Analytical review in planning an audit

A) Advantages
 Identify significant divergences in trends, earning components, assets
and liability structure and so on.
 Identify the effect of management policy decision an the company in
comparisons with industry average (may be good or bad or simply may
raise question)
 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:
 The clients may have operations that are significantly different
(at least in some portion) than the industry as a whole.
 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 the industry data.
 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 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 increases 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, with
competitiveness with other product. 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
cost of good sold has decreased to 55 per cent
of sales at the 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 increases The accounts payable 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 good 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:
 less stringent credit standards.
 Warranty problems (i.e., the
customers may not be paying because
problem with the product.) this would
be consistent with the interpretations
associated with inventory turnover.
 Unrecorded returned items or a
significant lag in issuing credit
memos associated with returned
items.
 Potential accounting recording
problems.

Employee turnover this is more difficult to interpret, but there is

60 per cent increases over previous year to a
rate that a 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 investment this ratio does not indicate a problem. In fact,

the company exceeds the industry average. An
alert auditors should wonder, however, how
the company is able to maintain a superior

Debt/equity ratio
return when there are problems with inventory
and receivables.
this ratio has increased substantially and is
double the industry average. The company has
become highly leveraged has three
implications the auditor ought to address.
 The existence of new debt covenants
that ought to be addressed as part of
the audit.
 A potential problem of remaining a
going concern should there be a
downturn in operations or a significant
increases in interest ate (on how the
debt is structured)
 There may be concern with how debt
proceeds have been utilised by the
company. Does it represent additional
capital, or it represents additional
capital, or is it being used for current
operating purposes? The auditor should
seek an answer to this question and
consider the implication of the answer
to the audit.

One important use of analytical procedures is to point to potential problems areas that
may affect the audit. The implication is that auditors should consider specifically how
the identified risk areas might reflect material misstatements in the financial report.
The risk areas identified above should lead the auditor to plan specific audit tests
including, but not limited to. The following:
 Expanded tests of inventory, pricing, return, warranties, and the accounting
procedures for recognising product returns.
 Expanded tests for potential inventory obsolescence include a detailed analysis
of industry trends, competitor products, current sales level, and so on.
 An expanded scope of receivables testing to determine the validity and
collectability of receivables that are increasingly older.
 A heightened awareness of any factors that might indicate fraud or material
misrepresentation on the part of management. The inconsistency reflected in
some of the economics data may indicate that management is deliberately
overstanding inventory and understanding cost of goods sold.
 These 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.
 In comparison with most standard audits, there should be a greater emphasis
on year end testing and very little reliance on management representation. The
risk of errors should point to a very sceptical audit.