3 Main Techniques Used in Cost Audit

This article throws light upon the three main techniques used in cost audit. The techniques are: 1. Audit Sampling and Statistical Sampling 2. Flow Charts 3. Ratio Analysis. 

Cost Audit: Technique # 1. Audit Sampling and Statistical Sampling:

“Audit sampling is the application of a compliance or substantive audit procedure to less than 100% of the items within an account balance or class of transactions to enable the auditor to obtain and evaluate evidence of some characteristic of the balance or class and to form or assist in forming a conclusion concerning that characteristic”.

The term ‘sampling’ denotes the selection of a part of the aggregate material representing the total affairs of a system. The term ‘statistical sampling’ refers to the whole process of carrying out a test on a scientific basis. It is designed to determine the degree of accuracy of a particular set of transactions rather to discover individual isolated errors.

Factors to be considered for ‘Audit Sample’ design:

In designing an audit sample, an auditor should apply his judgement in considera­tion of the important factors:

(i) Audit objectives,

(ii) Population,

(iii) Risk and assurance,

(iv) Tolerable error, and

(v) Expected error in the population.

Sampling, as the ‘process of learning about a lot by looking at a little’, helps the Cost Auditor in forming an opinion or submitting recommendations on a particular audit area by examining a small percentage of the transactions or operations.

It is a kind of audit tool that enables him to crystallize his thoughts into a recommendation. But, in the application of a sampling technique in an audit work, the Cost Auditor has to make sure, for sampling to be effective, that he has observed the three basic ingredients of successful sampling.

These are:

(i) Selection of the sample items,

(ii) Number of items to be selected, and

(iii) Evaluation of the sample results.

Therefore, with a view to applying the technique of Statistical Sampling successfully in a Cost Audit Assignment, the auditor needs to be cautious and should keep in his mind the following important points:

1. He must be aware of the principles involved in a scientific sampling—which should be used by him only when the audit objective necessarily so warrants depending on the circumstances.

2. Audit opinions should be based only on the sampled population but he must not be oblivious of the total population.

3. He must ensure that every item in the population has an equal opportunity of being selected for the sample.

4. A personal bias should not influence him in the selection process of a sample.

5. The patterns in the population should not be permitted to influence the randomness of the sample.

6. He should not come to his conclusion about the entire population from the ‘directed’ sample.

7. He should base his estimates of maximum-error rate on realistic grounds and not illusory.

8. Stratification should be resorted to by him, whenever necessary.

9. He should not set for himself unrealistic and unachievable goals. He should remember that all controls seek to reduce the extent and degree of audit risks.

10. After the sample results have been obtained, he should try to find out the reasons for the variances, and then recommend corrective measures or express his opinions.

Application in a Cost Audit Assignment:

‘Statistical sampling’ technique in a cost audit assignment could cover the following areas specifically:

(i) Purchases and Creditors;

(ii) Sales and Debtors;

(iii) Consumable stores and spares consumption;

(iv) Workmen’s attendance and leave records;

(v) Workmen’s pay-rolls;

(vi) Employees’ salaries;

(vii) Cash disbursements;

(viii) Consumable stores inventories;

(ix) Posting in Priced Stores Ledger, and tallying with the Bin Cards;

(x) Overheads (Works/Administration/Selling/Distribution).

Records or Transactions where Test-Checking Unsuitable:

The methods of test-checking are not suitable for their application to the following records and transactions specifically:

(i) Cash Book;

(ii) Bank Account;

(iii) Asset Records;

(iv) Shares Register;

(v) Investment Account;

(vi) Account of loans and advances;

(vii) Account of liabilities;

(viii) Profit and Loss Account;

(ix) Balance Sheet;

(x) Accounts of major raw materials/ components/process materials;

(xi) Direct Expenses;

(xii) Depreciation;

(xiii) Quantitative Production Records;

(xiv) Abnormal and non-recurring costs;

(xv) Cost Statements;

(xvi) Inter-company transactions.

Cost Audit: Technique # 2. Flow Charts:

It is one of the techniques used by an auditor for reviewing and evaluating internal accounting control of a company. It is a graph showing the flow of any work activity from start to end, into which the various stages of operation or work or process of the entire activity or system are charted sequentially with the aid of certain symbols universally adopted by the accountants and auditors.

There are two approaches in the preparation of a flow chart: vertical and horizontal. Most auditors, who use this technique for audit flow chart, prefer ‘horizontal’ charting for the purpose of making an intensive analysis of the movement of documents and accounting information between different employees and departments.

This way, they can obtain an understanding of how the ‘logic’ of a system operates, and can trace out the system’s weaknesses or inefficiencies. Special graph papers are used for the preparation of flow charts. Generally, four steps arc involved in flow charting technique—designing, symbolizing, outlining and completing.

The designing, it’s a first step, is very important as because the overall system of the organisation is carefully studied for dividing it into a number of appropriate logical sections. If the auditor designs a flow chart, he has to visualize the information flow and the documents being processed. If, however, he uses a client-constructed flow chart he should not only interpret the symbols but also draw useful conclusions about the system depicted in it.

Accounting or auditing flow charts may be drawn (for examples) to show:

(a) The flow of material from material stores through departments to the finished goods godown.

(b) The flow of inward mails in office through different sections to the filing section.

(c) The processing of vouchers and bills at different stages of recording up to finalization of accounts.

Thus, a system’s flow chart is one that gives “a pictorial image of the general flow of information from one document to another from one location to another, and, if applicable, from one machine to another”. By viewing this documentation, the auditor is able “to arrive at some tentative conclusions about the order or lack of order in the system”.

Cost Audit: Technique # 3. Ratio Analysis:

It is the most common of all analytical review procedures (i.e., analytical audit). It involves the following:

1. The computation of significant financial relationships.

2. The comparison of current period ratios with one or more of the following:

(a) Similar ratios of a prior period or periods,

(b) Similar ratios of the industry,

(c) Similar ratios designated as acceptable by bankers, other credit guarantors or the auditor.

3. The analysis of unusual and significant deviations between current period ratios and those with which they are compared.

Ratios may be classified based on their sources as follows:

1. Balance Sheet Ratios:

They deal with relationship between two items appearing in the balance sheet. These ratios are also known as financial position ratios since they reflect the financial position of the business. Examples are: Current ratio (=Current assets/Current liabilities) which measures short-term liquidity and Inventory-Working Capital ratio [=Inventory/(Current assets—Current liabilities)] which measures excessive inventory or insufficient working capital.

2. Income Statement Ratios:

They express the relationships between two individual or group of items appearing in the profit and loss statement. Since they reflect the operating conditions of a business, they are known as operating ratios. Examples: Gross profit ratio (=Gross profit/Sales) which measures pricing policy and Net Income ratio (= Net income/sales) which indicates operating efficiency.

3. Mixed Ratios:

They express the relationship between two items each appearing in different statement, i.e., one appearing in the balance sheet and the other in the income statement. These are also called ‘inter-statement ratios’. Examples: Inventory turnover ratio (= Cost of goods sold/Average inventory) measures inventory liquidity, and Return on assets (= Net income/Total assets) measures efficiency of asset utilisation.

In order to develop relevant and meaningful ratios, the auditor must use his knowledge of the client and its industry. Ratio analysis has limitations in that it concentrates on the past and deals in aggregates. Ratios serve as warning signs and indicators, and arc helpful in discovering existing or potential trouble spots when applied in trend analysis and variance analysis.

Ratios show a trend and may help in focusing attention to the more important areas where detailed checking may be necessary. Such ratio analysis may identify anything abnormal or anything which deviates from the expected and the known ratios highlight only symptoms. It is for the cost auditor to study those symptoms properly, correlate them, and reach definite conclusions or identify the areas for further enquiries.