8. Analytical Procedures Flashcards
Meaning of Analytical Procedures.
As per the Standard on Auditing (SA) 520 “Analytical Procedures”, the term “analytical procedures” means evaluations of financial information through analysis of plausible relationships among both financial and non-financial data. Analytical procedures also encompass such investigation as is necessary of identified fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount.
Examples of analytical procedures.
Examples of Analytical Procedures having consideration of comparisons of the entity’s financial information are:
i) Comparable information for prior periods.
ii)Anticipated results of the entity, such as budgets or forecasts, or expectations of the auditor, such as an estimation of depreciation.
iii) Similar industry information, such as a comparison of the entity’s ratio of sales to accounts receivable with industry averages or with other entities of comparable size in the same industry.
Examples of Analytical Procedures having consideration of relationships are:
i) Among elements of financial information that would be expected to conform to a predictable pattern based on the entity’s experience, such as gross margin percentages.
ii) Between financial information and relevant non-financial information, such as payroll costs to number of employees.
Scope/Objective of analytical procedures.
The objectives of the auditor are:
a) To obtain relevant and reliable audit evidence when using substantive analytical procedures; and
b) To design and perform analytical procedures near the end of the audit that assist the auditor when forming an overall conclusion as to whether the financial statements are consistent with the auditor’s understanding of the entity.
Timing of analytical procedures.
Experienced auditors use analytical procedures in all stages of the audit.
Analytical Procedures are required in the planning phase and it is often done during the testing phase. In addition, these are also required during the completion phase.
Analytical procedures in planning the audit.
a) In the planning stage, analytical procedures assist the auditor in;
i) Understanding the client’s business and
ii) Identifying areas of potential risk by indicating aspects of and developments in the entity’s business of which he was previously unaware.
b) This information will assist the auditor in determining the nature, timing and extent of his other audit procedures.
c) Analytical procedures in planning the audit use both financial data and non-financial information, such as number of employees, square feet of selling space, volume of goods produced and similar information.
Substantive analytical procedures.
a) The auditor’s substantive procedures at the assertion level may be tests of details, substantive analytical procedures, or a combination of both.
b) The decision about which audit procedures to perform, including whether to use substantive analytical procedures, is based on the auditor’s judgment about the expected effectiveness and efficiency of the available audit procedures to reduce audit risk at the assertion level to an acceptably low level.
c) The auditor may inquire of management as to the availability and reliability of information needed to apply substantive analytical procedures, and the results of any such analytical procedures performed by the entity. It may be effective to use analytical data prepared by management, provided the auditor is satisfied that such data is properly prepared.
Factors to be considered for substantive audit procedures.
The auditor should consider the following factors for Substantive Audit Procedures:
i) Availability of Data
The availability of reliable and relevant data will facilitate effective analytical procedures.
ii) Disaggregation
The degree of disaggregation in available data can directly affect the degree of its usefulness in detecting misstatements.
iii) Account Type
Substantive analytical procedures are more useful for certain types of accounts than for others.
Income statement accounts tend to be more predictable because they reflect accumulated transactions over a period, whereas balance sheet accounts represent the net effect of transactions at a point in time or are subject to greater management judgment.
iv) Source
Some classes of transactions tend to be more predictable because they consist of numerous, similar transactions, (e.g., through routine processes).
Whereas the transactions recorded by non-routine and estimation SCOTs (Significant Classes of Transactions) are often subject to management judgment and therefore more difficult to predict.
v) Predictability
Substantive analytical procedures are more appropriate when an account balance or relationships between items of data are predictable.
A predictable relationship is one that may reasonably be expected to exist and continue over time.
vi) Nature of Assertion
Substantive analytical procedures may be more effective in providing evidence for some assertions (e.g., completeness or valuation) than for others (e.g., rights and obligations).
vii) Inherent Risk or “What Can Go Wrong”
When inherent risk is higher, we may design tests of details to address the higher inherent risk.
When significant risks have been identified, audit evidence obtained solely from substantive analytical procedures is unlikely to be sufficient.
Techniques available as substantive analytical procedures.
Substantive analytical procedures generally take one of the following forms:
i) Trend analysis
Trend analysis is a commonly used technique.
It is the comparison of current data with the prior period balance or with a trend in two or more prior period balances.
The auditor evaluates whether the current balance of an account moves in line with the trend established with previous balances for that account, or based on an understanding of factors that may cause the account to change.
ii) Ratio analysis
Ratio analysis is useful for analysing asset and liability accounts as well as revenue and expense accounts.
An individual balance sheet account is difficult to predict on its own, but its relationship to another account is often more predictable (e.g. the trade receivables balance related to sales).
Ratios can also be compared over time or to the ratios of separate entities within the group, or with the ratios of other companies in the same industry.
iii) Reasonableness tests
Unlike trend analysis, this analytical procedure does not rely on events of prior periods, but upon non-financial data for the audit period under consideration (e.g., occupancy rates to estimate rental income or interest rates to estimate interest income or expense).
These tests are generally more applicable to income statement accounts and certain accrual or prepayment accounts.
iv) Structural modelling
A modelling tool constructs a statistical model from financial and/or non-financial data of prior accounting periods to predict current account balances (e.g., linear regression).
Analytical procedures used as substantive tests.
When designing and performing substantive analytical procedures, either alone or in combination with tests of details, as substantive procedures in accordance with SA 330, the auditor shall:
i) Determine the suitability of particular substantive analytical procedures for given assertions, taking account of the assessed risks of material misstatement and tests of details, if any, for these assertions;
ii) Develop an expectation of recorded amounts or ratios and evaluate whether the expectation is sufficiently precise to identify a misstatement that, individually or when aggregated with other misstatements, may cause the financial statements to be materially misstated;
iii) Evaluate the reliability of data from which the auditor’s expectation of recorded amounts or ratios is developed, taking account of source, comparability, and nature and relevance of information available, and controls over preparation; and
iv) Determine the amount of any difference of recorded amounts from expected values that is acceptable without further investigation.
Suitability of particular analytical procedures for given assertions.
1) Substantive analytical procedures are generally more applicable to large volumes of transactions that tend to be predictable over time.
2) The application of planned analytical procedures is based on the expectation that relationships among data exist and continue in the absence of known conditions to the contrary.
3) However, the suitability of a particular analytical procedure will depend upon the auditor’s assessment of how effective it will be in detecting a misstatement that, individually or when aggregated with other misstatements, may cause the financial statements to be materially misstated.
4) Different types of analytical procedures provide different levels of assurance.
5) The determination of the suitability of particular substantive analytical procedure is influenced by the nature of the assertion and the auditor’s assessment of the risk of material misstatement.
Extent of reliance on analytical procedures.
The following are relevant when determining whether data is reliable for purposes of designing substantive analytical procedures:
i) Source of the information available. For example, information may be more reliable when it is obtained from independent sources outside the entity;
ii) Comparability of the information available. For example, broad industry data may need to be supplemented to be comparable to that of an entity that produces and sells specialised products;
iii) Nature and relevance of the information available. For example, whether budgets have been established as results to be expected rather than as goals to be achieved; and
iv) Controls over the preparation of the information that are designed to ensure its completeness, accuracy and validity. For example, controls over the preparation, review and maintenance of budgets.
Evaluation of whether the expectation is sufficiently precise.
Matters relevant to the auditor’s evaluation of whether the expectation can be developed sufficiently precisely to identify a misstatement that, when aggregated with other misstatements, may cause the financial statements to be materially misstated, include:
i) The accuracy with which the expected results of substantive analytical procedures can be predicted.
For example, the auditor may expect greater consistency in comparing gross profit margins from one period to another than in comparing discretionary expenses, such as research or advertising.
ii) The degree to which information can be disaggregated.
For example, substantive analytical procedures may be more effective when applied to financial statements of components of a diversified entity, than when applied to the financial statements of the entity as a whole.
iii) The availability of the information, both financial and non-financial.
For example, the auditor may consider whether financial information, such as budgets or forecasts, and non-financial information, such as the number of units produced or sold, is available to design substantive analytical procedures. If the information is available, the auditor may also consider the reliability of the information.
Investigating results of analytical procedures.
If analytical procedures performed in accordance with SA 520 identify fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount, the auditor shall investigate such differences by:
i) Inquiring of management and obtaining appropriate audit evidence relevant to management’s responses:
Audit evidence relevant to management’s responses may be obtained by evaluating those responses taking into account the auditor’s understanding of the entity and its environment, and with other audit evidence obtained during the course of the audit.
ii) Performing other audit procedures as necessary in the circumstances:
The need to perform other audit procedures may arise when, for example, management is unable to provide an explanation, or the explanation, together with the audit evidence obtained relevant to management’s response, is not considered adequate.
Analytical procedures that assist when forming an overall conclusion.
The conclusions drawn from the results of analytical procedures designed and performed in accordance with, are intended to corroborate conclusions formed during the audit of individual components or elements of the financial statements.
This assists the auditor to draw reasonable conclusions on which to base the auditor’s opinion.
