Analytical Procedures & Materiality

Analytical Procedures…

involve comparisons of fin. and operational info to see if historial relationship are continuing forward into the period under review

range from simple comparisons to the use of complex models involving many relationships and elements of data

a basic premise underlying the application of A/P is that plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary

Usually involve trend analysis, ratio analysis, &/or reasonableness tests

What does A/P do?

it identifies that actual relationship are different than expected relationships, it does not detect errors

EX: Sales 5-10% in past few years, but 125% increase this year

Comparing the ending bal. in compensation expense account for several years: if unusual spike?

May indicate that fraudulent payments are being made to fake employees through the payroll system

BDE y/y: what if it is decreasing as a % of sales? 

Should vary in relation to sales

management may not be correctly recognizing bad debts in a timely manner

economy or customer based maybe getting “better”

Compare days sales outstanding in CY to amount for PY: what could affect this relationship?

relationship btwn receivable & sales should remain about the same over time

changes in the customer base, credit policy of the organization, or collection practices

Review the current ratio over several periods (CA/CL)

should be about the same each year, unless… entity has altered policies related to A/R, inventory or A/P/ other liabilities

Multiply # of employees by avg pay to estimate total annual compensation, compared to the actual total compensation expense for that period

Reasonableness test/ should change in relation to changes in entity size

AS No. 2110 

Identifying and Assessing Risks of Material Misstatement: A/P required by AS in the planning stage

suggests relational approach to A/P in assessing risk

Paragraph 46. AS 2110:

should be used to better understand client and to identify misstatement risk in areas of F/S that warrant further investigation

Paraghraph 47 AS 2110:

should perform on revenue and specifically identifies risk of fraud

Paragraph 48 AS2110:

auditor should use his or her understanding of the company to develop expectations about plausible relationship among data

Relational Approach

e.g. examine changes in revenue compared to changes in A/R as opposed to just looking at changes in revenue

What could explain the differences in changes in A/R compared to changes in revenue?

change in credit policy 

change in policy for allowances 

change in customer base

AS No. 1105

Audit Evidence

AS No.2305

Substantive Analytical Procedures - the auditors reliance on substantive tests to achieve an audit objective related to a particular assertion may be derived from tests of details, from analytical procedures or from a combination of both

A/P is not required by AS in the evidence gathering stage

True

Paraphrasing the standard:

1. develop an expectation

2. establish a tolerable difference (materiality)

3. Compare expected to actual

4. evaluate explanations and corroborate evidence

Developing an expectation in the evidence gathering stage

Examples of sources of info:

fin info for comparable prior period giving consideration to known changes

anticipated results (ex: budgets, forecasts including extrapolations from interim or annual data)

relationships among elements of fin info within the period

info regarding the industry in which the client operates (ex: gross margin info)

relationships of fin info with relevant nonfinancial info

Precision of the expectation

Expectations developed at detailed level generally have a greater chance of detecting misstatement of a given amount than broad comparisons

Examples of precision of expectation

monthly amounts will generally be more effective than annual amounts

Comparisons by locations or line of business usually will be more effective than company-wide comparisons

Analytical Procedures as substantive tests:

Test reasonableness of compensation expense

1. expectation

2. tolerable difference - depends on materiality

3. compare expected to actual

4. Evaluate/corroborate explanations

5. Calculate and re-estimate our expectations

A/P in the completion stage

A/P is required by AS in the completion stage

AS 2810

Performing Analytical Procedures in the Overall Review:

Auditor should read F/S and disclosures and perform A/P to a) evaluate auditors conclusions formed regarding significant accounts and disclosures and b) assist in forming an opinion on whether the F/S as a whole are free of material misstatement

the nature and extent of the A/P performed during the overall review may be similar to the A/P performed as risk assessment procedures

auditor should evaluate whether: the evidence gathered in response to unusual or unexpected txn identified during the audit is sufficient and fraud risk

What should the auditor document?

Expectation and factors considered in development of expectations 

results of comparison of recorded amounts/ratios with expectations

any additional audit procedures performed where inconsistencies arose

A/P using I/S generally more reliable than using only B/S

True

Where is A/P most effective?

misstatements not readily discernible from details

details not readily available

What is A/P most useful for?

high volume, low transaction value accounts (e.g. sales where sales consist of many small items)

low volume, repetitive txn accounts (e.g. payroll accounts)

How do auditors actually use A/P?

Generally rely on simple APs (e.g. comparisons with prior periods)

seniors and managers performed most planning APs historically, but more recently that has been pushed down to less-experienced staff

client generally the sources for expectations and when judging explanations/Client inquiry was most typical way to get explanations for differences

during substantive tests, auditors do generally verify explanations

in more recent years, auditors are using more non-financial data (1/3 of time) and using more precise inputs

A/P use has steadily increased as a substantive test in past 20 years

Auditors more likely to accept account as fairly stated if using a less precise explanation

auditors more likely to accept account as fairly stated if they can “quantify difference”(even if false)

What is the purpose of an audit?

The expression of an opinion on the fairness with which they present, in all material respects, financial position, results of operation, and its cash flows in conformity with GAAP

Why is “in all material respects” part of purpose of audits?

Auditing cannot provide a guarantee:

1) too costly to verify every penny for a client; no practical or possible

2) fraud is always a possibility; collusion very hard to detect

so must focus on materiality

PCAOB definition of materiality?

in interpreting the federal securities laws, the Supreme Court of the US has held that a fact is material if there is “substantial likelihood that the.. fact would have been viewed by the reasonable investor as having substantially altered the ‘total mix’ of information made available

What are the two primary differences between “old” ASB and PCAOB?

1) ASB uses “could influence”, PCAOB uses “would influence”

2) ASB uses “user”, PCAOB uses “reasonable investor”

Does ASB or PCAOB have the lower threshold for defining materiality?

ASB

Steps for Materiality in Planning

1) Determine Planning Materiality

2) Determine Tolerable Misstatement

3)Materiality in testing (class- account- and/or transaction-level materiality)

How do we determine planning materiality?

1) select a base - depends on the users

2) set a percentage/calculate amount - depends on uses

3) adjust for qualitative factors - dependent upon analytical and other risk assessment procedures

AS 2105.06

Materiality level for the F/S as a whole

What is tolerable misstatement?

An amount less than the level of planning materiality (working level of materiality)

Usually 50-75% of Planning materiality

Why do we use tolerable misstatement?

We sample and so may miss some errors

we audit estimates, so may not be able to determine actual errors, some errors are income-increasing, some are income decreasing, may “zero-out”

acts like a buffer for uncorrected and undetected errors

uncorrected errors cannot exceed TM

What are examples of classes, accounts, or other F/S components that may be assigned separate materiality values because of qualitative and other factors?

cahs is important/ should be “easy” to audit; may be set a very low materiality level specific to cash

What is an example of transactions being assigned separate materiality values (bc of quantitative or qualitative factors)

mergers and acquisitions or sales (especially at year-end)

Example of when we may set materiality separately for individual assertions for certain accounts, classes, or transactions?

The valuation assertion for inventory

Uncorrected errors cannot exceed TM.

True

How do we assess misstatements?

Known misstatements

Likely misstatements

What are known misstatements?

where the auditor identifies an actual $ error

An example of a known misstatement?

an invoice not accrued that should be, a check cleared that was not recorded

misapplication of GAAP

What is a likely misstatement?

Difference between auditor & mgmt judgements; often associated with estimates (different interpretations of GAAP)
Derived from extrapolation based on sampling or from analytical procedures (ex: assessing an allowance account)

What is a quantifying misstatement?

determining whether a misstatement is material

Two way to quantify misstatements?

1) Iron curtain method

2) Rollover method

What is the Iron Curtain method?

Cumulative effect of misstatement in the B/S, rather than just the impact in the current year

takes into consideration prior, similar misstatements

What is the Rollover method?

quantifies a misstatement based on the amount of error originating in the current year income statement 

ignores the effects of correcting the portion of the current year B/S misstatement that originiated in PY

What is an example of the Rollover method?

Situation: Determine materiality of $600 each year for a client. Company incorrectly depreciates a new asset, understating depreciation exp by $150/year

identifies a $150 annual misstatement in exp, which is immaterial. Could be considered an I/S approach

(AJE suggested, but not required in any year for an unqualified opinion)

What is an example of the Iron curtain method?

Situation: Determine materiality of $600 each year for a client. Company incorrectly depreciates a new asset, understating depreciation exp by $150/year

identifies $150 annual misstatement and considers PY misstatements, leading to a $300 total misstatement in year 2 and a $600 misstatement reflected in year 4. Fourth-year figure is materiality in year 4, and is now a material error. Could be considered a B/S approach

(AJE suggested each year, and entry required in year 4 for an unqualified opinion)

The iron curtain method tends to overstated CY expenses with AJE, since it results in the recognition of more cumulative errors in the Current period.

True

What does SAB 108 (Staff Accounting Bulletins) state?

for public companies, auditors should consider effects of both regarding materiality

PM increases with client size, but at a decreasing rate.

True

Big 4 firms asses PM at lower level than non-Big 4.

True

Effect of an account on net income is most significant qualitative factor affecting PM.

True

Client integrity affects PM (higher assessed integrity, higher PM)

True

Tolerable misstatement is lower for overall..

increased engagement risk

increased fraud risk

a history of identified misstatements

higher inherent risk

control deficiencies

What is a clearly trivial threshold?

normally equal to a small percentage of overall materiality (3-5%). Auditor can ignore any errors or omissions below this level, as they are so small they are considered negligible

auditor is required to record, consider, and report all misstatements identified in the course of the audit other than those considered ‘clearly trivial’

True

What is component materiality?

specific to group audits (examples: business lines and geographic segments)

In a group audit the auditor will ‘scope’ the components within the group that are considered significant and therefore require more in-depth audit procedures

True