Competition has become intense in the accounting profession in recent years. This condition has put pressure on auditors to become more efficient in their audits. The use of analytical procedures is one method of increasing auditor efficiency. Simple analytical procedures comparisons, ratio analysis, trend analysis, and common size financial statements are effective as attention directing tools in the planning and final review stages of the audit. Those procedures are also effective when used in conjunction with a minimum level of tests of details as a substantive test. As computer technology continues to develop, auditors will use regression models as an analytical procedure. It is the most effective and ultimately most efficient of the analytical procedures.
Through this post, I am going to discuss about “analytical procedure” used in auditing. Although this isn’t an extensive “how-to” step-by-step approach, it should arm you with enough basic knowledge about the “analytical procedure”. Enjoy!
What is the “Analytical Procedure”?
Analytical procedures consist of evaluations of financial information made by an auditor of plausible and expected relationships among both financial and nonfinancial data. They range from simple comparisons [e.g., the current year with the preceding year] to the use of complex models involving many relationships and elements of data [e.g., regression analysis].
According to US Statement on Auditing Standards [SAS] No. 56, issued in 1988, “Analytical Procedures” [American Institute of Certified Public Accountants [AICPA], Professional Standards, vol. 1, AU section 329]:
A basic premise underlying the application of analytical procedures is that plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary. Particular conditions that can cause variations in these relationships include, for example, specific unusual transactions or events, accounting changes, business changes, random fluctuations, or misstatements. [paragraph 2].
History and Authoritative Pronouncements Of the Analytical Procedure
The term analytical review procedures [changed to “analytical procedures“ by US Statement on Auditing Standards [SAS] No. 56] was introduced in the authoritative auditing literature in 1970 when Statement on Auditing Procedures [SAP] No. 54 [AU section 320.70] was issued. The Statement specified that sufficient competent evidential matter “is obtained through two general classes of auditing procedures: [a] tests of details of transactions and balances and [b] analytical review of significant ratios and trends and resulting investigation of unusual fluctuations and questionable items“.
Analytical procedures were being used, however, in audits prior to 1970. In fact, in 1950 the American Institute of Accountants [subsequently changed to the American Institute of Certified Public Accountants [AICPA]] states:
One way this [the analysis and review of data] is accomplished is by comparison of balances in the trial balance at the balance-sheet date with those in the trial balance at the end of the previous comparable period, noting for investigation any items which appear to be out of line with previous experience. Another comparison is that of the gross profit percentage during the current period with the corresponding percentages in previous periods [Audits by Certified Public Accountants, 1950].
Subsequent to the issuance of SAP No. 54, the AICPA required, recommended, or discussed the use of analytical procedures in the following authoritative pronouncements:
- SAS No. 21, 1977, “Segment Information.”
- SAS No. 23, 1978, “Analytical Review Procedures.”
- SAS No. 36, 1981, “Review of Interim Financial Information.”
- SAS No. 39, 1981, “Audit Sampling.”
- SAS No. 56, 1988, ”Analytical Procedures”[SAS No. 56].
- SAS No. 59, 1988, “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern.”
In 1987, the Report of the National Commission on Fraudulent Reporting [the Treadway Commission] recommended that standards should be established “to require independent public accountants to perform analytical review procedures in all audit engagements and should provide improved guidance on the appropriate use of these procedures.” The Auditing Standards Board of the AICPA responded to this recommendation by issuing SAS No. 56.
SAS No. 56 Analytical Procedures
In April 1988, in the USA, Statement on Auditing Standards SAS No. 56 was issued. It requires auditors to use analytical procedures to assist in planning the nature, timing, and extent of other auditing procedures and as an overall review of the financial statements in the final review of the audit. The Statement also indicates that analytical procedures may be used “as a substantive test to obtain evidential matter about particular assertions related to account balances on classes of transactions.”
The next section discusses the broad categories of analytical procedures, and the section after that contains a general discussion on the use and effectiveness of those procedures. The three sections after the general discussion section describe uses of analytical procedures in the planning, evidence accumulation, and final review phases of an audit, as well as research concerning the procedures applied in those three phases. Read on…
Categories of Analytical Procedures
Analytical procedures may be classified as follows:
- Comparisons of absolute numbers.
- Comparisons of the results of mathematical computations: [a] Ratio analysis [b] Common-size financial statements, and [c] Trend analysis.
- Regression analysis.
Let’s discuss each of the above category in more detail. Read on…
Comparisons of Absolute Numbers
This procedure involves the comparison of current year’s unaudited financial data with the prior year’s audited financial data.
Comparison of the Results of Mathematical Computations
Ratio analysis involves the computation of the relationship between two numbers. For income statement data, the relationship is usually based on, sales; therefore, the gross profit percentage is the relationship of gross profit to sales. Inter-statement ratios may also be computed. For example, the inventory turnover ratio is the relationship of average inventory [a balance sheet item] to cost of sales [an income statement item]. After ratios are computed, they are compared with company ratios from prior years or industry ratios.
Industry ratios may be obtained in the USA from commercially available data published by Standard & Poor’s Corp., Dun & Bradstreet, Robert Morris Associates, or industry trade associations.
A common-size financial statement is one in which all numbers are converted to percentages. For example, the dollar amounts of cash, receivables, inventory, and other assets in the balance sheet are converted to percentages based on the relationship of each asset to total assets. For income statement items, costs and expenses are converted to percentages based on their relationship to sales. Those percentages may be compared to prior years’ percentages or industry percentages. Industry percentages may be obtained in the USA from the organizations noted in the previous paragraph.
Trend analysis indicates the relative changes in data from period to period based on the data of a base year. Trend statements may be computed for any financial statement item. The statements may be computed for any financial statement item. The statements highlight departures from the norm in a company’s operations.
Regression analysis is the means by which presumed cause-and-effect relationships are used to make predictions. The relationships are expressed in terms of a dependent variable and one or more independent variables. Regression analysis is used to estimate or predict what an account balance should be for comparison with what that account balance is.
General Analytical Procedures in Auditing
In today’s highly competitive auditing environment, auditors must use effective and more efficient procedures in their audits. When applying analytical procedures, the auditor will, generally, do the following:
- develop expectations;
- define what will be considered a material difference between expected and recorded amounts;
- identify significant differences;
- investigate the causes of the significant differences; and
- reach a conclusion.
Research has been conducted for over twenty years to determine when analytical procedures are used, the effectiveness of those procedures, and the impact they have on auditors’ decisions.
Questions have been raised concerning the effectiveness of analytical procedures as a means of accumulating audit evidence. One study concludes that “many auditors lack confidence in analytical procedures because of the perceived low precision of the procedures and the perceived unreliability of the data that are necessary for the procedures, for example, monthly [or annual unaudited] data.”
On the other hand, a study of audit work papers found that of 281 errors requiring financial statement adjustments on 152 audits 27.1 percent of those errors were detected through the use of analytical procedures [Hylas, R. & Ashton, R. (1982). Audit detection of financial statement errors. Accounting Review, 57, 4, 75165. 1982]. What is not known, however, is the number and frequency of errors not detected when analytical procedures are used.
Another study concludes that “analytical procedures are useful for the auditor with respect to detecting overstatements of revenue, fictitious sales and receivables, fictitious and overvalued inventory, understated bad debts and allowances for doubtful accounts, unrecorded purchase liabilities, under accrual of expenses, and inappropriate expense capitalization. Analytical procedures, used effectively in those situations, would have revealed unusual relationships and significant changes in relationships. By following up the unusual relationships and the changes in relationships with other audit procedures, the auditor could have detected large errors in the financial statements” [Coglitore, F. & Berryman, R. G. (1988). Analytical procedures: A defensive necessity. Auditing: A journal of practice and theory, 7, 2, 15063].
A number of studies conclude that the auditor’s knowledge of the client and the client’s industry influenced the use and effectiveness of analytical procedures [Kinney, W. & Felix, W. L. (1980). Analytical review Procedures. Journal of Accountancy, 150, 4, 98103]. One study concludes that the auditor’s knowledge of analytical procedures and perception of the effectiveness of those procedures affected the auditor’s tendency to use those procedures and rely on the results of their application.
Auditor’s experience is a factor in the effectiveness of analytical procedures. When a procedure indicates that the actual data deviates from the expected data, the auditor must determine the cause. One of the advantages of experience is the ability to generate a greater number of plausible explanations for the deviation. The more experienced auditor is also more efficient in that he or she first investigates the more likely explanations for the deviation [Libby & Frederick, 1990]. At times, deviations from expected values are not caused by accounting errors but by environmental factors. One study concludes that “audit experience was positively associated with the number and ranking of environmental factors selected. Thus, accumulated direct experience does affect plausibility assessment and appears to enable auditors to understand that significant fluctuations in ratios do not necessarily indicate the occurrence of accounting errors“.
Other factors influence the use and effectiveness of analytical procedures. When those procedures produce deviations from expected results, auditors seek explanations from management. Auditors consider managers’ competence when evaluating the reliability of their explanations of deviations. That is, the greater the managers’ competence the more willing the auditor is to accept their explanations of deviation [Anderson et al., 1994].
The use and effectiveness of the more common analytical procedures depends on other factors. For example: if the auditor determines that a client’s internal control structure is strong, the auditor will have greater flexibility in planning the mix between analytical procedures and tests of details. That is, the quality of the client’s internal control structure influences the extent to which the auditor applies analytical procedures [Kinney, 1979].
Use of Analytical Procedures in Planning the Audit
In the audit planning phase, analytical procedures serve as an attention-directing device. They are used by auditors to help determine the nature, timing, and extent of their substantive procedures. The objective of using analytical procedures in this phase is to increase the auditor’s understanding of the client and identify specific audit risks by considering unusual or unexpected balances or relationships in aggregate data.
Analytical procedures used in planning the audit might include the following:
- Account balance comparison. Compare unadjusted trial balance amounts with adjusted tried balance amounts of the prior year.
- Computation of significant ratios. Compare current year ratios to current industry ratios and prior year computing ratios.
- Computation of ratios using nonfinancial and financial data. E.g., sales per square foot of sales space.
- Regression analysis [This procedure is discussed in a separate section below].
A question arises concerning the auditor’s response to the results of analytical procedures in the planning stage. One study indicates that when the results signal possible errors, the auditor assigned more hours to testing than when the results indicated the possibility of no errors. However, when the results indicated the possibility of no errors, the auditor did not reduce the hours preliminarily assigned to testing [Cohen, J. & Kida, T. (1989). The impact of analytical review results, internal control reliability and experience on auditors’ use of analytical review. Journal of Accounting Research, 27, 2, 263276]. Those results provide some confirmation of the auditor’s tendency toward conservation. That conservative tendency is one explanation why auditors increase their type I error risk [the risk of not accepting a materially correct balance] and decrease their type II error risk [the risk of accepting a materially incorrect balance]. Those results should not negate the fact that analytical procedures can increase audit efficiency by allowing the auditor to reduce sample sizes for substantive tests if the results of those procedures are favorable. Also, favorable results of analytical procedures will increase audit effectiveness by reducing the auditor’s risk of accepting an incorrect balance.
Most auditors use relatively simple types of analytical procedures in planning the audit. In one study it was found that simple quantitative techniques involving ratio and trend analysis were most commonly used [Holder, W. W. (1983). Analytical review procedures in planning the audit: An application study. Auditing: A Journal of Practice and Theory, 2, 2, 1007].
Another study found that the most commonly used analytical procedure in the planning stage was a comparison of the current year’s unaudited account balance with last year’s corresponding audited account balance [Coakley, J. R. (1987). Analytical review: A comparison of procedures and techniques used in auditing. Unpublished Ph.D. dissertation (University of Utah, 1982), cited by J. K. Loebbecke & P. J. Steinhart, An investigation of the use of preliminary analytical review to provide substantive audit evidence. Auditing: A Journal of Practice and Theory, 6, 2, 7489].
The effectiveness of analytical procedures in the planning stage is, to some degree, determined by the investigation threshold of the auditor:
the extent of deviations from expected values after which an auditor modifies the audit plan. Investigation thresholds usually are arbitrary. One study found that the most widely used decision rule in planning the audit was to investigate if the account balance had changed by more than 10 percent from the previous year [Coakley, 1982]. It has been recommended that investigation thresholds be computed more rigorously by using univariate and bivariate statistical distributions [Harper et al., 1990].
Studies also have concluded that analytical procedures in the planning phase can increase audit efficiency because if the results of those procedures are favorable, many auditors will reduce the extent of their substantive tests.
Use of Analytical Procedures as a Substantive Test
Although US Statement on Auditing Standards SAS No. 56 does not require the auditor to use analytical procedures as a substantive test, auditors use them for that purpose. The extent to which the auditor uses analytical procedures as a substantive test depends on the level of assurance the auditor wants in achieving a particular audit objective and the tolerable error for a specific account balance;
- The higher the level of assurance desired, the more predictable must be the relationship used.
- The higher the tolerable misstatement, the less predictable must be the relationship used.
As a general rule, relationships involving income statement accounts are more predictable than relationships involving only balance sheet accounts.
The results of one study indicate that analytical procedures may enhance audit effectiveness, especially when employed in conjunction with a minimum level of substantive auditing procedures. The auditor should, however, exercise caution in determining the degree of reliance to be placed solely on analytical procedures [Wheeler & Pany, 1990].
Another study a protocol study of five experienced auditors in the performance of an analytical review of inventory concludes that conventional analytical procedures have limited effectiveness. The most effective procedure was the gross profit percentage trend, and the most effective auditors were those who used that procedure and relied on it [Blocher, E. & Cooper, J. C. (1988). A study of auditors’ analytical review performance. Auditing: A Journal of Practice and Theory, 7, 2, 128].
Conventional analytical procedures comparisons, ratios, trend analysis do not have the precision necessary for the auditor to rely on them alone as a substantive test. Auditors believe that those procedures provide limited negative assurance, and therefore their use as a substantive test is limited. Some researchers believe that the expected effectiveness of analytical procedures depends on the assertion being audited and the design of the procedure. Analytical procedures may be somewhat more effective than tests of details for tests of completeness and reasonableness of reserves [e.g., doubtful accounts and depreciation]. Tests of details will be more effective in testing the existence or ownership assertion [Blocher, E. & Loebbecke, J. K. (1993). Research in analytical procedures: Implications for establishing and implementing auditing standards. The expectation gap standards. New York: AICPA. 177226].
Auditors who use analytical procedures as a substantive test consider deviations between the expected amount and the client’s amount as a likely error. At the conclusion of the audit if the total of the known error, likely error, and allowance for undetected error is less than the acceptable error established by the auditor, no further action is required. If, however, the total exceeds the amount of acceptable error, the auditor must investigate those deviations further.
Use of Analytical Procedures in Final Review of the Audit
The application of analytical procedures in the final review of the audit is one of the last audit tests. Those procedures assist the auditor in assessing conclusions reached concerning certain account balances and in evaluating the overall financial statement presentation. Procedures such as the following may be applied:
- Comparisons with similar financial data of the prior year or of the client’s industry.
- Ratio analysis.
- Trend analysis.
- Development of common-size financial statements.
The objective of analytical procedures in the final phase of the audit is similar to that in the planning phase attention directing. Unfavorable results will require the auditor to investigate the reasons for those results.
As a final step in the audit, the auditor must determine if the company has the ability to continue in business for at least one year from the balance sheet date [US Statement on Auditing Standards SAS No. 59, “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern” 1988]. Ratios such as the current ratio and the debt-to-equity ratio aid the auditor in making this assessment.
In assessing a company’s ability to continue as a going concern, auditors apply models using ratios and trends that have been developed to predict bankruptcy. Those models use various ratios. One of the models was developed using a statistical technique [multiple discriminant analysis] and five ratios. Those ratios for a public company are:
- Working Capital/Total Assets
- Retained Earnings/Total Assets
- Earnings before Interest and Taxes/Total Assets
- Market Value of Equity/Book Value of Total Debt
- Sales/Total Assets
Coefficients were determined for those ratios. The total of the five produces a “Z” score which, if below a certain level, indicates the strong possibility of impending bankruptcy within a year or two [Altman, E. I. & McGough, T. P. (1974). Evaluation of a company as a going concern. Journal of Accountancy, 138, 6, 507].
Use of Regression Analysis in Analytical Review
Analytical procedures discussed above give little comfort to auditors as a substantive test because of the absence of measurable precision. Auditors are, therefore, looking for more rigorous and more precise analytical procedures. Those procedures require the use of statistical techniques. The most common statistical technique for analytical procedures is regression analysis. Because of its relative complexity, however, regression analysis is not yet a widely used procedure.
Regression analysis uses the relationship between two or more variables so that one variable, the dependent variable, can be predicted from one or more independent or explanatory variables.
A simple regression model involves only one independent variable and is expressed as Y = a+bX, where Y is the dependent variable and X is the independent variable. Multiple regression analysis involves more than one independent variable to predict the value of the dependent variable and is expressed as Y = a+b1X1, + b2X2 . . . bnXn. The auditor uses the regression model to estimate or predict the value of the dependent variable [Y], conditional on the independent variables used, and compares that value with the client’s corresponding value.
After determining the dependent and independent variables and assembling a series of observations of those variables, the auditor computes the statistical attributes of the model, including a precision interval and a confidence interval. Given the statistical attributes, the auditor computes a point estimate of the dependent variable and determines a range around that estimate based on the precision interval. If the client’s account balance falls within that range, the auditor will have a certain degree of confidence [the confidence interval] that the client’s true account balance falls within that range. If, however, the client’s account balance is outside the range, the auditor will have to investigate further.
The development of regression models is relatively more costly than ratio analysis and requires statistical expertise. Regression analysis is, however, superior to other analytical procedures in detecting material hours. With the development of statistical based computer software, this procedure will be more frequently used.