Chapter 9 Analytical Procedures and Ratios

1. Chapter 9Analytical Procedures and Ratios Dr. Mohamed A. Hamada Lecturer of AIS

2. Learning Objective State the purposes of analytical procedures and the timing of each purpose. Select the most appropriate analytical procedure from among the five major types

3. Analytical procedures may be performed at any of three times • Analytical procedures are required in the planning phase to assist in determining the nature, extent, and timing of audit procedures • Analytical procedures are often done during the testing phase of the audit as a substantive test in support of account balances • Analytical procedures are also required during the completion phase of the audit

4. Learning Objective 7 Select the most appropriate analytical procedure from among the five major types.

5. Five Types of Analytical Procedures Compare client data with: 1. Industry data 2. Similar prior-period data 3. Client-determined expected results 4. Auditor-determined expected results 5. Expected results using nonfinancial data.

6. Compare Client and Industry Data Client Industry 2009 2008 2009 2008 Inventory turnover 3.4 3.5 3.9 3.4 Gross margin 26.3% 26.4% 27.3% 26.2%

7. Compare Client Data with Similar Prior Period Data 2009 2008 (000) Prelim. % of Net sales (000) Prelim. % of Net sales Net sales $143,086 100.0 $131,226 100.0 Cost of goods sold 103,241 72.1 94,876 72.3 Gross profit $ 39,845 27.9 $ 36,350 27.7 Selling expense 14,810 10.3 12,899 9.8 Administrative expense 17,665 12.4 16,757 12.8 Other 1,6891.22,0351.6 Earnings before taxes $ 5,681 4.0 $ 4,659 3.5 Income taxes 1,7471.2 1,4651.1 Net income $ 3,934 2.8 $ 3,194 2.4

8. Example • Suppose that the gross margin percentage between 26 and 27 percent for each of the past 4 years but has dropped to 23 percent in the current year. • This decline in gross margin should be a concern to the auditor if a decline is not expected. • The cause of the decline could be a change in economic conditions. • But, it could also be caused by misstatements in the financial statements, such as sales or purchase cutoff errors, unrecorded sales, overstated accounts payable, or inventory costing errors.

10. Learning Objective 8 Compute common financial ratios.

11. Common Financial Ratios • Short-term debt-paying ability • Liquidity activity ratios • Ability to meet long-term debt obligations • Profitability ratios

12. (Cash + Marketable securities*) Current liabilities (Cash + Marketable securities + Net accounts receivable) Current liabilities Short-term Debt-paying Ability Cash ratio = Quick ratio = Current ratio Current assets Current liabilities = *(Stocks , Bonds , Treasury Securities)

14. Liquidity Activity Ratios Accounts receivable turnover = Net sales Average gross receivables* Days to collect receivable = 365 days Accounts receivable turnover Inventory turnover = Cost of goods sold Average inventory Days to sell inventory = 365 days Inventory turnover *the average of the beginning and ending accounts receivable balances for the period

15. Ability to Meet Long-term Debt Obligation Debt to equity = Total liabilities Total equity Times interest Earned* = Operating income Interest expense *how many times a company can cover its interest charges. Failing to meet these obligations could force a company into bankruptcy

16. Profitability Ratios Earnings per share = Net income Average common shares outstanding Gross profit percent = (Net sales – Cost of goods sold) Net sales Profit margin Operating income Net sales =

17. Profitability Ratios Return on assets = Income before taxes Average total assets Return on common equity = (Income before taxes – Preferred dividends) Average stockholders’ equity

18. Summary of Analytical Procedures They involve the computation of ratios and other comparisons of recorded amounts to auditor expectations. They are used in planning to understand the client’s business and industry. They are used throughout the audit to identify possible misstatements, reduce detailed tests, and to assess going-concern issues.

19. End of Chapter 8