TUTORIAL

a) With reference to ISA 520 Analytical Procedures explain

i. what is meant by the term ‘analytical procedures’; (2 marks)
 Obtain understanding about the entity.
 The environment to enable to assess the risk of the entity.
 Overall review at the end of audit.

ii. the different types of analytical procedures available to the auditor; and (3 marks)
 Compare prior period information to identify any unusual or significant
fluctuations.
 Compare with industry average (Trend analysis, reasonableness test)
 Compare with anticipated/ budgeted/ forecast information.

iii. the situations in the audit when analytical procedures can be used. (3 marks)
 Planning stage (compulsory) – perform risk assessment, obtain understanding
of the entity, assess the risk of material misstatements.
 Analytical procedure as substantive procedure which is optional during the
fieldwork – risk of material misstatements in the financial statements.
 Review stage (compulsory) – overall conclusion is consistent with auditor’s
understanding of the entity.

Zak Co sells garden sheds and furniture from 15 retail outlets. Sales are made to individuals,
with income being in the form of cash and debit cards. All items purchased are delivered to
the customer using Zak’s own delivery vans; most sheds are too big for individuals to
transport in their own motor vehicles. The directors of Zak indicate that the company has had
a difficult year, but are pleased to present some acceptable results to the members.

The income statements for the last two financial years are shown below:

Income statement

31 March 2008 31 March 2007

$000 $000
Revenue 7,482 6,364 17.6%
Cost of sales (3,520) (4,253) -
17.23%
–––––– ––––––
Gross profit 3,962 2,111
88%
Operating expenses
Administration (1,235) (1,320) -
6.44%
Selling and distribution (981) (689)
42%
Interest payable (101) (105) -4%
Investment income 145 –
–––––– ––––––
Profit/(loss) before tax 1,790 (3)
====== ======

Financial statement extract

Cash and bank 253
(950) 73%

Required:
(b) As part of your risk assessment procedures for Zak Co, identify and provide a possible
explanation for unusual changes in the income statement. (9 marks)

Steps:

1. Calculate the fluctuations (amount + %)

2. Identify the points on the risk of material misstatements

Net Profit

Zak’s overall result have changed from net loss to net profit, given that the increase in sales is only
approximately 17% and the administrative expenses appear low. There is possibility of expenditure is
understated.

Sales increased by 17%

According to director, it is a difficult year, reason in the increase in the income doesn’t reflect the
statement by the director’s comment. Hence, if possible, get the comparison of industry average as a
whole to understand the result of Zak.

Cost of Sales decreased by 17%

A fall in the cost of sales is unusual given that the sales has increased by 17%. This could be due to
incorrect inventory valuation or they could have used a cheaper supplier. However, the use of a
cheaper supplier has a risk of faulty products in the future.
Gross profit increased by 88%

Compared to the previous year, the increase is due to the earlier discussed reasons on COS and the
increase in sales.

Administration expenses

It has reduced which is unusual as sales increased. Expenditure is understated, there is cost cutting
measures in Zak. (for example, the reduction in the admin staff.)

Selling and Distribution increased by 42%

 The increase is not in line with the increase in sale, which was just 17%.
 Misallocation of expenses from administrative expenses.
 The age of Zak delivery van has increased the additional service cost.

Interest Payable – small fall

Cash surplus, compared to overdraft amount for the previous year, this amount may be overstated.
Reason for the fall in the interest payment need to be identified, eg: identify the relevant loan that
have to be settled.

Investment Income – new this year

Given the cash surplus on the year, although the amount is very high, indicating possible error in the
amount or other income generating assets not disclosed on the balance sheet.