Analytical auditing procedures

Internal Auditor, Feb, 1997 by James E. Gauntt, Jr., G. William Glezen

More and more auditors are using analytical auditing procedures (AAPs), a technique based on the concept that there are relatively stable relationships among the economic events recorded in financial statements. The auditor's expectation is that the amounts in the financial records that summarize and represent these economic events will be marked by relatively stable relationships. When deviations from these expected relationships are identified, the auditor reacts by investigating to determine whether material errors, irregularities, or operating inefficiencies have occurred.

AAPs offer auditors a number of positive features. Since AAPs are useful in identifying areas where the risks of errors and irregularities are high, internal auditors can allocate scarce internal auditing resources more effectively. More internal audit time can be devoted to the high risk areas and less will need to be allocated to the low risk areas.

From an operational standpoint, the results of analytical procedures may be useful to internal auditors in their efforts to provide management with early warnings of financial and operating problems. In addition, the use of AAPs by internal auditors provides a basis for increased reliance on internal auditor work by external auditors.

* Developing Expectations

The most common approach to developing expectations is to use prior period amounts. The actual results from the prior period are generally assumed to be the expectation for the current period.

In some cases, however, an incremental approach to expectations is used, whereby the prior year actual amounts are adjusted for known changes. One method for capturing a growth trend, for example, is with a trend analysis. An average rate of growth in specific accounts can be computed over time and applied to the prior year amounts. The auditor would then look for current year amounts that break the trends.

Significant purchases or sales of assets, changes in lines and volumes of business, or other factors may also cause prior year amounts to differ significantly from current year amounts and prior trends. In those cases, prior year amounts would not represent expectations for the current year. However, adjusting prior period results for the changes may provide acceptable expectations.

Budgets and forecasts, another source of expectations, offer the advantage of including unusual, but anticipated, transactions and events in the current year. For example, if management anticipates and budgets the closing of a plant during the current year, the budget is more likely to approximate the current year than would prior year amounts. If budgets are properly prepared and realistic, they should provide effective expectations.

A third source of expectations involves relationships among accounts. Auditors expect certain accounts to vary in relation to others, both within a given financial statement and across financial statements. For instance, both selling expense and accounts receivable are generally expected to vary in relation to sales. Accounts with a large fixed component, such as rent expense, are expected to have little variation.

Some expectations can be developed from non-financial measures. Retail store sales can be expected to vary with the number of square feet of shelf space; gas utility revenues are related to degree days, which are temperature deviations from a historical norm; and oil company revenue is dependent upon barrels of oil produced. An advantage of non-financial measures is that they are usually generated outside of the accounting department.

Industry standards are often suggested as a source of expectations. This may be a reliable source in stable industries, but the auditor must keep in mind that industry data is usually dated. An industry trade association may require many months to collect, analyze, and publish information from the many entities within the industry. If this information is published only annually, the auditor will usually be working with prior year amounts. In a dynamic industry, prior year information may not be a basis for current year expectations.

Finally, expectations can often be developed from other units in the organization. For example, auditors for a company that operates several retail stores could compare the operations of different stores of similar sizes and locations. If a single unit is used as a"model," sufficient audit procedures should be applied to that unit to provide assurance that it is an appropriate standard.

When auditors develop expectations, the expectations should be considered as a range of outcomes rather than as a single expected value. Variations that fall within this range require no investigation. Variations that fall outside this range need to be investigated.

* Identifying Unexpected Variations

How large a variation should there be between actual and expected amounts before it is no longer considered a random difference and is an amount to be investigated? Given certain materiality and risk assumptions, this difference can be measured mathematically using regression analysis; but most auditors use professional judgment in determining which variations to investigate. Some rules-of-thumb exist, such as variations in excess of ten percent of the actual account balance or in excess of a specific amount.