CHAPTER 7

Analytical Procedures

The purpose of this chapter is to examine the guidance the International Standards on Auditing (ISA) and Public Corporation Accounting Oversight Board (PCAOB) provide on the use of analytical procedures and compare key differences between the ISA and PCAOB and discuss the implications of these differences on auditors operating in these two regimes. In this chapter in particular we focus on the following issues:

  • The nature of analytical procedures used in auditing
  • Guidance provided by the ISA versus PCAOB on the use of analytical procedures
  • Examine key differences between the ISA and PCAOB
  • Discuss the implications of these differences on auditors operating in these two regimes

Introduction

Guidance regarding the use of analytical procedures is provided in ISA 520 entitled Analytical Procedures. The corresponding standard in the United States is AU 329 of the PCAOB also entitled Substantive Analytical Procedures. We first discuss the key requirements provided by ISA 520 and then compare and contrast those requirements with AU 329. ISA 520 states that analytical procedures may help identify the existence of unusual transactions or events, amounts, ratio, and trends that might indicate matters that have audit implications. Unusual or unexpected relationships that are identified may assist the auditor in identifying risks of material misstatements, especially risks of material misstatement due to fraud. ISA 520 notes that the auditor should apply analytical procedures as risk assessment procedures to obtain an understanding of the entity and its environment and in the review at the end of the audit. In ISA 520, analytical procedures are defined as techniques for evaluation of financial information made by a study of plausible relationships among both financial and nonfinancial data. Analytical procedures also cover the investigation of identified fluctuations and relationships that are inconsistent with other relevant information or deviate significantly from predicted amounts. Overall, the procedures covered in analytical procedures allow the auditor to look at things overall and answer the question: Do the numbers make sense?

Analytical procedures are noted in the PCAOB’s AU 329 as an important part of the audit process. The analytical procedures consist of evaluations of financial information made by a study of plausible relationships among the financial and nonfinancial data. So the definition is identical to ISA 520. The PCAOB’s AU 329 states that analytical procedures should be used to assist the auditor in planning the nature, timing, and extent of other auditing procedures during the initial stage of the audit, as a substantive test to obtain evidential matter about particular assertions and finally in the final review stage of an audit for overall review purposes.

PCAOB’s AU 329 has an additional requirement not in ISA 520. It mentions that there could always be a possibility of management overriding controls. It requires auditors to use analytical procedures to evaluate this risk. Thus under the PCAOB’s AU 329, analytical procedures have a specific fraud detection role, which it does not have under ISA. This is a significant difference.

Examples of Analytical Procedures

Analytical procedures range from simple comparisons to the use of complex models involving many relationships. Paragraph 5 of PCAOB’s AU 329 states that analytical procedures involve comparisons of recorded amounts or ratios developed from recorded amounts to expectations developed by the auditor. The auditor should develop expectations by identifying and using plausible relationships that are reasonably expected to exist based on the auditor’s understanding of the client and of the industry in which the client operates. The following are examples of sources for the auditor expectations (based on paragraph 5 of AU 329):

  • Financial information for comparable prior periods giving consideration to known changes—by “known” changes it is meant changes anticipated by the auditors as a result of changes in circumstances or the environment that the auditor is aware of
  • Anticipated results—for example, client budgets or forecasts including extrapolations from interim or annual data
  • Relationships among elements of financial information within the period
  • Information regarding the industry in which the client operates—for example, gross margin information
  • Relationships of financial information with relevant nonfinancial information

Nature and Purpose of Analytical Procedures

A basic premise of using analytical procedures in ISA is that there exist plausible relationships among data and these relationships can be reasonably expected to continue. This is echoed in paragraph 2 of PCAOB’s AU 329. It notes that a basic premise underlying the application of analytical procedures is that plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary. In essence, paragraph 4 of ISA 520 note that analytical procedures include comparing the entity’s financial information with the following, which are the sources of auditor expectations for the client referenced above:

  • Comparable information for prior periods
  • Anticipated results of the entity (using budgets or forecasts or expectations of the auditor)
  • Similar industry information. This could include, for example, comparison of the entity’s ratio of sales to accounts receivable with industry averages or with other entities of comparable size in the same industry
  • ISA 520 also advises that analytical procedures should include consideration of the following relationships:
    • Among elements of financial information that would be expected to conform to a predictable pattern, based on the entity’s experience, such as gross profit percentage changes from one year to the next ° Between financial information and relevant nonfinancial information such as payroll costs to number of employees.

As mentioned before, paragraph 7 of ISA 520 states that analytical procedures should be used for the following purposes:

  • As risk assessment procedures to obtain an understanding of the entity and its environment
  • As substantive procedures when their use can be more effective or efficient than tests of details, which include procedures that aid in reducing the risk of material misstatement at the assertion level to an acceptably low level. (For example, the PCAOB’s AU 329 gives examples of uses of analytical procedures as tests for determining the extent of substantive tests to be conducted. For example a comparison of aggregate salaries with number of personnel may indicate unauthorized payments that may not be apparent from routine tests of controls.)
  • As an overall review of the financial statements at the end of the audit

These will be considered individually.

Analytical Procedures as Risk Assessment Procedures to Obtain an Understanding of the Entity and its Environment

This may indicate aspects of the entity of which the auditor was unaware and should assist in assessing the risks of material misstatement in order to determine the nature and level of further audit procedures.

Analytical procedures used as risk assessment procedures can use both financial and nonfinancial information. Examples included in paragraph 9 of ISA 520 could be the relationship between sales and square footage of selling space or volume of goods sold. It would be expected, for example, that if sales increase, then the volume of goods sold should have increased as well, changes in price of items sold being held constant.

Analytical Procedures as Substantive Procedures

Analytical procedures in their role as substantive procedures discussed in the previous paragraph can be used to assess risk, subject to certain provisos discussed later in this chapter. ISA 520 cautions auditors to, where possible, use analytical data prepared by the auditor, provided the auditor is satisfied that such data has been properly prepared by the client.

Analytical Procedures in the Overall Review at the End of the Audit

ISA 520, paragraph 13 recommends that the auditor apply analytical procedures at or near the end of the audit when forming an overall conclusion as to whether the financial statements as a whole are consistent with the auditor’s understanding of the entity. The conclusions drawn from the results of such audit procedures are intended to corroborate conclusions formed during the audit of individual components or elements of the financial statements and assist in arriving at the overall conclusions as to the reasonableness of the financial statements. However, they could also potentially identify a previously unrecognized risk of material misstatements. In such circumstances, the auditor may need to re-evaluate the planned audit procedures, based on the revised consideration of assessed risks for all or some of the classes of transactions, account balances or disclosures, and related transactions.

When to Use Analytical Procedures

When the auditor has determined that an assessed risk of material misstatement is a significant risk, the auditor should perform analytical procedures that are specifically targeted at assessing risk. Overall, ISA 520 notes that analytical procedures should also be used when the auditor feels that there are significant risks of material misstatement. In such a situation the auditor could use the analytical procedure results to help identify the existence of unusual transactions or events, amounts, and trends. These unusual or unexpected relationships may help the auditor in corroborating the existence of material misstatements.

The PCAOB’s AU 329 states that analytical procedures should be used for the following purposes (condensed from AU 329, paragraphs 4, 5, and 10):

  • To assist the auditor in planning the nature, timing, and extent of other audit procedures, AS 12 notes that analytical procedures can be used as substantive tests. The decision about which procedure or procedures to use to achieve a particular audit objective should be, in part, based on the auditor’s judgment after considering the results of the substantive analytical procedures. If they determine risks of material misstatement to be significant, the nature and extent of other audit procedures should be amended. In particular, AS 12 notes (paragraph 46) that analytical procedures in this regard have two main objectives; namely to (a) enhance the auditor’s understanding of the client’s business and the significant transactions and events that have occurred since the previous year-end and (b) identify areas that might represent specific risks relevant to the audit. These include the existence of unusual transactions and events, amounts, ratios, and trends that warrant investigation.
  • As an overall review of the financial information in the final review stage of the audit (e.g., AS 14, paragraph 4a).

These are the same requirements set forth in ISA 520. ISA 520 states that analytical procedures can also be applied as a tool in addition to substantive testing if the assessed risk of material misstatement is high and further tests are required. The purpose of analytical procedures is to further highlight risk areas, alerting the auditor of the need to devote additional attention to those areas. The PCAOB has a different focus. AS 12, which replaced AU 329 paragraphs 4 and 5, states that analytical procedures should be used as a primary test to assist the auditor in planning the audit based on risk assessment. The auditor is required to assess risk by performing risk assessment tests. Hence, the difference appears to be that ISA is of the notion that analytical procedures should be used as a tool in addition to substantive testing procedures if assessed risk of material misstatement is high. The PCAOB appears to believe that analytical procedures should be used as a primary test to assist the auditor in planning other audit procedures based on our reading of AS 12. So, as we understand it, there is a philosophical difference: The ISA feels analytical procedures should be used to complement substantive testing procedures, whereas the PCAOB provides a more prominent focus to analytical procedures as a primary test assertion about account balances or classes or transactions.

According to the PCAOB’s AS 12, analytical procedures should be used to see the big picture, that is, to obtain evidence to identify misstatements in account balances and thus to reduce the risk of misstatements. Analytical procedures should be done to enhance the auditor’s understanding of the client’s business and identifying unusual events, amounts, ratios, and trends.

The PCAOB’s AS 14 paragraph 4a notes that in the overall review stage (the final stage of the audit), analytical procedures should be used in the evaluation of the overall audit results, an evaluation that necessarily includes assessing the conclusions reached about the overall financial statement presentation. It may be used to detect material misstatements that other tests can overlook, such as those due to fraud or understatement.

Types of Analytical Procedures

General analytical procedures include trend analysis, ratio analysis, statistical and data mining analysis, and reasonableness tests. ISA 520 and the PCAOB’s AS 12 provide the following examples.

Trend Analysis

This is the analysis of changes in an account balance over time. For example, has the gross profit percentage increased from one year to the next?

Ratio Analysis

This is the comparison of relationships between different parameters in the financial statements or accounts, the investigation of relationships between financial and nonfinancial data, or the comparison of data across firms in an industry. For example, is the client entity’s gross profit percentage markedly different than its competitors?

Data Mining

This 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 or unexpected information or patterns. For these tests auditors generally use computer aided software.

Reasonableness Testing

This is the analysis of account balances or changes in account balances within an accounting period in terms of their reasonableness in the light of expected relationships between accounts. For example, if the gross profit percentage increases sharply but the product mix being sold remains the same, this might be seen as unreasonable pending acquisition of further information about pricing and cost of inventory to the entity.

ISA 520 recommends that the auditor use any of the techniques mentioned to test the operating effectiveness of controls. The extent of testing would be contingent on the auditor’s perception of assessed risks.

PCAOB’s AU 329 notes that, when designing substantive analytical procedures (using any of the techniques above), the auditor should also evaluate the risk of management override of controls. The auditor should also test the design and effectiveness of controls using the techniques mentioned. Overall, despite the differences in wording, it would appear that the responsibility to identify and detect fraud is the same under ISA and PCAOB. Both require effective controls. These controls, in turn, support more accurate information generation.

Stages in the Analytical Process

Hayes et al. uses a practitioner four stage approach. This approach is most common in the literature. The following are the four stages of this approach:

Stage one: Formulate expectations (expectations).

Stage two: Compare the expected value to the recorded amount (identification).

Stage three: Investigate possible explanations for a difference between expected and recorded values (investigation).

Stage four. Evaluate the impact of differences between expectation and recorded amounts on the audit and financial statements (evaluation).

Stage One: Develop Expectations

The PCAOB’s AU 329 paragraph 17 notes that the expectation should be precise enough to provide the desired level of assurance that differences may be potential material misstatements, individually or when aggregated with other misstatements. PCAOB AU 329 does not elaborate further. However, ISA 520 provides more guidance. The auditor should assess whether the expectation can be developed to be sufficiently precise to identify a material misstatement at the desired level of assurance. The key issue is whether the expectation can be developed to be sufficiently precise. In this respect paragraph 12e of ISA 520 recommends considering the following in determining whether a sufficiently precise expectation can be developed:

  • The accuracy with which the expected results of substantive analytical procedures can be predicted. For example, the auditor should ordinarily expect greater consistency in comparing gross profit margins from one period to another than in comparing discretionary expenses such as research on advertising.
  • The degree to which information can be disaggregated. For example, substantive analytical procedures may be more effective for disaggregated components of an entity than when applied to entities as a whole.

The PCAOB’s AU 329 provides the following guidance, guidance which overlaps with that given in ISA 520. This topic is covered in paragraph 19. The guidance is as follows: (1) expectations developed at a detailed level generally have a greater chance of detecting misstatement of a given amount than do broad comparisons. Further, (2) monthly amounts will generally be more effective than annual amounts and comparisons by location or line of business usually will be more effective than company-wide comparisons. And (3) the level of detail that is appropriate will be influenced by the nature of the client, its size, and its complexity. The risk that material misstatement could be obscured by offsetting factors increases as a client’s operations become more complex and more diversified. Disaggregation helps reduce the risk. This is similar to ISA 520. Whereas ISA 520 mentions the availability of information, the PCAOB’s AU 329 assumes it.

Stage Two: Compare the Expected Value to the Recorded Amount (Identification)

ISA 520 notes that this comparison should be influenced primarily by materiality and the consistency with the desired level of assurance. The auditor increases the desired level of assurance as the risk of material misstatement increases by reducing the amount of difference from the expectation that can be found without further investigation. There is more in terms of guidance. PCAOB’s AU 329 in paragraph 18 provides similar guidance.

Stage Three: Investigate Possible Explanations for a Difference between Expected and Recorded Values (Investigation)

This is covered in paragraphs 17 and 18 of ISA 520. These note that when analytical procedures identify significant fluctuations or relationships that are inconsistent with other relevant information or that deviate from predicted amounts, the auditor should investigate and obtain adequate explanations and appropriate audit evidence. The investigation of unusual fluctuations and relationships ordinarily begin with inquiries to management followed by:

  • corroboration of management’s responses, for example, by comparing them with the auditor’s understanding of the entity and other audit evidence obtained during the course of the audit; and
  • consideration of the need to apply other audit procedures based on the results of such inquiries if management is unable to provide an explanation or if the explanation is not considered adequate.

In this respect the PCAOB’s AU 329 provides guidance with a different slant. Paragraph 21 particularly notes that the auditor should evaluate significant unexpected differences. Reconsidering the methods and factors used in developing the expectation and inquiry of management may assist the auditor in this regard. Thus, there is an additional step in PCAOB AU 329, which involves reconsidering the methods used to derive expectations and checking whether the results are consistent. After this, management’s explanations should be requested. Both ISA 520 and the PCAOB’s AU 329 require that management responses should be corroborated with other evidential matter. In those cases when an explanation for the difference cannot be obtained, ISA520 and PCAOB AU 329 require that the auditor should obtain sufficient data about the assertion by performing other audit procedures to satisfy themselves as to whether the difference is a misstatement. In designing such procedures, the auditor should consider whether unexplained differences may indicate an increased risk of material misstatement due to fraud. The differences, it would appear to us, are subtle particularly with respect to evaluating significant unexpected differences by reconsidering methods and factors used in generating expectations.

Stage Four: Evaluate the Impact of Differences between Expectation and Recorded Amounts on the Audit and Financial Statements (Evaluation)

This stage as mentioned in ISA 520 involves evaluating the impact on the financial statements of the difference between the auditor’s 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 should attempt to quantify that portion of the difference for which plausible explanations can be obtained and, where appropriate, corroborated. If the amount that cannot be explained is sufficiently small, the auditor may conclude that there is no material misstatement.

Differences between PCAOB and ISA

Based on the above discussion, one can see some significant differences. PCAOB’s AU 329 covers the same ground as ISA 520 with respect to substantive analytical procedures. However, there is an additional purpose. Unlike ISA 520, the PCAOB’s AS 12 states that analytical procedures should also be used to assist the auditor in planning the nature, timing, and extent of other audit procedures. Another difference relates to the use of analytical procedures. The PCAOB’s AS 12 discusses analytical procedures as a primary test. Unlike the PCAOB’s AS 12, ISA 520 discusses the use of substantive tests (i.e., analytical procedures and tests of details) as a response to assessed risk of material misstatement.

The PCAOB’s AU 329 stipulates two additional requirements from the auditor relative to ISA 520 when performing analytical procedures as substantive tests. These are:

  • Evaluate the risk of management overriding controls
  • Test the design and operating effectiveness of controls over financial reporting (unless the auditor has performed other procedures to support the completeness and accuracy of the underlying information).

Whereas the PCAOB’s AU 329 paragraph 16 states that the auditor should test the operating effectiveness of controls, a testing which helps ensure the reliability of the information used in the analytical procedures, testing controls is not the primary purpose of AU 329. ISA 520 suggests that the auditor may consider testing the operating effectiveness of controls. The ISA approach is similar to that of the AICPA’s ASB approach.

Conclusions

Analytical procedures serve a very important function for the auditor in that inspection of different analytical procedure results (e.g., changes in gross margins as a percentage of sales from one year to the next) directs the auditor’s attention to potential problem areas. For example, if the gross margin as a percentage of sales increases sharply and the client cannot respond meaningfully to auditor inquiry, the auditor will now be alert to the need to investigate this area more fully. Understanding the differences between the ISA and the PCAOB approaches will help all readers of this book better understand steps taken in the audit process and the importance of the underlying information used by the auditors. Given that better organizational governance is vital, understanding the role of analytical procedures provides all with tools to employ in their own investigations of the creditworthiness or investment worthiness of company equity or liabilities. The following table, Table 7.1, summarizes some differences between the ISA and PCAOB analytical procedures discussions.

Table 7.1 Comparison of some Analytical Procedure (AP) requirements

Question ISA 520 coverage PCAOB AU 329

Detect management control override?

Not mentioned

Yes. Useful in designing audit procedures to detect management control override

AP focus?

As addition to substantive tests

Primary test measure

Significant unexpected differences?

Same as PCAOB AU 329 except for reconsideration of the way in which expectations were formulated

Same as ISA 520 except for one additional step required: reconsideration of the way in which expectations were formulated

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