Analytical Procedures - A Powerful Tool for Auditors - Essay Example

?REPORT: ANALYICAL PROCEDURES ANALYTICAL PROCEDURES: The assessment of financial information made through analyzing plausible relationships among thefinancial and non-financial information and data is called Analytical Procedures. These procedures include the comparison of the financial data of the company with financial information of prior periods, the expected results of the entity such as mentioned in forecasts, the auditor’s expectation or the financial information of other companies in the same industry in which the company operates. Moreover, the analysis of such financial information which may be expected to change over time in a predictable pattern and relationship between financial and non-financial information that are relevant to each other may also be performed through Analytical Procedures. While auditing a client, the analytical procedures are performed by the auditor at all stages of the audit. In planning stage, the analytical procedures are performed to gain a better understanding of the entity and identify and assess any risks that contradict the auditor’s basic understanding of the entity. At performance stage, the analytical procedures are performed as substantive procedures. The use of substantive analytical procedures during the audit increases the efficiency of the audit. The auditor shall also perform analytical procedures near the audit end. Those procedures will help the auditor to form an overall conclusion to evaluate whether the Financial Statements of the entity are consistent with the understanding of the auditor about the entity. During the audit, the analytical procedures may be applied by the auditor on the assertions of Completeness, Existence, Classification and Accuracy. Analytical procedures may be performed through various methods. These methods include simple comparisons and also complex mathematical and statistical analyses using advanced statistical formulae. The following mathematical and statistical tools are mostly used as analytical procedures: Financial ratio analysis Trend analysis Regression analysis Indicators analysis RATIO ANALYSIS: It is the most commonly used technique of financial analysis. The technique uses the study of relationships among several elements of the financial information. Various ratios may be found by using the formulae on the financial information of the company. The comparison may also be made by calculating ratios for the prior periods or the ratios for the competitor company. JD Sports Fashion PLC is a company engaged in selling and distribution sports goods and apparel. The company is the prospective audit client. Sports Direct International PLC is also engaged in the retailing and wholesale distribution of sports clothing, footwear and apparel. Thus, it stands as a strong competitor of JD Sports Fashion PLC. Financial Ratio Formulae JD Sports Fashion PLC Sports Direct International PLC 2008 2009 2010 2011 2011 Current Ratio Current Assets/ Current Liabilities 0.95 1.14 1.29 1.45 1.29 Acid Test Ratio Quick Assets/ Current Liabilities 0.30 0.50 0.73 0.87 0.53 Debt Ratio Total Liabilities/ Total Assets 0.57 0.53 0.54 0.50 0.64 Debt Coverage Ratio (Net Profit + Non-cash expense)/ Total debt 0.35 0.44 0.42 0.45 0.21 Return on Assets (Net Income/ Total Assets) x 100% 12.34% 11.11% 13.96% 15.19% 9.08% Return on Total Equity (Net Income/ Total Equity) x 100% 28.48% 23.62% 30.71% 30.35% 25.13% Net Profit Margin (Net Income/ Net Sales) x 100% 3.98% 3.65% 5.55% 6.32% 5.20% Cash Flow from Operations to Net Income Cash Flow from Operations/ Net Income 2.39 2.21 1.77 1.35 2.21 Cash flow Liquidity Ratio (Cash + Marketable Securities)/ Current Liabilities 0.13 0.28 0.49 0.62 0.21 The Ratio analysis, a tool of analytical procedures, may be used while making a decision about the financial performance of the entity. This will also assist the auditor to focus on any unusual deviations from expected amounts and thus, to evaluate whether these may cause a significant risk. The above table shows the financial ratios of JD Sports Fashion PLC for the financial years of 2008, 2009, 2010 and 2011. The table also shows the financial ratios of Sports Direct International PLC, which is a strong competitor of JD Sports Fashion PLC, for the year 2011. The current ratio ad acid test ratio determines the liquidity of its assets. It also helps to assess whether the company has sufficient ability to pay off its short-term liability with its liquid assets. In 2008, the company’s current ratio was 0.95 showing that the company has low ability to pay-off its current liabilities with its current assets. However, from 2009 onwards, the current ratio > 1 showing the company’s increasing ability to pay-off its current obligations. The competitor’s current ratio for 2011 is 1.29 against the company’s current ratio 1.45 which not only helps to determine the industry’s current ratio but also highlight the better current ratio of JD PLC against its competitor. The acid test ratio of JD PLC is also better than that of SD PLC. However, as acid test ratio < 1, it shows that the company’s cash and cash equivalents will not be sufficient alone to meet company’s current obligations. The debt ratio and debt coverage ratio of SD PLC for 2011 is 0.5 and 0.45 respectively. The debt ratio of the company has been decreasing since 2008 showing that the company’s long-term debts in relation to company’s assets have been decreasing over time. The company also possesses much better debt ratio than its competitor. The company’s debt coverage ratio has also been increasing over time and is better than that of SD PLC. These ratios show the increasing borrowing capacity of the company and increased degree of protection to suppliers of long-term funds. The return on assets and return on equity of JD PLC has been increased over time from 2008 to 2011. The ratios are also much better than that of its competitor SD PLC. However, in 2011, the return on total equity has been decreased negligibly. Such decrease, despite increase in company’s total equity, indicates that the income has increased to a greater extent. Thus, it is a positive sign for the company’s operating performance and its earning ability. Moreover, the return on assets has also been increased which describes the efficient management of assets by the company. The increase in JD PLC net income has also decreased the cash flows from operations to Net Income ratio from 2008 to 2011. Thus, such decrease is not a negative sign for the company. The cash flow liquidity ratio also shows that the cash inflow is increasing and thus, making up about 62% of the current liabilities of the company. This cash flow ratio also depicts the company’s short term borrowing capacity. The net Profit margin of JD PLC is also increasing and has reached to 6.32% by the end of 2011 as against to its competitor, SD PLC where such margin is 5.20%. Thus, the JD PLC is functioning viably and is a suitable choice for the investors to make investment. MEMORANDUM TO AUDIT PARTNER: To the Audit Partner of XYZ firm, JD PLC Company has approached to us for the audit of their Financial Statements. Before accepting the client, the auditor is required to perform certain audit procedures in order to evaluate whether to accept the audit client or not. In forming that opinion, we have performed analytical procedures as risk assessment procedures to identify any risks that may not be disclosed to the auditor. The analytical procedures have been performed according to applicable Financial Reporting Framework and have been used to evaluate the issues relevant to financial reporting of the entity. These procedures have also helped to assess the going concern of the company. The ratio analysis has been applied on all elements of financial statements. The results have revealed that the company is operating in a stable economic environment and is operating efficiently and effectively. The results also show a steady economic growth of the company and no unusual upward jump in the process of economic growth has been observed by us during the past five financial years of the company. The financial performance of the company also conforms to the financial performance of its competitor and the industry. Thus, nothing has come to our attention which may require us to believe that the company has been engaged in fraudulent Financial Reporting. We have also performed procedures to evaluate the legal eligibility of the firm to perform such engagement. The firm is legally competent and professionally qualified for such audit engagements. We have also contacted the retiring auditor for professional clearance. The screening procedures have also been performed on our side to check the acceptability of the company. We have evaluated the integrity and skills of the company’s management, significant accounting judgments made, accounting policies applied and internal controls of the entity over financial reporting. The volume and extent of unusual transactions that took place in the financial year have also been analyzed. After due verification, we report that nothing has come to our knowledge which may require us to disregard such audit engagement and therefore it is recommended that the company should be accepted as an audit client. References: 1. The Institute of Chartered Accountants of Pakistan, 2010. International Standard on Auditing 520- Analytical Procedures. International Federation of Accountants (IFAC). NY, USA. 2. Morning Star, 2012. FTSE Index Shares. [Online] Available at: [Accessed 25 October 2012]. 3. JD Sports Fashion PLC, 2011. Annual Financial Statements. [Online] Available at: [Accessed 25 October 2012]. 4. Sports Direct.com, 2011. The UK’S Number 1 Sports Retailer. [Online] Available at: [Accessed 25 October 2012]. 5. Accounting Concern.com. Analytical Procedures. [Online] Available at: [Accessed 25 October 2012]. 6. European Journal of Economics, Finance and Administrative Sciences, 2011. The Reality and Constraints of Using Analytical Procedures in the Control of Public Fund Jordanian Audit Bureau Case. [Online] Available at: [Accessed 25 October 2012]. 7. vuZs, 2012. Definition and Formulas Related to Ratio Analysis. [Online] Available at: [Accessed 25 October 2012]. 8. eHow, Marquis, C., 2012. What are Long-Term Debt Paying Ability Ratios? [Online] Available at: [Accessed 25 October 2012]. 9. Bizwiz. Cash Flow to Long Term Debt Ratio. [Online] Available at: [Accessed 25 October 2012]. 10. Transnational Auditors Committee, 2012. Client Acceptance and Continuance. [Online] Available at: [Accessed 25 October 2012]. 11. Learning Zone, 2009. Analytical Procedures- A Powerful Tool for Auditors. [Online] Available at: [Accessed 25 October 2012]. Read More