Audit Procedure Part 2 PDF

Summary

This document details various audit procedures, including cut-off examination, surprise checking, rotational tests, and walk-through tests. It explains the importance of these procedures and when they should be applied in an audit setting.

Full Transcript

## 2.9.4 Other Procedures ### A. Cut-Off Examination In case of a terminable venture which is formed for a limited period of time, transactions are settled within its lifetime and profits are calculated only once. But in case of a going concern, business operations and hence, transactions occur on...

## 2.9.4 Other Procedures ### A. Cut-Off Examination In case of a terminable venture which is formed for a limited period of time, transactions are settled within its lifetime and profits are calculated only once. But in case of a going concern, business operations and hence, transactions occur on a continuous basis. Thus, it is imperative to apply the periodic concept to assess its performance and financial state at regular intervals. However, there may be a number of items especially at the end of an accounting period that may have their impact carried to the next accounting period. Work in progress, goods in transit, goods sent on approval basis lying with the customers, outstanding and prepaid items are only a few. Even purchase and sale transactions during the end of the accounting period may have their impact on the next year. Improper treatment of these items and inclusion of items relating to one year in the next or previous year (like purchase and sales) may seriously distort the financial results and mislead the decision makers. Hence, an auditor, during the course of his audit work, should apply definite procedure to separate transactions at the end of one accounting period from those at the commencement of the next accounting period. Such a procedure is known as Cut-off Examination or Cut-off Procedure. Here, the auditor first decides a cut-off date (in case of annual audit, generally balance sheet date is considered to be the cut-off date) and then examines all the transactions that occurred within a definite time period prior and post such cut-off (known as cut-off period) date to discriminate transactions of current year from that of the next year. This is essential to eliminate any scope of manipulation in accounts. ### B. Surprise Checking Under traditional audit practices, an auditor generally informs the client about his routine checking plan and timing of next visit well in advance. This is considered essential so that the client's staff can keep the books of accounts complete in all respects and readily available for verification. Unfortunately, this also provides them ample scope for concealing any wrongdoing whatsoever. Thus it is generally recommended that an auditor must also conduct surprise tests of some material items without any prior communication with the client's office. These surprise checks, as a part of the normal audit procedure, are likely to increase the efficiency of the audit work. Hence, surprise checking may be defined as an audit procedure where verification of some material items is conducted on a non-routine and surprise basis. Though surprise checking can be applied while verifying transactions of any category, following are some specific instances where this procedure is particularly helpful. - Verification of cash balance. - Verification of investments. - Verification of stock and stores. - Verification of the effectiveness of any part of the internal control system. - Verification of appropriate maintenance of various statutory books of accounts, registers, etc. ### C. Rotational Tests This is another important audit procedure that is very useful while conducting audit of large organisations with operations located at different geographical locations. Rotational tests can be performed in two ways: - **By Rotating the Area of Emphasis** Here, the auditor conducts general system audit of all areas of the client's business every year but selects one or two specific areas (like payroll, stock control, sales, etc.) for in-depth checking. - **By Visiting Different Locations on a Rotational Basis** Here, the auditor visits different factories, branch offices, etc. on rotation, so that all the locations are covered though not within a single year but over a period of time. It must be mentioned clearly in this regard that rotational tests are only applicable in case the same auditor is engaged for audit over the years. Moreover, the selection of areas must also be made on a random basis without allowing the client’s staff to speculate anything. ### D. Walk Through Tests In course of the audit work, an auditor depends significantly on the effectiveness of the internal control system and finalises the scope of auditing. However, to form a conclusive opinion regarding the effectiveness of the accounting system and associated internal control procedure, he needs to have adequate understanding of the control environment. Walk through tests may come handy in this respect. Walk through test may be defined as tracing one or more transactions through the accounting system and observing how it is actually passed through the internal control system. For example, the auditor may decide to trace a purchase transaction from its initiation to its completion and recording. This will require him to see how are requisitions generated, orders placed with the suppliers, goods received and taken to the stores, bills processed and finally the accounting treatment done. If the auditor is satisfied about the appropriateness of all the relevant stages of the transaction, he may conclude that the internal control is functioning well. Accordingly, the auditor may decide to put reliance on the system to a certain extent and plan his audit work to verify some selective transactions only. Alternatively, if walk through test reveals serious weakness of the internal control system, the auditor may opt for verifying a larger sample under test checking or at the worst situation, be may go for routine checking of all transactions. ## 2.9.5 Suitability of an Audit Procedure It is worthy to mention in this respect that the different audit procedures described earlier are not always substitute to each other, rather in most of the cases, they appear to be complementary. Though it is up to the auditor to finally decide which procedure will be followed, simultaneous application of a number of procedures to verify different areas of client's accounts is always recommended. ## 2.10 Analytical Procedures ### 2.10.1 Concept and Definition Traditional audit procedures such as routine checking or test checking based on carefully selected representative samples help an auditor to identify the existence of material misstatements or misappropriation to a great extent. However, the books of accounts may sometimes contain complex errors or planned frauds that are difficult to identify by these traditional methods. Existence of such errors or frauds may be quite fatal as that will eventually make the audit report unreliable. Hence, the auditor should apply some innovative procedures to deal with a situation of that kind. Analytical procedure has become very effective in this respect. Analytical procedure may be defined as the process to carefully study the relationship between various financial and non financial data, analysing their behaviour or pattern to identify any unusual deviation from the expected value of the item or any inconsistency with the relevant information and the reason thereof. According to *SA520* on 'Analytical procedures', analytical procedure means evaluation of financial information through analysis of plausible relationships among both financial and non-financial data. Analytical procedures also encompasses 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. ### 2.10.2 Nature of Analytical Procedures As per *SA520*, the nature of analytical procedures includes the following: - **Analytical procedures consider comparison of entity’s financial information with:** - Comparable information of prior periods. - Any anticipated results of the organisation like budget or forecast or any estimation by the auditor like estimation of depreciation. - Similar information of any other comparable entity belonging to the same industry or the industry averages. - **Analytical procedures may also include consideration of relationships:** - Among different items of financial data that is expected to follow a predictable pattern like the operating profit margin. - Between financial and non-financial information like the number of employees and the total compensation cost. - **Analytical procedures consider application of diverse analytical tools that may range from a simple comparison to complex analysis involving advanced statistical techniques.** - **Analytical procedures may be applied either on standalone or on consolidated financial statements. Moreover they can be applied on any component or individual information of the statements.** ### 2.10.3 Application of Analytical Procedures According to *SA520*, analytical procedures can be applied at different stages of the audit work. These include: #### A. Audit Planning During the planning stage, the auditor may apply analytical procedures to have an understanding of the nature of client's business. This may help the auditor to identify the areas of potential risk by indicating different aspects and developments of which the auditor is aware. The auditor may use this information in determining the nature, timing and extent of other procedures such as routine checking or vouching. #### B. Substantive Test In order to reduce the audit risk by relying on substantive procedures, the auditor may apply substantive analytical procedures either alone or in combination with the test of details (i.e. vouching and verification) #### C. Forming Overall Conclusion The auditor may also apply the results of analytical procedures to assess how far the conclusions drawn based on individual components or elements of the financial statements are consistent and whether there is any need to revise them. #### D. Investigating Unusual Items If the analytical procedures performed in the organisation identify any inconsistency in relationships or any significant deviation from the respective expected value of the items, the auditor should investigate such items by enquiring the management or by collecting further evidences and by performing other audit procedures as required. ## 2.10.4 Tools and Techniques of Analytical Procedures As per *SA-520*, analytical procedures include application of the following tools and techniques: ### A. Trend Analysis This method analyses any fluctuation in the amount of any account or item by comparing current year's figure with that of either immediately preceding year or over the years. ### B. Testing of Reasonableness This is done by analysing the relationship of certain items or account balances with other accounts or balances. Some examples of reasonableness testing are: - Raw material consumption to production (quantity) - Percentage of wastage and scrap against production and raw material consumption - Work-in-progress based on material issued - Sales discount and commission against sales volume - Rental revenues based on occupancy of premises - Interest expenses against interest bearing obligations ### C. Ratio Analysis This technique calculates different ratios between various items of financial statements in order to study their relationships. Common ratios include: - Elements of income or gain as a percentage of turnover - Gross Profit Ratio - Receivable Turnover Ratio - Inventory Turnover Ratio - Any other profitability, leverage and liquidity ratio. ### D. Sources of Information Analytical procedures also require analysing the following sources of information: - Interim financial information - Budgets - Management Accounts - Non-financial information - Bank and cash records including confirmation from bank - VAT returns - Board minutes - Confirmation from customers and suppliers.

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