Analytical Procedures

When performing analytical procedures in the planning stage, the auditor most likely would develop expectations by reviewing which of the following sources of information? A. Unaudited information from internal quarterly reports B. Various account assertions in the planning memorandum C. Comments in the prior year's management letter D. The control risk assessment relating to specific financial assertion

Ans A. Analytical procedures applied during the planning stage would help enhance the auditor's understanding of the client's business and the transactions and events that have occurred since the last audit date. The auditor would also be scanning for areas that may represent specific risks relevant to the audit. The best answer choice to assist the auditor with planning would be to perform analytical procedures on the unaudited information from internal quarterly reports. Account assertions, comments on the management letter, and the control risk assessment would be addressed in later phases of the audit.

An important element in the effective application of analytical procedures is the development by the auditor of relevant expectations regarding the client's financial statements. As expectations on the part of the auditor become more precise: A. the range of expected differences become narrower, and, accordingly, the likelihood increases that significant differences from the expectations are due to misstatements. B. analytical procedures become less relevant in the final review stage of the audit due to the appropriateness of substantive tests performed during the audit. C. the range of expected differences becomes narrower, and, accordingly, the likelihood decreases that significant differences from the expectations are due to misstatements. D. the range of expected differences becomes broader, and, accordingly, the likelihood decreases that significant differences from the expectations are due to misstatements.

Ans A. When the expectations of the auditor are more precise, there is a greater likelihood that significant differences from the expectations are due to misstatements. This is due to the fact that auditors are better able to anticipate appropriate client results and results that are inconsistent with the auditor's expectations are likely to be the result of some form of financial statement error or fraud.

An auditor discovered that a client's accounts receivable turnover is substantially lower for the current year than for the prior year. This may indicate that: A. fictitious credit sales have been recorded during the year. B. employees have stolen inventory just before the year-end. C. the client recently tightened its credit-granting policies. D. an employee has been lapping receivables in both years.

Ans A. Accounts receivable turnover is affected by the balance in accounts receivable, so fictitious credit sales could be the cause. The other answer choices would not cause the turnover ratio to decrease. If fictitious sales were recorded, the net credit sales (numerator) would increase. Since the sales are not real, the ending accounts receivable balance would also be higher than normal. These "fake" receivables are also not being repaid. This in turn, means that the average receivables (denominator) would get larger. This would in all likelihood result in a lower receivable turnover ratio.

Which of the following actions is an analytical procedure that an auditor most likely would use while auditing a company's notes payable? A. Multiplying the average outstanding loan balance by the interest rate and comparing the result to interest expense actually recorded B. Performing calculations to determine if the company is in compliance with debt covenants C. Sending a confirmation to the lender requesting verification of the loan's outstanding balance D. Reviewing the details of the company's loan and interest expense accounts to determine that all payments were properly recorded

Ans A. Analytical procedures are the evaluation of financial information through analysis of plausible relationships among both financial and nonfinancial data. There is a plausible relationship to an average loan balance being multiplied by an interest rate and comparing the result to interest expense since interest expense is determined by multiplying a loan balance by an interest rate. Confirmation is another form of substantive procedures that is separate and distinct from analytical procedures. Calculations performed to determine compliance with debt covenants could be considered an analytical procedure on nonfinancial information but would not be useful to audit notes payable.

On December 30, 20X1, Vida Co. had cash of $200,000, a current ratio of 1.5:1 and a quick ratio of 0.5:1. On December 31, 20X1, all cash was used to reduce accounts payable. How did these cash payments affect the ratios? A. Increased current ratio and decreased quick ratio B. Increased current ratio and no effect on quick ratio C. Decreased current ratio and increased quick ratio D. Decreased current ratio and no effect on quick ratio

Ans A. Note that cash is included in the numerator and accounts payable is in the denominator of both ratios: Current ratio = Current assets / Current liabilities Quick ratio = Quick assets / Current liabilities In the case of the current ratio, assume that the 1.5:1 ratio represents $150 of current assets to $100 of current liabilities. If $50 of cash is used to pay off $50 of current liabilities the current ratio is increased to 2:1 (i.e., $100 of current assets to $50 of current liabilities). This would occur in any situation in which the ratio was greater than 1:1. If a ratio is less than 1:1, the opposite would hold true. In Vida Co.'s case the quick ratio would decrease.

Which of the following circumstances most likely would cause an auditor to suspect an employee payroll fraud scheme? A. There are significant unexplained variances between standard and actual labor cost. B. Payroll checks are disbursed by the same employee each payday. C. Employee timecards are approved by individual departmental supervisors. D. A separate payroll bank account is maintained on an imprest basis.

Ans A. Requiring that timecards be approved by supervisors and establishing a separate payroll bank account on an imprest basis are actually controls that would tend to prevent employee payroll fraud schemes. Although periodic rotation of duties may be desirable, there is nothing about having the same employee disburse payroll checks each payday that would cause an auditor to suspect an employee payroll fraud scheme. Of the responses provided, only significant unexplained variances between standard and actual labor cost would cause an auditor to suspect an employee payroll fraud scheme. Because a standard cost system is a budgeted unit cost system designed to alert management when actual costs of production differ from expected costs, the plausible relationships the auditor looks for in analytical procedures have been established, and variances from them would alert the auditor to potential problems.

An auditor's analytical procedures indicate a lower than expected return on an equity method investment. This situation most likely could have been caused by: A. an error in recording amortization of the excess of the investor's cost over the investment's underlying book value. B. the investee's decision to reduce cash dividends declared per share of its common stock. C. an error in recording the unrealized gain from an increase in the fair value of available-for-sale securities in the income account for trading securities. D. a substantial fluctuation in the price of the investee's common stock on a national stock exchange.

Ans A. The return on common stockholders' equity is (net income less preferred dividends) divided by the average common stockholder's equity. Reducing the cash dividend of common stock or a fluctuation in the price of the investee's common stock would not affect this ratio.

Which of the following statements is correct regarding the predictability of analytical procedures in a financial statement audit? A. Relationships involving only balance sheet accounts tend to be more predictable than relationships involving income statement accounts. B. Relationships involving income statement accounts tend to be more predictable than relationships involving only balance sheet accounts. C. Relationships involving transactions subject to management discretion tend to be more predictable than automated transactions. D. Relationships in a dynamic environment tend to be more predictable than relationships in a stable environment.

Ans B. AU-C 520.A10 states, "Relationships in a stable environment are usually more predictable than relationships in a dynamic or unstable environment. Relationships involving income statement accounts tend to be more predictable than relationships involving only balance sheet accounts because income statement accounts represent transactions over a period of time, whereas balance sheet accounts represent amounts of a point in time."

An auditor compares annual revenues and expenses with similar amounts from the prior year and investigates all changes exceeding 10%. This procedure most likely could indicate that: A. fourth quarter payroll taxes were properly accrued and recorded, but were not paid until early in the subsequent year. B. unrealized gains from increases in the value of available-for-sale securities were recorded in the income account for trading securities. C. the annual provision for uncollectible accounts expense was inadequate because of worsening economic conditions. D. notice of an increase in property tax rates was received by management, but was not recorded until early in the subsequent year.

Ans B. Analytical procedures are substantive procedures used in the planning and overall review stages of the audit. In the planning stage, an analytical procedure which compares annual revenues and expenses with similar amounts from the prior year-end would tell the auditor where the material misstatements may be, and which accounts may need more detailed testing. The auditor would be able to compare the income account for trading securities this year to last year and see that this year's balance had greatly increased. The next step would be to examine a detailed ledger for the account and determine what had been recorded in that account that either had not occurred last year or had been recorded in error. The best response to this question is that unrealized gains from increases in the value of available-for-sale securities were recorded in the income account for trading securities (when they should possibly have been recorded elsewhere according to generally accepted accounting principles). The accrual of payroll taxes, the provision for uncollectible accounts, and an increase in accounts payable for a property tax increase would be examined in an analytical review of the balance sheet, not the income and expenses.

An auditor's analytical procedures most likely would be facilitated if the entity: A. Segregates obsolete inventory before the physical inventory count. B. Uses a standard cost system that produces variance reports. C. corrects material weaknesses in internal control before the beginning of the audit. D. develops its data from sources solely within the entity.

Ans B. Analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data. A basic premise underlying the application of analytical procedures is that plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary. Because a standard cost system is a budgeted unit cost system designed to alert management when actual costs of production differ from expected costs, the plausible relationships the auditor looks for in analytical procedures have already been established in a standard cost system. Therefore, an auditor's analytical procedures most likely would be facilitated if the entity uses a standard cost system that produces variance reports.

Which of the following would not be considered an analytical procedure? A. Estimating payroll expense by multiplying the number of employees by the average hourly wage rate and the total hours worked B. Projecting an error rate by comparing the results of a statistical sample with the actual population characteristics C. Computing accounts receivable turnover by dividing credit sales by the average net receivables D. Developing the expected current-year sales based on the sales trend of the prior five years

Ans B. Analytical procedures evaluate significant ratios, operating statistics, and trends in financial data. Projecting an error rate by comparing the results of a statistical sample with the actual population characteristic is a use of tests of details, not analytical procedures.

Gil Corp. has current assets of $90,000 and current liabilities of $180,000. Which of the following transactions would improve Gil's current ratio? A. Refinancing a $30,000 long-term mortgage with a short-term note B. Purchasing $50,000 of merchandise inventory with a short-term account payable C. Paying $20,000 of short-term accounts payable D. Collecting $10,000 of short-term accounts receivable

Ans B. Original current ratio: Current assets $90,000 1 Current ratio = ------------------- = ----------- = --- Current liabilities $180,000 2 To improve its current ratio, Gil Corp. must produce either a net proportionate increase to its current assets or a net proportionate decrease to its current liabilities. While purchasing $50,000 of merchandise inventory with a short-term account payable increases both current assets and current liabilities by the same amount ($50,000), the proportionate increase is greater for current assets, thus improving the current ratio: $90,000 + $50,000 $140,000 14 28 1 23 ------------------ = -------- = -- = -- > - or -- $180,000 + $50,000 $230,000 23 46 2 46 (the beginning current ratio) This is greater than the original current ratio of 0.5%, so the current ratio improved in this situation. Refinancing a $30,000 long-term mortgage with a short-term note increases current liabilities. Paying $20,000 of short-term accounts payable decreases current assets (cash paid). The decrease to current assets is proportionately more than the decrease to current liabilities. Both of the transactions make the current ratio worse. Collecting $10,000 of short-term accounts receivable has no net effect; cash is increased, but accounts receivable is decreased.

An auditor discovered that a client's accounts receivable turnover is substantially lower for the current year than for the prior year. This may indicate that: A. obsolete inventory has not yet been reduced to fair market value. B. there was an improper cutoff of sales at the end of the year. C. an unusually large receivable was written off near the end of the year. D. the aging of accounts receivable was improperly performed in both years.

Ans B. The accounts receivable turnover ratio is: Net Credit Sales ------------------- Average Receivables If the divisor (average receivables) of this ratio increases without a change in the net credit sales, the ratio would be lower. This situation would occur if the company did not properly cut off sales at the end of the year and recorded more in accounts receivable than should have been recorded. The reduction of the value of obsolete inventory has nothing to do with the accounts receivable turnover ratio. If the company had written off an unusually large receivable near the end of the year, the average receivables would decrease, and the ratio would be higher. The aging of receivables would not change the average receivables calculation.

Which of the following comparisons would an auditor most likely make in evaluating an entity's costs and expenses? A. The current year's accounts receivable with the prior year's accounts receivable B. The current year's payroll expense with the prior year's payroll expense C. The budgeted current year's sales with the prior year's sales D. The budgeted current year's warranty expense with the current year's contingent liabilities

Ans B. The auditor is required to use analytical procedures in the planning stage of an audit. The assumption is made that there are reasonable relationships among the data from year to year. In evaluating costs and expenses, income statement items are most relevant. Of the answers listed, only "The current year's payroll expense with the prior year's payroll expense" compares expenses found on the income statement from one period to the next.

Heath Co.'s current ratio is 4:1. Which of the following transactions would normally increase its current ratio? A. Purchasing inventory on account B. Selling inventory on account C. Collecting an account receivable D. Purchasing machinery for cash

Ans B. The current ratio is computed by dividing current assets (CA) by current liabilities (CL). Thus, a current ratio of 4:1 means Heath has four times more current assets than current liabilities. Both inventory and accounts receivable are current assets which appear in the numerator when computing the current ratio. However, since inventory is sold on account at a price greater than its cost, current assets will increase by the sales price amount and decrease by the cost of inventory sold. Thus, selling inventory on account will increase the current ratio. Purchasing inventory on account increases current assets and current liabilities by the same amount. However, the absolute change is not all you need to consider. Because the current ratio is 4:1, the proportionate effect of an increase in CL will be greater than the effect of an equal increase in CA. Thus, the current ratio will decrease. Collecting an account receivable has no effect on the current ratio. Current assets increase (cash) and decrease (AR) by the same amount. Machinery is a noncurrent asset. Thus, purchasing machinery for cash decreases CA (cash) which decreases the current ratio.

An auditor's decision either to apply analytical procedures as substantive tests or to perform tests of transactions and account balances usually is determined by the: A. availability of data aggregated at a high level. B. relative effectiveness and efficiency of the tests. C. timing of tests performed after the balance sheet date. D. auditor's familiarity with industry trends.

Ans B. n discussing analytical procedures, AU-C 520.A7 notes that the choice of analytical procedures as a substantive test, when compared to the use of the tests of details of transactions and amount balances, depends "on the auditor's professional judgment about the expected effectiveness and efficiency of the available audit procedures."

An auditor is testing the reasonableness of dividend income from investments in publicly held companies (issuers). The auditor most likely would compute the amount that should have been received and recorded by the client by: A. reading the details of the board of directors' meetings. B. confirming the details with the investee companies' registrars. C. electronically accessing the details of dividend records on the Internet. D. examining the details of the client's most recent cutoff bank statement.

Ans C Analytical procedures compare recorded amounts with expectations developed by the auditor. Stronger, more reliable evidence to assist the auditor with developing the expectation comes from sources outside the entity. Only two choices represent sources outside the entity. Electronically accessing the details of dividend records on the Internet would be the best way for the auditor to quickly form an expectation for the amount of dividends the company should have received. The registrar keeps records of outstanding stock certificates for an issuer; it would not have knowledge of the dividends paid.

Which of the following would not be considered an analytical procedure? A. Converting dollar amounts of income statement account balances to percentages of net sales for comparison with industry averages B. Developing the current year's expected net sales based on the sales trend of similar entities within the same industry C. Projecting a deviation rate by comparing the results of a statistical sample with the actual population characteristics D. Estimating the current year's expected expenses based on the prior year's expenses and the current year's budget

Ans C Analytical procedures consist of evaluations of financial information through analysis of plausible relationships among both financial and nonfinancial data. A basic premise underlying the application of analytical procedures is that plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary. Analytical procedures involve comparisons of recorded amounts, or ratios developed from recorded amounts, to expectations developed by the auditor. Examples of sources of information for developing expectations include: comparable information for prior periods, anticipated results (e.g., budgets or forecasts including extrapolations from interim or annual data), relationships among elements of financial information within the period, similar industry information (e.g., gross margin information), and relationships of financial information with relevant nonfinancial information. Projecting a deviation rate by comparing the results of a statistical sample with the actual population characteristics is a procedure used to interpret the result of statistical sampling, and is not an analytical procedure.

Analytical procedures used in planning an audit should focus on: A. reducing the scope of tests of controls and substantive tests. B. providing assurance that potential material misstatements will be identified. C. enhancing the auditor's understanding of the client's business. D. assessing the adequacy of the available audit evidence.

Ans C. The auditor must obtain adequate knowledge of the client's business to plan and perform the audit in accordance with GAAS. This knowledge includes an understanding of: events, transactions, and practices which may have a significant effect on the financial statements, the nature of the entity's business, organization, and operating characteristics, and matters affecting the entity's industry. Therefore, the analytical procedures used in planning an audit should focus on enhancing the auditor's understanding of the client's business.

At December 31, 20X2, Curry Co. had the following balances in selected asset accounts: 20X2 Increase over 20X1 ------- ------------------ Cash $ 300 $100 Accounts receivable, net 1,200 400 Inventory 500 200 Prepaid expenses 100 40 Other assets 400 150 ----- ---- Total assets $2,500 $890 ====== ==== Curry also had current liabilities of $1,000 on December 31, 20X2, and net credit sales of $7,200 for the year then ended. What was the average number of days to collect Curry's accounts receivable during 20X2? A. 30.4 B. 40.6 C. 50.7 D. 60.8

Ans C. The average number of days to collect is 50.7: Accounts receivable turnover = Net credit sales / Avg. accounts receivable = $7,200 / (0.5 x ($800 + $1,200)) = $7,200 / $1,000 = 7.2 Avg. days to collect = Days in year / Accounts receivable turnover = 365 / 7.2 = 50.7 days =========

An auditor's decision whether to apply analytical procedures as substantive tests usually is determined by the: A. availability of documentary evidence that should be verified. B. extent of accounting estimates used in preparing the financial statements. C. precision and reliability of the data used to develop expectations. D. number of transactions recorded just before and just after the year-end.

Ans C. The procedures used to obtain sufficient appropriate audit evidence must be both effective and efficient. When making the decision of whether to apply analytical procedures or tests of details to a certain account balance or class of transactions, the auditor should consider the: nature of the assertion, plausibility and predictability of the relationship, availability and reliability of data, and precision of the expectation. The availability of documentary evidence (for example, if it is available only for a short period of time) would cause the auditor to change the timing of substantive tests instead of the nature of the tests. Each account balance or class of transactions should be addressed individually when determining the nature of the tests to be performed, rather than making the decision based on the overall number of estimates in the financial statements or on the number of transactions before or after year-end.

In auditing payroll, an auditor most likely would: A. Verify that checks representing unclaimed wages are mailed. B. trace individual employee deductions to entity journal entries. C. observe entity employees during a payroll distribution. D. compare payroll costs with entity standards or budgets.

Ans D. In auditing payroll, the crucial audit concern is: "Are recorded payroll costs accurate and as expected?" A comparison of actual to expected is the basis of analytical procedures. Thus, procedures for auditing payroll generally include an analytical comparison of recorded payroll costs with entity expectations, i.e., the standards or budgets. Payroll is well suited for substantive testing by analytical procedures because the relationships tend to be very predictable and recorded costs very reliable. Verifying that checks representing unclaimed wages are mailed, tracing employee deductions to journal entries, and observing a payroll distribution are tests of controls which provide no substantive evidence about the payroll amounts reported in the financial statements.

Which of the following ratios would an engagement partner most likely calculate when reviewing the balance sheet in the overall review stage of an audit? A. Quick assets ÷ Current assets B. Accounts receivable ÷ Inventory C. Interest payable ÷ Interest receivable D. Total debt ÷ Total assets

Ans D. Analytical procedures can be used as a substantive test to obtain audit evidence about particular assertions related to account balances or classes of transactions. Analytical procedures are required in the planning phase and overall review stages of the audit and consist of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial information. Analytical procedures can consist of ratios developed from recorded amounts. In the answer choices given, only Total debt ÷ Total assets provides a plausible relationship among financial data. Current assets are a component of the quick asset ratio. Accounts receivable and inventory are not related as neither are interest payable and interest receivable.