Applying Projection Modeling to Analytical Review
By Alex Vuchnich, CPA, CFE - Traditional analytical review techniques are usually premised under the assumption that prior year activity is representative of current year expectations. In many cases this logic stands up. If no significant changes in a company's operations have occurred than expecting the status quo is reasonable. Certain revenue and expense account also tend to exhibit behavior that is predictable based on historical trends. But all too often in practice we typically find ourselves looking at financial data that has changed dramatically from prior periods. In this situation a new model for analytical review needs to be applied in order to develop meaningful expectations about account balances.
In identifying an appropriate model for analysis, one place we can look to is our clients' internal financial management tools. The officers of a business regularly adjust their strategic and operational goals. In making these adjustments they must rely on forecasts and projections to understand the implications for the enterprise. Underlying a projection is the assumption that certain relationships in the financial statements should exist. It seems that this same approach can be used effectively for evaluating the actual financial performance of a company with our own independent expectations. Essentially the auditor can develop an independent budget and sales forecast for the company based on their knowledge of financial accounting and then compare this to actual results.
One method of developing this type of forecast is the sales growth driven model. The accountant starts by developing an expectation about sales for the period. Historical time series analysis can be a good predictor for this. Also many industry specific drivers exist that can also be applied in making this initial assumption. The client's actual sales will also be an important factor here. Once an independent forecast has been developed the auditor needs to evaluate that in the context of actual sales reported by the client. Any major variances must be dealt with before proceeding with the remainder of the analysis. Since sales is the primary driver for the analysis, any significant variance here will result in a forecast that is no longer comparable to what is portrayed on the client's financials.
Once sales have been forecasted, cost of goods sold can be back into based on gross margin percentage and trends in expense accounts can be developed. For the balance sheet, the relationship for many accounts will be tied directly to sales or cost of goods sold. Typically we expect certain turnover relationships between revenue and accounts receivable, inventory, fixed assets and payables. Once the capital needs associated with fixed assets have been identified we can develop expectations about what sort of financing would be needed to maintain the forecasted sales level. Many other factors can be tied into this type of forecast such as principal and interest payment amounts from loan amortization schedules or depreciation expense from fixed asset software projections. Finally, cash can be calculated using the indirect cash flow method to determine the change in cash from the prior period.
By integrating this type of approach into your analytical review process, a thorough understanding of where unexpected or unusual relationships in the financial statements can be obtained. Although traditional historical comparisons are still necessary as a starting point for analytical review, applying a projection model to develop independent expectations is essential for properly planning a meaningful engagement.