ANALYTICAL REVIEW TECHNIQUES FOR AUDITORS*
by
Robert G. May
Ernst & Whinney Professor of Accounting
University of Texas at Austin
March 24, 1983
INTRODUCTION
Analytical review techniques are among the most versatile and most
valuable techniques available to auditors. Yet, beginning auditors,
and especially auditing students, rarely feel confident in their abilities
to do analytical reviews of financial statements and therefore often
fail to appreciate fully the value of review techniques. This lack
of confidence is not so much due to a lack of fundamental skills as
it is to a lack of a cohesive approach. The purpose of this paper
is to provide such a cohesive approach -- one that leads the analyst
(auditor) through a series of sensible steps designed to stimulate
the right questions and provide a framework for answering them in
ways especially relevant to efficient auditing.
One of the roles of analytical review in auditing is that of an early
warning system. It may be used early in an audit to identify specific
audit risks, thus leading to better audit planning. It may also be
used as a substantive test of an account balance later in the audit.
In this role it may even provide sufficient audit assurance that the
account does not contain a material error, as to make other direct
tests of the account balance unnecessary.
Broadly speaking, one of an auditor's primary objectives in an individual
engagement is to perform a cost-effective audit. This means that the
auditor wants to perform sufficient audit procedures to reduce residual
audit risk to an acceptable level and, at the same time, hold the
cost of the procedures performed to a sufficiently low level that
the audit fee will (1) cover costs (including the cost of capital
invested in the practice) and (2) provide appropriate compensation
for the residual risk borne. As the center of Exhibit 1 illustrates,
residual audit risk is a function of (1) the probability that there
is an undetected, material misstatement in the financial statements
and (2) the expected loss, given that such an undetected misstatement
exists. The surrounding portions of Exhibit 1 illustrate that these
two central determinants of residual risk are, in turn, functions
of the following:
(a) the probability of a material misstatement occurring,
(b) the probability that such a misstatement will go undetected
by the audit procedures selected,
(c) the probability that the client will experience financial distress,
leading to an action being brought against the auditor, and
(d) the potential size of a financial loss (or effect of adverse
publicity) resulting from any action taken against the auditor (which
is influenced by such things as the size of the client, its capital
structure, the composition of its owners and creditors, etc.)
Among all these factors affecting residual audit risk, the ones of
greatest concern in planning a specific engagement are those factors
affecting the probability of material misstatements, because, to be
effective, audit procedures must be aimed at detecting such misstatements.
Other factors, such as capital structure and composition of owners
and creditors, may affect the engagement decision and/or fee negotiations
(because they may affect such things as third party beneficiary status
of certain owners or creditors), but planning of specific audit procedures
relates to them only tangentially. On the other hand, potential for
financial distress should influence audit planning because actual
or impending financial distress is usually the "triggering event"
that causes users of financial statements to take legal action against
auditors. This is so primarily because claims based on assertions
that financial statements are false or misleading usually hinge on
proof that the aggrieved "user" of the statements has sustained
financial damage.
Moreover, impending financial distress may alter the probability
of intentional misstatements and the appropriateness of certain accounting
methods (for example, if the going concern assumption is in doubt).
Unfortunately, intentional misstatements may be made to cover up symptoms
of financial distress and, therefore, may be difficult to detect with
analytical review procedures. This emphasizes the importance of auditing
"in the context of the client's business and industry,"
because it may be only in such a context that misstated elements of
the financial statements actually appear misstated.
Auditors wishing to use analytical review to plan audits, in effect,
become "users of their clients' financial statements" who
want to determine the "story" told by the statements and
its implications for the audit. Analytical review techniques will
be valuable at the general level of audit planning if they help the
auditor better understand the client's business and anticipate potential
financial distress. In addition, at the more specific level, they
should help the auditor allocate audit effort in a cost-effective
manner, that is, to accounts and transactions in direct relation to
specific risks of material misstatements. Analytical review techniques
will be all the more helpful in planing cost-effective audits if they
integrate well with other sources of audit efficiency. For example,
an auditor who anticipates relying on strengths in the client's internal
control system will value analytical techniques that focus on groups
of accounts related to specific subsystems of the client's internal
control system.
Financial Ratios
The traditional tools of financial analysis are various financial
ratios. Several traditional ratio groups (with which readers probably
have some familiarity) are illustrated in the case presented later
in the paper. To be at least minimally useful, ratios must be individually
interpretable; that is, they must be indicative of some relationship
or condition relevant to the analysis. However, financial ratios have
little more than minimal (diagnostic) value unless they are used in
conjunction with some standard of comparison. Some useful standards
of comparison are industry averages, local economy averages and national
economy averages of the given ratio. Perhaps the best all-around standards
of comparison for using ratios to determine what happened to a firm
during a given period are the values of the same ratios for the firm
for a prior period or date (or several prior periods or dates). Such
"time-series" of ratios help determine the direction in
which the firm is headed and possibly reveal long-term trends of behavior.
As useful as financial ratios may be, there are problems with the
traditional ratio approach. Most importantly, too few analysts, especially
beginners, can do anything with it. If the analyst does not have a
proven approach to tie the ratios together and to the underlying plans
or activities of the business, they are of very little value. For
instance, a current ratio that is lower than some standard of comparison
can be equally indicative of either liquidity problems or efficient
utilization of current assets or astute utilization of sources of
credit. For example, suppose a firm has a choice between a revolving
line of credit related to its eligible accounts receivable (a current
liability) and a term loan (a long-term liability) of the same initial
maximum. The former may never have to be paid off (or even reduced
if eligible accounts receivable do not decline), but the latter will
have to be paid off over a specified period, making regular demands
on available funds. Yet, if the firm chooses the revolving line of
credit, it will have a smaller (and by traditional standards less
desirable) current ratio.
Therefore, there is a need for guidelines about how to tell the "story"
of the firm's plans or activities from (with) its financial statements,
and to address in that story of the relevant questions at issue in
the analysis. In this context ratios and industry comparisons may
fit in but do not, themselves, tell the story.
The EBV (Evaluating Business Ventures) approach was developed by
a banker to solve this problem for other bankers. However, it is easily
adapted to the needs of auditors and managers as well. The approach
was later refined and a book was written for bankers by W. Keith Henderson
(the banker-developer), Robert G. May and Lawrence D. Schall, entitled,
Evaluating Business Ventures (copyright @ 1982 United States
National Bank of Oregon). The remainder of this paper presents an
approach to analytical review based on the EBV approach but thoroughly
adapted to an auditor's perspective. This adaptation is called Analytical
Review Techniques for Auditors or ARTA.
CONCEPTS UNDERLYING THE ARTA APPROACH
The ARTA approach provides cohesion to an analysis of financial statements
by supplying the following elements that are missing from the literature
on traditional ratio analysis:
- A mechanical and conceptual framework that facilitates an analysis
aimed at understanding the client's business;
- A complete conceptual framework for examining potential financial
distress; and
- A logical step-by-step sequence to guide the analysis.
The Mechanical Framework
The mechanical framework is merely a way of viewing the financial
statements that facilitates understanding the business and its activities
through the statements. ARTA makes full use of the income and funds
flow statements, but it uses the classified balance sheet as illustrated
in Exhibit 2 as the primary focus of financial analysis. There are
several advantages to using the classified balance sheet as a basis
for financial statement analysis. First, current assets and current
liabilities generally are managed differently from long-lived assets,
long-term debt and owners' equity and, in general, are directly affected
by short-run changes in volume of activity, i.e., by short-run operating
decisions. The classified balance sheet, therefore, is useful in focusing
on functional causes and explanations of changes in the composition
of financial position over time -- with changes in working capital
items being much more a function of operations, and changes in long-lived
assets, long-term debt and owners' equity more functionally related
to investment and financing decisions.
Second, the dual definition of working capital noted in Exhibit 2
helps interrelate (a) the effects of operations on changes in current
assets and operations-related current liabilities with (b) the implications
of such changes for long-term financial and investment activities
of the firm. For example, if an increase in volume of operations implies
an increase in current assets, either current liabilities must increase
by an equal amount or working capital must increase. For most firms,
that is, firms with more current assets than current liabilities,
an increase in current liabilities equal to the increase in current
assets represents a greater percentage increase in current liabilities.
This means that current liabilities will be utilized to a greater
extent relative to the terms offered by current creditors, possibly
at a higher relative cost. For example, the firm might achieve the
more-than-proportionate increase by reducing the proportion of discounts
taken on accounts payable. An increase in working capital, in turn,
implies that the difference between (a) long -- term debt and owners'
equity and (b) the investment in long-lived assets must increase by
a sufficient amount to finance the net increase in investment in current
assets. (Note: failing to anticipate such implications is how many
firms manage to grow themselves out of business).
Conceptual Framework for Analysis
Accountants, especially accounting students, are accustomed to viewing
financial statements through the medium of the accounting or bookkeeping
cycle as illustrated in Exhibit 3. From this perspective, the balance
sheet (financial position) of the firm as of a given date is a function
of (1) its balance sheet as of some prior date, and (2) the transaction
entries, adjusting entries and closing entries made in the intervening
period. To understand a business, however, it is necessary to adopt
a different perspective -- one that recognizes that the structure
of a firm's financial position and changes therein are a function
of its marketing, production, administrative, investment and financial
plans and activities. The relationships implied by this perspective
are the keys to developing a real ability to decipher what
happened to a firm from its financial statements and to derive
what is going to happen to a firm as a result of its plans. These
relationships are illustrated in Exhibits 4-7.
The reader should study the relationships shown in Exhibit 4, representing
the influence of marketing plans or activities on components of financial
position and income. The relationships (arrows) show that, for example,
not only does the price-volume decision of a firm affect sales revenue,
but the use of credit granting for sales promotion purposes will also
have an effect on interest income and, along with price and volume,
will influence the level of accounts receivable. They also illustrate
that marketing considerations can affect investment in finished goods
inventory (prevention of lost sales) as well as marketing facilities
and equipment -- and even investments in affiliated companies (for
example, to achieve vertical integration in order to gain access to
channels of distribution). As with all other business activities,
the volume of marketing activities will determine the volume of purchased
goods and services to support those activities. Together with the
terms of credit from suppliers, the volume of purchases will determine
the level of current liabilities owed to suppliers.
Exhibit 5 similarly shows the relationship between production, administration,
and investment activities and the various income and financial position
components they influence. Investment activities involve acquisition
and retirement of facilities and other assets of all types, with emphasis
on optimizing the rate of return on investments in assets for the
risks taken. Investment activities, therefore, obviously influence
the levels of assets, especially long-lived assets.
Production involves conversion of raw materials into finished goods
and thus influences balance sheet and income statement accounts such
as inventory, cost of goods sold and production facilities, which
reflect acquisition, conversion, and storage of goods for sale. Production,
administration and investment activities account for the acquisition
of much of the goods and services used by a firm. Therefore, given
the terms of credit, these activities are responsible for the bulk
of the current liabilities owed to suppliers at any point in time.
Exhibit 6 shows the influences of financing activities which involve
optimizing the sources, terms, and timing of acquisitions of capital,
returns to capital, and repayments of capital. Financing activities
affect all liabilities and owners' equity items, some assets, such
as marketable securities, and interest income and expense.
Exhibit 7 shows the influence of the residual elements of income,
namely, income tax expense and net income after taxes, on the financial
position of the firm.
Conceptual Framework for Financial Distress
Financial distress is a subtle concept. It exists in many variations
and to varying degrees. Therefore, it is easier to define what it
is not than what it is. Very simply, a firm that is able to pay all
its obligations in due course and generate returns that make its owners
happy is not in financial distress. Firms that cannot pay their obligations
or cannot earn satisfactory returns in the long run are in financial
distress to some degree.
Ultimately most cases of financial distress are related to real or
apparent lack of profitability. The exceptions are cases of ineptness
in financial management and, perhaps, localized inefficiencies in
the capital markets. If the capital markets are reasonably efficient
and, if a firm is demonstrably able to earn a competitive rate of
return on the assets it employs for the risks taken, then it will
be able to attract and retain sufficient funds to finance those assets.
On the other hand, if the firm cannot generate a competitive return,
the owners, whose returns will definitely reflect the shortfall, at
a minimum will be dissatisfied and will wish to disinvest in the firm.
This is a form of financial distress in that it threatens the life
of the firm. In the extreme, a firm that is unprofitable consumes
more funds than are generated by its operations -- a situation which
can not persist. Eventually, if the owners do not force a halt to
operations, the creditors' interests will be jeopardized and they
will begin proceedings which eventually may lead to bankruptcy or
reorganization.
Therefore, a substantial part of any overall analysis of financial
statements should be an analysis of relative profitability and trends
therein. But, while lack of profitability is the ultimate cause of
financial distress in most cases, it is difficult to judge profitability
from financial statements. Accounting income, for instance, is not
identical with so called economic income. In addition, during times
of significant inflation or deflation, accounting income probably
diverges more and more from economic income. Finally, no one knows
for certain what a "competitive" level of profit is. A firm
is competitive if it earns as much as any firm could with the same
assets employed, considering the risk taken.
These limitations notwithstanding, trends in accounting income are
probably significantly correlated with trends in economic income at
the individual firm level. Also, within relatively homogeneous industries
significant departures from the norm in accounting measures of profitability
are probably indicative of a like departure from the norm in economic
profitability.
Whereas, lack of profitability is, in the long run, the root of virtually
all financial distress, in the short run it is the more immediate
net flow of funds that determines whether the firm has moved closer
to or farther from the "brink." Thus an examination of the
sources and uses of funds for the period is an integral part of an
analysis of financial statements. Broadly speaking, a firm that generates
more funds than it consumes, is in a better position at the end of
the period to meet its obligations and fulfill its plans than it was
at the beginning of the period. However, this generalization is subject
to a number of qualifications. For instance, net funds generated must
be invested efficiently or eventually the firm will not earn competitive
profits. Also, this period's sources of funds generally become uses
of funds in the future; that is, all sources of funds other than liquidations
of assets eventually require some form of servicing. For example,
long-term creditors require repayment of principal as well as interest
and owners may required dividends or other distributions to keep them
happy. The point is that sources of funds may improve the current
position of the firm; but if there is no foreseeable way that the
firm can satisfactorily service those sources in the future, they
merely represent postponement of the inevitable. This ties back to
the point that profitability is the key to long-run financial health,
and profitability depends on earning a competitive return on all assets
employed by the firm. Thus, the short-run flow of funds should be
interpreted in the context of profitability, efficient utilization
of assets, and ability to service obligations.
Another important part of a conceptual framework for evaluating potential
for financial distress is the concept of "reserve funds."
A firm has reserve funds if, after planned investments are fully funded,
the firm still has either (1) assets that can be liquidated that are
not essential to sustain planned operations (e.g., marketable securities),
(2) unused creditor commitments, and/or (3) untapped, but identifiable,
sources of additional debt or equity capital. Reserve funds represent
a "margin of protection" against short-run demands on the
firm's funds, in excess of what is generated by its operations or
other planned sources.
The first category of reserve funds noted above needs no elaboration.
The second category of reserve funds consists of such sources of ready
credit as (a) the difference between the firm's accounts payable balance
at a given date and what it would be if no discounts had been taken,
and (b) the difference between the limit of the firm's revolving line
of credit and the actual amount utilized at a given date. The third
category of reserve funds is, of course, the most tenuous of all the
categories. Firms that experience significant, unexpected demands
for funds are not necessarily in good positions to go into the capital
market and attract new sources of borrowed or equity funds. Once again,
this takes us back to profitability. Firms with demonstrable, long-run,
competitive profit prospects may have little difficulty; but for firms
whose profit prospects are dim or very uncertain, seemingly temporary,
unexpected demands for funds can precipitate the end of the firm's
economic existence.
The final concept in a framework for analyzing potential financial
distress is the criterion for recognizing distress when it clearly
already exists. A firm clearly is in financial distress if (a) some
or all of its obligations are past due, and (b) it has no reserve
funds, as defined above, or it has insufficient reserve funds to cover
the past-due portion of its obligations.
In summary, to be sensitive to a firm's potential for financial distress,
analytical review procedures should include (1) an evaluation of relative
profitability and trends therein, (2) an examination of sources and
uses of funds, (3) consideration of the efficiency of utilization
of net funds generated, and (4) determination of the state of servicing
of obligations (the relationship between the manner in which they
are being serviced and the creditors' terms), along with an assessment
of the reserve funds position of the firm. These steps are included
in the ARTA sequence of analysis outlined in the next section.
THE ARTA APPROACH
The ARTA approach to analytical review consists of three stages:
first, the mechanics of producing relevant statistics on which to
base the analysis; next, an analysis of what happened to the firm
during the period under study and its comparative condition at the
end of the period; and, finally, an evaluation of the audit implications
of unusual or unexpected changes in (or levels of) account balances.
This section outlines these stages and the next section illustrates
their application to a hypothetical company.
Mechanics
Earlier, it was noted that financial ratios, by themselves, are
not very informative about a firm's performance or financial condition.
Nevertheless, the financial ratios and other statistics are the basic
data on which a financial analyst draws. The steps outlined below
represent a reasonably complete, but minimal, set of such statistics
on which to base an ARTA-type analysis. However, nothing about the
ARTA approach is intended to be restrictive or to discourage the reader
from generating other statistics or measurements perceived to be relevant
to analyses of businesses, in general, or, especially, an analysis
of a particular business. But it is recommended that the following
financial statistics be produced as a foundation for further analysis
of the financial statement information of any industrial company,
large or small:
- Generate statistics on revenues, expenses, income and relative
profitability such as (but not limited to):
Comparative income statement components as percentages of revenues
Growth (decline) percentages in income statement components
Comparative rates of return on, for example, assets and owners'
equity
- Generate statistics on long-lived assets, long-term debt and
owners' equity such as:
The sources and uses of funds and the increase or decrease in
working capital (hint: the simplest way to prepare a statement
of sources and uses of funds is with a block diagram of changes
in the classified balance sheet, as illustrated in Exhibit 8)
Unusual changes in long-lived assets, long-term debt and owners'
equity accounts relative to prior balances and the client's plans
for the period
Timing of payments on long-term debt in relation to terms of credit
or indenture agreements Restrictive debt covenants, if any
- Generate statistics on current assets such as:
Changes and percentage changes in individual current asset accounts
Balances in relationship to related income statement accounts
(e.g., turn-day ratios, such as the number of days average sales
in the accounts receivable balance)
- Generate statistics on current liabilities such as:
Changes and percentage changes in individual current liability
accounts
Balances in relationship to related income statement accounts
(e.g., turn-day ratios)
Balances in relationship to line of credit limits and percentages
of collateral, if applicable
Tell the Story Conveyed by the Financial Statements
To be able to tell a cogent story about a firm's performance and
its financial condition from its financial statements is no trivial
matter. First, it is necessary to examine the various vital statistics
calculated in the previous stage and pick out what is truly significant.
Second, it is necessary to write a concise narration that captures
all of the essentials and is totally uncluttered with nonessentials.
This takes discipline, but the guidelines below should help even beginners
to do a reasonably creditable job (provided they take seriously the
writing limitations included in the guidelines).
- Analyze the profit picture for the current period compared
to the past period(s) and plans for the current period, noting
the significant components contributing to any change in income
or profitability. Describe your findings in two or three sentences.
- Analyze the significant sources and uses of funds, noting any
items of an unusual or unexpected nature or size, and note the
net change in working capital. Describe your findings in two or
three sentences.
- Note the changes in current assets and what they imply with
respect to efficient utilization of such assets. Describe your
findings in two or three sentences.
- Note: (a) what the change in working capital and the change
in current assets implied for the change in utilization of current
liabilities; (b) the distribution of the change among the current
liability accounts; (c) the apparent manner in which debts were
serviced during the period and whether current liabilities are
within terms at the end of the period; and (d) the "reserve
funds" position of the client as of the end of the review
period. Describe your findings in three or four sentences.
Evaluate the Implications for Audit Planning
The same set of statistics that provide a basis for telling the story
of the firm's overall performance and financial condition serve as
starting points in deriving audit implications from the firm's financial
statements. In this stage the auditor should again start with the
elements of the income statement, but should focus his/her attention
on the related balance sheet accounts, as well. For example, the evaluation
of sales should lead directly to a consideration of all the other
accounts related to the sales transaction cycle, such as accounts
receivable, sales returns and allowances and discounts. The analysis
should include the following steps:
Isolate unusual or unexpected items relative to (1) prior periods,
(2) plans, and/or (3) industry averages, using a "materiality"
criterion as well as raw differences and percentage changes
Explain unusual or unexpected items in terms of:
Possible business explanations,
Possible implicit change(s) in accounting principles or method(s)
of application, and/or
Possible types of errors and irregularities that could explain
them
Follow the above steps for accounts that are dependent on other
accounts as their valuation bases such as the allowance for doubtful
accounts which is dependent on accounts receivable for its proper
valuation.
Follow the above steps for independent accounts such as marketable
securities
Consider the audit implications of the analysis, make follow-up
inquiries and make recommendations for subsequent audit procedures
(as to both those that should be emphasized and those that should
be deemphasized or eliminated)
CASE ILLUSTRATION
In this section the ARTA approach is illustrated using a simplified
case. The case is simplified in three respects: (a) the firm illustrated
is a small, relatively simple business; (b) plans and industry averages
of ratios are not given, thus restricting comparative analysis to
time-series comparisons; and (c) as with most case scenarios true
follow-up is not possible. While these restrictions are significant
they are necessary to prevent the illustration from being overly arduous
and difficult for beginners to follow.
Haynes Distributing Company
Haynes Distributing Company is a franchised wholesale distributor
of consumer durables in a population center of 650,000 people. The
company competes with other distributors, each of which is franchised
by manufacturers of different brand names. You are a new member of
the audit team on the 19x5 Haynes audit. The firm you work for has
audited Haynes for three years. However, this year several new staff
members have been added to the audit team, and a discussion with the
firm's officers indicates that it has experienced significant growth
in volume and profits under the new controller. The in-charge auditor
therefore wants you to do a thorough preliminary study of the client's
nine-month comparative financial statements. The comparative financial
statements are shown in Exhibits 9 and 10.
Through inquiries of the client's personnel, depositories, creditors,
etc., you have learned the following, in addition to the information
contained in the financial statements:
- There was no increase or decrease in inventory during the first
nine months of 19x4.
- Property, plant, and equipment dispositions had book values
of $40,000 and $20,000, net of accumulated depreciation, for the
first nine months of 19x5 and 19x4, respectively, and no gains
or losses were realized on dispositions (taken as a whole) in
either period.
- Dividends totaling $9,200 were paid in the first nine months
of 19x4. Total assets at 12/31/x3 amounted to $210,000.
- The bank loan is a revolving line of credit, secured by accounts
receivable. The agreement with the bank limits the loan balance
to 100% of eligible accounts receivable, which consist of all
accounts that are within terms ($62,000 as of 9/30/19x5 and $43,000
as of 9/30/19x4). The bank was satisfied that the line of credit
was properly secured at 9/30/x4 and 12/31/x4. The same bank is
the lender for the revolving line and the term loan. The line-of-credit
agreement requires a current ratio of at least 1.25:1.0. The term
loan re-quires that the debt to equity ratio not exceed 6:4 and
restricts dividends to retained earnings in excess of $40,000.
- All purchases and sales are made on account with terms of 1%,
10 days; net, 30 days for both.
- Total interest expense, included in "administrative expenses,"
was $20,000 and $35,000, respectively, for the nine months ended
9/30/x4 and 9/30/x5.
- During the nine months ended 9/30/x5 the company capitalized
expenditures previously considered to be routine maintenance expenses
because the new controller, upon review of policies, concluded
that all such expenditures in some way add to property, plant,
and equipment. These expenditures, which amounted to $10,000,
were treated as before for tax purposes (i.e. as current expenses).
$200 in depreciation expenses applied to the capitalized amount
during the first nine months of l9x5. This change represents the
only timing difference between the company's financial accounting
and tax methods. Heretofore, there have been no timing differences
and, therefore, no deferred taxes.
- The business is basically non-seasonal and the increase in
volume during 19x5 took place from the start of the year as a
result of increased advertising by the firm and its suppliers
and a more reasonable credit granting policy for new customers.
- During the remainder of 19x5: (a) the firm will take delivery
of $30,000 in additions to plant and equipment requiring immediate
payment, (b) the firm must pay a $10,000 semi-annual installment
on the long-term liabilities (bank term loan), and (c) the firm
expects the rate of sales to grow another 20% and quarterly net
income to be $20,000 after taxes. If the firm's line of credit
is fully utilized, the controller feels that it must maintain
an average daily cash balance of $10,000 to avoid frequent cash
shortages.
Haynes' Financial Statistics
- Statistics on revenues, expenses, income and relative profitability:
(a) Income statement components as percentages of revenues
for Haynes' nine-month comparative statements and (b) growth percentages
in income statement components between the two statements are
presented in Exhibit 11 Comparative rates of return on assets
and owners' equity: Return on Beginning Owners' Equity
19x5: $43,740 / $151,500 = 28.9%
19x4: $27,540 / ($140,000 - $27,540 + $9,200) = 22.6%
(Note: alternatively, return on equity may be calculated on the
average of beginning and ending equity, giving rates of 21.1%
for 19x4 and 29.9% for 19x5.) Return (pretax income plus interest
expense) on Beginning Assets
19x5: ($72,940 + $35,000) / $225,000 = 48.0%
19x4: ($51,000 + $20,000) / $210,000 = 33.8%
(Note: alternatively, return on assets may be calculated on the
average of beginning and ending assets, giving rates of 32.6%
for l9x4 and 41.5% for 19x5.)
- Statistics on long-lived assets, long-term debt and owners' equity:
The sources and uses of funds and the decrease in working
capital are identified in the block diagram in Exhibit 12, showing
the changes in Haynes' classified balance sheet from 12/31/19x4
to 9/30/19x5. These data are also presented in the Statement of
Changes in Financial Position in Exhibit 13. Percentage changes
in long-lived assets, long-term debt and owners' equity accounts
between 12/31/x4 and 9/30/x5 are shown in Exhibit 14. The noteworthy
items are the 100% increase in the term loan and the 20.39% decline
in retained earnings. Restrictive debt covenants:
Current ratio must exceed 1.25:1.00 Actual current ratio = 1.27
Debt to equity ratio must not exceed 6:4 (1.5) Actual debt to
equity ratio = 1.092
Dividends only to the extent retained earnings exceed $40,000
(actual = $41,000)
- Statistics on current assets:
The percentage increases in Haynes' current assets
between 12/31/19x4 and 9/30/19x5 are shown in Exhibit 14; the
amounts of the changes are shown in Exhibit 12
Cash balance = $20,000; minimum requirement = $10,000
Cash declined by $10,000 from 12/31/19x4 to 9/30/19x5
Number of Days Sales in Accounts Receivable:
(Note: the number of days in nine months is approximately 274)
19x5: $82,222 / $627,800 x 274 days = 35.9 days
19x4: $50,000 / $502,000 x 274 days = 27.3 days
Number of Days Sales in Inventory:
19x5: $43,000 / $398,000 x 274 days = 29.6 days
19x4: $27,000 / $331,500 x 274 days = 22.3 days
- Statistics on current liabilities:
Changes and percentage changes in individual current
liability accounts are shown in Exhibits 12 and 14, respectively
Number of Days Purchases in Accounts Payable:
(Note: purchases are estimated using cost of goods sold and the
change in inventory, if any)
19x5: $54,000 / ($398,000 + $18,000) x 274 days = 35.6
19x4: $30,000 / $331,500 x 274 days = 24.8
Percent Utilization of Bank Line of Credit:
9/30/x5 $50,000 / $62,000 = 80.7%
9/30/x4 $20,000 / $43,000 = 46.5%
Haynes Performance and Financial Conditions
Before reading the capsule statement of Haynes Distributing Company's
performance over the first nine months of l9x5 and its condition on
9/30/19x5, the reader should make an independent effort to tell the
"story" using the guidelines given earlier and drawing on
the above statistical summary.
The "Story"
Sales during the first nine months of l9x5 increased by 25% over
the comparable period of 19x4. Although administrative expenses rose
more than proportionately, cost of goods sold, selling expenses and
income tax expense rose less than proportionately, causing net income
to increase by 59%. The rates of return on average assets and equity
increased from 32.6% to 41.5% and from 21.1% to 29.9%, respectively.
Acquisitions of property, plant and equipment, dividend payments
and term loan payments required more funds than were provided by dispositions
of assets, proceeds of new term loans and operations, causing working
capital to decline by $24,500.
The investment in current assets grew by $36,000 (33%), with growth
in accounts receivable of $25,000 (51%) and growth in inventory of
$18,000 (72%), partially offset by a $10,000 (33%) decline in cash.
The turnovers of both accounts receivable and inventory have slowed
considerably.
The decline in working capital, coupled with the increased investment
in current assets, required an increase in utilization of current
liabilities of $60,500 or 113%. The principal sources of the overall
increase were accounts payable, which increased by $26,500 (96%),
and the bank line of credit, which increased by $30,000 (150%).
All restrictive covenants were being met, and all liabilities were
within terms as of 9/30/19x5, except accounts payable, which equaled
approximately 36 days purchases at average rates. The past-due portion
of approximately $9,000 can be covered by either the $10,000 excess
of the cash balance over the minimum cash requirement, or the $12,000
in un-used credit under the revolving line. However, these are the
firm's only apparent reserve sources of funds. With expenditures on
operations exceeding $60,000 per month and current liabilities exceeding
$100,000, the firm does not appear to be in a good immediate position
to withstand unforeseen funding requirements. (Note: this latter conclusion
might be moderated by the results of follow-up inquiries of management.)
Audit Implications
Sales, Accounts Receivable and Allowance for Doubtful Accounts Management
has indicated that 19x5 sales volume was up (25%) from the very beginning
of l9x0 due to increased firm and supplier advertising and a change
in credit policy. However, in light of the less-than-proportionate
increase in selling expenses, it would appear that supplier advertising
and Haynes' softening of credit policy were more significant in explaining
the increase in sales.
The softening of the credit policy for new customers is reflected
in the significant increase in the number of days sales in accounts
receivable, which increased from 27.3 days as of 9/30/x4 to 35.9 days
as of 9/30/x5 (this corresponds to 51% increase in accounts receivable
on a sales increase of 25%). The slowdown in turnover raises a question
as to whether there has also been a change in expected collectability,
as well. The allowance for doubtful accounts, on the other hand, is
the same percentage of accounts receivable at 9/30/x5 as at 9/30/x4,
raising the issue of appropriate valuation.
Therefore, in planning the audit procedures in the sales transaction
area and direct tests of the related accounts, special attention should
be given to (a) the client's new credit policy for new customers,
(b) the client's recent experience in collecting from new customers,
(c) the client's aging and write-off policies, (d) the client's projected
collectability for each age category, and (e) the client's rate of
allowance for doubtful accounts for each age category.
Cost of Goods Sold and Inventory
Although sales for the first nine months of 19x5 increased by 25%over
the comparable period of 19x4, cost of goods sold increased by only
20%, declining to 63.4% of sales from 66%. If cost of goods sold had
remained 66% of sales, the 19x5 nine-month total would have been $16,500
greater. This would have reduced before-tax income by a like amount
or 23%, which is clearly material.
At the same time, inventory increased by 72% from 12/31/x4 to 9/30/x5,
and slowed down in turnover from 22.3 to 29.6 days sales on hand,
between 9/30/x4 and 9/30/x5. The significant increase in inventory
and the material decline of cost of goods sold as a percent of sales
may be related through inventory errors. Therefore, extra attention
should be given to (a) observation of the physical count, especially
in reviewing and observing the client's methods of detecting obsolescence
and damage, (b) inventory costing policy, method of application and
accuracy, and (c) procedures for detecting unrecorded purchases (unrecorded
liabilities).
Other Expenses and Related Accounts
There was a disproportionate (38.22%) increase in administrative
expenses. One readily identifiable cause of this significant increase
in expenses is a probable loss of discounts on purchases and an increase
in interest costs on other debt. Between 12/31/x4 and 9/30/x5, the
client's total liabilities increased by more than 100%. This led to
a 75% increase in total interest expense, which is one component of
total administrative expenses. When interest expense is backed out
of total administrative expenses, the latter increased by only 19%
or less than the percentage increase in sales.
At the same time there is at least one source of possible understatement
in administrative (and, perhaps, selling) expenses, namely, the change
in accounting for maintenance expenditures. Since the effect of the
new policy on maintenance expenditures was to reduce current expenses
by as much as $9,800, total administrative expenses may be understated
by this amount. If such an amount were added, and interest expenses
were disregarded, total administrative expenses would have grown by
44.6% or more than in proportion to sales. Moreover, pretax income
would have been 13.4% less, which is very likely material.
Income tax expense declined from 46% to 40% of income before taxes;
that is, while pretax income increased by a greater percentage than
sales, income tax expense increased in proportion to sales. This suggests
an understatement of income tax expense, probably due to the divergence
(for the first time) between the accounting and tax treatment of maintenance
expenditures and the apparent failure to allow for deferred taxes
thereon.
Therefore, the new policy on treatment of maintenance expenditures
should be reviewed thoroughly for propriety. If the new accounting
method is appropriate, then income tax expense is understated due
to the divergence of accounting and tax methods. Thus, an adjustment
will be necessary either to expense a larger amount (perhaps all)
of the maintenance expenditures of the year or to recognize the appropriate
amount of income tax expense and to set up a deferred taxes account.
APPLICATION OF ARTA TECHNIQUES TO FINANCIAL PLANS
In addition to wanting to derive audit implications from actual (annual
or interim) financial statements, auditors have a natural interest
in evaluating the client's plans for (a) the duration of the fiscal
year under audit and the period subsequent to the audit. In the former
case, the interest is in refining the assessment of audit implications
and modifying audit plans accordingly. In the latter case, the interest
is in projecting the assessment of the probability of financial distress
into the future, and getting a feel for how the statements under audit
might look in light of expected subsequent events. A corollary benefit
to an ARTA evaluation of the client's plans is that the auditor may
be able to advise the client of any difficulties he/she sees in the
plans, thus offering an extra element of client service to the audit.
To evaluate formal financial plans of a client (meaning plans set
forth in a balance sheet and articulating income statement), the same
steps should be followed as for actual financial statements. Then,
the auditor should consider the following four factors of success:
- Management's ability to carry out the plans;
- Consistency of the plans with expected environmental conditions;
- The operational practicality of the plans; and
- The adequacy of supporting funds.
Adequacy of supporting funds is a matter of judgment. However, the
concept of adequacy of supporting funds can be defined and is important
to anyone concerned with financial analysis and/or planning. Supporting
funds are adequate when there are sufficient funds to provide for
the total investment in assets implied by a firm's plans and also
to provide a margin for error in case the plans do not turn out as
favorably as expected. A margin for error exists if, after planned
investments are fully funded, the firm will still have some significant
amount of reserve funds.
An analysis of a firm's plans also should include consideration of
questions raised by the plans, e.g., threats to financial well-being,
new types of transactions, changes in accounting entity, reorganizations,
changes in organization structure or control systems, etc.
Haynes' Plans for the Duration of 19x5
The Haynes case illustrates the slightly more complex process that
the auditor must follow before evaluating the less formal plans that
are especially characteristic of small clients. Recall Haynes' plans
for the duration of 19x5 contained in the supplemental information
given earlier. They consisted of minimal details of a sales and profit
plan, plus a few expected financing and investment activities. To
work with such plans the auditor must fill in the gaps with appropriate
assumptions (preferably with the help of the client) and determine
the financial consequences of the more complete picture. For this
purpose, it is recommended that the auditor fill in a block diagram
of the various balance sheet changes implied by the client's informal
plans. Basically, this technique involves considering each current
and noncurrent asset, liability and equity account and determining
what the plans (as stated) imply for that account. (Note if the plans
are silent about a particular account or there are no implicit changes
to be expected, it may be ignored.) Such a diagram is illustrated
in Exhibit 15, based on the plans of Haynes Distributing Company for
the duration of 19x5 plus the following assumptions and derived amounts:
a. It is assumed that the cash balance will not be driven down
unless the bank line of credit is first fully utilized. (See b
below.)
b. It is assumed that accounts receivable, inventory, accounts
payable and the bank loan will grow in proportion to sales.
Accounts receivable: $82,222 x .2 =$16,444
Allowance for D. A.: $-8,222 x .2 = $-1,644
Inventory: $43,000 x .2 = $ 8,600
Accounts payable: $54,000 x .2 = $10,800
Bank loan: $50,000 x .2 = $10,000
c. The income tax liability is assumed to go up in proportion
to profits:
$10,000 x (($20,000 / (43,740 / 3)) - 1) = $3,717
d. Depreciation for the last three months of 19x5 is assumed
to be in proportion to the first nine months:
$25,000 / 3 = $8,333
After filling in a block diagram such as Exhibit 15, the auditor
can readily determine whether the firm's financial plans are feasible
and/or efficient, and whether they foretell potential financial distress.
The test for financial feasibility or efficiency is an application
of the dual definition of working capital mentioned earlier. If the
working capital change implied by all the individual changes in current
assets and current liabilities is greater than the working capital
change implied by all the changes projected for long-lived assets
and long-term debt and equity, then the plans are not financially
feasible. If, on the other hand, the latter projected change is significantly
greater than the former, then the plans contain potential inefficiency,
in that projected funds to be generated significantly exceed planned
uses. The auditor judges the potential for financial distress exhibited
by plans in the same way he/she judges such potential from actual
financial statements, namely, by assessing the reserve funds position
implied by the plans.
Implications of Haynes' Plans
The lower half of the block diagram in Exhibit 15 shows that the
firm's expected sources and uses of funds for the remaining three
months of 19x5 is such that working capital will decline by $11,667.
At the same time, if accounts receivable, inventory, accounts payable
and the bank loan expand proportionately with sales (and the tax liability
with profits), working capital can decline by only $1,117. This means
that either cash must decline toward the minimum, or current liabilities
will have to expand to absorb the additional projected decline in
working capital of $10,550. Therefore, more pressure will be placed
on current liabilities, probably using a portion of the remaining
unused line of credit or causing greater delinquency in accounts payable.
Thus, if growth continues, the firm may be headed for a period of
financial distress, unless more long-term financing is arranged or
the bank or suppliers increase the short-term credit available to
the company. If the projected growth in sales is accompanied by a
further slowing of collections or deterioration in collectability
(which was not assumed above), this could increase the probability
of distress, accelerate its occurrence, or both.
SUMMARY
The ARTA approach supplies a systematic way for auditors to (a) generate
relevant statistics from a client's financial statements, (b) tell
the Ed story" of the client's performance and financial condition
as it should appear to any user of the statements, (c) assess the
client's potential for financial distress, (d) determine the implications
of financial statement items for planning the audit, and (3) evaluate
even the most informal financial plans (to satisfy the same purposes
as the evaluation of actual statements).
The techniques are grounded on the use of the income statement,
the statement of changes in financial position, and the classified
balance sheet (the principal statements available to other users),
and on the concept of "auditing in the context of the business."
The ARTA approach also outlines concrete concepts of potential financial
distress, including:
Relative profitability,
The flow of funds,
Servicing of debt, and
Reserve funds
The ARTA approach provides step-by-step guidelines for each stage
of analytical review, including identification of specific audit risks
and determining their implications for audit planning. So even a relative
beginner can do a creditable job of analyzing a client's financial
statements.
*This article contains
copyrighted material or adaptations of copyrighted material from Evaluating
Business Ventures, copyright @ 1982, United States National Bank
of Oregon, used with the permission of the copyright holder. Do not
copy or quote without the expressed permission of the author. The
author gratefully acknowledges the helpful comments on an earlier
draft of the paper from Rick Tabor, Assistant Professor of Accounting,
and Sherry Stewart and Linda Wininger, Masters in Professional Accounting
students, The University of Texas at Austin.
Exhibit 1
AUDIT RISK, ASSURANCE AND THE ENGAGEMENT DECISION
Source: Robert G.May, Ernst and Whinney Professor of
Accounting, University of Texas at Austin.
Exhibit 2
THE CLASSIFIED BALANCE SHEET*
*Source: W. Keith Henderson, Robert G. May and Lawrence D. Schall,
EVALUATING BUSINESS VENTURE (Portland: United States National Bank
of Oregon, 1982).
