Analytical Procedures (Encyclopedia of Business and Finance)
Analytical procedures have become increasingly important to audit firms and are now considered to be an integral part of the audit process. The importance of analytical procedures is demonstrated by the fact that the Auditing Standards Board, the board that establishes the standards for conducting financial statement audits, has required that analytical procedures be performed during all audits of financial statements. The Auditing Standards Board did so through the issuance of Statement on Auditing Standards (SAS) No. 56 in 1988, which requires that analytical procedures be used by auditors as they plan the audit and also in the final review of the financial statements. In addition, SAS No. 56 encourages auditors to use analytical procedures as one of the procedures they use to gather evidence related to account balances (referred to in auditing as a substantive test). The purpose of this article is to provide the reader with a general understanding of analytical procedures and to describe the process that auditors use in applying analytical procedures.
SAS No. 56 describes analytical procedures as the "evaluation of financial information made by a study of plausible relationships among both financial and nonfinancial data" (AICPA, 1998, 56 p. 1). Accounting researchers have helped to clarify the process that auditors use to perform analytical procedures by developing models that describe the various stages of the process. One such model developed by Hirst and Koonce (1996) describes the performance of analytical procedures as consisting of five components: expectation development, explanation generation, information search and explanation evaluation, decision making, and documentation. Due to the importance of each of these five components to understanding the analytical procedures process, each of them is described in more detail.
The first step in the analytical procedures process is the development of an expected account balance. SAS No. 56 and auditing textbooks (e.g., O'Reilly et al., 1998) provide some guidance as to the sources of information an auditor can use to develop these expectations. Examples of such sources include the following:
- Financial information from comparable prior periods adjusted for any changes expected to affect the current-period balances. For example, an expectation of sales revenues for the current year might be based on the prior year's sales, adjusted for factors such as price increases or the known addition or loss of major customers.
- Expected results based on budgets or forecasts prepared by the client or projections of expected results prepared by the auditor from interim periods or prior comparable periods.
- Available information from the company's industry. For example, changes in sales revenue or gross margin percentages might be based on available data from industrywide statistics.
- Nonfinancial information. For example, sales revenue for a client from the hotel industry might be based on available data as to room occupancy rates.
After an auditor has developed an expectation for a particular account balance (e.g., sales revenue), the next step in the analytical procedures process is to compare the expected balance to the actual balance. If there is no significant difference (referred to by auditors as a material difference) between the expected and actual balance, this conclusion provides audit evidence in support of the account balance being examined. However, if there is a material difference between the expected and actual balance, the auditor will investigate this difference further. At this point the auditor will develop an explanation for the difference. Hirst and Koonce (1996) interviewed auditors from each of the six largest accounting firms and found that the source of the explanation usually depends on what types of analytical procedures are being performed. If analytical procedures are being performed during the planning phase of the audit, the auditor usually asks the client the reason for the unexpected difference. However, if the analytical procedures are being performed as a substantive test (method of obtaining corroborating evidence) or during the final review phase of the audit, in addition to asking the client, auditors will often generate their own explanation or ask other members of the audit team for an explanation.
When developing an explanation for an unexpected change in account balances, an auditor considers both error and nonerror explanations. Nonerror explanations are sometimes referred to as environmental explanations, since they refer to changes in the business environment in which the client operates. For example, an environmental explanation for an unexpected decline in gross profit (sales revenue less cost of sales) may be that the client faces increasing foreign competition and has been forced to reduce selling prices. An error explanation, on the other hand, might be that the client has failed to record a profitable sale to a major customer. If this mistake is unintentional, then auditors refer to the mistake as an "error." However, if this mistake was intentional (i.e., the client failed to record the sale on purpose), auditors refer to the mistake as a "fraud." Auditors are much more concerned about errors and fraud than changes resulting from environmental factors. In fact, auditors are most concerned about fraud, since this raises doubts about the integrity of the client as well as about the process of recording transactions affecting other account balances.
Once an auditor has a potential explanation, whether self-generated or obtained from the client, the next step in the analytical procedures process is to search for information that can be used to evaluate the adequacy of the explanation. Similar to the explanation generation phase of the process, the extent of information search and explanation evaluation depends on the type of analytical procedures being performed. Hirst and Koonce (1996) found that during the planning phase of analytical procedures, auditors do little if any follow-up work to evaluate an explanation. Instead, consistent with SAS No. 56, auditors typically use analytical procedures at the planning stage to improve their understanding of the client's business and to develop the audit plan for the engagement. For example, if analytical procedures performed on inventory during audit planning indicated the inventory balance was higher than expected, the auditor would most likely adjust the audit plan by increasing the number of audit tests performed on inventory or assigning more experienced personnel to the audit of inventory. Thus, if an error or fraud has occurred with inventory, the revised audit plan for obtaining corroborating evidence will lead to detection of the error or fraud.
If analytical procedures are being performed as a substantive test, the auditor will need to gather information to evaluate the explanation being considered, since the primary purpose of substantive analytical procedures is to provide evidence as to the validity of an account balance. The type and amount of corroboration for the explanation will vary based on factors such as the size of the unexpected difference, the significance of the difference to the overall financial statements, and the risks (e.g., internal control and inherent) associated with the account balance(s) affected. As any of these factors increase, the reliability of the information obtained in support of the explanation should also increase. SAS No. 56 provides guidance for auditors in the evaluation of the reliability of data. Some of the factors to be considered by the auditors include the following:
- Data obtained from independent sources outside the entity are more reliable than data obtained from sources within the entity.
- If data are obtained from within the entity, data obtained from sources independent from the amount being audited are more reliable.
- Data developed under a system with adequate controls are more reliable than data from a system with poor controls.
After an auditor gathers information for purposes of evaluating an analytical procedures explanation, it is a matter of professional judgment in determining whether the evidence adequately supports the explanation. This is one of the most important steps of the analytical procedures process and is referred to as the decision phase of the process. Factors the auditor should consider in evaluating the acceptability of an explanation include the materiality of the unexpected difference, reliability of the evidence obtained to support the explanation, and whether the explanation is sufficient to explain a material (significant) portion of the unexpected difference. If, after evaluating the evidence, the auditor finds that the explanation being considered does not adequately explain the unexpected difference, the auditor should return to the "explanation generation" phase of the process. If the auditor believes that the audit evidence obtained adequately supports the explanation, the auditor may proceed to the final step of the process, which is "documentation." While the extent of written documentation will vary depending on the materiality of the unexpected difference, the audit work papers will generally include a written description of material unexpected differences, an explanation for the difference, evidence that corroborates the explanation, and the judgment of the auditor as to the adequacy of the explanation.
The purpose of this article has been to pro vide the reader with a basic understanding of analytical procedures. Space limitations, how ever, preclude discussing in more detail some of the complexities associated with analytical procedures. Thus, the interested reader is referred to Statement on Auditing Standards No. 56 (AICPA, 1988) or to Montgomery's Auditing (O'Reilly et al., 1998) for a more in-depth discussion. Further, while the focus of this article has been on the use of analytical procedures during financial statement audits, portions of analytical procedures can also be helpful to both management and investors. For example, managers of a business may develop certain key ratios and statistics, which can be used to monitor the progress of the business. For example, a manager may use data such as the number of new customers, number of customer complaints, and other customer satisfaction measures to monitor the sales revenue and profitability of the company. An investor might also use analytical procedures to evaluate his or her investment portfolio. For example, an investor may try to forecast the future sales of a company based on knowledge of the industry in which the company operates and the prior sales history of the company. The sales forecast could then be used to develop an earnings forecast for that company, which is a critical component in developing an investment decision. Thus, while analytical procedures are an integral part of the audit process, they can also be a useful tool for managers and investors.
American Institute of Certified Public Accountants. (1988). Statement on Auditing Standards No. 56: Analytical Procedures. New York: Author.
Hirst, Eric D., and Koonce, Lisa. (Fall 1996). "Audit Analytical Procedures: A Field Investigation." Contemporary Accounting Research: 457-486.
O'Reilly, Vincent M., McDonnell, Patrick J., Winograd, Barry N., Gerson, James S., and Jaenicke, Henry R.(1998) Montgomery's Auditing, 12th ed. New York: Wiley.