Activity Based Risk Evaluation Model of Auditing

HOME >> BASIC CONCEPTS >> AUDIT ACTIVITIES >> EVIDENCE GATHERING >> SUBSTANTIVE PROCEDURES >> ANALYTICAL PROCEDURES

Analytical procedures

The term "analytical procedures" refers to a collection of activities performed by auditors to gather evidence in four of the five audit stages (i.e. all except the control testing stage). When they are performed in the substantive testing stage, they are considered to be a "substantive procedure".

Analytical procedures involve a comparison of the value of an actual ratio/ trend/ account balance/ transaction etc. (i.e. based on amounts recorded in the accounting system) with the value of the expected ratio/ trend/ account balance/ transaction etc.. The objective of this comparison is to identify and investigate the reason for any unusual or unexpected relationship between the actual and expected values ^[fn]. Auditors estimate the expected value (of the ratio/ trend/ account balance/ transaction etc.) before calculating the actual value in order to avoid the actual value biasing the auditor's estimate of the expected value. (Auditors may be similarly biased towards evidence that is not significantly different from the unaudited values ^[fn] ). When the application of an analytical procedure does not identify any unusual or unexpected difference, then, by inference, the results provide evidence in support of management's assertions.

Analytical procedures may be performed in the client acceptance/retention stage in order to assist in obtaining a better understanding of the client's business; in the audit planning stage to identify possible problem areas ^[fn]; in the substantive testing stage as a means of gathering substantive evidence in relation to one or more account balances or classes of transactions (i.e. as a substantive procedure); and in the opinion formulation stage, as a means of gathering evidence as to the consistency of the financial statements with the auditor's knowledge of the business of the entity ^[fn].

Analytical procedures include:

• reasonableness tests: In a reasonableness test, the expected value is determined by reference to data partly or wholly independent of the accounting information system, and for that reason, evidence obtained through the application of such a test may be more reliable than evidence gathered using other analytical procedures. e.g. the reasonableness of the recorded value of the total annual revenue of a freight company may be estimated by comparing the recorded value with the expected value, where the expected value is equal to the product of the total tonnes carried during the year and the average freight rate per tonne. The performing of a reasonableness test is sometimes referred to as a "predictive testing".
• scanning. An auditor may scan (or "eyeball") account balances, listings of transactions etc., with the object of detecting any unusual or unexpected balances or transactions. In this instance, the expected value of the account balances, transactions, etc. is based on the auditor's knowledge of the business of the entity or perhaps intuitive knowledge.
• review . An auditor may review reconciliations, compilations and aggregations of transactions and/or account balances, again with the object of detecting any unusual or unexpected balances or transactions. Again, expectations are based on the auditor's knowledge of the business of the entity.
• regression analysis . In regression analysis the expected, or predicted, value is determined using the statistical technique of simple (or multiple) regression.
• roll forward procedures . Where substantive evidence of a detailed nature has been gathered in relation to a particular account balance at a point of time prior to balance date, analytical procedures called "roll forward procedures" are used to determine the reasonableness of the value of the account balance as at balance date. For example, if customer balances comprising the account balance "trade accounts receivable" were confirmed as at the end of October and balance date was the end of December, then the auditor will perform roll forward procedures to determine the reasonableness of trade accounts receivable as at balance date. Roll forward procedures comprise:
  • the execution of cut-off tests as at the point of time in which the substantive evidence was gathered. (In the above example, the auditor would execute cut-off tests for the account balance "trade accounts receivable" as at the end of October.)
  • a review of movements on the account balance over the period of time between when the substantive evidence was gathered and balance date. (In the example, the auditor would review movements — such as the total of various classes of transactions debited and credited each month — in "trade accounts receivable" for the months of November and December.)
  • the scanning of the individual underlying transactions that have been recorded in total during the period of time between when the substantive evidence was gathered and balance date. (In the example, the auditor would scan the individual transactions debited and credited to the account balance "trade accounts receivable" in the months of November and December.)
  • the review of any reconciliations relating to the account balance as at balance date. (In the example, the auditor would review the reconciliation between the total of a listing of customer balances as at the end of December and the balance of "trade accounts receivable" in the general ledger as at that date).
• ratio analysis . The computation and comparison of the actual value of a ratio with the expected value. The expected value may be based, for example, on:
  • prior period values.
  • values in other divisions of the entity.
  • industry averages.
  • forecast values.
  • non financial information, such as general economic conditions, technological changes in the client’s industry, and new products from competitors ^[fn].
  Once again, the objective of this analytical procedure is to detect any unusual or unexpected value for the ratio. Examples of ratios used in ratio analysis include:
  • days sales in receivables.
  • days sales in inventory.
  • gross profit percentage.
  • inventory turnover.
  See the Journal of Accountancy article Irrational Ratios.
• common size analysis is a type of cross-sectional analysis used for comparing the percentage components of balance sheets and income statements of one entity, or a division of an entity (expected values), with comparable data from one or more other entities/ divisions (actual or recorded values). This analysis may be used for either (i) the comparison of a (prospective) client's data with the industry average and/or an industry competitor or (ii) for the comparison of income statements of different divisions of the same entity.

Note that if the expected values referred to above are based on evidence internally generated and subject to control procedures that are either not effective or not known to be effective, the evidence gathered using the analytical procedure may not be reliable. For example, if the auditor is scanning a listing of receivables with the object of detecting unusual balances, and the auditor has not gathered evidence as to the effectiveness of controls relating to receivables, the auditor does not consider the evidence gathered as a result of the scanning to be reliable evidence. In this instance, the auditor (depending on the extent of the risk of material misstatement) may need to gather additional corroborative evidence. However if an analytical procedure is one in which expectations are based on evidence that is independent of the accounting information system (as with a reasonableness test) and inherent risk is not HIGH, auditors ordinarily place some reliance on the evidence gathered using such an analytical procedure.

Analytical procedures generally provide less reliable substantive evidence than the other category of substantive procedures/tests, (tests of detail). The substantive evidence gathered using analytical procedures is thus generally used to corroborate other substantive evidence gathered, rather than used as a sole source of evidence. See The CPA Journal article entitled The Hidden Risk in Analytical Procedures: What WorldCom Revealed.

Copyright, Australian Educational Research Pty Ltd. Any person accessing this site agrees to the Terms of Use.