Assume that an auditor wishes to use analytical procedures as a substantive procedure. Indicate how substantive analytical procedures could be used in assisting the auditor in testing the following accounts:
a. Interest expense related to bonds outstanding
b. Natural gas expense for a public utility company
c. Supplies expense for a factory
d. Cost of goods sold for a fast-food franchisor like McDonald’s. Note that cost of goods sold tends to average about 35% of sales in fast food franchises.
e. Salary expense for an office (region) of a professional services firm
What is a related party transaction? Provide examples of transactions that would be considered related-party transactions and then locate an example of a related party transaction that has been questioned in a company and what were the end results?
Comment #1 DN
According to Breger (2016), “substantive analytical procedures (SAPs) are tests an auditor can perform to obtain evidence about the reasonableness of an account balance. In conducting SAPs, auditors first develop an expectation for an account balance by evaluating plausible relationships among financial and nonfinancial data.”(p. 9) therefore, substantial analytical procedures are techniques that work to obtain evidence on the relation between financial and non-financial data, whether direct or indirect. Such procedures vary depending based on assertion tested, rigor of procedure required to be performed and other factors. To assess possible misstatement, the auditor applies analytical procedures to use the knowledge of data relations to form an expectation about the true account balance. Then, the expectation is compared to the current year’s book values. For a small difference, the book values may be accepted as not materially misstated (Kinney & McDaniel, 1996).
Substantive analytical procedures can be used for the analysis on the following cases:
a. Interest expense related to bonds outstanding can be analyzed using ratio analysis, tend analysis, regression analysis and reasonableness test. For example, a ratio analysis over the years can be computed and analyzed as to the variation over the years, any unjustified variation towards the current balance should be quantified and corroborated by the client.
b. The natural gas consumption will be directly or to a great extent related to the production process of the company, therefore, any increase or decrease in natural gas expense should be in tune with the variations in production levels over the periods. The auditor can observe any changes in the production process and the usage of natural gas for various different production processes.
c. The supplies expense for a factory is directly related to the amount of production in a given period. The auditor can ascertain the percentage of supplies used in past periods and ensure they are as per industry and company standard. Then he can check whether the levels of supplies usage in the current period are as per already computed levels.
d. According to Buckley (2019), “food and labor costs are calculated as a percentage of the total volume of sales. If a restaurant does $20,000 per week and the total cost of food and beverages is $7,000 for that week, then the food cost is considered 35 percent.” (par. 4), saying that the cost of goods sold for fast food franchisor is set at approximately 35%, the auditor can analyze the cost of goods sold over the past period and compare the same with industry and company set standards. Any unjustified variations should be investigated and justification from the client should be obtained.
e. Salary is an expense that has various factor that impact its value, such as the duration of employment, the industry standards, performance of certain employees, etc. As salary expense is dependent on various factors, which can be non-financial, only certain analytical procedures can be used in its analysis, such as disaggregation.
Comment #2 DT
A related party transaction is defined by Accounting Standards Codification (ASC) 850 as one that takes place in between parent company and its subsidiaries (Hardon, 2018). These transactions are often questionable in an audit as the contracts for goods or services can be priced at less or more favorable than those transactions involved with third parties (Hardon, 2018). For example, a subsidiary may lease an office space from the parent company at an unreasonably low market rate. For an auditor it is important to find any discrepancies in these transactions; for this reason, auditors gather documents and data sources to help uncover errors and signs of fraud. Some documents auditors may gather may include a list of company’s transactions to related parties, disclosures from board members and seniors regarding ownership of other entities, and bank statements showing transactions involving intercompany wires, automated clearing house (ACH) transfers, and check payments (Hardon, 2018).
The procedure for auditing related party transactions starts by testing how these transactions are inputted into the company’s enterprise resource planning (ERP) system (Hardon, 2018). The auditor will then interview accounting employees responsible for reporting these transactions in the financial statements and analyze how the entries are presented (Hardon, 2018). One example that made history was the Enron scandal that involved related party transaction fraud to keep losses off the books of the parent company. In Enron’s case, the company would build an asset and immediately record the profit on the books without making a single cent. In addition, if the revenue from the asset resulted in a loss, they would transfer the asset to an off-books corporation where the loss would go unseen (Segal, 2019). At the time, Enron would use Special Purpose Entities (SPEs) to hide a ton of debt and toxic assets from investors and creditors (Segal, 2019). The auditor in charge of auditing the company would clear the financial reports with an unqualified opinion on purpose as he had a conflict of interest with the company (O’Leary, n.d.). Related party transactions are still happening today and is important for an auditor to take into consideration that a company may be committing fraud to up their revenues. Similarly, the auditor must look into subsidiaries, disclosures and transaction reports between companies.
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