The Use of Analytical Procedures

Abstract

Auditors facing competitive market pressures for audit services continually reassess the efficiency of audit procedures while maintaining the overall effectiveness of the audit plan. Current guidance for the application of analytical procedures as part of the audit is found in Statement on Auditing Standards no. 56, Procedures. In 1993, the auditing standards board formed a task force to consider certain issues related to SAS no. 56 and the need for additional guidance. Although the task force concluded that SAS no. 56 did not need to be amended, it recommended an auditing procedures study be developed to aid practitioners in applying analytical procedures. The purpose of this article is to discuss common concerns expressed to the task force about the use of such procedures in practice and to emphasize some of the cautions about their use. THE NEED FOR AN EXPECTATION An expectation is an estimate of an account balance based on * The auditor's analysis of the trend of the account. * Related financial ratios. * Explicit financial models of factors that affect the account. One question posed to the task force was whether an expectation is a prerequisite to performing analytical procedures. Paragraph 5 of SAS no. 56 says, Analytical procedures involve comparisons of recorded amounts, or ratios developed from recorded amounts, to expectations developed by the auditor. (Emphasis added.) Proper application of analytical procedures in accordance with SAS no. 56 requires the development of an expectation. This is true regardless of the audit phase (planning, substantive testing and final review) in which analytical procedures are used. The expectation is compared with the recorded amount--or other benchmarks derived from recorded amounts--to assess the potential for misstatement. Without an expectation as the first part of an analytical procedure, the procedure is potentially biased by other irrelevant information. For example, a comparison of current and prior year balances is biased by the presumption that prior year balances are relevant predictors of what current balances should be. Using the current-to-prior-year comparison approach increases the chance auditors will not properly identify an account for which the balance should have changed significantly, for example, because of the effect a sharp increase in utility rates has on utility expenses. Using analytical procedures without starting with an expectation can be compared to a medical doctor performing a routine physical on a patient without consulting the patient's medical records. The patient's blood pressure and weight as observed in a physical, for example, cannot be interpreted properly outside the context of his or her complete medical history. Moreover, for the doctor to consult the records after having observed the patient introduces bias, as the doctor naturally has already begun to consider potentially irrelevant and distracting hypotheses for the patient's observed condition. SOME EXPECTATIONS ARE BETTER THAN OTHERS Auditors commonly use three broad types of analytical procedures (or methods) to form an expectation: 1. Trend analysis. The comparison of a current account balance or item with the prior year balance or with a trend in two or more prior periods' balances. 2. Ratio analysis. The comparison of a ratio calculated for the current year with a related ratio for a prior year, an industry average or budget. Ratios commonly have financial statement data in the numerator and the denominator. 3. Model-based procedures. The use of client operating data and relevant external data (industry and general economic information) to develop an expectation for the account balance or item. There are two types of procedures--reasonableness tests and regression analysis. Model-based procedures differ from ratio and trend analyses in two key ways: 1. …