PROFITCENTS ANALYTICAL PROCEDURES EXPECTED VALUE METHODOLOGY

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1 PROFITCENTS ANALYTICAL PROCEDURES EXPECTED VALUE METHODOLOGY INTRODUCTION This document includes an analysis of the projection methodology used in ProfitCents Analytical Procedures in calculating expectations for the financial statements. The purpose of this guide is to assist the auditor in understanding the reasoning behind the various underlying assumptions used in the expected value calculation and to assist the auditor in responding to variances identified in the preliminary analytical review process. Included in this guide is a lineby-line reference to the calculation of each expected value. This should be used as a quick reference for auditors when analyzing the results of the expected values generated in ProfitCents Analytical Procedures. MODEL FOR PROJECTING EXPECTED VALUES The expected values generated in ProfitCents Analytical Procedures are based on using the historical periods of financial data to create a one year projection based on a sales growth driven model. Projected sales revenue is the primary driver using this projection model and changes in sales will have a pervasive impact on the rest of the expected values. This follows from the fact that if sales increases then we typically expect that cost of goods sold, selling expenses, outstanding accounts receivables, inventory carrying amounts, etc. should all increase correspondingly. For many line items the expected value is not a simple historical trend calculation applied to historical balances, rather a trend in an underlying ratio, such as days sales in receivables is identified and then applied to the historical sales trend. This is why the expected sales value is so pervasive in this projection model. HISTORICAL TREND ANALYSIS The historical trends used in the model are calculated using a statistical regression formula known as Holts-Winters Exponential Smoothing. This form of regression places heavier emphasis on whether or not a particular financial statement line item or ratio appears to trend 1 P a g e

2 in a certain direction over time or if it tends to fluctuate up and down from period to period. In cases where trending is consistent from year to year more weight is applied to that trend when projecting the current year s expected value. In cases where the account balance oscillates up and down from period to period very little weight is applied to any trend identified and therefore the expected value will conform to a value within a corridor of high and low values. Also many exceptions have been built into the model to handle special circumstances and to add a level of artificial intelligence to the model. The potential exceptions are too numerous to enumerate however in each ProfitCents Analytical Procedures report a complete detail of every calculation made is provided that will document any deviations from the default calculations noted later in this guide. For the purpose of calculating sub-accounts (mappings to general ledger account balances) the calculation applied to the financial statement account line will generally be applied to the sub account as well. Calculation of sub-account expected values are also included in the calculation section of the ProfitCents Analytical Procedures report if further reference is needed. APPLICATION TO PRELIMINARY ANALYTICAL REVIEW The most important take-away from this guide for the auditor using ProfitCents Analytical Procedures is the importance of understanding the impact that the expected sales trend will have on the rest of the expected values in the analysis. Underlying the historical trend assumption is the idea that the results that are projected are what would occur if management of the company did not make any changes to the operations of the business during the current period. In reality this is almost never the case, rather, using historical trend analysis is the starting point for understanding where management may have changed operational characteristics that impact the financial statements. For this reason, the auditor should always start the preliminary analytical review using ProfitCents Analytical Procedures by analyzing the sale revenue expectations. For instances where the sales trend varies materially from the actual the auditor should stop the analysis and through inquiry of management and other procedures obtain an understanding of what is driving the change in sales. From here the auditor can document that understanding and how they will address or respond to the variance and any identified risks surrounding revenue. When returning to the preliminary analytical review the auditor should then override the sales expectation to the actual if they are in agreement with management s initial responses to their inquiries. After overriding the sales expectation the ProfitCents Analytical Procedures report will be updated to reflect new expected values that are based on calculations that include sales as a driver. If the auditor fails to do this then the remaining expected values will not be comparable to the actual. 2 P a g e

3 APPLICATION TO SUBSTANTIVE ANALYTICAL PROCEDURES Once an understanding is gained regarding the methodology behind the projection model used for calculating expectations in ProfitCents Analytical Procedures, the opportunities to apply these expected values to substantive analytical procedures becomes more apparent. One example is the commonly used substantive analytical procedure for calculating interest expense. For smaller organizations where debt may consist of only a few loan balances, it is not uncommon to apply a simple average interest calculation to the average loan balance in developing a judgment about the reasonableness of interest expense during the period. Under the projection model used in ProfitCents Analytical Procedures, an interest rate trend is developed using regression analysis and this is applied to the expected outstanding debt balance. In cases where the company s debt structure is adequately described by this model than this will eliminate the need to perform the separate simple average calculation. Depreciation expense is another good example of where this type of substantive analytical procedure can be applied. Within PPC s Audit Program for Property, calculating depreciation as a percentage of the gross fixed asset base is listed a procedure for testing the reasonableness of depreciation expense. Again this expectation is built into the expected value calculated in ProfitCents Analytical Procedures. If no variances were detected in this area during preliminary analytical review it is not necessary to recalculate this during substantive fieldwork. In order to develop substantive analytical procedures using Profitcents Analytical Procedures it is necessary to understand that for many of the expectations the amount that has been quantified is based on applying the prior period balance or expected sales times an appropriate ratio. From here the auditor can develop the procedure using the following steps: 1. For the account expectation identify the components of the calculation, either: a. Historical trends (useful for expense variance analysis), or b. Prior year s balance X an applicable ratio (such as interest rate trend), or c. Sales Expectation X an applicable ratio (Days sales in receivable for instance) 2. Evaluate the appropriateness of the ratio or trend in the context of the account you are analyzing and the audit evidence that is desired (completeness, existence, etc.) 3. Establish a reasonable (material) range of values from the expected value calculation. 4. Compare the actual amount and determine if it is within the range of reasonable values based on the expectation developed in ProfitCents Analytical Procedures. 3 P a g e

4 Account Formula Trending Method Methodology Rationale and Audit Implication Income Statement Sales Prior Year's Sales x % Sales Growth Trend Time Series analysis has long been held to have meaningful predictive value for forecasting trends in revenues. The predictive value of this measure shows the trend in sales growth assuming management makes no changes from the prior year. Any variances here should be addressed by management inquiry to understand what was done differently to change this trend. Once you have documented your inquiries and have developed your audit response you should override this variance with the actual and rerun the preliminary analytical review. The projected values used in this model are projected using a sales driven model. As a result there will be a pervasive impact on expected account balances compared to actual if sales varies significantly. Overriding the sales expectation once you have addressed what is driving that variance will normalize the remaining expected values. Cost of Goods Sold (1 - Gross Margin % Trend) x Expected Sales Cost of Goods Sold should correlate with forecasted sales based on the historical trend in gross margin percentage. There is usually an acceptable range of margins that cost of goods sold should fluctuate within. Variances here typically indicate either changes in allocations to cost of goods solds or changes in economic conditions that result in fluctuations of materials, labor or overhead inputs. Since this is a function of forecasted sales, if a variance is present in the sales expectation then the auditor should focus on gross margin percentage for analyzing the cost of good sold expectation rather than the calculated expected value. Gross Profit Expected Sales - Expected Cost of Goods Sold Gross Profit Margin Expected Gross Profit / Expected Sales As noted above for cost of goods sold, gross profit margin percentage should fluctuate within an acceptable range from periodto-period. When sales trends vary significantly from actual sales it provides one of the most accepted metrics for annalyzing cost of goods sold. 4 P a g e

5 Depreciation Expense Trend of Depreciation Expense as a % of Gross Fixed Assets x Expected Gross Fixed Assets The ratio of depreciation expense to the related property provides a blended depreciation rate of the entire fixed asset population. As a ratio it provides a starting point for analyzing depreciation expense for the period. For firms using PPC guidance, PPC's Audit Program for Property identifies this as one test for developing audit evidence for depreciation expense in Program Step 6(a). Amortization Expense Trend of Amortization Expense as a % of Gross Intangible Assets x Expected Gross Intangible Assets Same rationale as described for depreciation expense above. Selling, General & Administrative Expenses (S,G&A) Prior Year's S,G&A x % S,G&A Growth Trend The underlying assumption for most expense analysis is that expense accounts tend to follow historical trends unless something occurs during the audit period to change the historical pattern. Expense accounts that fluctuate significantly from historical trends should be investigated further during substantive fieldwork to understand the underlying changes taking place in those accounts. As noted in regards to cost of goods sold above, if significant variances are identified in sales, S,G&A may vary significantly as a result as well and may be explained by the change in sales (there should be a visible correlation if that is the case). For instance if sales increases 10% more than the expectation is there a corresponding variance from the expectation in payroll and wages of 10% +/- 5%? Prior Year's Other Operating Income x Same rationale as described for sales above. % Other Operating Income Growth Trend Prior Year's Other Operating Expense x Same rationale as described for S,G&A expense above. Other Operating Income Other Operating Expense % Other Operating Expense Growth Trend Operating Profit Gross Profit - Depreciation Expense - Amortization Expense - S,G&A Expenses + Other Operating Income - Other Operating Expense Interest Expense Trend of Interest Expense as a % of Debt x Expected Debt This method of calculating interest applies time series analysis to the interest rate and then calculates simple interest expense. This provides a more meaningful expectation than using just a simple average interest calculation during preliminary analytics. Any variances here should be documented by the auditor and can be responded to during the substantive testwork for debt to address new borrowings or repayments of debt. 5 P a g e

6 Other Income Prior Year's Other Income x % Other Same rationale as described for sales above. Income Growth Trend Other Expense Prior Year's Other Expense x % Other Same rationale as described for S,G&A expense above. Expense Growth Trend Net Profit Before Tax Operating Profit - Interest Expense + Other Income - Other Expense Adjusted Net Profit Net Profit Before Tax + Prior Year's Before Tax Owner's Compensation Net Profit Margin Adjusted Net Profit Before Tax / Sales EBITDA Net Profit Before Tax + Interest Expense + Depreciation Expense + Amortization Expense Taxes Paid Prior Year's Taxes Paid as a % of Prior Year's Net Profit Before Tax x Expected Net Profit The prior period marginal income tax rate is used as an estimate for expected income tax expense. Before Tax Extraordinary Gain N/A Expectation is set to zero Extraordinary Loss N/A Expectation is set to zero Net Income Net Profit Before Tax - Taxes Paid + Extraordinary Gain - Extraordinary Loss 6 P a g e

7 Balance Sheet Cash Accounts Receivable Calculated using indirect cashflow reconciliation based on expected changes in balance sheet accounts Trend in Days Sales in Receivables / 365 x Expected Sales Having projected net income above and the various changes in the expected balance sheet accounts the expected cash balance is reconciled from the beginning cash (prior period cash balance) using the indirect cash flow method. This model assumes no new capital or dividend distributions. It implicitly follows that the outstanding balance for accounts receivable should correlate to the historical trend in accounts receivable turnover. In this model we measure turnover as a function of days sales in receivables divided by the days in the year. Inventory Trend in Inventory Days / 365 x Expected Sales It implicitly follows that the outstanding balance in inventory should correlate to the historical trend in inventory turnover. In this model we measure turnover as a function of inventory days divided by the days in the year. Other Current Assets Prior Year's Other Current Assets x % Other Current Assets Growth Trend Total Current Assets Cash + Accounts Receivable + Inventory + Other Current Assets Gross Fixed Assets Prior Year's Gross Fixed Assets x % Gross Fixed Assets Growth Trend Accumulated Prior Year's Accumulated Depreciation + Expected Depreciation Depreciation Expense Net Fixed Assets Gross Fixed Assets - Accumulated Depreciation Other current assets, such as prepaid expenses, typically do not follow any predictable turnover patterns. For that reasons historical trends applied to the balances tends to be the most predictive measure of these account balances. Material variances here almost always merit further documentation and should be addressed in substantive testwork. Same as other current assets above 7 P a g e

8 Gross Intangible Assets Prior Year's Gross Intangible Assets x % Gross Intangible Assets Growth Trend Accumulated Prior Year's Accumulated Amortization + Expected Amortization Amortization Expense Net Intangible Assets Gross Intangible Assets - Accumulated Amortization Same as other current assets above Other Assets Prior Year's Other Assets x % Other Same as other current assets above Assets Growth Trend Total Assets Total Current Assets + Net Fixed Assets + Net Intangible Assets + Other Assets Accounts Payable Trend in Accounts Payable Days / 365 x Expected Sales It implicitly follows that the outstanding balance in accounts payable should correlate to the historical trend in accounts payable turnover. In this model we measure turnover as a function of accounts payable days divided by the days in the year. Short Term Debt Current Portion of Long Term Debt Prior Year's Short Term Debt x % Short Term Debt Growth Trend Prior Year's Current Portion of Long Term Debt x % Current Portion of Long Term Debt Growth Trend Short term debt which consists primarily of operating lines of credit is driven by the historical borrowing trends of the company to determine whether the expected cash flow needs of the company are increasing or decreasing. The model assumes that there are no new debt issuances, therefore over time the historical trend should be predictive of the current year balance as long as that holds true. For instance over several year as a loan moves towards maturity the current portion of long term debt will show and increasing trend over that period. Other Current Liabilities Total Current Liabilities Notes Payable / Senior Debt Prior Year's Other Current Liabilities x % Other Current Liabilities Growth Trend Accounts Payable + Short Term Debt + Current Portion of Long Term Debt + Other Current Liabilities Prior Year's Senior Debt + Prior Year's Senior Debt as a % of Long Term Liabilities x (the change in Gross Fixed Assets + the change in Other Assets) Same as other current assets above The underlying assumption for debt is that any changes in fixed assets or other assets will be financed through the use of debt facilities. The amount of the change in these assets is allocated among senior debt, subordinated debt and other long term liabilities on a pro rata basis. 8 P a g e

9 Notes Payable / Subordinated Debt Other Long Term Liabilities Prior Year's Subordinated Debt + Prior Year's Subordinated Debt as a % of Long Term Liabilities x (the change in Gross Fixed Assets + the change in Other Assets) Prior Year's Other Long Term Liabilities + Prior Year's Other Long Term Liabilities as a % of Long Term Liabilities x (the change in Gross Fixed Assets + the change in Other Assets) Senior Debt + Subordinated Debt + Other Long Same as notes payable / senior debt above Same as notes payable / senior debt above Long Term Liabilities Term Liabilities Total Liabilities Total Current Liabilities + Long Term Liabilities Preferred Stock Held constant Model assumes no changes to the prior year's captial account balances and that the auditor will address any variances here as part of the substantive testwork for the equity section. Common Stock Held constant Same as preferred stock above Additional Paid-in Held constant Same as preferred stock above Capital Other Stock / Equity Held constant Same as preferred stock above Ending Retained Prior Year's Retained Earnings + Expected Earnings Net Income Total Equity Preferred Stock + Common Stock + Additional Paid-in Capital + Other Stock / Equity + Ending Retained Earnings 9 P a g e