The audit strategy: analytical procedures as substantive tests

National Public Accountant, The, May, 1991 by Arlette C. Wilson, Janet L. Colbert

An audit strategy involves the evaluation of internal controls and the performance of substantive tests. Substative tests may be derived from test of details, analytical procedures or any combination of the two. Tests of details involve examining details of an account in an attempt to reconstruct and draw conclusions about the reported account balance, while analytical procedures involve drawing conslusions based on expected amounts calculated by the auditor. Generally, it is easy to obtain the necessary data to perfrom the analytical analysis regardless of the size or complexity of a company's accounting system.

Auditor objectives usually can be accomplished with less time and cost by applying analytical procedures rather than tests of details. In addition, the auditor may need to rely on analytical procedures when detailed evidence is not readily available for a particular item. Therefore, the auditor should be more aware of this part of the audit since it may not only be more cost effective but may provide evidence when other procedures would be ineffective.

Types of Analytical

Procedures

The recent accounting standard states that the analytical procedures range from simple comparisons to the use of complex models involving many relationships and elements of data." Data used to help determine expected amounts for account balances can be obtained from sources such as results of prior periods, budgets, forecasts, industry data and current financial and operative data. There is not given set of analytical procedures for use by all auditors on all audits. The analytical procedures available for use are limited only by the availability of reliable data and the creativity of the auditor. However, the more common procedures may be classified into four types: trend analysis, reasonable tests, ratio analysis and strutural modeling.

Trend Analysis

Trend analysis is the most commonly used analytical procedure. The auditor may choose either a diagnostic or a causal approach. Applying the diagnostic approach, the auditor would evaluate whether the current balance of an account is out of line with the trend establish with previous balances for that account. Alternately, the causal approach calculates an expected balance for the account based on an understanding of factors that cause the account to change. This expected amount is then compared to the actual amount recorded in the books and the difference is judged as to reasonableness. Those differences indicated as unreasonable are signaled for additional audit attention.

The causal approach is generally preferable according to SAS No. 56, "Analytical Procedures". However, this procedure requires more effort than the diagnostic approach. The auditor should consider the higher costs involved with application of the causal approach in relation to the additional benefits received in determinig which approach should ultimately be used.

Generally trend analysis relies on the balance of the account under audit consideration for prior periods. Different methods of applying trend analysis would include an expected amount based on:

1. Last year's balance;

2. Last year's balance plus the change between the two prior years;

3. Average change in the account balance over a given number of previsous years added to last year's balance;

4. Simple average of the account balance over a given number of previous years;

5. Last year's balance plus the percentage change in the account between the two prior years; or

6. Last year's balance plus the average percentage change in the account balance over the past several years.

Other methods could be developed based on the auditor's knowledge of factors that would affect the change in the account.

Trend analysis is more useful for expense and revenue accounts than it is for assets and liabilities. Because trend analysis focuses on the change in account balances from prior periods, it is not as useful with balance sheet accounts which are relatively unpredictable.

Reasonable Tests

Reasonable tests involve the calculation of an expected amount for the account balance based on nonfinancial data for the current period. Unlike trend analysis, this analytical procedure does not rely on events of past periods, but only operating data for the audit period under consideration. For example, revenue from renting apartments would be related to average occupancy rate and average rent per apartment. Although the exact calculation of total rent revenue would rely on knowing the number of months each individual apartment was rented and the rent per month for each apartment, an estimate could be calculated by multiplying the average number of months per year the apartments were rented times the total number of apartments times the average rent per apartment. This estimate would then be compared to the recorded amount of revenue, and unreasonably large discrepancies would need further investigation and justification.

Tests of reasonableness use operating data to establish expected amounts and operating data typically measure flows; therefore, these procedures are generally more applicable to income statements accounts rather than balance sheet accounts. Since information for current periods may be easier to obtain than data of prior years, reasonable tests may be easily applied.