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
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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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