Efficient Tests of Balances Series—No. 8: Using Highly-Effective Analytical Procedures
Analytical procedures consist of absolute comparisons of dollar balances with prior years’ account balances, or with budgets, ratio comparisons and trend analysis, and computations based on financial or operational data designed to predict the balance in a general ledger account. Analytical procedures also extend beyond numerically-based procedures to become a part of an auditor’s thought process.
Challenging financial information or the lack of such information that appears unusual, maintaining a positive, healthy skepticism when considering client responses to inquiries, and searching for the cause of a problem beyond its symptoms are examples of analytical thinking. The term “professional skepticism” is used in the audit literature to describe this kind of thinking. It is loosely defined as neither blindly trusting every client or, on the other hand, considering each client dishonest as we gather information.
Most common analytical procedures are corroborative in their nature. Their primary purpose is to corroborate evidence gathered from other tests designed to verify financial statement assertions. Corroborating procedures performed at lower levels of detail are more effective than corroborating procedures based on balances of financial statement classifications.
When the results of analytical procedures contribute evidence to verify financial statement assertions, related tests of balances can be reduced at least to a limited extent.
The extent of the reductions of tests of balances depends on the effectiveness of the analytical procedures. Determination of the effectiveness of a procedure must be based on the procedure’s contribution of substantive evidence for evaluating the financial statement assertions. Computations designed to predict the balance in a general ledger account based on audited financial or operational data, e.g. quantity reconciliations and reasonableness tests, are normally the most effective analytical procedures.
Examples of analytical procedures, in the order of their effectiveness, are:
1. Quantity reconciliations:
Multiplying the number of units sold times sales price or the number of employees times weekly or monthly salaries, for example, can substantially verify all the financial statement assertions for the applicable general ledger account. Few, if any, other tests would be necessary for the affected accounts if the data used in the computations has been audited.
To achieve maximum effectiveness, the reliability of the underlying data for these procedures must be established by other tests. For example, performing a quantity reconciliation for copy sales by a quick-copy business would simply require multiplying the number of copies sold times sales price. The number of copies could be obtained from the client’s copy log; however, we’d have to physically obtain beginning and ending numbers from the meter to establish the reliability of the log. To determine the meter had not been altered, we may also decide to trace the number of copies to billings for copy machine rentals from the supplier. Copy prices would have to be determined by references to sales tickets or price lists.
2. Reasonableness tests:
Depreciation computations performed by computing depreciation by financial statement classification and method, based on average lives and one-half year for additions and disposals, is an example of a reasonableness test. Computing interest expense based on average note balances and interest rates is another example.
Different from quantity reconciliations, reasonableness tests are based on averages and estimates. Reasonableness tests are, therefore, not as effective as quantity reconciliations in substantially verifying financial statement assertions. Since they are usually applied to smaller account balances, however, other tests of balances may not be necessary. Other limited tests of controls or balances, on the other hand, may be necessary to complete the verification of the relevant assertions for material balances.
3. Corroborating procedures:
The most common analytical procedures, such as absolute dollar comparisons and ratio analysis, provide evidence that corroborates other tests of controls and balances. While using corroborating analytical procedures may enable us to modify the nature, extent and timing of tests of balances procedures, certain minimum tests of balances procedures will be necessary for satisfactory verification of the financial statement assertions.
The lower the level of detail of the corroborating procedures, the more effective they are. Gross profit margin computed by product line, for example, is more effective than when computed using amounts in financial statement classifications. Risks of material misstatements, in other words, are more easily identified using corroborating procedures at lower levels of detail.
The current risk assessment standards instruct us to perform analytical procedures during the planning phase of an engagement to help identify potential risks of misstatements. Analytical procedures should also be used to generate substantive evidence during engagement performance and during the review phase of an engagement to evaluate the results of completed work.
Minimum analytical procedures performed during planning may consist of comparing material unadjusted, current year account balances with prior year final balances. Significant variances usually indicate the need for adjusting journal entries. These differences should be investigated, documented in the working papers and, if necessary, adjustments proposed to correct errors.
When corroborating or predictive procedures are part of an audit strategy, the auditor must develop and document expectations of the results prior to performing the procedures. From the comparison of the expectations to recorded balances, the auditor may determine that variances are not indicative of a problem or, on the other hand, that they are caused by an error or conditions that could cause errors in financial information. We may, or may not, determine adjustments are necessary.
I have developed an illustrative Analytical Procedures Program to support my live and on-demand webcasts which illustrates some of the common types of analytical procedures applicable to material financial statement classifications, and the planning process that should guide their use. If you’d like a free copy please make your request under the “Contact Us” tab on my website, www.cpafirmsupport.com.