3.5 AUDIT DATA ANALYTICS AND ANALYTICAL PROCEDURES
Determine the overall purpose and objectives of the ADA and select the ADA that is likely best suited for the intended purpose and objectives, including the methods, tools, graphics, and tables to be used.
plan the ADA
professional skepticism and exercise professional judgment.
ADAs are methods of performing various audit procedures, including those applied in (a) risk assessment (planning), (b) tests of controls, (c) substantive analytical procedures, (d) tests of details, or (e) final review (forming an overall conclusion). The auditor should plan and perform ADAs and other procedures with
visualizations. they also often help auditors process large volumes of complex data.
ADAs include reports and
the understanding of the client's business and significant transactions and events since the last audit. They also may identify unusual transactions or events and amounts, ratios, and trends that might indicate matters with audit planning implications. But when they use highly aggregated data, they provide only broad indications about the RMMs.
Analytical procedures applied as risk assessment procedures at the beginning of the audit may improve
a study of plausible relationships among financial and nonfinancial data.
Analytical procedures are evaluations of financial information made by
substantive procedures.
Analytical procedures may be applied not only as risk assessment procedures (analytical procedures used to plan the audit) but also as _______
budgeted results- If management's budget at the beginning of the period includes cost of sales of $100,000, the auditor expects cost of sales to approximate $100,000 at year end. The use of standard costs and variance analysis facilitates the application of analytical procedures in this context.
Anticipated Results,
cogs/sales This ratio measures the percentage amount of sales consumed by cost of goods sold. Nonproportional changes in either affect the ratio.
COGS ratio
industry inventory turn over ratio- If the usual inventory turnover ratio in the industry is 10 times per year, the auditor expects the client's turnover ratio to be approximately 10 times.
Comparable Information from the Client's Industry
Document the steps and results in the audit documentation (working papers).
Evaluate the results and conclude whether the purpose and objectives have been achieved.
trend of sales- If a client's prior reported sales were $120,000 in Year 1, $130,000 in Year 2, and $140,000 in Year 3, respectively, the auditor is likely to predict Year 4 sales to be approximately $150,000 based on the trend. If management's reported sales are materially different, the auditor increases the assessed RMM and investigates the underlying causes.
Financial Information from Comparable Prior Period(s)
investigating fluctuations or relationships that (a) are inconsistent with other information or (b) differ significantly from expectations.
Plausible relationships among data are reasonably expected to exist and continue in the absence of known conditions to the contrary. Analytical procedures also include
total income/equity This is an overall measure of a rate of return on investment. Changes in net income or changes in equity may affect this ratio. A return on average total equity or on common equity also may be calculated.
ROE
relation of sales and A/R-If the auditor determines that sales increased by 25% for the year, accounts receivable should increase by approximately that amount.
Relationships among Elements of Financial Information,
labor costs and hours worked-If the number of hours worked increased by 30%, the auditor expects an increase in labor costs of approximately 30%.
Relationships between Financial and Relevant Nonfinancial Information
Financial Information from Comparable Prior Period(s) Anticipated Results, such as budgets or forecasts prepared by management (or others) prior to the end of the period Relationships among Elements of Financial Information, such as those among the balances on the financial statements Comparable Information from the Client's Industry Relationships between Financial and Relevant Nonfinancial Information
The auditor develops expectations or predictions of recorded balances or ratios. The candidate should learn the five sources of information used to develop analytical procedures. They are frequently tested on the CPA exam.
Nature of the assertion. Plausibility and predictability of the relationship. Availability and reliability of the data used to develop the expectation. Precision of the expectation.
The auditor's judgment about expected effectiveness and efficiency in reducing the assessed RMMs to an acceptable level determines the procedures chosen. For some assertions, analytical procedures alone may provide the necessary assurance. The effectiveness and efficiency of analytical procedures depend on the following factors:
Determine their suitability for specific assertions after considering the assessed RMMs and any tests of details. Evaluate the reliability of data used to develop an expectation of an amount or ratio. Develop an expectation and determine whether it is sufficiently precise to identify a material misstatement. Use them to assist in forming an overall conclusion near the end of the audit about whether the statements are consistent with the auditor's understanding of the entity.
When applying substantive analytical procedures, the auditor should
As the assessed risk increases, the amount of acceptable difference decreases.
acceptable differences: The determination that differences between expectations and recorded amounts are acceptable without additional investigation is a function of materiality and the desired degree of assurance. It also considers that the sum of individually insignificant items may be significant.
Format and filter the data. Consider the ability to maintain data security and integrity.
access and prepare the ADA
"the science and art of discovering and analyzing patterns, identifying anomalies, and extracting other useful information in data underlying or related to the subject matter of an audit through analysis, modeling, and visualization for the purpose of planning or performing the audit."
audit data analytics
Reliability is affected by the source of the data and the conditions under which they were gathered. For example, data are considered more reliable when Obtained from independent sources outside the entity, Obtained from sources inside the entity independent of those responsible for the amount being audited, Developed under reliable internal control, Subjected to audit testing in the current or prior years, and Obtained from a variety of sources.
availability and reliability of data used to develop expectation
Evaluate the relevance, availability, and reliability of the data.
consider the relevance and reliability of the data
current assets/current liabilities Changes in the ratio may be caused by changes in the components of current assets (typically cash, receivables, and inventory) and current liabilities (typically accounts payable and notes payable). If the current ratio is less than 1.0, equal increases in the numerator and denominator increase the ratio, and equal decreases decrease the ratio.However, if the current ratio is more than 1.0, equal increases in the numerator and denominator decrease the ratio, and equal decreases increase the ratio.
current ratio
expectation,The factors used to develop the expectation,The results of the comparison of the expectation with the recorded amounts or ratios, and Any additional auditing procedures performed to resolve differences and their results.
documentation: When substantive analytical procedures are performed, the auditor should document the
365/inventory turnover This ratio has the same components as inventory turnover and is affected by changes in inventory or cost of sales. The number of days in a year may be 365, 360 (a banker's year), or 300 (number of business days).
days sales in inventory
365/receivables turnover This ratio has the same components as receivables turnover and is affected by changes in sales or receivables. The number of days in a year may be 365, 360 (a banker's year), or 300 (number of business days).
days sales in receivables
debt/equity This ratio measures how much external parties contribute to assets relative to owners. Shifts in debt or equity affect this ratio. The ratios of total assets to total equity and total assets to total debt provide similar analysis and conclusions.
debt to equity
plan the ADA access and prepare the data consider the relevance and reliability of the data perform the ADA Evaluate the results and conclude whether the purpose and objectives have been achieved.
five basic steps are an approach an auditor might use to plan, perform, and evaluate the results of an ADA:
(1) the adequacy of evidence regarding unusual or unexpected balances detected during the audit and (2) such balances or relationships not detected previously. If analytical procedures detect a previously unrecognized RMM, the auditor should revise the assessments of the RMMs and modify the further planned procedures.
forming overall conclusion: Analytical procedures used to form an overall conclusion ordinarily include reading the financial statements and considering
net sales-cogs/net sales The gross margin percentage measures earnings from the sale of products. Nonproportional changes in net sales and cost of goods sold affect the ratio.
gross margin %
An auditor calculated the following ratios in an audit of a wholesaler: 20X1 20X2 Current ratio 3.0 4.0 Quick ratio 1.0 1.0 Sales 500 700 Receivables turnover 9 6 What are the likely issues for auditor investigation? Because the quick ratio is essentially the same as the current ratio except for the exclusion of inventory, an increase in reported inventory is the likely cause of the increase in the current ratio. The auditor may suspect that inventory in 20X2 is overstated. The increase in sales when receivables turnover has decreased suggests that sales were made to customers with poorer credit ratings, resulting in more overdue balances and bad debts. The auditor may scrutinize the allowance for doubtful accounts for potential understatement. A more subtle inference is that an increase in quick assets caused by an increase in receivables (turnover decreased) has been offset by an increase in current liabilities. The reason is that the quick ratio [(Current assets - Inventory) ÷ Current liabilities] did not change. The auditor may be interested in those changes and their causes.
inference from ratio analysis
cogs/average inventory Auditors often calculate this ratio using ending inventory as the denominator because it is the balance being audited. Changes in cost of goods sold or inventory affect this ratio. A high turnover implies that the entity does not hold excessive inventories that are unproductive and lessen its profitability. A high turnover also implies that the inventory is truly marketable and does not contain obsolete goods.
inventory turnover
(1) inquiries of management, (2) corroboration of responses with other audit evidence, and (3) performance of any necessary other procedures. Moreover, the RMMs due to fraud should be considered.
investigating results: Inconsistent fluctuations or relationships or significant differences should result in
Analytical procedures may be effective when tests of details may not indicate potential misstatements. For example, they may be effective for testing the completeness assertion.
nature of assertion
operating income/sales Operating income is calculated before subtracting interest and taxes. Nonproportional changes in either operating income or net sales cause a change in the ratio.
net operating margin %
Obtain output and judge whether the identified items warrant further auditor consideration.
perform the ADA
Relationships in stable environments are more predictable than those in unstable environments, and income statement amounts tend to be more predictable than balance sheet amounts. The reason is that income statement amounts are based on transactions over a period of time, but balance sheet amounts are for a moment in time. Amounts subject to management discretion may be less predictable.
plausibility and predictability of relationship
As the expectation becomes more precise, significant differences between the expectation and management's reported number are more likely to be caused by misstatements. Ordinarily, the more detailed the information, the more precise the expectation. For example, monthly data provide more precise expectations than annual data.
precision of expectation
current assets-inventory/liabilities Quick assets are convertible to cash quickly. Auditors ordinarily calculate this ratio as current assets minus inventory. Thus, changes in inventory do not affect the quick ratio, but other components of the current ratio do.
quick ratio
sales/avg net receivables Auditors often calculate this ratio using ending net receivables as the denominator because it is the balance being audited. Changes in sales or receivables affect this ratio. In principle, the numerator should be net credit sales, but this amount may not be known. The ratio can also be calculated using gross receivables rather than net receivables. The key is to be consistent with the values in the ratios used for comparison purposes.
receivables turnover
a type of analytical procedure using auditor judgment to identify significant or unusual items to test.
scanning
These are procedures (tests of details and analytical procedures) designed to detect material misstatements at the assertion level.
substantive procedures
(net income+interest expense+income tax expense)/interest expense Times interest earned measures the ability of an entity to pay its interest charges. Taxes are added back to net income because interest is paid before taxes. Interest is added back to net income because it is included in the calculation of net income. An alternative is to exclude interest from the numerator and to add 1.0 to the quotient once the calculation is made. Changes in interest and net income may affect this ratio. If earnings decline sufficiently, no income tax expense will be recognized.
times interest earned
net sales/total assets This ratio calculates how many times the total assets turn over in sales. It is affected by changes in sales and total assets. The denominator also may be average total assets.
total asset turnover