Annual Audit Manual

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5025 Measures used, internally and externally, to assess the entity’s financial performance
Sep-2022

In This Section

Measures used, internally and externally, to assess the entity’s financial performance

Measures used, internally and externally, to assess the entity’s financial performance

CAS Requirement

The auditor shall perform risk assessment procedures to obtain an understanding of (CAS 315.19):

(a) The following aspects of the entity and its environment:

(iii) The measures used, internally and externally, to assess the entity’s financial performance;

CAS Guidance

An understanding of the entity’s measures assists the auditor in considering whether such measures, whether used externally or internally, create pressures on the entity to achieve performance targets. These pressures may motivate management to take actions that increase the susceptibility to misstatement due to management bias or fraud (e.g., to improve the business performance or to intentionally misstate the financial statements) (see CAS 240 for requirements and guidance in relation to the risks of fraud) (CAS 315.A74).

Measures may also indicate to the auditor the likelihood of risks of material misstatement of related financial statement information. For example, performance measures may indicate that the entity has unusually rapid growth or profitability when compared to that of other entities in the same industry (CAS 315.A75).

Management and others ordinarily measure and review those matters they regard as important. Inquiries of management may reveal that it relies on certain key indicators, whether publicly available or not, for evaluating financial performance and taking action. In such cases, the auditor may identify relevant performance measures, whether internal or external, by considering the information that the entity uses to manage its business. If such inquiry indicates an absence of performance measurement or review, there may be an increased risk of misstatements not being detected and corrected (CAS 315.A76).

Key indicators used for evaluating financial performance may include (CAS 315.A77):

  • Key performance indicators (financial and non‑financial) and key ratios, trends and operating statistics.

  • Period-on-period financial performance analyses.

  • Budgets, forecasts, variance analyses, segment information and divisional, departmental or other level performance reports.

  • Employee performance measures and incentive compensation policies.

  • Comparisons of an entity’s performance with that of competitors.

External parties may also review and analyze the entity’s financial performance, in particular for entities where financial information is publicly available. The auditor may also consider publicly available information to help the auditor further understand the business or identify contradictory information such as information from (CAS 315.A79):

  • Analysts or credit agencies

  • News and other media, including social media

  • Taxation authorities

  • Regulators

  • Trade unions

  • Providers of finance

Such financial information can often be obtained from the entity being audited.

The measurement and review of financial performance is not the same as the monitoring of the system of internal control (discussed as a component of the system of internal control in paragraphs A114‑A122), though their purposes may overlap (CAS 315.A80):

  • The measurement and review of performance is directed at whether business performance is meeting the objectives set by management (or third parties).

  • In contrast, monitoring of the system of internal control is concerned with monitoring the effectiveness of controls including those related to management’s measurement and review of financial performance.

In some cases, however, performance indicators also provide information that enables management to identify internal control deficiencies.

Considerations specific to public sector entities

In addition to considering relevant measures used by a public sector entity to assess the entity’s financial performance, auditors of public sector entities may also consider non‑financial information such as achievement of public benefit outcomes (for example, the number of people assisted by a specific program) (CAS 315.A81).

OAG Guidance

In addition to the examples of risk indicators included in the CAS guidance, consider whether information related to management’s review of the entity’s performance provides a reliable basis and is sufficiently precise for such purpose. Included below are elements important to the assessment of financial performance; specifically, there are events of conditions which may indicate a risk of material misstatement and information that may be useful in developing our understanding in these areas.

Events or conditions which may indicate a risk of material misstatement Examples of information that may be used by management and may be useful  to developing our understanding

Financial performance: It is essential management understands how their key financial objectives support the entity’s strategic objectives and the creation of value. In particular, it is important to pay attention to the cost of capital for the group as a whole and for each business unit.

Other internally generated information used by management to measure the entity’s financial performance may include budgets, variance analyses and benchmarks. Additionally external information such as analysts’ reports and credit rating agency reports may provide information useful to our understanding of the entity being audited and its environment.

Internal measures may also highlight unexpected results or trends requiring management’s inquiry of other in order to determine their cause and take corrective action. Performance measures may also indicate to us a risk of misstatement of related financial statement information. For example, performance measures may indicate that the entity has unusually rapid growth or profitability when compared to that of other entities in the same industry. Such information, particularly if combined with other factors such as performance-based bonus or incentive remuneration, may indicate the potential risk of management bias in the preparation of the financial statements.

  • A focus on accounting profits in isolation may mask business units or activities that are underperforming and/or destroying value

  • Inadequate focus on cash flow management, particularly in a growth phase or during a downturn in economic activity

  • Incorrect investment decisions being made

  • Cost of capital (e.g., weighted average cost of capital)

  • Return on equity

  • Operating cash flows

  • Budgets and benchmarking key metrics with competitors

  • External information (e.g., analyst’s reports, credit rating agency reports)

Financial position: Most entities experience at least some level of challenge to their financial performance. These challenges can introduce new business risks that may give rise to risks of material misstatement. Consistent underperformance can highlight issues within an entity as financial distress occurs. Changes in the financial position of the entity are typically reflected on the balance sheet and in key financial ratios related to an entity’s liquidity.

  • Capital structure not sufficient for the current stage of the entity’s life cycle

  • Complex funding arrangements with many different forms of finance and funding institutions

  • Insufficient cash resources/borrowing facilities to provide the working capital to support forecasted growth

  • Funding of long‑term capital projects using short‑term debt facilities

  • Reliance on timing of non‑recurring cash receipts to satisfy debt or other recurring cash payment obligations

  • Evidence of compliance with debt covenants

  • Nature and terms of credit facilities – amounts, duration, and covenants

  • Condition of tangible assets – age and quality of tangible assets, remaining useful life observed and noted on assets listings.

  • Capital expenditure detail (maintenance expenditures vs. incremental asset purchases)

Operating Segment/Business Unit performance: It is important to understand performance of an entity’s individual business segments in order to assess the underlying performance of the entire organization. These segments align with how the overall business is managed, whether by geography, business unit, or product area.

  • Individual businesses, products/service offerings may be performing well below expectations while the overall business is showing profits

  • Segment information/analysis used by management

    • Operating cash flow by segment/business unit (historic and prospective)

    • Cost of capital by segment/business unit

    • Return on investment by segment/ business unit

    • Future revenue growth potential by segment/business unit

    • Contribution by segment/business unit, e.g., by product, geography, or service

Understanding the measures used, internally and externally, to assess the entity’s financial performance affects

  • the development of expectations for risk assessment analytics (see OAG Audit 5012.2).

  • the development of initial expectations of significant FSLIs (see OAG Audit 4031). 

Example:

In the retail industry, shrinkage is an internal measure tracked by management. Shrinkage pertains to a loss of inventory that has not been sold to customers (e.g., theft, damage). This measure is usually calculated as the ending inventory value less the physically counted inventory value. These differences result in adjustments to the Inventory FSLI. Unexpected changes in the inventory balance may indicate a higher level of the risk of material misstatement due to fraud or error related to the existence assertion for inventory.