Role of Financial Statement

Analysis
in conducting
Statutory Audits of
Corporations…….

Audit framework and

regulations
 Link between Financial Statement
Analysis and Statutory Audit

“Within the function of Statutory Audit (which

has been narrated in upcoming slides) is heavily
reliant on Financial Statement Analysis or
Analytical Review or AR. Yes this is how Financial
Statement Analysis is termed technically in
AUDIT ”

“ This relationship is attempted to explain and

highlight in upcoming part of the discussion”

Audit framework and

regulations
 MOST COMPANIES….

SHAREHOLDER

COMPANY

MANAGEMENT

Audit framework and

regulations
 DEFINITIONS…….
..of ASSURANCE ..of AUDIT
“An ASSURANCE engagement “ An AUDIT of Financial
is one in which a Statements enables the
practitioner expresses a auditors to express an
conclusion designed to opinion as to whether the
enhance the degree of Financial Statements are
confidence of the intended prepared, in all material
users other than the respects, in accordance
responsible party about the with an applicable financial
outcome of the evaluation reporting framework. The
or measurement of a form the audit conclusion
subject matter against takes is that auditors state
criteria” whether the Financial
Statements give a true and
fair view. This is an
expression of reasonable
assurance”

Audit framework and

regulations
 AUDIT OBJECTIVE
INDEPENDENT
EXPERT

EXPRESS AN
OPINION

FINANCIAL
FINANCIAL STATEMENTS ARE
STATEMENTS ARE NOT MATERIALLY
“TRUE & FAIR” FINANCIAL
STATEMENTS MISSTATED
PREPARED
IN ACCORDANCE
WITH LAW
& REGS
 Materiality………….

“Information is material if its

omission or misstatement could
influence the economic decisions of
users taken on the basis of the
Financial Statements”
ISA 320 (this standard has been revised.
Details will be discussed in ch6)

Audit framework and

regulations
 TRUE & FAIR
TRUE……….. FAIR………….
• Not false • Free from self-
• Genuine interest
• Balanced • Not biased
• Properly aligned • Not excessive or
Accurate extreme
•
• Conforming with
established
standards

Audit framework and

regulations
 DEFINITIONS…….
..of ERROR ..of FRAUD

 a wrong action attributable to  intentional deception resulting

bad judgment or ignorance or in injury to another person
inattention
 deception made for personal
 inadvertent incorrectness gain

 misconception resulting from  illegal acts characterised by

incorrect information deceit, concealment or
violation of trust
 An act, assertion, or belief
that unintentionally deviates  the use of one's occupation
from what is correct, right, or for personal enrichment
true through the deliberate misuse
or misapplication of employing
ERROR IS NOT INTENTIONAL an organisation's resources or
assets

FRAUD IS INTENTIONAL

Audit framework and

regulations
 ERROR
MANAGEMENT RESPONSIBILITY
o Designing and implementing a system of internal control
capable of preventing, or detecting and correcting, errors in
the financial records

AUDITORS RESPONSIBILITIES
o Assessing and testing internal controls and ensuring they
are capable of preventing/detecting error
o Designing procedures to detect errors
o Detecting material misstatements of which some may be
errors
o Reporting “SIGNIFICANT DEFICIENCIES” to those
charged with governance (CFOs, FMs, Finance directors etc)
o Provide an opinion whether the Financial Statements are
free from material misstatement caused by error

Audit framework and

regulations
THE PLANNING PROCESS

Develop audit Select

Select
Assess strategy based Assess appropriate
Audit
RISK on RISK materiality audit
Team
assessment procedures

Audit planning
 How do we assess risk

Assess
RISK

OBTAIN KNOWLEDGE OF
THE BUSINESS

ANALYTICAL REVIEW

Audit planning
 ANALYTICAL REVIEW
• Used in all 3 stages of the audit (planning, execution and
completion)

• Compare similar data to identify trends ie debtors days, net

profit margin

• To begin with generally we compare P&L and BS year-on-

year to determine unusual variances

• Then auditors will generally do further testing on balances

ie ratio analysis, statistical trends

• This will focus our attention to certain key areas requiring

further testing

Audit planning
 Benefits and limitations of Analytical
Review
Benefits: Limitations:
• Identifies items for attention • Good business knowledge is
that detailed tests may miss required to accurately assess the
results
•Makes use of information outside
accounting records ie budgets •Consistent material errors/fraud
may be concealed
•Allows comparison of data from
different sources •Professional scepticism may not
be applied

•An experienced and

knowledgeable member of the
team must do the review

•Reliable data may not be

available

Audit planning
Selecting appropriate
audit procedures….
The auditor must assess
the risk of material
CONTROLS TESTS misstatement to FS’s
OF DETAIL then plan and carry out
work that addresses the
risk and ensures a
ANALYTICAL
conclusion can be drawn:
PROCEDURES
- true and fair view
- FS’s are not materially
misstated

Audit planning
Procedures available
 Tests of control
 Tests of detail ie on assertions
 AR
 External confirmations
 CAAT’s
 Internal audit
 Work of others
 Management representation
Audit procedures
 GENERAL
Things you always need to do in an audit:
o Understand the system
o Analytical review
o Document your work
o Obtain sufficient audit evidence to reduce the risk to an
acceptable level

Things to always consider:

o The event/transaction that took place
o The nature of the item (asset, liability, income or expense)
o The assertion being tested
o If a BS item, the balance at the year-end
o Presentation and disclosure

Audit procedures
 AR RATIOS
• Profitability – Gross Margin
- Net Margin

• Efficiency - Receivable days

- Payable days
- Inventory turnover

• Liquidity - Current ratio

- Quick ratio
- Gearing ratio

• Returns - ROCE

Audit procedures
 AR RATIOS
• Gross Margin: Gross Profit / Sales * 100%
• Purpose: For most business the margin b/w Sales & COS is what
generates the profits the biz needs to pay the wages, service any debts
& eventually pay dividends to shareholder. The Lower the Margin the
greater the Sales volume is needed
• Net Margin: PBT/Sales * 100%
• Purpose: PBT is what left after all costs and its simplest enables
dividends to be paid to sharehodlers

• Receivable days: Receivables / Sales Revenue *365

• Purpose: Indicates how quickly or slowly the business is generating cash
by collecting it in from customers. Detoriration may be an indication of
disputes with the customers or non recoverability of receivables
-

Audit procedures
 AR RATIOS
• Payable days : Payables / COS* 100%
• Purpose: To show how long the company is taking to pay its
suppliers. May be indicative of cash flow problems or extended
credit terms taken
• Inventory turnover: Inventory / Cost of Sales * 100%
• Purpose: How many days worth of cost of sales are tied up in
inventory. To show how much the buz has invested in its inventory.
Slower Inventory turnover may indicate excessive inventory
holdings. Over optimistic valuation or building up inventory for the
launch of new product

• Current ratio : Current Assets / Current Liabilities

• Purpose: Indicates the biz ‘s ability to settle its current liabilities

Audit procedures
 AR RATIOS
• Quick ratio : Quick Assets / Current Liabilities
• Purpose: A refinement of the CR which eliminates less liquid assets
(inventory) from the equation
• Gearing ratio : Share Capital+Reserves / Borrowings
• Purpose: To show relative reliance of the business on the external or
internal sources of finances. Biz with higher leverage are regarded
as more risky – greater danger of being financially over stretched,
but the opportunity of greater rewards for individual shareholders

• ROCE : PBIT/ Share Capital+Reserves

• Purpose: Is the biz giving sufficient returns compared with other
possible investments? ROCE is useful measure for large diversified
group that can switch its funds. Not very useful measure for small or
owner managed where choice of investemetns limited

Audit procedures
ANALYTICAL PROCEDURES
 When must AR be used?

 What type of AR procedures can be used?

 In order to use AR, you need to do the following:

- create an expectation of what the balance should be
- compare the expectation to the actual results
- investigate significant variations

ie debtors days should be 35 days in line with prior year as

there have been no significant changes in products/collections
procedures. Debtors days work out to be 50 days so discuss
with management to determine why there is a large variation

When would AR not be useful?

Audit procedures
ANALYTICAL PROCEDURES
 Example 2: Create an expectation of payroll cost for the year
by taking last year’s cost and inflating for payrise and change in
staff numbers – proff in total
 Example 3: Plot monthly sales data for the prior year and plot
against the current year and investigate any unusual trends –
Trend Analysis .
 Example 3: using client’s depreciation policy, re-compute the
expected depreciation charge and compare it with the actual
depreciation charge. If there is a significant difference it
should be investigated

When would AR not be useful?

Audit procedures
AR 4 CONSIDERATIONS
 Is AR suitable?
For example, AR cannot confirm existence of inventory
 Is AR reliable?
If controls are weak then AR may give limited reliability
 Will AR give precision?
For example, AR is unlikely to give precision where there is
discretionary spend ie R&D
 Can a standard acceptable variation be used?
Not really

Audit procedures
 AUDIT ASSERTIONS
 Occurrence – did the transaction actual take place?
 Existence – do the assets/liabilities actually exist?
 Rights and obligations – does the client have the right to
own the asset? Is there a genuine obligation to pay?
 Cut-off – are transactions recorded in the right period?
 Valuation – is the value accurate?
 Completeness – are all transactions/balances that should be
included in the FS’s actually included?
 Accuracy – is all the data relating to the transaction /event
recorded appropriately?
 Presentation & disclosure – are transaction included in the
right place (correct general ledger) then mapped to the
right financial statements heading and in line with
accounting standards?

Audit procedures
 FILE REVIEW

FINANCIAL WORK
STATEMENTS PERFORMED

- AR - In line with plan

- Compliance OPINION - Appropriately
- Completion flexed plan if
procedures required
- Report - Right work
wording - Enough work
- Issues (inc CG &
errors)

Completion and review

ANALYTICAL PROCEDURES
 ABC co has done Sales Revenue of 1m while Gross Profit margins
are 35%. Calculate COS?
 DU Corporation Sales Inventory Blance is $2m and Inventory
days is 40days. Calculate Cost of Sales?
 UT Company has achieved Sales revenue of $3m. While balance
of Receivable $300,000. Calculate Receivable Turnover in days
and in times .
 If Jam Corporation has Total Sales figure of $10m out of which
$8m is on credit. Their Receivable days balance is 35days.
Calculate the balance of Receivable
 AMD company’s Annular report is showing opening balance of
the inventory as $1m. The closing balance is $2m. Purchases
during the period is $9m. Calculate Inventory Turnover?

Audit procedures