The analysis usually considers both comparisons and relationships.

Comparisons
Financial information is compared, for example, with:

• prior periods (historical data);
• budgets and forecasts (future-oriented data);
• predictive estimates (e.g., of the annual depreciation charge);
• industry averages.

It is common practice for the auditor to prepare a schedule of account balances for the current year (unaudited) with comparatives (audited) with ± difference columns expressed in both absolute (i.e, $) and relative (i.e., %) terms.

Relationships
Typically, relationships are considered between:

• elements of financial information which are expected to adhere to a predicted pattern (e.g., gross profit percentages);
• financial and non-financial information (e.g., hotel revenue to room occupancy).

Methods used
Methods of analysis vary considerably, from simple comparisons to complex analyses using advanced statistical techniques. Analytical procedures may be applied to:

• consolidated financial statements;
• components (e.g., subsidiaries, divisions, segments);
• individual elements of financial information (e.g., account balances).

Purposes

• To assist in PLANNING the nature, timing and extent of other audit procedures.
• As SUBSTANTIVE procedures when their use is more effective or efficient than tests of detail.
• As an overall REVIEW, to conclude whether financial statements as a whole are consistent with auditors’ knowledge of the business.

Application of analytical procedures
The first standard in both ISA 520 and SAS 410 states that auditors "should apply analytical procedures at the planning and overall review stages of an audit". Analytical procedures at these stages are therefore essential and are required (i.e., mandatory) in the conduct of any audit. Both ISA 520 and SAS 410 go on to state, that analytical procedures may be performed as substantive procedures (i.e., are optional).

At the planning stage
Analytical procedures at this stage (sometimes called ‘preliminary analytical review’) assist in:

• increasing knowledge and understanding of the business through the accumulation of information on trends in key relationships;
• identifying areas of potential risk (e.g., relating to the enterprise’s financial condition);
• determining the nature, timing and extent of other audit procedures (i.e., audit strategy ) by directing tests to areas of potentially material misstatement.

Ratio analysis (i.e., the comparison of relationships between account balances and classes of transactions over several accounting periods) is particularly useful in identifying fluctuations for investigation. Because of the inter-dependency of many ratios, breaking them down and further refinement into specific components will identify the source of individual fluctuations.

For example, breaking down return on capital employed (ROCE) into gross profit on sales and asset turnover, then inventory turnover, average debt collection period, etc.

Importance of financial condition
It is particularly important that the financial condition of a business and its ability to meet debts as they fall due is assessed at the planning stage. A deterioration in liquidity, gearing or profitability indicators potentially increases inherent risk as the risk of deliberate misstatement or manipulation is increased.

Information availability
Financial information available at the planning stage may include:

• interim financial information;
• budgets or forecasts;
• management accounts;
• a ‘trial balance’ (i.e., a list of balances extracted from the general ledger);
• draft financial statements.

Analysis of gross profit
Consider the following scenario:

Tivoli manufactures a small range of gardening tools and supplies them to wholesalers. Turnover for the year ended 31 December 1999 was approximately $2 million. The products of the company have not altered for many years, and turnover and profits have recently increased broadly in line with the rate of inflation.

As auditor, you attended the stocktake (i.e., physical inventory count) and undertook a direct confirmation of amounts due from customer for the year ended 31 December 1999 prior to the production of any management accounts for the year. On receipt of the draft management accounts for the year, your analytical procedures reveal that:

If you are asked something along the lines of "suggest possible reasons for the increase in the gross profit margin":

• think rather than guess;
• seek valid, business reasons and possible errors rather than speculating on improbable frauds and irregularity.

For example, it is nonsense to suggest that the increase in gross profit percentage is due to inflation. If turnover and profits are increasing broadly in line with inflation then cost of sales must also be increasing at the same rate and the gross profit percentage will be unchanged. The scenario does not state what the rate of inflation is and it is unnecessary to speculate whether, for example, it is 2% or 20%.

Consider then, if sales have increased in line with inflation but the gross profit percentage has increased, cost of sales must have fallen. Now consider the components of cost of sales namely:

• opening inventory;
• add: cost of production (raw materials consumed + conversion costs);
• less: closing inventory.

Clearly, cost of sales will have fallen if a cheaper unit cost of production has been achieved. This could have resulted from:

• more efficient production methods; and/or
• cost savings on materials, direct labour wage rates, production overheads.

As auditor you would expect Tivoli’s management to be aware if cost reductions have been achieved during the year. You would also expect to be able to substantiate costs by reference to costing records. If however, management are not aware of such cost reductions, the possibility of error needs to be considered, for example:

• sales may be overstated;
• opening inventory may be understated;
• purchases (or other components of manufacturing cost) may be understated;
• closing inventory may be overstated.

Are these all equally likely? Think about each in turn bearing in mind that we are looking for causes of potential material error ((36% – 32%) x $2m = $80,000).

(a) Sales overstatement
If sales (credit entries) are overstated then either cash is overstated and/or trade accounts receivable (i.e, debtors) are overstated. Fictitious cash receipts would be picked up on monthly bank reconciliations. Any material overcharging of bona fide customers (whether in error or through fictitious sales invoices) will be brought to light by the direct confirmation of customers’ accounts. Thus deliberate overstatement of sales seems unlikely.

Sales could also be overstated due to a cut-off error e.g., January 2000 sales being invoiced as December 1999. However, Tivoli is only generating $167,000 monthly revenue (on average) so a cut-off error of $80,000 would be obvious.

(b) Opening inventory understatement
Opening inventory was audited as last year’s closing inventory. If it was materially understated last year last year’s gross profit percentage would have been understated also. This would seem unlikely as the scenario does not suggest that last year’s auditors report was qualified in respect of the inventory valuation.

(c) Purchases understatement
Purchases could be understated if materials or components received before the year end have not been recorded until after the year end. Such an error might indicate a general lack of control over cut-off.

If purchase invoices are unrecorded (whether deliberately suppressed or omitted in error) liabilities as well as expenses will be understated. This would be brought to light by an examination of suppliers’ statement reconciliations.

(d) Closing inventory overstatement
Closing inventory could be overstated due to:

• an error in the physical count (e.g., double counting);
• errors in pricing (e.g., work in progress being costed to reflect too high a degree of completion, thereby over-allocating labour and overhead).

Exercise
Suggest a valid business reason and a possible accounting error which could have contributed to findings 2 and 3 relating to Tivoli.

Suggested solution
2 Increase in closing inventory/purchases ratio
Business reasons

• Substantial year-end purchases of materials or components may have been made in anticipation of price increases.
• Lax inventory control could have lead to a build-up of raw materials stocks.
• Lack of customer demand or unsaleability may have resulted in slower-moving finished goods.
• A change in the ‘mix’ of goods held (e.g., more WIP and finished goods compared to raw materials).

• Overstatement of closing inventory quantities or prices — see (d) above.
• Understatement of purchases — see (c) above.
• As the fluctuations noted are based on draft management accounts, it is possible that the Tivoli has not yet processed certain routine year-end adjustments (e.g., to achieve an accurate purchase cut-off).
• Inadequate provisions against slow-moving products, or a reduction in general provision compared to the previous year.
• A change in accounting policy for inventory, e.g.
  • to FIFO valuation (previously LIFO);
  • to include additional categories of overhead;
  • using different bases of apportionment/absorption.

3 Decreases in last month’s purchases
Business reasons

• Management could have deliberately cut back on purchases in the last month having realised that stock levels were increasing. (The substantial purchase in 2 above would need to have been made prior to December 1999 for both fluctuations to be explained.)
• Alternatively, a regular monthly purchase may have been delayed from December 1999 to January 2000, perhaps for cash flow reasons (seasonal factors are unlikely to significantly influence sales or purchases).

• Understatement of purchases and liabilities due to inaccurate cut-off (see (c) above).

Substantive analytical procedures
Analytical procedures at stages other than the planning and overall review stages are optional. Substantive analytical procedures (‘SAPs’) are based on the expectation that relationships which are known to exist may be expected to continue in the absence of clear evidence to the contrary. For example, the relationship between gross profit and sales revenue may be expected to remain constant unless there are changes in sales prices, sales mix and/or cost structure.

• Analytical procedures can themselves provide sufficient audit evidence where an item can be verified directly by reference to another (valid) item. For example, commission on sales, bank interest receivable (or payable), rental income (or expense) and depreciation charges. (See ‘proof in total’ later.)
• Analytical procedures may also be effective in testing for understatement (i.e., completeness). For example, in predicting sales from purchases and known margins. Sometimes overall reconciliations between unit sales, purchases and inventory may be the only satisfactory way to test for completeness.
• However, where sufficient substantive evidence is not obtained by analytical procedures alone, some tests of detail will also be required. Note that tests of control at this stage of the audit would be inappropriate.

Extent of use
Factors determining the extent of use of substantive analytical procedures include:

• The closeness of relationships between items of data. Analytical procedures are more appropriate when relationships are plausible and predictable (e.g., between sales commission and sales revenue). A plausible relationship is one which may reasonably be expected to exist.
• Audit objectives (e.g., see assertions in Payroll illustration below) and the extent to which the results of analytical procedures are reliable (see below).
• The degree of disaggregation in available information. For example, a detailed review of gross profit margins by major product would be more effective than the review of an overall gross profit.
• The availability and reliability of financial data (e.g., budgets) and non-financial data (e.g., units produced). Independently prepared non-financial data should facilitate more effective procedures.
• The relevance of available information. For example, budgets based on expectation are more useful than targets.
• The comparability of available information. For example, summary statistics such as the Retail Price Index (RPI) may not be relevant in technologically advanced industries.
• The auditor’s cumulative knowledge and experience. Effective analytical procedures are based on recognizing unusual or unexpected variations. If knowledge is limited, it is difficult to know what to expect.
• The nature of the enterprise and its operations. When steady trends develop it is easier to know what to expect and identify variations.

The auditor is more likely to use analytical procedures for:

• existing well-established clients;
• in well-known, stable industries;
• where predictive information is readily available; and
• accounting and internal control systems are effective.

Extent of reliance
Factors determining the extent of reliance on substantive analytical procedures include:

• The risk that analytical procedures fail to identify a material misstatement. This is inter-linked with the materiality of items involved. The less significant an account balance or class of transactions, the more reliance may be placed on analytical procedures.
• Other audit procedures directed to the same financial statement assertion. For example, a reduction in the extent of tests of detail will be justified where significant fluctuations and inconsistencies have been corroborated.
• The accuracy of predictions. Income and expenditure accounts tend to be more predictable than balance sheet accounts because they are composed of large numbers of like transactions (whereas balances tend to be a net amount). Non-recurring accounting entries (e.g., asset revaluations) and discretionary expenses (e.g., research and development) do not lend themselves to effective analytical procedures.
• Risk assessments. For example, if internal control over the processing of sales orders is weak (i.e., control risk is high) more reliance on tests of details for drawing conclusions on receivables may be required.
• The effectiveness of controls, if any, over the preparation of information used for analytical procedures.
• The type of analytical procedure used (see below). The more appropriate the analytical procedure, the more reliance can be placed thereon.

Types of analytical procedure
Substantive analytical procedures include:

• trend analysis (e.g., graphical time series and regression analysis);
• ratio analysis; and
• reasonableness tests (also called ‘proof in total’).

Trend analysis
Trend analysis compares current data with prior periods and is particularly useful for analysing income and expenditure (e.g., monthly turnover). Methods include:

• ‘Scattergraphs’ and other graphical techniques which rely on visual inspection;
• Time-series analysis which isolates trends from data by removing seasonal fluctuations; and
• Statistical regression (e.g., calculating the ‘line of best fit’) using a computer program.

These techniques are not examinable in paper 6.

Ratio analysis
Useful ratios include:

• financial ratios such as the receivables collection period (i.e., debtor days) and inventory (i.e., stock) turnover ratios; and
• ratios which relate account balances to another account balance (e.g., expense accounts as a percentage of sales revenue).

Because ratios identify stable relationships they tend to be more relevant than absolute changes which could be influenced by many factors. Comparisons can be made with prior periods and against budgets and industry statistics.

Ratios may be used more in planning (see above) and review (see below) than in obtaining substantive evidence.

Reasonable tests
These provide an independent check on the total value of a population and are most useful for income and expenditure accounts. The mechanics are:

• calculate the expected value of a population. Base data must be independent of the population being tested (or otherwise confirmed to be materially correct);
• compare with recorded value;
• difference should not be material.

Such ‘proofs in total’ may remove the need for further substantive procedures (i.e., tests of detail). The following illustrations indicate how even simple models can be very effective.

Illustrations
1 Depreciation
For each category of asset calculate:

(Cost + Additions – Disposals) x straight-line % = Charge for year

Alternatively, using reducing balance method, adjust accumulated depreciation for additions and disposals before calculating depreciation on the net amount.

2 Payroll
Use information about the workforce: numbers of starters and leavers, wage rates, pay rises, productivity bonuses etc., to construct a model for the total payroll figure.

Last year’s audited expense (i.e., confirmed base data) ± starters/leavers adjusted for pay rises.

3 Hotel revenue
Calculate income for the year as:

Occupancy x Room rate.

Alternatively:

Last year’s income (audited) x (1+i)% where i is the increase in room rate.

4 Fuel (petrol) costs
For each category of vehicle running on different grades of fuel (e.g., leaded, unleaded, diesel) calculate consumption as:

Mileage (per tacograph or mileometer)/consumption rate (e.g., miles per gallon or kilometres per litre)
Cost consumption at an average cost per litre or gallon to estimate the charge for the year.

Investigation of fluctuations
Unexpected trends or deviations should be discussed with relevant client’s staff and explanations obtained. For example, the production foreman may be more knowledgeable about problems with production scheduling than the finance officer.

Explanations must not be accepted at face value but corroborated either:

• using cumulative audit knowledge and experience; and/or
• verifying other supporting evidence.

In the first instance explanations might be expected to be of a business nature, for example, a change in company policy about taking up discounts offered by suppliers or extending credit terms to customers. If the client is not aware of occurrences which could account for inconsistencies, the auditor must consider the types of material errors (e.g., due to cut-off) which could give rise to the fluctuations.

Reasons such as the deliberate concealment of errors, ‘window-dressing’, theft and fraud will usually only be considered as a last resort (unless the auditor has reason to suspect such irregularities).

Late adjustments to draft financial statements to correct cut-off and other errors may result in unusual fluctuations where previously none had been noted. Further explanation and corroboration will therefore be required.

At the overall review stage
Analytical review at this stage is required in forming an overall conclusion as to whether the financial statements as a whole are consistent with the auditor’s knowledge of the business. The review may also identify the need for further substantive procedures.

Ratio analysis is particularly useful in testing the consistency of the inter-relationships of amounts disclosed in the financial statements. It is usual to compare ratios calculated at this stage with those of the preliminary analytical review

Conclusion
As analytical procedures have applications covering three of the principal stages of an audit, it is highly likely that in any paper 6 examination you will have some opportunity to refer to them. However, such vague and general comments as "perform analytical procedures" are clearly unworthy of marks when another candidate writes, for example, "Schedule monthly payroll expenses and corroborate fluctuations by reference to starters/leavers and pay rises" or "Compare delivery vehicle running expenses to the number of vehicles with the prior year".