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
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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.
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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.
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Account
Formula
Trending
Method
Methodology Rationale and Audit Implication
Income Statement
Sales
Prior Year's Sales x % Sales Growth Trend
Adjusted Holt-Winters
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
Adjusted Holt-Winters
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
Gross Profit Margin
Expected Sales - Expected Cost of Goods Sold
Expected Gross Profit / Expected Sales
Direct Calculation
Direct Calculation
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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.
Depreciation Expense
Trend of Depreciation Expense as a % of Gross
Fixed Assets x Expected Gross Fixed Assets
Adjusted Holt-Winters
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
Adjusted Holt-Winters
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
Adjusted Holt-Winters
Other Operating
Income
Other Operating
Expense
Operating Profit
Prior Year's Other Operating Income x
% Other Operating Income Growth Trend
Prior Year's Other Operating Expense x
% Other Operating Expense Growth Trend
Gross Profit - Depreciation Expense Amortization Expense - S,G&A Expenses +
Other Operating Income - Other Operating Expense
Trend of Interest Expense as a % of Debt x
Expected Debt
Adjusted Holt-Winters
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%?
Same rationale as described for sales above.
Adjusted Holt-Winters
Same rationale as described for S,G&A expense above.
Interest Expense
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Direct Calculation
Adjusted Holt-Winters
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.
Other Income
Other Expense
Net Profit Before Tax
Adjusted Net Profit
Before Tax
Net Profit Margin
EBITDA
Taxes Paid
Extraordinary Gain
Extraordinary Loss
Net Income
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Prior Year's Other Income x % Other
Income Growth Trend
Prior Year's Other Expense x % Other
Expense Growth Trend
Operating Profit - Interest Expense +
Other Income - Other Expense
Net Profit Before Tax + Prior Year's
Owner's Compensation
Adjusted Net Profit Before Tax / Sales
Net Profit Before Tax + Interest Expense +
Depreciation Expense + Amortization Expense
Prior Year's Taxes Paid as a % of Prior Year's
Net Profit Before Tax x Expected Net Profit
Before Tax
N/A
N/A
Net Profit Before Tax - Taxes Paid +
Extraordinary Gain - Extraordinary Loss
Adjusted Holt-Winters
Same rationale as described for sales above.
Adjusted Holt-Winters
Same rationale as described for S,G&A expense above.
Adjusted Holt-Winters
Direct Calculation
Direct Calculation
Direct Calculation
Direct Calculation
The prior period marginal income tax rate is used as an estimate
for expected income tax expense.
Expectation is set to zero
Expectation is set to zero
Direct Calculation
Balance Sheet
Cash
Calculated using indirect cashflow reconciliation
based on expected changes in balance sheet
accounts
Direct Calculation
Accounts Receivable
Trend in Days Sales in Receivables / 365 x Expected
Sales
Adjusted Holt-Winters
Inventory
Trend in Inventory Days / 365 x Expected Sales
Adjusted Holt-Winters
Other Current Assets
Prior Year's Other Current Assets x % Other
Current Assets Growth Trend
Adjusted Holt-Winters
Total Current Assets
Cash + Accounts Receivable + Inventory +
Other Current Assets
Prior Year's Gross Fixed Assets x % Gross
Fixed Assets Growth Trend
Prior Year's Accumulated Depreciation + Expected
Depreciation Expense
Gross Fixed Assets - Accumulated Depreciation
Direct Calculation
Gross Fixed Assets
Accumulated
Depreciation
Net Fixed Assets
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Adjusted Holt-Winters
Direct Calculation
Direct Calculation
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.
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, 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
Gross Intangible
Assets
Accumulated
Amortization
Net Intangible Assets
Prior Year's Gross Intangible Assets x % Gross
Intangible Assets Growth Trend
Prior Year's Accumulated Amortization + Expected
Amortization Expense
Gross Intangible Assets - Accumulated Amortization
Other Assets
Prior Year's Other Assets x % Other
Assets Growth Trend
Total Current Assets + Net Fixed Assets + Net
Direct Calculation
Intangible Assets + Other Assets
Trend in Accounts Payable Days / 365 x Expected Sales Adjusted Holt-Winters
Same as other current assets above
Short Term Debt
Prior Year's Short Term Debt x % Short
Term Debt Growth Trend
Adjusted Holt-Winters
Current Portion of
Long Term Debt
Prior Year's Current Portion of Long Term Debt x %
Current Portion of Long Term Debt Growth Trend
Adjusted Holt-Winters
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
Prior Year's Other Current Liabilities x % Other Current Adjusted Holt-Winters
Liabilities Growth Trend
Accounts Payable + Short Term Debt + Current
Direct Calculation
Portion of Long Term Debt + Other Current
Liabilities
Prior Year's Senior Debt + Prior Year's Senior Debt as a Direct Calculation
% of Long Term Liabilities x (the change in Gross
Fixed Assets + the change in Other Assets)
Total Assets
Accounts Payable
Notes Payable /
Senior Debt
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Adjusted Holt-Winters
Same as other current assets above
Direct Calculation
Direct Calculation
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.
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.
Notes Payable /
Subordinated Debt
Other Long Term
Liabilities
Long Term Liabilities
Total Liabilities
Preferred Stock
Common Stock
Additional Paid-in
Capital
Other Stock / Equity
Ending Retained
Earnings
Total Equity
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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
Term Liabilities
Total Current Liabilities + Long Term Liabilities
Held constant
Direct Calculation
Same as notes payable / senior debt above
Direct Calculation
Same as notes payable / senior debt above
Held constant
Held constant
Direct Calculation
Direct Calculation
Same as preferred stock above
Same as preferred stock above
Held constant
Prior Year's Retained Earnings + Expected
Net Income
Preferred Stock + Common Stock + Additional
Paid-in Capital + Other Stock / Equity + Ending
Retained Earnings
Direct Calculation
Direct Calculation
Same as preferred stock above
Direct Calculation
Direct Calculation
Direct Calculation
Direct Calculation
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.