The Use of Analytical Procedures in Auditing
The use of analytical procedures is one method of increasing auditor efficiency. Analytical procedures consist of evaluations of financial information made by an auditor of plausible and expected relationships among both financial and non-financial 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).
“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“.
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. These 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).
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.
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.
It has been recommended that investigation thresholds be computed more rigorously by using “univariate” and “bivariate” statistical distributions.
Use of Analytical Procedures as a Substantive Test
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.
Here are the rules:
- 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.
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.
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 the 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 the client’s industry.
- Development of common-size financial statements.
- Ratio analysis.
- Trend analysis.
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. 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 discriminate 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” scores which, if below a certain level, indicates the strong possibility of impending bankruptcy within a year or two.
The development of regression models is relatively costlier 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.
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.