Question

2. In addition to the analytical procedures already listed in the memo, analyze an additional four that are useful in the planning process for the EarthWear audit. Discuss the meaning of the analytical procedures included and how they may affect your audit plan/procedures. Work Paper 3-6 and the Common Size Balance Sheet and Income Statement for EarthWear have been provided to assist you.

Analyze 4 additional analytical procedures that were completed in the planning process.

EarthWear's Quick Ratio is 0.73 and the industry average is 0.80

Discuss the meaning of the analytical procedure and how it may affect risks relating to the EarthWear audit or your planned audit procedures.

EarthWear's Inventory Turnover is 3.88 and the industry average is 6.20

Discuss the meaning of the analytical procedure and how it may affect risks relating to the EarthWear audit or your planned audit procedures.

EarthWear's Gross Profit Percentage is 43.90% and the industry average is 38.80%

Discuss the meaning of the analytical procedure and how it may affect risks relating to the EarthWear audit or your planned audit procedures.

EarthWear's Debt to Equity ratio is 0.50 and the industry average is 0.84

Discuss the meaning of the analytical procedure and how it may affect risks relating to the EarthWear audit or your planned audit procedures.

Answer 1

Meaning of the analytical procedure :- Evaluations of financial information through analysis of plausible relationships among both financial and non-financial data. Analytical procedures also encompass such investigation as is necessary of identified fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount. The auditor’s choice of procedures, methods and level of application is a matter of professional judgement.

Features of Analytical Procedure :-

1. This Audit Procedure use as a Substantive Procedure

2. The auditor shall design and perform analytical procedures near the end of the audit that assist the auditor when forming an overall conclusion as to whether the financial statements are consistent with the auditor’s understanding of the entity

3. Basically it involve comparison or relationships of Entities’ information whether financial or non financial like,

• Comparable information for prior periods.
• Anticipated results of the entity, such as budgets or forecasts, or expectations of the auditor, such as an estimation of depreciation.
• Similar industry information, such as a comparison of the entity’s ratio of sales to accounts receivable with industry averages or with other entities of comparable size in the same industry.
• Among elements of financial information that would be expected to conform to a predictable pattern based on the entity’s experience, such as gross margin percentages.
• Between financial information and relevant non-financial information, such as payroll costs to number of employees.

Analytical Procedures Tools

Trends

Analysing account fluctuations by comparing current year to prior year information and, also, to information derived over several years.

Reasonableness

Tests are made by reviewing the relationship of certain account balances to other balances for reasonableness of amounts. Examples of accounts that may be reasonably tested are:

• Interest expense against interest bearing obligations
• Raw Material Consumption to Production (quantity)
• Wastage & Scrap % against production & raw material consumption (quantity)
• Work-in-Progress based on issued of materials & Sales (quantity)
• Sales discounts and commissions against sales volume
• Rental revenues based on occupancy of premises

Ratios

Analysis by computation of ratios includes the study of relationships between financial statement amounts. Commonly used ratios include:

• Elements of income or loss as a percentage of sales
• Gross profit turnover
• Accounts receivable turnover
• Inventory turnover
• Profitability, leverage, and liquidity

Sources of information

• Interim financial information
• Budgets
• Management accounts
• Non-financial information
• Bank and cash records
• Indirect Tax returns
• Board minutes
• Discussion or correspondence with the client at the year-end

Other Aspects :-

If Auditor identify fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount, the auditor shall investigate such differences by:

(a)      Inquiring of management and obtaining appropriate audit evidence relevant to management’s responses; and

(b)     Performing other audit procedures as necessary in the circumstances.

How it may affect risks relating to the EarthWear audit :-  The auditor’s determination of the amount of difference from the expectation that can be accepted without further investigation is influenced by materiality and the consistency with the desired level of assurance, taking account of the possibility that a misstatement, individually or when aggregated with other misstatements, may cause the financial statements to be materially misstated. if the diffrence is significate from expectation or last years values than it is a red flag and need to investigate further. it requires the auditor to obtain more persuasive audit evidence the higher the auditor’s assessment of risk.

1. Quick Ratio

Quick (or acid test) ratio :- Current assets (except inventory)/Current liabilities
The quick ratio is useful when inventory is turned over slowly, as the payment of current liabilities will depend on receivables and cash. A quick ratio of less than one is often worrying, but it again depends on the business and comparatives. generally it should be 1:1. Here quick ration is lower than industry we can say realisation of cash is low or again of debtors is on question mark. 2. Inventory Turnover :- Inventory turnover is a ratio showing how many times a company's inventory is sold and replaced over a period of time. Cost of good sold divided by Avarage of opening and closing inventory. lower the ratio shows convertion of inventory into sales is very low.