The Use of Analytical Procedures

Journal of Accountancy, February 1996, p. 53.

The Use of Analytical Procedures

The Importance of Expectation and Precision.

by Edward Blocher and George F. Patterson Jr.

EXECUTIVE SUMMARY

CURRENT GUIDANCE ON ANALYTICAL procedures is found in Statement on

Auditing Standards no. 56, Analytical Procedures. An auditing standards board task force

concluded amendments to the statement were not necessary but that practitioners did need

additional help in applying the procedures.

AN EXPECTATION-AN ESTIMATE OF an account balance based on an auditor's

analysis of the account-should be the first step in an analytical procedure. Otherwise, the

procedure is potentially biased by irrelevant information.

TO FORM EXPECTATIONS, AUDITORS commonly use three broad types of analytical

procedures, including trend analysis, ratio analysis and model-based procedures. There are

two types of model-based procedures - reasonableness tests and regression analysis.

PRECISION-THE AUDITOR'S MEASURE of the potential effectiveness of an

analytical procedure represents the degree of reliance that can be placed on the procedure

and the audit assurance that can be derived from it. Auditors consider four key factors

when assessing precision: the type of method (procedure) used to form the expectation, the

reliability of the data, aggregation, and the predictability of the account.

OTHER FACTORS THAT DO NOT AFFECT an analytical procedure's precision but do

affect the reliance and assurance derived from it include the nature of the assertion tested,

the auditor's assessment of control risk for the entity and the results of the auditor's

evaluation of significant differences.

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, Analytical 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

The Use of Analytical Procedures http://business2.fiu.edu/1048733/www/Spring_2010_ACG4651_U02/Art...

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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:

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.

1.

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.

2.

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

3.


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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:

While expectation formation is implicit in trend and ratio analyses, expectation formation is

explicit in model-based procedures.

1.

Model-based procedures use operating and external data in addition to financial data to

develop the expectation.

2.

While all three procedures are widely used in auditing, they differ significantly in their ability to

identify potential misstatement. Trend analysis is the weakest; it relies on data for only a single

account. In contrast, ratio analysis incorporates directly the expected relationships between two

or more accounts. For example, turnover ratios are useful because there typically is a stable

relationship between sales and other financial statement accounts, especially receivables and

inventory. Thus, ratio analysis is more likely than trend analysis to identify potential

misstatement.

Both ratio and trend analyses are limited in that the development of expectations is implicit. The

presumption is that the balance or ratio should compare with the prior year or with the industry

average. Since model-based procedures incorporate expectation development explicitly, they are

likely to be much more effective at signalling misstatement. Putting the expectation formation

step first helps emphasize the importance of assumptions implicit in the estimate (if the prior

year's balance is still relevant for a comparison) and also will focus the auditor's attention on the

means to make the estimate (and therefore the analytical procedure) most effective, as described

in SAS no. 56.

Moreover, the modelling approach is more effective because it links financial data directly to

relevant operating data. When, as often is the case, changes in operations are the principal cause

of changes in the financial statements, model-based procedures provide an effective way of

incorporating the relevant operating data. In effect, model-based procedures are a direct test of

the consistency between the operating and financial data-an important test in many types of

financial statement assertions such as completeness. An example is the test of rental revenues for

a real estate management firm. In this case, the use of an analytical procedure to form an

expectation for rental revenues based on capacity, occupancy rates and rental charges should

provide reliable evidence about the accuracy and completeness of recorded rental revenues. The

possibility of unrecorded revenues is likely to be identified in this way.

Research on the effectiveness of analytical procedures shows that model-based procedures

outperform ratio and trend analyses. Similarly, research has shown that explicitly incorporating

expectations significantly improves the auditor's use of analytical procedures. Thus, a

model-based procedure can increase the effectiveness of an analytical procedure. Other ways to

improve an expectation's precision, and thereby the effectiveness of an analytical procedure, are

discussed below.

THE IMPORTANCE OF PRECISION

Precision is the auditor's measure of the potential effectiveness of an analytical procedure, and

therefore of the degree of reliance that can be placed on the procedure and the audit assurance

(reduction in audit risk) derived from it. Effectiveness refers to the procedure's ability to identify

accounts with or without misstatement-that is, to correctly identify whether a given fluctuation in


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an account balance or ratio results from a misstatement. For example, a fluctuation in interest

expense could be due to a misstatement or to a change in interest rate or outstanding balance. The

greater the precision of the expectation, the more likely the analytical procedure will identify

correctly whether or not a misstatement is the cause of a fluctuation.

The auditor's consideration of the degree of precision needed for an expectation depends on

whether the analytical procedure is used in planning, as a substantive test or in the final review.

Precision is important in all three phases but is most important in the substantive testing phase

because the procedure is relied on to provide audit assurance. In the planning and review phases,

analytical procedures developed with greater precision are desirable as they will more effectively

identify the accounts and items with the greatest potential for misstatement.

There are four key factors, discussed in the exhibit below, that an auditor should consider when

assessing the precision of a given expectation. Specific consideration of each factor is necessary

to determine the degree of assurance derived from a procedure. Other factors that do not affect

an analytical procedure's precision but that affect the reliance and assurance derived from it

include the nature of the assertion tested, the auditor's assessment of control risk for the entity

and the results of the auditor's investigation and evaluation of significant differences.

Exhibit 1: Key Factors Affecting the Precision of Expectation

Methods (procedures) used to form an expectation. The auditor chooses

among three methods of forming an expectation-trend analysis, ratio analysis

and model-based. Model-based methods provide the most precise

expectations.

1.

The reliability of data used. The data used in an analytical procedure may

consist of client financial data, operating data or external industry and

economic data. The more accurate the data, the more reliance can then be

placed on the procedure. The reliability of the financial and operating data

will depend in part on the effectiveness of the client's internal control systems

for this data, while the accuracy of external data will depend on the credibility

of the data source. The auditor makes a judgment of the reliability of the data

based on the process used to develop the data. For example, U.S. Census data

are developed from known procedures, and therefore have a known reliability,

but industry survey data may have very little or very high reliability,

depending on the survey methods used.

2.

Aggregation. An expectation has greater precision if the analysis is done at a

relatively detailed account level. For example, expectations formed at the

product line or plant level are more likely to be effective than those formed at

the entity level since there are more factors influencing an entity-level

balance. For the same reason, an expectation formed using monthly data is

more precise than one formed using quarterly or annual data.

3.

Predictability of the account. The development of an expectation for some

accounts is likely to be more precise and effective than for others. SAS no. 56

points out, "As higher levels of assurance are desired from analytical

procedures, more predictable relationships are required to develop the

4.


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expectation." The statement says that in a stable environment, relationships

usually are more predictable than in a dynamic or unstable environment.

Relationships involving income statement accounts tend to be more

predictable than those involving balance sheet accounts since the former

represent transactions over a period of time; balance sheet accounts represent

amounts at a point in time. Relationships involving transactions subject to

management discretion can be less predictable. For example, it may be

difficult to form a precise expectation for cash because of the influence of

nonoperating factors and management discretion.

Nature of assertion tested. SAS no. 56 cautions that for certain assertions, analytical procedures

may not be as effective or efficient as tests of details in providing the desired assurance level.

Examples of such assertions are rights and obligations. Conversely, SAS no. 56 recognizes that for

other assertions, analytical procedures are effective in providing the appropriate level of

assurance. One example is the completeness assertion in which analytical procedures are likely to

be very useful in examining for unrecorded sales.

Control risk. Although the auditor's assessment of such risk does not affect the expectation's

precision, it can affect the level of assurance derived from an analytical procedure. There may be

cases when the performance of analytical procedures as the exclusive test of an assertion is not

appropriate due to the absence of effective controls. The AICPA audit and accounting guide

Consideration of the Internal Control Structure in a Financial Statement Audit points out that a

test of details usually is required when testing a material assertion if control risk and inherent risk

for the assertion are assessed at the maximum, even though a "very effective" analytical

procedure could be developed.

Significant differences. SAS no. 56 says auditors should evaluate significant unexpected

differences. This investigation and evaluation should begin with an inquiry of management,

followed-up ordinarily with corroboration by other evidential matter. If the unexpected difference

cannot be satisfactorily explained, the auditor performs additional audit procedures to determine

whether the difference is a likely misstatement.

IMPORTANT AUDIT TOOL

Analytical procedures are an important audit tool, made even more effective by proper attention

to expectation formation and assessment of the precision of the expectation. However, analytical

procedures should not be used as an easy and inexpensive audit approach. Although many think

analytical procedures generally do not provide much audit assurance, we believe they are

effective substantive tests that provide assurance commensurate with the planning and effort

invested in their development.


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The Use of Analytical Procedures

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