Prospective financial information: ISAE 3400

An audit looks back. It has facts to work with: receivables that were later paid, inventory that was later sold. Many users, though, want to know about the future. A bank deciding on a loan wants a cash flow forecast. A bidder defending a takeover wants a profit forecast.

Accountants are asked to examine this forward-looking information, but there are no facts yet to test, so the work is different and the report is carefully worded.

This topic covers prospective financial information (PFI) and International Standard on Assurance Engagements (ISAE) 3400, which governs how it is examined and reported. The key ideas are the difference between a forecast and a projection, the procedures to test assumptions, and the report, which can give only negative assurance on the assumptions.

The nature of PFI

Traditionally the auditor has given assurance on historical information, where factual evidence usually exists. For example, receivables may have been paid and inventory sold after the year end, which supports their year-end values. As business has changed, there has been more demand for professional accountants to give assurance on information about the future. PFI is used both inside the entity and outside it.

Internal uses are forecasts and projections of revenue, capital expenditure, revenue expenditure, profits, cash flows and working capital, used as management information.

External uses include profit forecasts given to the stock market, cash flow forecasts that support a bank loan application, and profit forecasts that support or defend a takeover bid.

The profession has been cautious about firm opinions on future periods, and work on PFI is closely regulated. Accountants must use careful wording in their reports.

Definitions

A forecast is a best estimate of what is expected to happen. A projection shows what is likely to happen if certain conditions or events were to occur. ISAE 3400 focuses mainly on numerical information.

Accepting a PFI engagement

The usual acceptance points apply: the availability of staff with the right expertise, the time scale and the fee. The accountant also agrees with the client the form of the report. It is especially important that the client understands that only negative assurance can be given on forward-looking information, and that the firm will follow ISAE 3400. An engagement letter is agreed and signed by both parties before work starts.

The accountant also establishes:

• the nature of the information;
• its intended use and the intended recipients of the report;
• whether it is for general distribution or limited to a few users;
• the nature of the assumptions, best estimate (a forecast) or hypothetical (a projection); and
• the period it covers.

Procedures in a PFI engagement

In deciding the nature, timing and extent of the procedures, the auditor considers:

• the likelihood of material misstatement;
• knowledge gained in earlier similar engagements;
• the competence of management in preparing PFI;
• how far the PFI depends on management’s judgement; and
• the adequacy and reliability of the underlying data and assumptions.

The general approach is like that for an audit, with changes for the nature of the work. The procedures include:

1. where the firm does not know the entity, getting enough knowledge of it and its environment;
2. for a forecast, seeking evidence to support the best estimate assumptions;
3. for a projection, assessing whether the hypothetical assumptions are realistic and whether their full implications are reflected in the PFI;
4. assessing whether the PFI contains all the relevant material items and nothing significant is left out;
5. if part of the period has passed, comparing actual results for that part with the forecast or projection, because the differences help to judge reliability; and
6. checking the arithmetical accuracy and consistency of the PFI.

The auditor obtains management’s representations on its acceptance of responsibility for the information and its intended use.

Procedures on a profit forecast: an example

For a profit forecast supporting a bank loan application, the procedures might be:

1. Understand the basis of the forecast by asking the preparer, then test the calculation by its method. If it was extrapolated from past results, redo the extrapolation.
2. Consider whether the assumptions are consistent with each other. For example, will sales grow at that rate without more marketing cost?
3. Consider whether the forecast is reasonable against known facts such as current economic conditions and past trading.
4. Discuss the key variables and sensitivities with management, typically sales demand, sales price and the gross profit ratio, and find out how the estimates were made.
5. Review internal consistency, for example whether the same interest rate and growth rate are used throughout.
6. Compare the assumptions and the bases with information used internally, such as by the marketing department.
7. Compare figures with other forecasts for consistency. For example, depreciation should appear in both the profit forecast and the capital expenditure forecast.
8. Compare figures with available evidence, such as quotations for work to be done, and assess costs for reasonableness.
9. Consider whether all items of cost are included. For a new product launch, have the initial running costs, such as marketing and set-up costs, been included?
10. Consider whether the forecast of finance needed allows for working capital.

Completeness of the assumptions

• The forecasts of profit and cash flow should include the cost of borrowed finance.
• Forecasts of costs and revenues should allow for estimated inflation.
• Sensitivity analysis should show how far the estimates would need to differ before the forecast profit becomes a forecast loss.

Tutorial note. If an exam asks for procedures on a particular forecast, think about what the forecast will and will not contain. A cash flow forecast, for example, will not include depreciation.

Reporting on PFI

The report from the audit or accountancy firm contains:

1. a title;
2. an addressee;
3. identification of the PFI, for example by page references;
4. a reference to the ISAE;
5. a statement that management is responsible for the PFI, including the assumptions;
6. a reference to the purpose of the PFI and any restriction on distribution to a limited number of users;
7. a statement of negative assurance on whether the assumptions provide a reasonable basis for the PFI;
8. an opinion on whether the PFI is properly prepared on the basis of the assumptions and is presented in line with the financial reporting framework;
9. warnings that the PFI is a forecast or projection and the results may not be achieved; and
10. the date, address and signature.

The unmodified report on a forecast

The syllabus example, addressed to the board of Entity AZ, says that the firm has examined the forecast in line with ISAE 3400, that management is responsible for the forecast and its assumptions, that based on the examination of the evidence supporting the assumptions nothing has come to attention which causes the firm to believe that they do not provide a reasonable basis for the forecast, and that in the firm’s opinion the forecast is properly prepared on the basis of the assumptions and presented in accordance with the framework.

It ends with a warning that actual results are likely to be different because anticipated events frequently do not occur as expected and the variation may be material.

The unmodified report on a projection

A projection report adds the purpose of the projection and says that, because it uses hypothetical assumptions (for example, for a start-up), the assumptions include events and actions that are not necessarily expected to occur. Readers are cautioned that it may not suit other purposes. The negative assurance is given “assuming that” the hypothetical assumptions occur.

The final warning says that even if the events under the hypothetical assumptions occur, actual results are still likely to differ.

When an unmodified report is not possible

The auditor may issue a qualified report, an adverse report, or decide to withdraw from the engagement.

The rules in more depth

Why only negative assurance

There are no facts to test, only assumptions about events that have not happened. The practitioner can say that the evidence supports the assumptions as a reasonable basis, but cannot say that the assumptions will come true. That is why the wording is “nothing has come to our attention” and why the warning about actual results is in every report.

Best estimate and hypothetical assumptions

For a forecast the question is whether management’s best estimates are supported by evidence. For a projection the question is whether the hypothetical assumptions are realistic and sensible, and whether the figures follow properly from them. A start-up with no history can only produce a projection, so the report gives more warnings.

Why a failure to include borrowing costs or inflation matters

A forecast that leaves out interest or inflation may look profitable when it is not. These are the typical omissions the auditor checks for, together with working capital needs, which are often forgotten in new ventures.

Worked example: a forecast for a bank loan

Scenario. Pearl Bakeries Ltd applies for a loan to open a second factory. Its profit forecast for next year is: revenue ₦600 million, variable costs ₦360 million (60% of revenue), fixed costs ₦150 million and loan interest ₦30 million. Forecast profit before tax is ₦600 million − ₦360 million − ₦150 million − ₦30 million = ₦60 million. Revenue is assumed to grow by 20% from ₦500 million this year.

Step 1: test the arithmetic and consistency. The practitioner re-performs the calculation and agrees the interest to the loan terms and the depreciation to the capital expenditure forecast.

Step 2: test the key assumption. Growth of 20% depends on the new factory. The practitioner asks what sales orders and contracts support it, compares it with past growth (say 8% a year for the last three years), looks at market data and checks whether marketing costs have been increased.

Step 3: sensitivity. The contribution margin is 40%. Fixed costs plus interest are ₦150 million + ₦30 million = ₦180 million. Break-even revenue is ₦180 million ÷ 40% = ₦450 million. That is 25% below the forecast of ₦600 million, which looks safe. But it is lower than this year’s ₦500 million, which means the existing business would have to shrink by 10% for the loan not to be covered.

The practitioner also tests a case in which growth is only 8%: revenue is ₦540 million, profit is ₦540 million × 40% − ₦180 million = ₦36 million.

Step 4: completeness. The practitioner checks that inflation of costs is allowed for, that working capital for the new factory is included in the finance required and that the start-up costs are in the costs.

Step 5: report. If the evidence supports the assumptions, the report is unmodified with the negative assurance wording and the warning. If management cannot support the 20% growth, the practitioner discusses it and, if the matter is not resolved, issues a qualified or adverse report or withdraws.

How to score full marks

• Define the terms with the assumptions. Forecast: best estimate. Projection: hypothetical or mixed. Target: what management wants.
• State that only negative assurance is possible, and why.
• Tailor the procedures to the forecast. Think what it contains. A cash flow forecast has no depreciation and a profit forecast has no capital expenditure.
• Include sensitivity analysis. It is the clearest way to show how far assumptions can move.
• Give the report warnings. Actual results are likely to differ and the variation may be material.

Common mistakes in the exam

• Saying that the auditor gives a positive opinion that the forecast will be achieved.
• Confusing forecast and projection.
• Listing audit procedures for historical balances, such as confirmations, instead of procedures on assumptions.
• Forgetting to check that borrowing costs and inflation are included.
• Leaving out the management representations.
• Leaving out the warning that results may differ.

Quick revision

• PFI: financial information based on assumptions about the future.
• Forecast: best estimate. Projection: hypothetical or mixed. Target: management’s wish.
• ISAE 3400: engagement letter, negative assurance only.
• Procedures: understand the entity, support assumptions, check completeness, compare elapsed actuals, check arithmetic, get representations.
• Check borrowing costs, inflation, working capital. Run sensitivity analysis.
• Report: management responsible, negative assurance on assumptions, opinion on preparation, warning that results may differ.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

The real ICAN paper has no multiple-choice section. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

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