Reasonableness Test
The reasonableness test, in the context of accounting and auditing, is a high-level analytical procedure that auditors or accountants use to determine if the numbers or values in financial statements or other records appear reasonable and are free of material misstatements. It’s essentially a sanity check to ensure that figures aren’t grossly out of line with what’s expected based on the auditor’s or accountant’s knowledge of the business, industry norms, or other comparative data.
The reasonableness test can involve:
- Comparing current year amounts to prior year amounts and evaluating the changes for consistency with known changes in the business or industry.
- Comparing actual amounts to budgets or forecasts to see if there are any significant and unexplained variances.
- Applying common financial ratios (like gross profit percentage or current ratios) and comparing them to industry norms or past periods.
- Comparing non-financial data to financial data. For example, if a hotel’s reported revenue significantly increased, but occupancy rates stayed the same, an auditor might question the reasonableness of the reported revenue increase.
Example of the Reasonableness Test
Let’s explore the reasonableness test in a scenario involving a manufacturing company’s production and inventory.
Scenario: ABC Manufacturing Company produces a line of home appliances. At the end of the fiscal year, the company reported a significant increase in finished goods inventory without a corresponding increase in sales or production numbers.
- Sales revenue growth: 5% increase
- Production growth: 4% increase
- Finished goods inventory growth: 50% increase
- Comparison with Historical Data: The first thing an auditor might do is compare the growth rates of the finished goods inventory to the growth rates in previous years. If ABC Manufacturing consistently had similar patterns in the past without any issues, the increase might not be as concerning.
- Non-Financial Data Examination: The auditor would also review non-financial data. For instance, were there any production quality issues or recalls that could explain the surge in inventory (i.e., produced but not saleable)?
- Industry Benchmarking: The auditor might compare ABC Manufacturing’s inventory growth to industry benchmarks or competitors. If other companies in the industry are experiencing similar trends, the increase could be part of a larger industry pattern.
- Ratio Analysis: The auditor could apply some ratios, like inventory turnover (cost of goods sold divided by average inventory). A decreasing inventory turnover ratio, especially when diverging from industry norms, could be a red flag.
- Inquiry: After the preliminary tests, the auditor would discuss the discrepancy with ABC Manufacturing’s management. Maybe there’s a valid explanation — for instance, the company might be ramping up inventory for an anticipated massive sales campaign next quarter.
Outcome:
If the reason for the sharp increase in inventory is justified and backed by evidence (e.g., upcoming marketing blitz, large confirmed orders for the next quarter, etc.), the auditor might consider the amount reasonable. If not, the auditor would perform more detailed testing on the inventory balance to ensure it’s not overvalued or misstated.
This example illustrates how a reasonableness test, based on expected correlations between related financial and non-financial data, can highlight areas that require deeper investigation.
