Prospective Financial Information

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1 Introduction

For example, the auditor (or other firm of accountants) has been asked to report on:

• An asset ("capital") expenditure budget
  

• A profit forecast
  

• A cash flow budget
  

Often, the report is requested by a potential supplier of capital, such as a bank beginning or renewing a loan agreement, or by a venture capitalist considering the supply of equity finance.

Prospective financial information ('PFI') is financial information based on assumptions about events and possible actions that may occur (ie in the future). PFI can be:

• A forecast: based on what is expected to happen. Uses 'best-estimate' assumptions (ie most likely outcomes) and is usually for not more than a year.
  

• A projection: includes hypothetical assumptions about events and actions that are not necessarily expected to take place (eg for a business start-up). It may illustrate the possible outcomes of 'what-if' scenarios.
  

• A combination (eg a one-year forecast and a five-year projection).
  

The distinction is important as projections have greater uncertainty and less supporting evidence than forecasts.

2 Positive or negative assurance?

It should be obvious that it is not possible to express positive (reasonable) assurance that there are no material errors in the financial information that is subject to the report. It would be a foolhardy accountant would would be willing to say that about any budget or projection. The future is simply too uncertain and the forecast subject to many assumptions.

The best that the accountant can provide is negative (limited) assurance. This simply states that nothing suggests that the assumptions are unreasonable (as a basis for the PFI) and that the PFI has been properly prepared based on those assumptions. The report will also include:

• the basis of the accountant's examination (eg in accordance with ISAE 3400)
  

• the purpose of the PFI (and a caveat that it may not be appropriate for any other purpose)
  

• management's responsibilities (for the PFI and assumptions)
  

• a caveat that actual results may materially differ from the PFI.

3 Acceptance of engagement

An accountant should not accept or withdraw from an engagement if assumptions are clearly unrealistic or results not suitable for intended use. For example, a budget showing sales and profits doubling without any convincing reason has probably been drawn up based on assumptions that give the answer required (eg cashflows sufficient to stay within an agreed overdraft limit). Similarly, if finance were being requested to support the opening of an additional shop, the budget for that shop’s results might be reasonable and show a profit, but if the rest of the business were in financial difficulties, presenting a cash flow for the only viable part of the business would not really be suitable for a supplier of loan finance.

4 Examination procedures

Factors that may affect the nature, timing and extent of examination procedures include:

• The likelihood of material misstatement
  

• Knowledge obtained in previous engagements (e.g. the audit)
  

• Management’s competence in preparing PFI
  

• The extent to which the PFI is affected by management’s judgment
  

• The adequacy and reliability of underlying data used.
  

In order to report on PFI, the auditor must obtain sufficient appropriate evidence that:

• Assumptions are reasonable and consistent with the purpose of the PFI
  

• The PFI has been properly prepared (through arithmetic checks and a review of consistency)
  

• Both the PFI and all material assumptions have been adequately disclosed.
  

Analytical procedures are likely to be used extensively, with verification of amounts wherever possible. For example, if a profit forecast shows a 10% increase in revenue:

• Is that increase in volume and/or prices? (How realistic is an increase in price?)
  

• Is it consistent with the forecast cost of sales? (If not, why not?)
  

• Does production have capacity for the increase? If not, what investment must be made in plant and equipment? Verify reasonableness of cost of investment to a supplier’s price list. Will employees have to work overtime? Verify reasonableness of costs to payroll information.
  

• Is the timing of the increase in sales consistent with the timing of the investment in plant and how long it takes to manufacture goods?
  

The auditor must obtain written representation regarding:

• intended use of PFI
  

• completeness of significant management assumptions
  

• management’s acceptance responsibility for PFI.

5 Example

Clairvoy Co

It is 5/1/2019 and Clairvoy Co is applying to its bank for loan finance. The loan would amount to $10,000,000, repayable in equal instalments over the three years 2019, 2020 and 2021.

In support of this application, the company cash flow forecast for the next three years.

Clairvoy Co is not one of your clients, but the company has asked you to provide a report to the bank on the cash flow forecast that has been prepared.

Describe the work that you would perform in the examination of the prospective financial information.

6 Solution - issues to consider

The great thing to remember with all types of budgets and forecasts is that nearly everything on the document is an assumption and therefore its reasonableness should be considered - both the amount and its timing. If an amount is not an assumption then it must be an historical amount (such as the opening cash balance) and that must be checked too. So ALL amounts are open to scrutiny. Usually, as here, you would also be asked to describe examination procedures.

So here we would:

• Agree the opening cash balance to the cash book balance.
  

• Agree actual 2018 amounts to the historical financial statements (eg sales to the statement of profit or loss and tax paid to the cash flow statement). Note that the cash flow statement should show no investment in long-term assets (and remember that it would only show payments to suppliers and employees if prepared under the direct method).
  

• Sales have increased 7%, 13% and 6% pa. This rate of growth looks impressive (though we don’t know the industry sector) and needs to be justified by sales budgets, marketing reports and budgets, competitor analysis etc.
  

• Calculate relevant ratios based on the 2018 figures for use in analytical procedures on the projections:
  

  • GP% = 4,500/7,000 = 64%. Note that the GP% has then become 4,800/7,500 = 64%, 5,500/8,500 = 64.7% and 5,500/9,000 = 61%. We need to ask (eg the sales director) why this percentage has changed.
    

  • Wages/sales = 1,000/7,000 = 14%. Note that this ratio has then become 14%, 13% and 12%. What is causing these efficiency gains?
    

  • Administration/sales = 800/7,000 = 11%. Not that this ratio has then become 11%, 10.6% and 10%. Again there are slight efficiency gains that should be investigated.
    

  • In 2018, 6,900/7,000 cash from sales was received = 98.6%. This rises to 99% in 2020 then 104% in 2021. The 2021 figure certainly looks odd and it is not clear why the cash receipts are higher than the sales.
    

  • In 2018, 100% of purchases were paid for. This falls to 2,600/2,700 = 96%, 2,700/3000 = 90% to 3,000/3,500 = 86%. More credit is being taken from suppliers and we need to investigate if this is a reasonable assumption. For example, talk to buyers and payable ledger supervisors.
    

• The timings of receipts from customers and payments to suppliers need to be examined in detail as timings of receipts and payments are crucial to cash flow budgets. (Note that taking opening trade receivables and payables balances from the 2018 accounts it would be possible to calculate the average collection and payment periods for further examination.)
  

• Depreciation shouldn’t appear in the forecast as it is not a cash flow. What other errors could the preparer have made?
  

• What is the asset expenditure for? Has it been authorised by the board? Is it in the correct year? Is it complete? Is there really no asset expenditure in other periods? Look at board minutes, expansion plans, asset expenditure budgets and authorisations.
  

• Are the tax payments calculated properly?
  

• No interest has been included on the cash budget. This is material. For example, if interest was charged at 5% then $10,000,000 x 5% = $500,000 pa
  

• No capital repayments appear in the cash budget. The potential loan agreement should be examined to see the proposed repayment schedule.
  

As the budget stands there is a forecast balance of $10,920,000 at the end of the three year period. That would be enough to cover the loan - not accounting for interest.

An exam question might also require you to explain the matters you should consider before agreeing to an engagement. For this example, we should perhaps be a little suspicious that we have been asked to do this work, yet we are not the company’s auditors. It would be normal to ask the auditors to carry out these types of assurance engagement because, as they are normally required urgently, auditors can complete the work efficiently because of their client knowledge. Of course, the auditors might not have had time or resources to produce a report quickly, but we should be on our guard that we have been approached because we do not have detailed knowledge about Clairvoy Co and that makes it easier for the company to mislead us.

7 Before starting the work

The duties of an auditor are well-defined in both statute and auditing standards. For example, statute gives the auditors a right to see any documents they wish and to ask for all explanations they require. But, of course, auditors are careful to send an engagement letters to each client, a copy of which has to be signed and returned. The engagement letter sets out the work that will be performed by the auditor and the responsibilities and duties of the client.

Non-audit work, however, is not well-defined. Each job is unique and it is essential that it is well-defined. For example, in the case of Clairvoy Co, it would be essential for the accountant to:

• Tell the client that the assurance will be limited (negative) not reasonable (positive).
  

• Confirm how many years or months the forecast covers (obviously, the longer the period, the greater the amount of work). Also the nature of assumptions (best-estimate of hypothetical).
  

• Find out the purpose of the cash flow forecast and who will receive it. The wider its use or distribution the greater the risk to the accountant.
  

• Agree with the client that the required information and source data will be made available.
  

• Agree a fee.
  

• Agree a deadline
  

As noted earlier, before agreeing to perform the detailed work, the accountant should initially review the cash flow forecast and assumptions to ensure that the information does not appear inappropriate for its intended use or that the assumptions are not clearly unrealistic.