in product mix. In any event, audit
attention should be directed to these areas. Accounts
payable increase The
A/P increase could reflect credit problems or other financing problems.
Such problems could make it difficult for the company to carry out its
on-going activities. It may simply
reflect the purchase of an unusual amount of inventory just before year-end.
Inventory
turnover
Inventory turnover has decreased by 33 percent.
This points to and confirms the problems identified by the increase in
inventory and decrease in cost of goods sold.
Either there are substantial obsolescence problems, material items are
not correctly recorded, or the inventory has been increased in anticipation of
some unusual event early next year, such as a raw material shortage, strike, or
unusual demand. Average
number of days to collect This ratio has increased by 23 percent over the
previous year and is 33 percent above the industry average.
The increase in the ratio could represent a number of problems: o
Less
stringent credit standards. o
Warranty problems (i.e., the
customers may not be paying because of problems with the products.)
This would be consistent with the interpretations associated with
inventory turnover, o
Unrecorded
returned items or a significant lag in issuing credit memos associated with
returned items. o
Potential
accounting recording problems. Employee
turnover
This is more difficult to interpret, but there is a 60 percent increase
over previous years to a rate that is double that of the industry.
This might indicate problems with morale, quality control, or other
dissatisfaction with the manner in which the company is being run. Return
on investments
This ratio does not indicate a problem.
In fact, the company exceeds the industry average. An alert auditor, should wonder however, how the company is
able to maintain a superior return when there are problems with inventory and
receivables. Debt/Equity
ratio
This ratio has increased substantially and is double the industry
average. The company has become
highly leveraged. The increased
leverage has three implications the auditor ought to address: o
The existence of new debt covenants
that ought to be addressed as part of the audit. o
A potential problem of remaining a
going concern should there be a downturn in operations or a significant increase
in interest rates (on how the debt is structured). o
There
may be concern with how the debt proceeds have been utilized by the company.
Does it represent additional capital, or is it being used for current
operating purposes? The auditor
should seek an answer to this question and consider the implications of the
answer to the audit. One
important use of analytical procedures is to point to potential problem areas
that may affect the audit. The implication is that the auditor should consider
specifically how the identified risk areas might reflect material misstatements
in the financial statements. The
risk areas identified above should lead the auditor to plan specific audit tests
including, but not limited to, the following: o
Expanded tests of inventory,
pricing, returns, warranties, and the accounting procedures for recognizing
product returns. o
Expanded tests for potential
inventory obsolescence include a detailed analysis of industry trends,
competitor products, current sales level, and so on. o
An expanded scope of receivables
testing to determine the validity and collectibility of receivables that are
increasingly older. o
A heightened awareness of any
factors that might indicate fraud or material misrepresentations on the part of
management. The inconsistency
reflected in some of the economic data may indicate that management is
deliberately overstating inventory and understating cost of goods sold. o
There should be a specific analysis
of going concern issues. The
expanded debt, the employee turnover, and the inventory and receivable problems
all point to significant operating issues. o
In comparison with most standard
audits, there should be a greater emphasis on year-end testing and very little
reliance on management representations. The risk of error should point to a very skeptical audit. 4-42.
(Analytical Review and Planning the Audit) a.
Conclusions regarding risk: o
There is a significant trend toward a declining current and quick ratio
which would indicate liquidity problems for the company, often relating to
operating problems. o
Interest coverage has decreased significantly and is substantially below
the industry average, indicating that the company is vulnerable to any downturn
in operations or changes in interest rates.
Although it may not immediately signal problems as to remaining a going
concern, it could indicate that such problems could surface in the near future. o
There is a significant increase in the number of day's sales in
receivables, which is one of the key danger signals for any
company of this nature. The
increase could reflect potential problems from product quality, less stringent
credit policies, governmental concerns with the product, fictitious sales, or
unrecorded product returns. o
Inventory turnover is steadily decreasing, reflecting a deterioration of
the company's major product and the inability to introduce new products in the
market. There may be realizability
problems related to inventory as well as future operating problems. o
The number of day's sales in inventory has been steadily increasing.
This is the same problem as the decreasing inventory turnover identified
above. Some people find that this
ratio better visualizes the problem. o
Indanola has steadily decreased its investment in R&D, to a current
level that is less than 33 percent of the industry average.
This signals potential long-run problems with the company, because unless
successful research and development is the key to success in the pharmaceutical
industry, the company develops and successfully introduces new products, it has
potential going-concern problems. o
Cost of goods sold as a percentage of sales appears to be a positive
development. On further analysis,
however, there may be clouds in this silver lining as well:
(1) the primary production of older products rather than the introduction
of newer products and/or (2) accounting errors in recording inventory, sales, or
receivables. o
The debt/equity ratio has increased significantly.
There is less interest coverage. In
addition, there may be concerns with debt covenants that may have been violated. o
The significant decrease in earnings per share hampers the company's
ability to raise new capital. Also,
the significant decrease that has taken place in the past three years may cause
investors to question current management's ability.
Potential suits may be brought against management if there are signs of
mismanagement. The amount and
extent of personal bonuses or potential misuse of corporate funds become
important and heighten the auditor's awareness of potential abuses and lower the
qualitative materiality for investigating corporate expenditures that reimburse
or provide benefits to management. o
The sales/tangible asset ratio indicates that the company is not
generating an industry normal volume for assets.
This may indicate that there is substantial idle capacity or that new
capacity has not yet gone on line. (The
inference of new capacity is brought about by the increase in the debt/equity
ratio.) There may be problems with
interest capitalization or write-offs of excess capacity. o
The sales/total assets ratio is well below industry average.
But more significant is the fact that it is markedly lower than the
sales/tangible assets average. This
would indicate that the company has substantial capitalized intangible assets.
Given the declining profitability and operations of the company, there
may be substantial valuation problems associated with these intangible assets. o
Sales growth has increased but less than the industry average. It is also evident that the increase has come with poorer
credit. The
preceding analysis points out a number of areas on which audit attention ought
to be focused. The company is
publicly traded and SEC reports are required.
The dependence on one major product with a patent about to expire,
decreased research and development, and decreased operating performance all
point to potential realization problems. The
audit work will likely be modified as follows: o
Audit risk will be set at a level below the industry norm, reflecting the
increased engagement risk associated with the client. o
Work on specific audit areas more likely to contain misstatements (e.g.,
receivables and inventory) will be expanded. o
There will be greater concentration on realizability problems, especially
in the area of intangibles. The
audit approach will exhibit a great deal of skepticism and will need to
corroborate all important management representations.
b. Other
information that might be gathered as part of this audit engagement would
include o
Analysis of industry product trends including the identification of
competitor products and other new product developments.
(obtained from industry journals). o
The status of client's drugs submitted for approval by the Food and Drug
Administration, as well as the status of competitor products (obtained initially
from company but verified by either reviewing FDA correspondence or confirming
status with the FDA). o
Client plans for new products and use of new capacity (management). o
Management's budget, operating plans, and strategy for dealing with
current problems (management) o
Correspondence with financial advisers regarding debt structuring, loan
covenants, and so on (review of company files, confirmation with financial
advisers if applicable).
c. Actions
that took place in the year preceding the current year would likely have
included o
A major issuance of debt reflected in the debt/equity ratio. o
The acquisition of another company or of
other intangible assets reflected in the decrease in the sales/total assets
ratio, which has decreased more than the sales/tangible assets ratio.
This possibility is also evidenced by the 15 percent growth in sales over
the previous year, an increase significantly higher than the previous best year
growth of 4 percent. o
A major sales problem may exist with
significant increases in number of day's sales in inventory increasing
reflecting some panic thinking on the part of the company. d.
Important accounting issues that may be addressed during the conduct of
the upcoming audit include o
Recording intangible assets on acquisition, including the determination
of appropriate life over which to amortize them.
For example, does declining profitability indicate that the useful life
over which the assets are amortized should be decreased? o
Capitalization of research and development. o
Treatment of patents. o
Interest capitalization on new construction. o
Determining an appropriate allowance for uncollectible receivables. o
Determining the realizability of inventory, including an analysis of
government approval for new products. 4-43.
(Utilizing Financial and Operating Ratios) a.
Current ratio 1.
Current Assets / Current Liabilities 2.
The ratio measures the liquidity of the company, in particular its
ability to meet current obligations with existing liquid assets. Generally, the higher the ratio, the better the company's
ability to meet current obligations. Some
debt covenants specify that the borrower must maintain a minimum current ratio
such as 2 to 1. However, because
the ratio includes both accounts receivable and inventory, an increase in the
ratio could also reflect realizability problems with those two assets. 3.
The auditor compares the ratio over time and with industry averages to
note important changes. 4.
A decreasing trend in the current ratio to a point that is considered
below industry average would indicate potential problems in meeting current
obligations. The company may have
difficulty in meeting current payables. The
trend may also put the company in violation of debt covenants. Materiality
would be changed if it appeared that the client would be close to violating debt
covenants. Any misstatement that would put the company in violation of
its covenants would be considered material. b.
Quick ratio 1.
Current Assets less Inventory / Current Liabilities 2.
This is considered a better indicator of the client's ability to meet
current obligations than is the current ratio because inventory is not readily
converted into liquid form. Presumably,
accounts receivable can be converted to liquid assets by either selling or
factoring the receivables. 3.
The analysis of the trend associated with the quick ratio is essentially
the same as with the current ratio. 4.
A decrease in the quick ratio would indicate potential liquidity problems
that may affect the organization's ability to carry out its operations in a
normal manner. c.
Number of days’ sales in receivables 1.
Accounts Receivable times 360 / Annual Net Sales 2.
This ratio is designed to measure the validity and the collectibility of
accounts receivable. It may also
reflect the validity of recorded sales. 3.
This ratio is one of the most important for manufacturing or retail
industries. A significant increase
in this ratio, or a trend in it over time, can signal o
Less-stringent credit standards. o
Warranty problems, (the customers may not be paying because of problems
with the products). o
Unrecorded returned items or a significant lag in issuing credit memos
associated with returned items. o
Potential accounting
recording problems, such as recording fictitious sales. 4.
The auditor determines which of the possible preceding explanations best
reflects the current status of the audit client and then adjusts audit
procedures accordingly. The auditor
might design procedures to test for fictitious recording of receivables.
This might involve an examination of sales transactions but would most
likely include direct correspondence with the customer to determine the extent
and validity of the receivable. The
auditor may also closely examine the company's treatment of returned merchandise
at year-end. d.
Number of days’ sales in inventory 1.
Inventory times 360 / Net Annual Sales
This
is sometimes computed in relation to cost of goods sold rather than net annual
sales. The auditor often wants to
compute the ratio on the basis of sales because it provides an analysis related
to the end result of holding inventory. 2.
Characteristics that would be identified by the ratio would include
Potential obsolescence of inventory or inventory product lines.
Net realizability of inventory due to overstocking conditions.
Potential warranty problems associated with returns of goods sold. 3.
The auditor looks for any significant increases in the ratio,
particularly in comparison with industry trends or prior year results.
The auditor complements this initial analysis with knowledge obtained
from reviews of industry journals. 4.
The auditor expands audit tests to consider any of the three potential
explanations identified in part 2 including detailed analysis of sales by
product lines, analysis of goods returned, and discussion with management of
their plans to deal with overstocked inventory positions.
e.
Debt/Equity ratio 1.
Long-Term Debt / Total Stockholder's Equity 2.
This ratio is a measure of the corporation's indebtedness and indicates
potential constraints on its operations. Some
auditors also classify short-term debt as long-term debt in computing this ratio
if it appears that short-term simply rolls over and is never repaid.
It is a measure of the company's leverage and indicates vulnerability to
economic downturns or interest rate changes. 3.
The auditor analyzes changes over a period of time.
Frequently, the auditor complements this initial analysis with a
calculation of times interest earned as a measure of the extent to which
the company's operations are able to sustain the debt load. 4.
The analysis does not necessarily lead to additional tests.
However, the auditor will have added awareness of potential default (and
thus going concern implications) and potential violation of debt covenants. f.
Gross margin 1.
Net Sales minus Cost of Goods Sold / Net Sales 2.
This is a measure of operating effectiveness.
3.
The auditor is alert for significant changes in the ratio (in either
direction) and significant deviations from industry averages.
Significant decreases in the ratio may indicate operating problems and
actions taken by management to meet competitive pressures.
On the other hand, significant increases in the ratio may indicate
improved operating effectiveness or by manipulation of reported sales or cost of
goods sold. 4.
Once the auditor determines the most likely cause of a change in the
ratio, the audit plan is modified to search for evidence that either
corroborates or refutes the potential explanation. g.
Net operating margin
2.
This is an indication of overall operating efficiency. 3.
The ratio provides a first look at potential changes in operations and is
useful in identifying changes in operating expenses.
Although there is not enough detail to determine which accounts may have
changed the most, it does provide initial data on the existence of significant
changes the auditor may want to examine. The
ratio also is used to measure a firm's ability to take on additional debt or to
service existing debt. 4.
The auditor uses the initial analysis to determine whether more detailed
review of specific account balances is needed. h.
Earnings before interest and
taxes 1.
Net Income + Interest Expense + Tax Expense. 2.
This is a measure of a company's ability to service current debt or to
take on additional debt. 3.
The auditor uses this information to measure potential problems in
servicing existing debt, to analyze whether the firm may need to restructure
debt to continue operations or to determine whether the company may be subject
to debt covenant constraints. 4.
The auditor likely performs significant "what-if" analysis to
determine the effects of potential downturns in the economy or changes in
interest rates because they may affect the client's ability to remain in
operation. i.
Number
of times interest earned 1.
Earnings before Interest and Taxes / Annual Interest Expense 2.
This is a another measure of a company's ability to service current debt
or to take on additional debt. 3.
The auditor uses this information to measure potential problems in
servicing existing debt, to analyze whether the firm may need to restructure
debt to continue operations or to determine whether the company may be subject
to debt covenant constraints. 4. The auditor likely performs significant "what-if" analysis to determine the effects of potential downturns in the economy or changes in interest rates because they may affect the client's ability to remain in operation.
|