Ratios as analytical procedures
AU-C 520 has the auditor develop an expectation, compare the recorded amount with it, and investigate differences above a threshold. Turnover and days ratios are natural expectations: if sales are flat, DSO should be close to last year; if product lines have not changed, inventory turnover should be too. A swing that management cannot explain is a risk indicator under AU-C 315.
Rising DSO can mean slower collections, an understated allowance, or revenue recorded early or fictitious. Falling inventory turnover can mean obsolete or overstated stock. A lengthening cash conversion cycle (DIO + DSO − DPO) ties up working capital and can feed into the going concern assessment.
Common questions
How do you calculate inventory turnover?
Inventory turnover = cost of goods sold ÷ average inventory, where average inventory is (opening + closing) ÷ 2. Days inventory outstanding = days in the period ÷ inventory turnover.
How do you calculate DSO (days sales outstanding)?
DSO = average receivables ÷ credit sales × days in the period, which equals days ÷ receivables turnover. Many reviewers also compute it on the closing balance to compare with the aging.
How do you calculate working capital?
Working capital = current assets − current liabilities. Expressed as a share of revenue it is easier to compare across years and peers.
How are ratios used in an audit?
In planning, ratios help identify risks of material misstatement (AU-C 315); as substantive analytical procedures they test whether balances are consistent with expectations (AU-C 520); and near the end of the audit they support the overall review. Unexpected movements need explanation and corroboration.
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