By Alex Vuchnich, CPA, CFE - The risk standards require auditors to perform preliminary analytical review as part of the risk assessment process in order to identify any unusual or unexpected relationships in the financial statements. Similarly, the review standards require auditors to develop analytical expectations about the financial statements. Guidance on what constitutes an unusual relationship versus an unexpected relationship as well as what defines an expectation is not entirely clear. Many firms I have spoken with, understand that they need to identify these relationships as part of their engagement but are unclear of what a properly developed expectation looks like. As a starting point we can begin by understanding the difference between unusual and unexpected relationships.
As auditors most of us are pretty well versed in identifying unusual relationships. We have always been required to perform preliminary analytical review as part of the planning process and so we have applied analytical review that tends to point out variances from the prior period results. This is a key step in the planning process that assists the auditor in understanding where the client's financial statements are as of the end of the most recent period in relation to the prior year. This is also probably the most common procedure performed by auditor's during the preliminary analytical review process and is one common thread between all audit firms when performing analytical review. This type of variance analysis is best suited for identifying unusual relationships such as the addition or deletion of an account or changes in key financial ratios.
The standards require auditors to additionally identify unexpected relationships. This inherently requires that the auditor has developed an expectation about the balances and relationships that should be present in the financial statements. The variance analysis described above that is useful in identifying unusual relationships is generally not sufficient for developing expectations about the financial statements. In order to develop an expectation the auditor needs to apply a predictive model to the financial analysis rather than a historical review. Developing expectations for preliminary analytical review is similar to the process used by the client's internal finance department for generating projections and forecasts. The difference in application is that auditors will be comparing the forecast to a historical period rather than to a prospective period. Different forecasting models exist but the key point is that the model should be comprehensive and allow the auditor to objectively establish meaningful expectations about the financial statements. Common techniques include using regression analysis to create trends and identifying key drivers, such as gross margin percentage and various asset turnover ratios to calculate expectations in account balances.
I have seen many firms that have struggled with this part of the analytical review process. The majority of firms have used variance analysis as the cornerstone of preliminary analytical review in the past so adjusting to a requirement to identify unusual expectations will entail a change management process. However once this type of analysis is integrated into a firms attest engagements their should be both an increase in audit efficiency as well as quality.