Question

You have obtained the following information:

STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR TO 31 DECEMBER

			20X8	20X7
		Note	Draft ($m)	Actual ($m)
Revenue		(1)	645.5	606.5
Other income		(2)	15.6	14.4
Changes in inventories			3.8	(16.4)
Cost of materials			(334.1)	(286.8)
Employee benefits expense			(91.0)	(83.9)
Depreciation		(3)	(29.8)	(23.6)
Other expenses		(4)	(116.3)	(100.6)
Interest income, net		(5)	12.3	(20.9)
Profit before tax			106.0	130.5
Income tax expense			(44.4)	(47.7)
Profit for the year			61.6	82.8

STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER

			20X8	20X7
		Note	Draft ($m)	Actual ($m)
Assets
Non-current assets
Intangible assets		(6)	47.8	40.5
Property, plant and equipment		(7)	124.5	102.5
			172.3	143.0
Current assets
Inventories		(8)	30.3	27.9
Trade receivables			73.1	50.3
Cash and cash equivalents			111.4	86.0
Total assets			387.1	307.2
Equity and liabilities
Equity			5.8	5.8
Share capital			15.3	15.3
Share premium			112.1	80.1
Retained earnings			133.2	101.2
Non-current liabilities
Provisions		(9)	160.1	121.4
Current liabilities
Trade payables			33.5	31.8
Tax			50.4	44.3
Other liabilities			9.9	8.5
Total equity and liabilities			387.1	307.2

Notes

(1)   Revenue from business activities:

Revenue from business activities
	20X8 ($M)	20X7 ($M)
Vehicles	588.0	526.0
Parts and accessories	39.6	36.8
Other	17.9	43.7
	645.5	606.5

Other income includes gains on the disposals of tangible assets and income from the reversal of provisions.

Average number of employees:

	20X8 (Draft)	20X7 (Actual)
Wage earners	484	499
Salaried employees	483	477
Apprentices and trainees	36	37
	1,003	1,013

Other expenses include costs for warranties, administration and distribution, maintenance and insurance.

Interest income, net:

	20X8 (Draft ($m)	20X7 (Actual $m)
Interest and similar income	16.8	25.1
Interest and similar expenses	(4.5)	(4.2)
	12.3	20.9

Intangible assets include development costs, also franchises and industrial rights and licenses. During the year, $12.7 million (20X7 - $6.3 million) was spent on developing a new sports model, the Fox.

Property, plant and equipment:

	Land and Buildings	Equipment	Assets under construction	Total
	$m	$m	$m	$m
Cost
1 January 20X8	61.8	212.1	19.0	292.9
Additions	5.0	28.9	9.4	43.3
Disposals	0.0	(4.5)	0.0	(4.5)
Reclassification	3.0	8.9	(11.9)	0.0
31 December 20X8	69.8	245.4	16.5	331.7
Depreciation
Current year	1.9	18.4	0.0	20.3
Accumulated	28.7	178.5	0.0	207.2
Net book value
31 December 20X8	41.1	66.9	16.5	124.5
31 December 20X7	34.9	48.6	19.0	102.5

(8)   Inventories comprise:

	20X8 (Draft $m)	20X7 (Draft $m)
Raw materials, consumables and supplies	8.3	7.3
Work-in-progress	6.8	4.8
Finished goods	15.2	15.8
	30.3	27.9

(9) Provisions mainly cover manufacturing warranty, product liability and litigation risks. Also, provisions have been established for deferred maintenance and IT reorganization.

The following additional information is available:

(i) Pavia has achieved record sales in 20X8 with the delivery of 10,153 vehicles (20X7 – 7,642 vehicles).

(ii) Although some sales are direct to individual customers the majority are ordered through dealers who take new vehicles on consignment.

(iii) Since 1 January 20X8 Pavia has offered 0% finance for three years on new vehicle sales in its most competitive markets.

(iv) The launch of the Fox has been postponed from late 20X8 to early 20X9 as internal trials have revealed that the doors are not sufficiently secure at high speeds.

(v) A car part required for the Cipeta model is bought-in exclusively from an overseas manufacturer. Deliveries of supplies have been unpredictable in 20X7 causing disruption to the Cipeta model assembly schedules.

1. Evaluate how you might use analytical procedures to provide audit evidence and reduce the level of detailed substantive procedures.

N.B these are pointers are for this question:

Analytical Procedures - Examples: o Receivables - Receivables - Compare gross margin % with previous years (by product line). (Possible misstatement – Over/understatement of sales and accounts receivable). This analytics will reduce the detailed substantive procedure because we have identified that there may be a possible over/understatement of sales so now we need to perform additional audit procedures on sales/revenue. For example by selecting a sample of invoices generated throughout the year and comparing to the General Ledger to ensure completeness and accuracy. Note: Use the information in the case to calculate the analytical procedures you have identified. Also, explain how the analytical procedures will provide audit evidence and help to reduce the level of detailed substantive procedures.

Answer 1

Answer:-

Analytical procedures are a type of evidence used during an audit. These procedures can indicate possible problems with the financial records of a client, which can then be investigated more thoroughly. Analytical procedures involve comparisons of different sets of financial and operational information, to see if historical relationships are continuing forward into the period under review. In most cases, these relationships should remain consistent over time. If not, it can imply that the financial records are incorrect, possibly due to errors or fraudulent reporting activity.

Examples :-

• Comparing the days sales outstanding metric to the amount for prior years. This relationship between receivables and sales should remain about the same over time, unless there have been changes in the customer base, the credit policy of the organization, or its collection practices. This is a form of ratio analysis.
• Reviewing the current ratio over several reporting periods. This comparison of current assets to current liabilities should be about the same over time, unless the entity has altered its policies related to accounts receivable, inventory, or accounts payable. This is a form of ratio analysis.
• Compare the ending balances in the compensation expense account for several years. This amount should rise somewhat with inflation. If not, there is a chance that fraudulent payments are being made to fake employees through the payroll system. This is a form of trend analysis.
• Examining trend line of bad debt expenses. This amount should vary in relation to sales. If not, management may not be correctly recognizing bad debts in a timely manner. This is a form of trend analysis.
• Multiply the number of employees by average pay to estimate the total annual compensation, and then compare the result to the actual total compensation expense for the period. The client must explain any material difference from this amount, such as bonus payments or employee leave without pay. This is a form of reasonableness test.

When the results of these procedures are materially different from expectations, we should discuss them with management. A certain amount of skepticism is needed when having this discussion, since management may not want to spend the time to delve into a detailed explanation, or may be hiding fraudulent behavior. Management responses should be documented, and could be valuable as a baseline when conducting the same analysis in the following year.

Analytical procedures include comparison of financial information (data in financial statement) with

1. prior periods
2. budgets
3. forecasts
4. similar industries and so on

It also includes consideration of predictable relationships, such as:

1. gross profit to sales,
2. payroll costs to employees,
3. financial information and non-financial information, for examples the CEO's reports and the industry news

Part B How the analytical procedures will provide audit evidence and help to reduce the level of detailed substantive procedures ?

Answer:-

Performing analytical procedures generally follows this four-step process:

1. Form an expectation. Here, we will develops an expectation of an account balance or financial relationship. Developing an independent expectation helps the auditor apply professional skepticism when evaluating reported amounts. Expectations are formed by identifying relationships based on the our understanding of the company and its industry. Examples of data that auditors use to develop their expectations include prior-period information (adjusted for expected changes), management’s budgets or forecasts, and ratios published in trade journals.
2. Identify differences between expected and reported amounts. we must compare our expectation with the amount recorded in the company’s accounting system. Then any difference is compared to the auditor’s threshold for analytical testing. If the difference is less than the threshold, the auditor generally accepts the recorded amount without further investigation and the analytical procedure is complete. If the difference is greater than the threshold, the next step is to investigate the source of the discrepancy.
3. Investigate the reason. The auditor brainstorms all possible causes and then determines the most probable cause(s) for the discrepancy. Sometimes, the analytical test or the data itself is problematic, and the auditor needs to apply additional analytical procedures with more precise data. Other times, the discrepancy has a “plausible” explanation, usually related to unusual transactions or events or accounting or business changes. For example, if a retail business reports higher-than-expected revenues, it could be explained by a change in the product mix or the opening of a new store.
4. Evaluate differences. The auditor evaluates the likelihood of material misstatement and then determines the nature and extent of any additional auditing procedures. Plausible explanations require corroborating audit evidence. For example, if a manufacturer’s gross margin seems off, the accounting department might explain that its supplier increased the price of raw materials. To corroborate that explanation, the auditor might confirm the price increase with its top supplier. Or, if an increase in cost of sales in one month was attributed to an unusually large sales contract, the auditor might examine supporting documentation, such as the sales contract and delivery dockets.

For differences that are due to misstatement (rather than a plausible explanation), the auditor must decide whether the misstatement is material (individually or in the aggregate). Material misstatements typically require adjustments to the amount reported and may also necessitate additional audit procedures to determine the scope of the misstatement.

The company being audited is likely to notice when an analytical procedure unearths a major difference between expected and reported results. How? First, the auditor will ask management to explain the discrepancy. Then the auditor might ask for supporting evidence to corroborate management’s response. In some cases, the auditor will conduct more in-depth testing than in previous years when analytical procedures reveal a major discrepancy. This will reduce the level of detailed substantive procedures which an auditor is required to follow in case he is not willing to implement Analytical procedures.