During an audit assignment, auditors must perform various audit procedures to verify different aspects of financial statement items. These aspects generally come in the form of assertions. For every financial statement item, the assertion tested will differ. Therefore, auditors must use different procedures to verify all of them. Similarly, the assertions also vary based on whether auditors are examining balances from the Statement of Financial Position or transactions from the Statement of Profit or Loss. The audit procedures performed by auditors help them reach conclusions about whether each item presents a true and fair view and is free from material misstatements.
There are different types of audit procedures that auditors can perform. First of all, auditors can inspect documents or records of the company or its physical assets. Similarly, auditors can observe the client’s processes to obtain an understanding of or identify any weaknesses in the internal control systems of the client. Likewise, auditors can recalculate transactions or balances or re-perform internal control processes. Auditors also have permission to inquire about the personnel or management of the client about matters relevant to the audit. Finally, auditors can also perform analytical procedures on the financial statements of the client.
While all of these audit procedures are powerful and allow auditors to gather different forms of audit procedures, analytical procedures help with different types of analysis of the financial statements. Among analytical procedures, auditors also have an analytical test known as reasonableness or reasonability test.
What is the Reasonableness Test?
Reasonableness testing refers to the analysis of the financial statements to develop expectations for items. Based on these expectations, auditors assess the reasonableness of accounting transactions or balances present in the financial statements. Usually, auditors use historical information for particular amounts to develop these expectations.
The reasonableness test is among one of the most popular analytical procedures that auditors carry out during the audit engagement. It allows auditors to test transactions for any discrepancies and identify unexpected transactions. In some circumstances, auditors can also use reasonableness testing to determine whether the reported balances or transactions makes sense.
In some other circumstances, auditors may also use reasonableness testing to check whether a transaction or balance reported is logically reasonable. For example, auditors may determine whether the average sale prices multiplied with the average number of sale units for products is close to the reported sales figure. Similarly, auditors can multiply the standard sale prices of products to their units sold to compare with the sales figure.
Importance of Reasonableness Test in Auditing
Reasonableness test can help auditors in the detection of discrepancies or one-off items that may affect a balance or transaction. Through reasonableness testing, auditors can compare the actual reported figures with their expected figures to identify any differences. When there are variations between the expected and actual figure, auditors must investigate it. Usually, these differences come from specific circumstances or transactions. However, sometimes, they may also be an indicator of fraud or error.
Apart from playing a critical role in the detection of fraud or error, reasonableness testing allows auditors to develop a better understanding of the client and its activities. Through developing an expectation for transactions and balances, auditors can understand the underlying processes at the client better. Similarly, by identifying and discussing any differences, auditors can get a better idea of any one-off activities or events that took place during the accounting period.
Why Should We Use the Reasonableness Test?
While using the reasonableness test in an audit is not compulsory or required by auditing standards, it is still a crucial part of auditing. Auditors usually use the reasonableness test to identify any discrepancies in the financial statements of the client. While analytical procedures generally relate to the financial statement items as a whole, reasonableness testing can help auditors go deeper with individual transactions or balances.
The reasonableness test also helps auditors to compare the actual reported amounts in the financial statements with their expected amounts. Through this, auditors can identify any significant changes or events that might have affected them. Once auditors identify these differences, they can enquire the client’s management to obtain a better understanding of the client’s accounting treatments. In case they fail to respond or justify their side, auditors can investigate the difference to verify any chances of fraud.
Example
During the audit of ABC Co., its auditors may come across several financial statement items that they can develop an expectation for, based on historical data. By comparing the expected amounts with the actual ones, they can identify any differences that they may need to investigate. Therefore, some of the reasonableness tests that auditors perform for ABC Co. include the following.
- Multiply the average loan amount with the interest rate to check whether the interest charge meets the expected expense in the financial statements.
- Obtain a list of products sold and multiplying them with their retail prices to identify any anomalies in the sale amount.
- Compare the VAT charges with the expected VAT based on sales multiplied with the relevant VAT rate.
- Identifying the gross profit margin and comparing it with ABC Co.’s competitors and other companies within the industry to identify discrepancies.
- Calculating the cost of sales to sales ratio of the company based on historical performance and comparing it with its current ratio.
- Calculating salaries expense by multiplying hours worked for employees with standard rates and comparing it with the actual expense. Auditors can also multiply the average number of employees with their average salary to check it is close to the actual amount.
- Analyzing the trend for accounts receivable and payable balances to develop an expected closing balance. Using the expected amounts to compare with the actual balance to check if they are close.
- Develop expectations for the depreciation or amortizations of the company and comparing it with the actual amount to check for reasonableness.
- Based on historical information, calculate the expected provisions of the company and compare it with the actual amount.
Apart from these, auditors can also develop expectations for other parts of the financial statements of the client and compare it with actual information. However, auditors must understand that for some items, it may not be possible to develop expectations. Once they identify any differences, they must evaluate whether the differences are material to investigate. For material differences, auditors must enquire the management. After investigation, auditors must use their professional judgment to ascertain whether the reasons given by them are reasonable.
Benefits of Reasonableness Tests
Reasonableness tests can provide many advantages during the audit process. First of all, reasonableness tests are cost-effective as they do not require extra effort on the auditors’ part. Auditors can perform these tests using a spreadsheet program or other dedicated software. It allows them to not only reduce the time required to perform these procedures but also reduce the chances of errors.
Reasonableness tests also include a better view of the company’s operations during the period. Through reasonableness testing, auditors can identify any events or transactions that may affect different parts of the financial statements. Similarly, by investigating these events or transactions, auditors can also detect any chances of fraud or errors.
Limitation of Reasonableness Tests
There are certain limitations of reasonableness tests as well. First of all, reasonableness tests depend on the information provided in the client’s financial statements. Therefore, these tests are prone to manipulation by the client. For example, a client may undervalue or overvalue its financial statement items to avoid detection through the reasonableness test.
Similarly, it is difficult for auditors to develop estimates in some specific circumstances. Likewise, some companies or businesses may be volatile and, therefore, reasonableness tests fail to account for these changes. While it can give auditors an idea of the areas of the financial statements where volatility is prevalent, it does not help identify any discrepancies or differences. If auditors investigate all these differences, it may take a long time. Therefore, it is better to use other procedures than to fixate on reasonableness tests.
Conclusion
Auditors can use various audit procedures to obtain audit evidence regarding the financial statements of a client. One of these procedures includes analytical procedures, which further consist of the reasonableness test. With reasonableness testing, auditors develop expectations for financial statement items and compare the actual amount reported with it. Based on the comparison, auditors can identify differences and investigate them through the client’s management. Reasonableness tests are critical in detecting fraud or error and help auditors get a better idea of the client’s operations in the relevant accounting period.
