12.3 Testing the Reasonableness of Reconstructed Figures

Testing the Reasonableness of Reconstructed Figures

Sections 12.1 and 12.2 showed how to derive missing figures from incomplete records. Both techniques share a dangerous property: they always produce an answer. A cash account will always balance, because the balancing figure absorbs whatever is left over. A capital comparison will always yield a profit figure, because it is arithmetic on two net asset totals. If the opening statement of affairs omitted a £9,000 liability, the method does not object — it simply reports £9,000 of profit that was never earned.

The AAT FAPS specification therefore requires you to understand whether a given figure is reasonable, why an actual balance and a calculated balance can be different, the importance of checking information produced by accounting software for accuracy, and when and how to apply professional scepticism. This is the step that separates a reconstruction from a guess.

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1. The Six Reasonableness Tests

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2. Worked Example: Testing a Reconstructed Takings Figure

A reconstruction of the records of a single-counter café for the year produced cash takings of £187,200. The trading figures were: opening inventory £4,000, purchases £96,000, closing inventory £5,000, giving cost of sales of £95,000.

Test 1 — Scale and proportionality. The café trades six days a week for 50 weeks, which is 300 trading days.

• Takings per trading day = £187,200 ÷ 300 = £624
• At an average spend of £6.50, that is 96 customers a day, or about 10 an hour across a ten-hour day.

That is entirely plausible for a small café, so the figure passes this test. (Had the reconstruction produced £560,000, the same arithmetic would give £1,867 a day and 287 customers — one every two minutes, all day, through a single till — which would fail immediately and send you back to look for a double-counted receipt or a capital injection wrongly treated as takings.)

Test 2 — Gross margin consistency. This is where the figure fails.

• Gross profit = £187,200 − £95,000 = £92,200
• Gross margin = £92,200 ÷ £187,200 × 100 = 49.3%
• The trade benchmark for comparable cafés is around 62%, and the proprietor confirms that selling prices were not reduced during the year.

Working the benchmark backwards: at a 62% margin, cost of sales represents 38% of takings, so cost of sales of £95,000 implies takings of £95,000 ÷ 0.38 = £250,000 — about £62,800 more than the reconstruction produced. A gap of that size is not rounding. Four explanations are consistent with it, and they are not mutually exclusive:

1. Takings are understated. Cash was taken from the till before it was banked and has not been disclosed — as drawings, as cash wages, or as cash purchases.
2. Goods taken for own use have not been deducted. Food and drink consumed by the proprietor's household remains inside purchases, inflating cost of sales. The correction is Dr Drawings, Cr Purchases at cost (Section 9.1).
3. Stock loss. Wastage, spoilage of perishable stock, or theft by staff or customers.
4. Purchases are overstated. Personal grocery shopping put through the business account, or a supplier invoice posted twice.

The accountant's job is not to pick one and post it. It is to raise each with the proprietor, obtain evidence, and quantify what can be quantified before the financial statements are prepared.

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3. Why an Actual Balance and a Calculated Balance Differ

When a physical count or a bank statement disagrees with a reconstructed figure, the difference has a cause. Establishing which cause applies matters more than clearing the difference, because the accounting treatment is completely different in each case.

The rule: an unexplained difference is never posted to a convenient expense heading to make the account balance. Undisclosed drawings, an unrecorded expense, a cut-off error and theft can all produce an identical figure, and each requires a different entry, a different disclosure and a different conversation with the client.

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4. Checking Information Produced by Accounting Software

Many "incomplete records" clients are not record-free at all — they have bookkeeping software with an automatic bank feed and a set of reports that look authoritative. A report that is beautifully formatted and internally consistent is not thereby correct, and the trial balance agreeing proves only that debits equal credits.

The specific failures to look for:

• Duplicated bank feed entries. The same receipt imported twice from the feed and again from a manual entry, inflating both sales and the bank balance.
• Automatic matching to the wrong invoice. A bank feed rule allocates a receipt to the oldest open invoice rather than the one actually paid, leaving the receivables ledger accurate in total but wrong in detail.
• Wrong VAT codes. Zero-rated food coded as standard-rated, or an exempt item coded as zero-rated, distorting both the VAT control account and the expense.
• Mis-dated postings. An invoice posted with today's date instead of the document date silently moves profit between two periods (Section 7.3).
• Unallocated receipts and payments parked in a suspense or holding account and never cleared.
• Personal transactions coded as business expenses by an untrained user — the single most common finding in a small trader's records.

The control totals worth running before you rely on any software report: the closing bank balance against the actual bank statement; total output VAT against the VAT returns already submitted for the year; total wages against the payroll records and the P60 figures; the gross margin, month by month, looking for a month that breaks the pattern; and a review of every entry in any suspense or unallocated account.

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5. Applying Professional Scepticism

Professional scepticism (Section 7.3) applies with particular force here, because in incomplete records work the accountant is producing figures from evidence supplied by the person whose profit — and whose tax bill — depends on the answer.

• Ask the question, and record the answer. A material margin shortfall requires a written explanation from the proprietor, retained on file.
• Do not accept the first plausible answer. "It must be wastage" explains £2,000 in a café; it does not explain £62,800.
• Corroborate independently. Bank statements, VAT returns, till readings, supplier statements and lodgement slips all come from outside the client.
• Document the test, not just the result. Write down the margin test you performed, the benchmark you used and where it came from, and the conclusion you reached. If the figures are challenged later, the file is the only evidence that the work was done.
• Know when to stop. If a material difference cannot be explained and the proprietor will not engage with it, the figures should not be presented as though they were reliable. Consider whether the matter engages the reporting obligations in Section 1.3.

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6. Reasonableness Checklist

1. Recast every reconstruction before investigating anything else — the difference is often arithmetic.
2. Calculate the implied gross margin and compare it with the prior year, the stated pricing policy and the trade norm.
3. Reduce takings to a per-day or per-customer figure and ask whether the business could physically have done it.
4. Compare every reconstructed expense line with the prior year and explain any step change.
5. Check the sign of every answer: negative inventory, negative drawings or a loss in a visibly prospering business is always an error.
6. Corroborate the key figures against bank statements, VAT returns and supplier statements.
7. Establish the cause of any material unexplained difference before choosing its accounting treatment.
8. Record the tests performed, the explanations obtained, and any matter left unresolved.