ESTABLISHING PROCEDURES FOR OBTAINING AUDIT EVIDENCE INCLUDING BALANCE AND TRANSACTION TESTING, ANALYTICAL PROCEDURES AND MANAGEMENT REPRESENTATION

Analytical Procedures

Introduction

APB statement of auditing standard 410 covers ‘Analytical Procedures’.
The standard requires auditors to apply analytical procedures at the planning
and overall review stages of the audit.
The standard defines ‘Analytical procedures’ as the analysis of relationships
between:
(a) Items of financial data, or between items of financial and non-financial
data, deriving from the same period; or
(b) Comparable financial information deriving from different periods or
different entries, to identify consistencies and predicted patterns or
significant fluctuations and unexpected relationships, and the results
of investigations thereof.
Analytical procedures are designed primarily to assist in planning the audit
and as part of the evaluation of the financial statements.
Analytical procedures may also be performed as substantive procedures
designed to obtain evidence directly.

Nature and Purpose of Analytical Procedures

Analytical procedures include the consideration of comparisons of the entity’s
financial information with, for example:
(a) Comparable information for prior periods;
(b) Anticipated results of the entity, from budgets or forecasts;
(c) Predictive estimates prepared by the auditors, such as an estimation of
the depreciation charge for the year; and
(d) Similar industry information, such as a comparison of the entity’s ratio
of sales to trade debtors with industry averages, or with the ratio relating
to other entities of comparable size in the same industry.
Analytical procedures also include consideration of relationships:
(a) Between elements of financial information that are expected to conform
to a predicted pattern based on the entity’s experience, such as the
relationship of gross profit to sales; and
(b) Between financial information and relevant non-financial information,
such as the relationship of payroll costs to number of employees (Chitty,
2004).
Various methods may be used in performing the analytical procedures. These
range from simple comparisons to complex analyses using advanced statistical
techniques. Analytical procedures may be applied to consolidated financial
statements, financial statements of components (such as subsidiary
undertakings, divisions or branches) and individual elements of financial
information. The auditors’ choice of procedures, methods and level of application
is a matter of professional judgement.
Analytical procedures are used by auditors:
(a) To assist in planning the nature, timing and extent of other audit
procedures;
(b) As substantive procedures when their use can be more effective or
efficient than other procedures in reducing detection risk for specific
financial statement assertions; and
(c) As part of the overall review of the financial statements when finalising
the audit.

Analytical Procedures in Planning the Audit

Auditors should apply analytical procedures at the planning stage to assist in:
(a) Understanding the entity’s business;
(b) Identifying areas of potential audit risk; and
(c) Planning the nature, timing and extent of other audit procedures.
Analytical procedures at this stage are usually based on the entity’s interim
financial information, budgets and management accounts. Discussions with
the entity’s management, focused on identifying significant changes in the
business since the prior financial period, may also be useful.
Application of analytical procedures may indicate:
(a) Aspects of the entity’s business of which the auditors were previously
unaware; and
(b) Assist in determining the nature, timing and extent of other audit
procedures.

Analytical Procedures as Substantive Procedures

The decision about whether to use analytical procedures as substantive
procedures and the nature, timing and extent of their use is based on the
auditors’ judgement about the expected effectiveness and efficiency of the
available procedures in reducing detection risk for specific financial statements
assertions.
Auditors usually enquire of management as to the availability and reliability
of information needed to apply analytical procedures and the results of any
such procedures performed by the entity.
It may be efficient to use analytical data prepared by the entity, provided the
auditors are satisfied that such data is properly prepared.
When intending to apply analytical procedures as substantive procedures,
auditors consider a number of factors such as:
(a) The plausibility and predictability of the relationships identified for
comparison and evaluation. For example, there is a strong relationship
between certain selling expenses and turnover in businesses where the
sales force is paid by commission;
(b) The objectives of the analytical procedures and the extent to which their
results are reliable;
(c) The degree to which information can be disaggregated, for example,
analytical procedures may be more effective when applied to financial
information on individual sections of an operation or to financial
statements of components of a diversified entity, than when applied to
financial information relating to the entity as a whole;
(d) The availability of information, both financial (such as budgets or
forecasts) and non-financial (such as the number of units produced or
sold);
(e) The relevance of the information available, for example, whether budgets
are established as results to be expected rather than as goals to be
achieved;
(f) The comparability of the information available, for example, broad
industry data may need to be supplemented to make it comparable with
that of an entity that produces and sells specialised products; and
(g) The knowledge gained during the previous audits, together with the
auditors’ understanding of the effectiveness of the accounting and
internal control systems and the types that in prior periods have given
rise to accounting adjustments (Chitty, 2004).
The reliability of the information used in analytical procedures is likely to be
enhanced:
(a) If it comes from sources independent of, rather than internal to, the entity;
(b) If the information is produced internally, its reliability is enhanced if it
is produced independently of the accounting system or there are
adequate controls over its preparation; and
(c) If the necessity for the evidence on the reliability of such information
depends on the results of other audit procedures and on the importance
of the results of analytical procedures as a basis for the auditors’ opinion.
The extent of reliance that auditors place in the results of analytical procedures
when used as substantive procedures may also depend on the following factors:
(a) Other procedures directed towards the financial statement assertions.
For example, other procedures auditors undertake in reviewing the
collectibility of debtors, such as the review of subsequent cash receipts,
may confirm or dispel questions arising from the application of analytical
procedures to an aged profile of customers’ accounts;
(b) The accuracy with which the expected results of analytical procedures
can be predicted. For example, auditors normally expect greater
consistency in comparing discretionary expenses, such as research or
advertising; and
(c) The frequency with which a relationship is observed, for example, a
pattern repeated monthly as opposed to annually.
The application of analytical procedures is based on the expectation that
relationships between data exist and continue in the absence of known
conditions to the contrary. The presence of these relationships provides audit
evidence as to the financial statement assertions relating to the data produced
by the accounting system. However, reliance on the results of analytical
procedures depends on the auditors’ assessments of the risk that the analytical
procedures may identify relationships as expected whereas, in fact, a material
misstatement exists (Chitty, 2004).

Analytical Procedures as Part of the Overall Review when Completing

the Audit

APB SAS 410 titled “Analytical procedures” states that, “when completing the
audit, auditors should apply analytical procedures in forming an overall
conclusion as to whether the financial statements as a whole are consistent
with their knowledge of the entity’s business”.
The conclusions drawn from the results of such procedures are intended to:
(a) Corroborate conclusions formed during the audit regarding individual
components or elements of the financial statements; and
(b) Assist in arriving at the overall conclusion as to whether the financial
statements as a whole are consistent with the auditors’ knowledge of
the entity’s business. However, they may also identify areas requiring
further audit procedures.

Investigating Significant Fluctuations or Unexpected Relationships

APB SAS 410 states that when significant fluctuations or unexpected
relationships are identified that are inconsistent with other relevant information
or that deviate from predicted patterns, auditors should:
(a) Investigate; and
(b) Obtain adequate explanations and appropriate corroborative evidence.
The investigation of significant fluctuations and unexpected relationships
ordinarily begins with enquiries of management, followed by corroboration of
management’s responses:
(a) By comparing them with the auditors’ knowledge of the entity’s business
and with other evidence obtained during the course of the audit; or
(b) If the analytical procedures are being carried out as substantive
procedures, by undertaking additional audit procedures where
appropriate to confirm the explanations earlier received from entity’s
management.
Where the explanation obtained from the entity’s management is considered
inadequate, the auditors may determine the additional audit procedures to be
undertaken to obtain an explanation for the fluctuation or relationship noted.

MANAGEMENT REPRESENTATIONS

Introduction

APB Statement of Auditing Standard 440 covers “Management Representations”.
SAS 440 establishes standards and provides:
(a) Guidance on the use of management representations as audit evidence;
(b) The procedures to be applied in evaluating and documenting
management representations; and
(c) The action to be taken if management refuses to provide confirmation
of appropriate representations.
In the course of an audit, many representations are made to the auditors. The
representations may be:
(a) either unsolicited or in response to specific enquiries;
(b) critical to obtaining sufficient appropriate audit evidence on which to
base their audit opinion; and
(c) on general matters, for example that the directors have made all
accounting records available to the auditors.
The possibility of misunderstanding between auditors and management is
reduced when oral representations are confirmed in writing. Written
confirmation of representations may take the form of:
(a) A representation letter from management; or
(b) A letter from the auditors outlining their understanding of management’s
representations, duly acknowledged and confirmed in writing by
management; or
(c) Minutes of meetings of the board of directors, or similar body, at which
such representations are approved.
An example of representations from management in the form of a letter is set
out in the latter part of this section.
APB SAS 440 states that; “auditors should obtain written confirmation of
appropriate representations from management before their report is issued”.
The standard describes, in the context of management representations,
‘management’ as including directors, officers and others who perform senior
managerial function.
The standard defines ‘Directors’ as the ‘directors of a company or other body,
the partners, proprietors, committee of management or trustees of other forms
of entities, or equivalent persons responsible for directing the reporting entity’s
affairs and preparing its financial statements.

Acknowledgement by the Directors of their Responsibility for the
Financial Statements

Auditors should obtain evidence that the directors acknowledge their collective
responsibility for the preparation of the financial statements and have approved
the financial statements.
The directors’ acknowledgement of such collective responsibility and approval
may be obtained by the auditors receiving a signed copy of the financial
statements which incorporate a statement of the directors’ responsibility for
the financial statements.
Relevant minutes of meetings of the board of directors or similar body, or by
attending such a meeting; or a written representation from the directors.
When auditors have responsibility for reporting on the financial statements of
a group of companies, acknowledgement by the directors of their responsibility
for the financial statements applies to both the group financial statements and
the financial statements of the parent undertaking (Chitty, 2004).

Representations by Management as Audit Evidence

Auditors often rely on representations by management as part of their audit
evidence by:
(a) Obtaining representations from the directors as to their responsibility
for the financial statements; and
(b) Relying on representations by management.
Auditors should obtain written confirmations of representations from
management on matters which are material to the financial statements and
when those representations are critical to obtaining sufficient appropriate audit
evidence.
The auditors should discuss such matters with those responsible for giving the
written confirmation before they sign it to ensure that they understand what
they are confirming.
When representations to the auditors relate to matters which are material to
the financial statements, they:
(a) Seek corroborative audit evidence;
(b) Evaluate whether the representations made by management appear
reasonable and are consistent with other audit evidence obtained,
including other representations; and
(c) Consider whether the individuals making the representations can be
expected to be well-informed on the particular matters’ (Chitty, 2004).
The auditors should not regard representations by management to be a
substitute for other audit evidence that auditors expect to be available. If
sufficient appropriate audit evidence regarding a matter that may have a
material effect on the financial statements is not available, this constitutes a
limitation on the scope of the audit, even if a representation from management
has been received on the matter. In these circumstances it may be necessary
for the auditors to consider the implications for the purpose of their report.
Management representations may be the only audit evidence available in
certain instances, such as:
(a) Where knowledge of the facts is confined to management (for example,
when the facts are a matter of management intentions); or
(b) When the matter is principally one of judgement or opinion (for example,
on the trading position of a particular customer).
In some exceptional cases, the matter may be of such significance that the
auditors refer to the representations in their report as being relevant to a proper
understanding of the basis of their opinion.
If a representation appears to be contradicted by other audit evidence, the
auditors should:
(a) Investigate the circumstances to resolve the matter; and
(b) Consider whether it casts doubt on the reliability of other representations.
The investigation of apparently contradictory audit evidence regarding a
representation received involve further enquiries of management to ascertain
whether the representation has been misunderstood or whether the other audit
evidence has been misinterpreted, and obtaining corroboration of
management’s responses.
If management is unable to provide an explanation or if the explanation is not
considered adequate, further audit procedures may be required to resolve the
matter.

Basic Elements of a Management Representation Letter

When requesting a management representation letter, the auditors ought to
request that it should be:
(a) Addressed to them;
(b) Contain specified information;
(c) Appropriately dated;
(d) Approved by those with specific knowledge of the relevant matters; and
(e) Discussed and agreed by the board of directors or similar body, and on
their behalf by the chairman and secretary, before they approve the
financial statements, to ensure that the board as a whole is aware of the
representations on which the auditors intend to rely in expressing their
opinion on those financial statements.
The auditors may also wish to consider whether to take the opportunity to remind
the directors that, under section 369 of the Companies and Allied Matters Act,
it is an offence to mislead the auditors.
A management representation letter is normally dated on the day the financial
statements are approved by the directors.
If there is any significant delay between the date of the management
representation letter and the date of the auditors’ report, the auditors may
consider it necessary to obtain further representations regarding the intervening
period for the purpose of their report.

Action if Management Refuses to Provide Written Confirmation of
Representations

If management refuses to provide written confirmation of a representation that
the auditors consider necessary, the auditors should:
(a) Consider the implications of this scope limitation for their report.
(b) Not place reliance on other representations made by management during
the course of the audit.

Example of Management Representation Letter

Company letterhead)
(To the auditors)
We confirm to the best of our knowledge and belief, and having made
appropriate enquiries of other directors and officials of the company, the
following representations given to you in connection with your audit of the
financial statements for the period ended 31 December ………
(a) We acknowledge as directors our responsibilities under the Companies
and Allied Matters Act for preparing financial statements which give a
true and fair view and for making accurate representations to you. All
the accounting records have been made available to you for the purpose
of your audit and all the transactions undertaken by the company have
been properly reflected and recorded in the accounting records. All
other records and related information, including minutes of all
management and shareholders’ meetings, have been made available
to you.
(b) The legal claim by ABC Nigeria Limited has been settled out of court by
a payment of N5 million. No further amounts are expected to be paid,
and no similar claims have been received or are expected to be received.
(c) In connection with deferred tax not provided, the following assumptions
reflect the intentions and expectations of the company:
(i) Capital investment of N10 million is planned over the next three
years;
(ii) There are no plans to sell revalued properties; and
(iii) We are not aware of any indications that the situation is likely to
change so as to necessitate the inclusion of a provision for tax
payable in the financial statements.
(d) The company has not had, or entered into, at any time during the period
any arrangement, transaction or agreement to provide credit facilities
including loans, quasi-loans or credit transactions) for directors or to
guarantee or provide security for such matters.
(e) There have been no events since the balance sheet date which necessitate
revision of the figures included in the financial statements or inclusion
of a note thereto.
We confirm that the above representations are made on the basis of enquiries
of management and staff with relevant knowledge and experience (and, where
relevant, of inspection of supporting documentation) sufficient to satisfy
ourselves that we can properly make each of the above representations to you.
As minuted by the board of directors at its meeting on…………………(date)
…………………….                                       ...........……….........
Chairman                                                                   Secretary

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