Flaws in Preliminary Analytical Review

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By Alex Vuchnich, CPA, CFE - With the official release of SSARS No. 17, our standards have once again reflected the trend that their is an increasing focus on what types of analytical procedures should be performed in a review engagement and how those procedures should be documented. We have seen a similar trend in audit standards. Recently the risk assessment standards and SAS 99 have both placed increased emphasis on the need to perform more effective analytical techniques in both planning and performing the engagement. Traditional techniques used in preliminary analytical review have consisted primarily of period to period comparisons of account balances and key financial ratios. Firms that have developed niche practices typically will also identify the key drivers for their niche and use available economic or industry data to supplement the analytical review process. However this traditional analytical review framework is primarily founded on the concept that the prior year's results are an effective benchmark for developing expectations about the current year financial activity.

Although I do not dispute the importance of scanning current year and prior year amounts on the trial balance and financial statements as a procedure to orient the auditor during planning, the question is whether this procedure alone is effective enough. If this is the main preliminary analytical technique performed during planning then it is essential that it is highly effective not only in providing context for evaluating the account balances but also in developing expectations about relationships between financial statement accounts. Ratio analysis is intended to provide a simple means for relating financial statement elements but with the emphasis on prior period comparison I believe the effectiveness of this technique has been impaired. When we use prior periods as the sole baseline for comparison then the tendency is to try and explain away the changes we see rather than to obtain an understanding of what relationship should be present. In order for the analysis to be effective, what we need to do is develop analytics that are predictive in nature (forward-looking) so that we can establish a reasonable basis for expectations about what the account balances should be. I propose that we need an analytical framework that incorporates prospective financial analysis into the historical trend analysis that has been the cornerstone of our analytical review process.

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