Substantive Analytical Procedures: Relevance and Efficacy in an Audit

SAP procedures consist of evaluating financial information through analysis of plausible relationships among both financial and non-financial data. It also consists of investigation of identified fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount. The basic presumption behind the use of SAP by an auditor is that correlation between data can be expected to exist in the absence of any condition either financial or non-financial disturbing such relationship. However it is to be noted that while performing any form of SAP, prior knowledge of the industry in which the entity operates is very crucial along with the understanding the efficiencies and limitations that are harbored in adapting such procedures. SAP are subject to auditor judgment including evaluation of the data to be used and understanding the conclusions reached.

SAP may be performed using various methods like statistical techniques and Computer Assisted Audit Techniques (“CAAT’s”). They can be performed at financial caption level or at a disaggregated detailed level of information. The auditor may choose to apply SAP on financial statements as a whole or on any specific component of the financial statements. The decision about which audit procedures to perform, including whether to use SAP, is based on the auditor’s experience about the expected effectiveness and efficiency of the available audit procedures to reduce audit risk at the assertion level to an acceptably lower level.

SAP are generally used by the auditor at the following stages of audit:

•     Risk assessment procedures (termed as planning SAP) which assist the auditor in identifying and assessing the risks of material misstatement thus allowing them to provide a basis for designing and implementing the audit procedures. For instance – revenue trend analysis, gross margin analysis, effective tax rate reconciliation, etc.

•     Substantive procedures (termed as SAP) to obtain corroborative audit evidence about relevant assertions and the risks attached to such assertions. For instance, payroll logic test, interest costs as a percentage of borrowings, etc.

•     Final analytical procedures – to perform an overall review of the financial statements (termed as final SAP) to aid the auditor while forming an overall conclusion as to whether the financial statements are consistent with the auditor’s understanding of the entity and its business.

Suitability of a particular analytical procedure for a given assertion:

SAP are generally more applicable to large volumes of transactions that tend to be predictable over time. However, the suitability of a particular analytical procedure will depend upon the auditor’s assessment of how effective it will be in detecting a misstatement that, individually or when aggregated with other misstatements, may cause the financial statements to be materially misstated. Different types of SAP provide different levels of assurance.

For example building up an expectation of payroll cost (as demonstrated in the case study discussed later) can provide persuasive evidence and may eliminate the need for further verification by means of tests of details, provided the information used and the elements of the payroll cost is appropriately tested.

On the other hand, calculation and comparison of effective tax rate to profit before tax can be deemed as a means of confirming the completeness of tax provision, however this will provide less persuasive evidence, but may be reduce the detail of work that needs to be performed for other audit steps performed on the caption.

It is imperative that the auditor has adequate assurance over the efficacy of the internal controls around over financial reporting of an enterprise before he concludes to place reliance solely on analytical procedures to get comfort over any financial statement caption.

    Reliability of data

Before placing reliance on the assurance obtained from SAP the auditor needs to evaluate and confirm the data used to perform SAP. The reliability of data is influenced by its source and nature and is dependent on the circumstances under which it is obtained. Some of the parameters that may be considered by an auditor to evaluate the reliability of the data are:

    i. Source of the information available, for instance, information may be more reliable when it is obtained from independent sources outside the entity.

    ii. Comparability of the information available, for instance, information from the same industry may be more reliable than information of the entities operating in the cluster of industries.

    iii. Nature and relevance of the information available. For example, whether budgets have been established as results to be expected rather than as goals to be achieved; and

    iv. Controls over the preparation of the information that are designed to ensure its completeness, accuracy and validity. For example, controls over the preparation, review and maintenance of accounting information. The auditor may choose to test the operative effectiveness of controls over preparation of data giving him further assurance on the reliability of the data used to perform SAP.

While devising substantive analytical procedures, an auditor considers comparison of the entity’s financial information with:

•     Comparable information of the prior period for the caption on which assurance is planned to be achieved through SAP.

•     Anticipated results of the entity including budgets and forecasts made by the management.

•     Expectations made by the auditor, for example – comparing actual with estimated lease rent or an estimation of depreciation.

•     Information of the industry in which the entity operates – for instance, the comparison of the debtors’ turnover ratio of the enterprise with that of the industry to identify nuances in the entity’s operating cycle, industry growth with sales growth of the enterprise.

The auditor also considers relationships amongst the various elements of financial information to obtain assurance on the trend/variation in financial statement captions. An illustrative inventory of such relationships is as given below:

• relationship between variation in turnover and debtors

• variation in material cost consumption with variation in input prices, manufacturing yield, capitalization of new machinery, variation in cost of repairs of plant and machinery

• correlation of variation in payroll costs with employee count, labor turnover

correlation between labor efficiency rates and production costs

• variation in power and fuel consumption costs with variation in manufacturing output/power tariffs.

Let us understand SAP with the help of a practical example:

Background:

ABC India Private Limited (‘ABC’) is a service provider whose primary business is to act as customer care center for its clients. The business model involves setting up of a call center with relevant IT, telecommunication and other infrastructure facilities and hiring and training graduates with good communication skills who are required to attend to customer calls. As far as execution of services is concerned, the employee pyramid comprises of a large number of graduates, related proportion of supervisors/ team leaders and delivery heads. ABC also has a robust sales and marketing team. The company has signed agreements with various customers where its revenue is
based on an agreed charge-out rate and the number of executives requested for by the customer. the executives may be assigned on a 24×7 basis or otherwise depending on     the    customer     requirements.    The    major    expenses     for ABC comprise of payroll cost.  

Application of SAP on Payroll Cost

Scenario 2:
The    salary    cost    of    the    company    as    per    the    draft    financials     is rs. 34.57 crore which is different than the salary cost as arrived by the auditor in his expectation. however the difference between the expectation  i.e.rs. 31.26 crore and the actual cost (rs. 34.57 crore) is rs. 3.31 crore which is greater than the allowable difference set by the auditor during the commencement of this exercise.

In such a case the auditor would investigate into the reasons for the variance arrived at by him so as to bring the variance to an acceptable level. he may also chose to do further audit procedures on this caption to get the required level of assurance.

Some reasons for variance may be:

• Joining of senior personnel in a band with salary far higher than average

• Large number of joiners at month end or vice versa

• Increment during the period for certain bands of employees, including mid-term increment

• Exceptional/discretionary bonus or other payouts, etc.

• Revision is statutory obligations such as percentage of provident fund/superannuation contribution, minimum wages payable under labor laws, changes in retiral benefits    such    as    gratuity,    basis    of    leave    encashment

• Revision in assumptions made for payroll liabilities which are actuarially valued such as pension, compensated benefits, gratuity, post medical retirement benefits etc.

After investigating the difference, the auditor may rebuild his expectation so as to take effect of the newly identified factors and modify his evaluation of the difference identified based on those factors.

In this case, the auditor may also be able to build up an expectation on the revenue for a reporting period for ABC as the revenue model is entirely based on the category of employees who have been assigned to customers. one could apply the agreed charge out rates on the average number of employees employed during a period and arrive at the expectation. a similar exercise of comparing and challenging the actual results against the actual results could provide insights on what further audit procedures need to be undertaken to obtain assurance on the revenue recognised during a given period.

Conclusion

Use of SAP during the planning, execution and completion stages of an audit enables an auditor to obtain sufficient and appropriate audit evidence to address the risk of material misstatement as also brings efficiencies in the audit process by way of reduced effort on substantive testing. Substantive analytical procedures provide the auditor with an overall perspective of the financial impact of significant events that have taken place in an enterprise during the reporting period. It could be said that SAP aids the auditor in setting the level of professional skepticism in terms of identifying areas where additional or detailed substantive testing may be required to be performed.