Chapter 8

Analytical Procedures

8.1 Learning Objectives

After studying this chapter you should be able to:

1. Understand the general nature of analytical procedures.

2. Describe four general nature analytical procesudures.
3. Explain ow expectations are developed and what sources are used.
4. Clarity how the effectiveness of an analytical procedures is a function of the
nature of the account and the reliability and other characteristics of the data.
5. Calculate the customary ratios that are used during the planning phase to
determine accounts that may represent significant risks to the entity of
liquidity, solvency, profitability and activity.
6. Understand some indications that the going concern assumption may be
questioned.
7. Comprehend why and how analytical procedures may be used at each audit
phase.
8. Grasp how analytical procedures are used in substantive procedures/
9. Describe some of the analytical procedures carried out by computer alded
audit techniques.
10.Illustrate data mining methods, techniques and algorithms used to analyse
clien data.
11.Portray the auditors procedures when analytical procedures identity
significant fluctuations that deviate from predicated amounts

8.2 Introduction

Analytical procedures are evaluations of financial information through analysis of

plausible relationships among both financial and non-financial data. Analytical
procedures also encompass such investigation as is necessary of identified
fluctuations of relationships that are inconsistent with other relavant information or
that differ from expected values by a significant amount. Put another way,
analytical procedures entail the use of comparisons and relationships to determine
whether account balance or other data appear reasonable. Such procedures allow
the auditor to look at things in overview and answer the question; Do the number
sense?

.Relationships Among Data

A basuc premise of using analytical procedures is that there exist plausible

relationships among data and these relationships can reasonably be expected to
continue. Analytical procedures include the comparison of the entitys financial
statements with prior period information, abticipated results such as budgets, and
similar industry information.

Analytical procedures are used to determine relationships among financial

information that would be expected to conform to predictable [atterns based on the
entitys experience, such as gross margin percentages, and between financial and
non-financial information such as the relationships between payroll costs and the
number of employees

.Types of Analytical Procedure

General analytical procedures include trend analysis, ratio analysis, statistical and
datamining analysis, and reasonableness tests. Trend analysis is the analysis of
changes in an account balance over time. Ration analysis is the comparison of
relationships between financial statements accounts, the comparison of an accounr
with non-financial dara, or the comparison of relationships between firms in an
industry. Reasonableness testing is the analysis of account balance or changes in
account balances within an accounting period in terms of their reasonableness in
light of expected relationships between accounts. Data mining is a set of computer
assisted techniques that use sophisticated statistical analysis, including artificial
intelligence techniques, to examine large volumens of data with the objective of
indicating hidden or unexpected information or patterns. For these tests auditors
generally use computer alded audit software (CAATs).

Computer Assited Audit Techniques CAATs)

The use of computer assisted audit techniques (CAATs) may enable more extensive
testing of electronic transaction and account filles. CAATs can be used to select
sample transaction from key electronic files, to sort transaction with specific
characteristics, or to test an entire population instead of a simple.

When analytical procedures identify significant fluctions or relationships that are

inconsistent with other relavant information or thet deviate from predicted amounts,
the auditor should investigate and obtain adequate explanations and appropriate
corroborative evidence. The investigation of anusual fluctions and relationships
ordinarily begins with inquiries of management followed by corroboration of
managements responses and other audit procedures based on the results of these
inquires.

8.3 The Analytical Review Process

The process of planning, executing, and drawing conclusions from analytical

procedures is called analytical review. There are several views, theoretical and
practical, of the subprocesses involved in analytical review.

The theoretical is that the review process consists of four diagnostic processes:
 1. Mental representation.
2. Hypothesis generation.
3. Information search.
4. Hypothesis evaluation.

In particular, auditors hypothesis causes and related probabilities, gather evidence

to test the hypotheses, and ultimately select which hypotheses are most likely to
cause the fluctuation.

Four-Phase Process

Here we use a practitioner approach, the four-phase process most-common in

professional literature

Phase one formulate expectations (expectations);

Phase two compare the expected value to the recorded amount (identification);

Phase three investigate possible explanations for a difference between expected

and recorded values (investigation)

Phase four evaluate the impact of the differences between expectation and
recorded amounts on the audit and the financial statements (evaluation)

Phase One

According to ISA 520, the auditor should evaluate the reliability of data from which
the auditors expectation of recorded amounts or ratios is developed, taking
account of source, comparability, and nature and relevance of information available,
and controls over preparation. In phase one of the analytical review process, the
auditor developes expectations of what amounts should appear in financial
statement account balancea based on prior year financial statements, budgets,
industry information and non-financial information. Expectations are the auditors
estimations of recorded accounts or rations. The auditor develops his expectation in
such a way that a signification difference between it and the recorded amount will
indicate a misstatement.

Phase Two

Phase two of the analytical review process (signification) is when the auditor
compares his expected value with the recorded amount. Audit efficiency and
effectiveness depend on competency in recognizing error patterns in financial data
and in hypothessing likely causes of those patterns to sarve as a guide for further
testing.

The auditor should determine the amount of any difference of recorded

amounts from expected values that is acceptable without of further investigation.
The Auditor must comsider how large a difference between expected balue and
recorded amount be wil accept. The threshold amount may very well relate to or
derived from materiality. If the difference is less than acceptable thereshold, the
auditor accepts the book value without further investigation. If the difference is
greater, the next step in to the difference.

Phase Three

In ohase three of the analytical review process (investigation), the auditor

undertakes an investigation of possible explanations for the expected/recorded
amount difference. The difference between an auditors expectations and the
recorded book value of an account not subject to auditing procedures can be due to
misstatements, inherent factors that affect the account being audited, and factors
to the reliability of data used to develop the expectation

Phase four

The final phase (phase four evaluation) of tge analytical review process involves
evaluating in the impact on the financial statements of the differences between the
auditors expected value and the recorded amount. It is usually not practical to
identify factors that explain the exact amount of a difference investigated. The
auditor attempts to quantify that portion of the difference for which plausible
explanations can be obtained and, where appropriate, corroborated. If the amount
that cannot to explained is sufficiently small, the auditor may conclude there is no
material misstatement. However, if the amount that cannot be explained exceeds
the threshold (phase four), additional substantive procedures are required.

8.4 Formulating Expectations

Expectations are developed by identifying plausible relationships that are

reasonably expected to exist based on the auditors understanding of the client and
of this industry. These relationships may be dterminated by comparisons with the
following sources

- Comparable information for prior periods

- Anticipared results (such as budgets and forecasts, or auditor expectations)
- Elements of financial information within the period;
- Similar industry information;
- Non-financial information

8.5 General Analytical Procedures

The general analytical procedures are trend analysis, ratio analysis, statical and
data mining analysis, and reasonableness tests. Determining which type of
analytical procedure is appropriate is a metter of professional judgement

- Trend Analysis

Trend analysis is the analysis of changes in an account balance or ration over

time. Trend analysus could compare last years account balance to the current
unaudited balance or balance in many tme periods

- Ratio Analysis

Ratio Analysis is the comparison of relationships between financial sratement

accounts. The comparison of an account with non-financial data, or the
comparison of rekationships between firms in an industry. Another example of
ration analysis (which is sometimes referred to as common size analysis) is to
set all the account balances as either a percentage of total assets or revenue.

Types of Ratio Analysis

1. Ratios that compore client and industry data;

2. Ratios that compore client data with similar prior period data;
3. Ratios that compore client data with client determined expected results;
4. Ratios that compore client data with auditor-determined expected results;
5. Ratios that compore client data with expected results using non-financial

Tren Analysis, Ratio Analysis and Reasonableness Tests Compared

Tren analysis, ratio analysis and reasonableness test differ as to the number of
independent predictive variables considered, use of external data, and statistical
precision. Trend analysis is limited to a single predictor, does not allow the use of
potentiall relevanr operating data, as do the other types of procedures. Because
ratio analysis employs two or more related financial of non-financial sources of
information, the result is a more precise expectation.

Standard Clien and Industry Ratios

At the planning stage of an audit, there are certain customary rations that are
always calculated to determine accounts that may represent significant risks to the
entity of liquidity, solvency, profitability and activity. These rations gel to answer
some key questions:

- Is there a possible going concern problem (liquidity rations)?

- Is the entitys capital structure sustainabllle (solvency ratins)?
- Is gross margin reasonable (profitability))?
- Could inventory be overstated (activity)?
 - Liquidity and Going Concern

Auditors must determine the possibility that the company is having liquidity
problems that. Is there a possibility that the company may no longer be a going
concern?

Analytical procedures may pount to indications of risk that the going concern
assumption need to be questioned. The significance of the indications can often be
mitigated by other factors. For example, the effect of an entity being unable to
make its normal debt repayments may be counterbalanced by managements plas
to maintain adequate cash flows by alternative means, such as disposal of assets.

8.6 Analytical Procedures During; Different Phases in the Audit Process

Analytical procedures are used: :a) to assist the auditor in planning the nature,
timing and extent of audit procedures: (b) as substantive procedures, and (c) as an
overall review of the financial statements in the final stage if the audtit. The audior
is required to apply analytical procedures at overall review stages of the audit.

8.7 Analytical Procedures as Substantive Tests

Substantive procedure in the audit are designed to reduce detection risk relating to
specific financial statement assertions. Substantive test include test of details
(either of balances or of transactions) and analytical procedures. Auditors use
analytical procedures to identify situations that require icreased use of other
procedures (i.e tests if controls, substantive audit procedures), but seldom to reduce
audit effort.

Analytical Procedures Instead of Tests of Details

In planning an audit that uses analytical procedures an substantive

procedures, the auditor should:

- Determine the suitability of particular substantive analytical procedures

forngiven assertions, considering the assessed risks of material
misstatement.
- Evaluate the reliability of controls, as well as the source, comparability and
relevance of the information.
- Evaluate whether the expectation is sufficiently precise to identify a
misstatement that may cause the financial statements to be materially
misstated.
- Determine the amount of any difference of recorded amounts from expected
values that is acceptable without further investigation.

Disadvantages of Analytical Procedures

Substantive analytical procedures will not necessarily deliver the desired

results every year. In periods of instability and repid change, it may be more
appropriate to apply tests of details. For example, if in economy reaches
hyperinflation, it is unlikely that we will be able to develop meaningful expectations
efficiently, except in limited circumstances.

Corroboration

Substantive Analycal Procedures Exampkes

Payroll

8.8 Computer Assited Audit Techniques (CAATs) and Generalised Audit Software
(GAS)

- Regression Analysis: Regression Analysuis is the use of statistical models to

quantify the auditors expectation in financial (euro, dollar0 terms, with measurable
risk and precision levels

- Generalised Audit Software (GAS): packages contain numerous computer assited

audit techniques for bth doing analytic al procedures and statistical sampling
bundled into one piece software

-Audit Tasks

In general terms, file interrogation can accomplish the following six types of audit
task:

1. Convert client data into common formal;

2. Abalyse data
3. Compare different sets of data;
4. Confirm the accuracy of calculations and make computations;
5. Sampe statically;
6. Test for gaps or duplicates in a sequence

Audit tests that can be performed with GAS include the following:

- Identify all inventory items relating to products no longer cold

- Select all inventory items with no recorded location.
- Summarise inventory items by location to facilitate physical observation.
- Review account receivable balances for amounts over credit limits or older
then a specified period.
- Summarise accounts by age for composirson to the clints schedules.
- Review inventory quantiyies and unit costs for negative or unusually large
amounts.
- Isolate all inventory items that have not moved since a specified date.
- Review assets for negative net book values.
 - Summarise inventory vy age to assess the reasonableness of obsolescence
provisions

8.9 Analytical Procedures Using Data Mining Techniques

Data Mining is a set of computer-assisted techniques that use sophisticated

statistical analysis, including artificial intelligence techniques, to examine large
volumes of data with the objective of indicating hidden to as knowledge discovery in
database (KDD)

Alogarithms Decision Tree, Apriori, Neural Network

Data mining most frequently uses three algorithms.

- A decision tree is a predictive model that classifies data with a hierarchical

structure. It consists of nodes, which contain classification questions, and
branches that are rge result of the questions (For example the question Does
this item increase at the same rate as revenue? may be answered yes
which leads to one branch gwoth similar to revenue or may be answered no
which leads to another branch.)
- The apriori algorithm attempts to discover frequent item sets using rules to
find associations between the presence of absence of items (Boolean
ssociation rules). The group of item sets that most frequently come together
is identified.
- A neural network is a computer model based on the architecture of the train.
It first detects a pattern fro dta sets then predicts the best classifiers of that
pattern, and finally learns from the mistakes.

8.10 Follow Up In Case of Unexpected Deviations

Investigation : the investigation of unusual fluctuations and relationships ordinarily

begin with inquires of management, followed by corroboration of management
responses and determination if additional audit procedures are needed.

Furthwrmore, be must determine whether

- The tests of controls show an appropriate basis for reliance on the controls.
- Additional tests of controls are necessary; or
- The potential risks of misstatement need to be adderessed using substantive
procedures.