Analytical procedures

What Are Analytical Procedures?

Analytical procedures are an essential component of the auditing standards process within the broader category of Auditing and Financial Analysis. They involve the evaluation of financial information through the analysis of plausible relationships among both financial and non-financial data. Auditors use analytical procedures to identify fluctuations or relationships that are inconsistent with other relevant information or that differ significantly from expected values. These procedures can range from simple comparisons to the use of complex models, providing auditors with insights into the financial health and operational consistency of an entity. Analytical procedures are critical for understanding the client's business and identifying areas of potential material misstatement.

History and Origin

The concept of using analytical methods in auditing has evolved significantly over time. Early forms of analytical procedures involved basic comparisons of current financial data with prior periods. In the United States, formal guidance on analytical procedures began to take shape with the issuance of Statements on Auditing Procedure (SAPs) by the Committee on Auditing Procedure of the American Institute of Accountants (predecessor to the AICPA) starting in 1939. These SAPs were later superseded by Statements on Auditing Standards (SASs) issued by the Auditing Standards Board of the American Institute of Certified Public Accountants (AICPA), which provided more explicit guidance on the use of analytical procedures. Notably, SAS No. 56, issued in 1988, formalized the requirement for auditors to use analytical procedures in the planning and overall review stages of all audits¹⁹, ²⁰. Following corporate scandals in the early 2000s, the Public Company Accounting Oversight Board (PCAOB) was established to oversee the audits of public companies. The PCAOB adopted and later proposed to update its own auditing standard, AS 2305, which specifically governs substantive analytical procedures for public company audits, emphasizing their role in acquiring and evaluating audit evidence efficiently¹⁷, ¹⁸.

Key Takeaways

• Analytical procedures involve evaluating financial information by studying relationships among financial and non-financial data.
• They are used at various stages of an audit, including planning, substantive testing, and overall review.
• The effectiveness of analytical procedures depends on the predictability of relationships and the reliability of the underlying data.
• Significant unexpected differences identified through analytical procedures require further investigation and corroboration.
• These procedures help auditors gain an understanding of the entity and identify potential areas of concern for more detailed examination.

Interpreting Analytical Procedures

Interpreting the results of analytical procedures requires professional judgment and a deep understanding of the audited entity and its industry. Auditors develop an expectation for account balances or relationships, and then compare recorded amounts to these expectations¹⁶. If the actual figures deviate significantly from the auditor's expectation, it signals a potential misstatement or an unusual event that warrants further investigation. For instance, a significant increase in revenue without a corresponding increase in cost of goods sold might suggest an issue with revenue recognition.

The precision of the expectation is crucial; a more precise expectation enhances the effectiveness of the analytical procedure in detecting a material misstatement¹⁵. Factors influencing precision include the level of detail of the data (e.g., monthly vs. annual data), the reliability of the data sources, and the plausibility and predictability of the relationships being analyzed. When significant differences arise, the auditor must investigate them by inquiring of management, corroborating management's responses, and performing other auditing procedures as necessary¹⁴.

Hypothetical Example

Consider a hypothetical manufacturing company, "Widgets Inc.," undergoing an annual audit. The auditor decides to perform analytical procedures on the company's utility expenses.

1. Develop an Expectation: The auditor reviews Widgets Inc.'s historical utility expenses for the past five years, noting an average monthly expense of $10,000, with slight variations based on seasonality and production volume. They also obtain the company's production volume data for the current year. For the current year, the average monthly production volume increased by 10% compared to the prior year.
2. Calculate Expected Value: Assuming a direct correlation between production volume and utility usage, the auditor expects the utility expense to increase proportionally.
   Expected Utility Expense = Previous Year's Average Monthly Expense × (1 + % Increase in Production Volume)
   Expected Utility Expense = $10,000 × (1 + 0.10) = $11,000 per month.
3. Compare to Actual: The auditor then examines the actual recorded utility expense for the current year, which averages $15,000 per month.
4. Identify Difference: The actual expense ($15,000) is significantly higher than the expected expense ($11,000). This $4,000 difference flags a potential issue.
5. Investigate: The auditor would then inquire with management about the discrepancy. Possible explanations could include: a new, energy-intensive production line; a significant increase in utility rates; or, less favorably, an error in expense recording or a fraudulent transaction. Further investigation might involve examining utility bills, contracts, or performing tests of details on the utility accounts to corroborate the explanation provided.

Practical Applications

Analytical procedures are widely applied across various aspects of financial oversight and business analysis. In financial auditing, they are mandatory at the planning and overall review stages of an audit and can be used as substantive tests to obtain evidence about account balances or classes of transactions. ¹², ¹³This includes examining relationships in key financial statements like the income statement, balance sheet, and cash flow statement. For example, auditors often use ratio analysis to compare a company's financial ratios (e.g., gross profit margin, debt-to-equity ratio) to industry benchmarks or prior periods, and trend analysis to observe patterns over time.
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Beyond external audits, analytical procedures are also used in internal auditing, management reviews, and financial planning. Management may use these techniques for performance monitoring, identifying operational inefficiencies, or evaluating the reasonableness of financial projections and budgeting. For instance, a company might use analytical procedures to monitor its sales commissions as a percentage of revenue, comparing it to historical trends and budgeted figures to ensure appropriate expense recognition and to identify any anomalies. The Public Company Accounting Oversight Board (PCAOB) provides detailed standards, such as AS 2305, on the application of these procedures by auditors of public companies, underscoring their importance in maintaining audit quality and protecting investors.
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Limitations and Criticisms

While analytical procedures are powerful tools, they have inherent limitations. One primary criticism is the potential for auditors to over-rely on weak analytical procedures, especially when the results do not indicate a significant difference, which can lead to insufficient audit evidence. ⁸The effectiveness of analytical procedures is directly tied to the predictability of the relationships being examined and the reliability of the underlying data. ⁷If relationships are not stable or the data used is inaccurate, the procedures may fail to detect a material misstatement.

Furthermore, analytical procedures provide plausible relationships rather than conclusive evidence. They are often best used to identify areas for further investigation through more rigorous substantive testing, such as tests of details, rather than serving as the sole source of audit assurance for significant risks. ⁶Weaknesses in a company's internal control system can also impair the reliability of internal data, thereby limiting the auditor's ability to rely on analytical procedures. ⁵Additionally, complex or unusual transactions might not follow predictable patterns, making analytical procedures less effective in detecting misstatements related to these specific events. An academic study highlights that many auditors may not fully utilize analytical procedures due to obstacles like weak accounting systems and inadequate internal controls, impacting audit performance.
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Analytical Procedures vs. Tests of Details

Analytical procedures and tests of details are both types of substantive auditing procedures used to obtain audit evidence, but they differ fundamentally in their nature and purpose. Analytical procedures involve evaluating financial information by studying plausible relationships among data to identify unexpected fluctuations or relationships. Their objective is to highlight areas where potential misstatements might exist, providing a broad overview and identifying inconsistencies. For example, an auditor performing an analytical procedure might compare the current year's revenue to the previous year's revenue and the industry average to spot an unusual trend.

In contrast, tests of details involve examining the individual transactions, balances, or disclosures that make up an account balance. This approach seeks to directly verify the accuracy, completeness, and validity of specific financial assertions. For instance, following an analytical procedure that indicates a potential issue, an auditor might perform a test of details by selecting a sample of sales invoices to verify the actual revenue transactions. While analytical procedures are more efficient for a general review and risk assessment, tests of details provide more conclusive evidence regarding the accuracy of specific account balances. Auditors often use a combination of both to achieve sufficient and appropriate audit evidence.

FAQs

What is the primary purpose of analytical procedures in an audit?

The primary purpose of analytical procedures is to assist the auditor in planning the nature, timing, and extent of other auditing procedures, to serve as a substantive test to obtain audit evidence, and to perform an overall review of the financial statements at the end of the audit. ³They help identify unusual trends or relationships that could indicate material misstatement.

What kinds of data are used in analytical procedures?

Analytical procedures use both financial and non-financial data. Financial data includes information from the income statement, balance sheet, and cash flow statement, as well as internal budgets and forecasts. Non-financial data might include production units, number of employees, square footage of retail space, or industry statistics.

Can analytical procedures detect fraud?

Analytical procedures can help indicate the presence of unusual patterns or significant unexplained variances that might be indicative of fraud. However, they are generally not designed to detect specific instances of fraud directly. They serve as a red flag, prompting the auditor to conduct more in-depth investigations and tests of details to uncover the root cause of the anomaly.

When are analytical procedures performed during an audit?

Analytical procedures are typically performed at three main stages of an audit:

1. Planning Stage: To assist in understanding the entity and identifying areas of significant risk assessment.
2. Substantive Testing Stage: As substantive tests to obtain audit evidence about specific account balances or classes of transactions.
3. Overall Review Stage: Near the completion of the audit, to assess the reasonableness of the financial statements and ensure consistency with the auditor's understanding of the entity.¹, ²