What are Analytical Procedures?
Definition: Analytical procedures are used in the financial audit to assist in the understanding of business operations and in the identification of potential risk areas that need to be addressed. In other words, they are actions taken by auditors to understand the company’s finances, operating environment, and history.
What Does Analytical Procedures Mean?
Analytical procedures are auditing procedures that involve analysis of relationship between financial and non-financial data. These involve investigation of identified variances and relationships that seem inconsistent with each other or with other available audit evidence.
Analytical procedures are carried out at the planning stage to assess the risk inherent in the financial statements as a whole and in each account head. They are carried at the execution stage to obtain audit evidence. They are also carried out at the time of finalization of an audit to make sure the overall conclusions drawn are consistent.
Examples of analytical procedures are as follows:
- Compare the days sales outstanding metric to the amount for prior years. This relationship between receivables and sales should remain about the same over time, unless there have been changes in the customer base, the credit policy of the organization, or its collection practices. This is a form of ratio analysis.
- Review the current ratio over several reporting periods. This comparison of current assets to current liabilities should be about the same over time, unless the entity has altered its policies related to accounts receivable, inventory, or accounts payable. This is a form of ratio analysis.
- Compare the ending balances in the compensation expense account for several years. This amount should rise somewhat with inflation. Unusual spikes may indicate that fraudulent payments are being made to fake employees through the payroll system. This is a form of trend analysis.
- Examine a trend line of bad debt expenses. This amount should vary in relation to sales. If not, management may not be correctly recognizing bad debts in a timely manner. This is a form of trend analysis.
- Multiply the number of employees by average pay to estimate the total annual compensation, and then compare the result to the actual total compensation expense for the period. The client must explain any material difference from this amount, such as bonus payments or employee leave without pay. This is a form of reasonableness test.
Purposes of Analytical Procedures
Analytical procedures are used throughout the audit process and are conducted for three primary purposes:
1. Preliminary analytical review – risk assessment (required by ISA 315)
Preliminary analytical reviews are performed to obtain an understanding of the business and its environment (e.g. financial performance relative to prior years and relevant industry and comparison groups), to help assess the risk of material misstatement in order to determine the nature, timing and extent of audit procedures, i.e. to help the auditor develop the audit strategy and programme.
2. Substantive analytical procedures
Analytical procedures are used as substantive procedures when the auditor considers that the use of analytical procedures can be more effective or efficient than tests of details in reducing the risk of material misstatements at the assertion level to an acceptably low level.
3. Final analytical review (required by ISA 520)
Analytical procedures are performed as an overall review of the financial statements at the end of the audit to assess whether they are consistent with the auditor’s understanding of the entity. Final analytical procedures are not conducted to obtain additional substantive assurance. If irregularities are found, risk assessment should be performed again to consider any additional audit procedures are necessary.
Use and Stages
Analytical procedures are performed at three stages of audit: at start, in middle and at end of audit. These three stages are risk assessment procedures, substantive analytical procedures, and final analytical procedures.
- Risk assessment procedures are used to assist the auditor to better understand the business and to plan the nature, timing and extent of audit procedures.
- Substantive analytical procedures are used to obtain evidential matter about particular assertions related to account balances or classes of transactions.
- Final analytical procedures are used as an overall review of the financial information in the final review stage of the audit.
What are the Four Phases of the Analytical Audit Process?
Performing analytical procedures generally follows this four-step process:
- Form an expectation. Here, the auditor develops an expectation of an account balance or financial relationship. Developing an independent expectation helps the auditor apply professional skepticism when evaluating reported amounts. Expectations are formed by identifying relationships based on the auditor’s understanding of the company and its industry. Examples of data that auditors use to develop their expectations include prior-period information (adjusted for expected changes), management’s budgets or forecasts, and ratios published in trade journals.
- Identify differences between expected and reported amounts. The auditor must compare his or her expectation with the amount recorded in the company’s accounting system. Then any difference is compared to the auditor’s threshold for analytical testing. If the difference is less than the threshold, the auditor generally accepts the recorded amount without further investigation and the analytical procedure is complete. If the difference is greater than the threshold, the next step is to investigate the source of the discrepancy.
- Investigate the reason. The auditor brainstorms all possible causes and then determines the most probable cause(s) for the discrepancy. Sometimes, the analytical test or the data itself is problematic, and the auditor needs to apply additional analytical procedures with more precise data. Other times, the discrepancy has a “plausible” explanation, usually related to unusual transactions or events or accounting or business changes. For example, if a retail business reports higher-than-expected revenues, it could be explained by a change in the product mix or the opening of a new store.
- Evaluate differences. The auditor evaluates the likelihood of material misstatement and then determines the nature and extent of any additional auditing procedures. Plausible explanations require corroborating audit evidence. For example, if a manufacturer’s gross margin seems off, the accounting department might explain that its supplier increased the price of raw materials. To corroborate that explanation, the auditor might confirm the price increase with its top supplier. Or, if an increase in cost of sales in one month was attributed to an unusually large sales contract, the auditor might examine supporting documentation, such as the sales contract and delivery dockets.
Analytical procedures include comparison of financial information (data in financial statement) with prior periods, budgets, forecasts, similar industries and so on. It also includes consideration of predictable relationships, such as gross profit to sales, payroll costs to employees, and financial information and non-financial information, for examples the CEO’s reports and the industry news. Possible sources of information about the client include interim financial information, budgets, management accounts, non-financial information, bank and cash records, VAT returns, board minutes, and discussion or correspondence with the client at the year-end.
Types of Analytical Procedure Audits
Ratios are expressed as one financial statement data in relation to another. For example, current ratio is calculated by dividing current assets with current liabilities. Auditors use ratio analysis in their audit to compare ratios for the current year with ratios for a prior year, budget or an industrial average. Any material differences in the ratios must be explained by the auditors.
Trend analysis refers to the comparison of a current balance with a previous year’s balance. An auditor may choose to use either the diagnostic or casual approach. The diagnostic approach is used to evaluate if a balance of a current account deviates significantly from the trend established in the previous year’s balances for that account. In the casual approach, the auditor calculates a balance expected for the account then compared to the actual amount.
Nonfinancial data for the current period is used to calculate an expected amount for the account balance. This procedure does not use previous period events; rather, it uses operating data for the period under consideration for the audit. These procedures are therefore more applicable to income statements because data for current period may be easier to attain than previous years’ data. The calculated amount is then used to check for reasonableness in the account balances under audit.
Model-based procedures use client-operating data and external data, such as industry and economic information, to predict account balances for items under audit. These models also use financial and nonfinancial data as well. The most commonly used procedure is regression analysis, which is used for income statements using monthly data for the past three years. The 36 monthly observations are used to establish a relationship that is used to predict current account balances.