7032 Suitability of Analytical Procedures

In This Section Suitability of particular analytical procedures Types of analytical procedures Financial statement analysis in analytical procedures Overview This topic explains:

Suitability of particular analytical procedures Types of analytical procedures Financial statement analysis in analytical procedures

Suitability of particular analytical procedures

ISA Requirement When designing and performing substantive analytical procedures, either alone or in combination with tests of de accordance with ISA 330, The Auditor's Responses to Assessed Risks, the auditor shall determine the suitability o procedures for given assertions, taking account of the assessed risks of material misstatement and tests of details, 520.5(a))

ISA Guidance Substantive analytical procedures are generally more applicable to large volumes of transactions that tend to be predictable over time. The application of planned analytical procedures is based on the expectation that relationships among data exist and continue in the absence of known conditions to the contrary. However, the suitability of a particular analytical procedure will depend upon the auditor's assessment of how effective it will be in detecting a misstatement that, individually or when aggregated with other misstatements, may cause the financial statements to be materially misstated. (ISA 520.A6)

PwC Guidance In determining the suitability of substan the assertions, consider:

a) The assessment of the risk of mater

The following are important consideratio material misstatement:

In some cases, even an unsophisticated predictive model may be effective as an analytical procedure. For example, where an entity has a known number of employees at fixed rates of pay throughout the period, For example, if we have no or limited ev it may be possible for the auditor to use this data to estimate the total order processing and we will have to der payroll costs for the period with a high degree of accuracy, thereby details rather than substantive analytical providing audit evidence for a significant item in the financial to receivables, substantive analytical pro

Understanding of the entity and i Materiality and likelihood of mis Nature of the assertion

statements and reducing the need to perform tests of details on the payroll. The use of widely recognized trade ratios (such as profit margins for different types of retail entities) can often be used effectively in substantive analytical procedures to provide evidence to support the reasonableness of recorded amounts (ISA 520.A7). Different types of analytical procedures provide different levels of assurance. Analytical procedures involving, for example, the prediction of total rental income on a building divided into apartments, taking the rental rates, the number of apartments and vacancy rates into consideration, can provide persuasive evidence and may eliminate the need for further verification by means of tests of details, provided the elements are appropriately verified. In contrast, calculation and comparison of gross margin percentages as a means of confirming a revenue figure may provide less persuasive evidence, but may provide useful corroboration if used in combination with other audit procedures (ISA 520.A8).

any, assurance. As another example, wh ordinarily we would not rely only on sub when performing audit procedures on th to have a higher likelihood of misstatem For further guidance on developing our 7010.

b) Any tests of details directed toward

The determination of the suitability of particular substantive analytical procedures is influenced by the nature of the assertion and the auditor's assessment of the risk of material misstatement. For example, if controls Types of analytical procedures over sales order processing are deficient, the auditor may place more reliance on tests of details rather than on substantive analytical Choose among the following five types procedures for assertions related to receivables (ISA 520.A9). appropriate based on our objectives for t test, desired level of assurance). Particular substantive analytical procedures may also be considered suitable when tests of details are performed on the same assertion. For 1. Trend analysis - the analysis of c example, when obtaining audit evidence regarding the valuation 2. Ratio analysis - the comparison, assertion for accounts receivable balances, the auditor may apply relationships between financial s analytical procedures to an aging of customers' accounts in addition to account and non-financial data. performing tests of details on subsequent cash receipts to determine the 3. Reasonableness testing - the anal collectability of the receivables (ISA 520.A10). accounts between accounting per development of a model to form data, non-financial data, or both. 4. Regression analysis - the use of s expectation, with measurable risk 5. Scanning analytics - the identific items within account balances or scanning or analysis of entries in ledgers, general ledger control ac accounts, reconciliations, and oth analytics always has to be combi details following up on the anom

Substantive analytical procedures may b tests of details are performed on the sam considerations are factors that affect the substantive analytical procedure as discu (disaggregation, reliability, predictability etc.). For example, if source data for a su not reliable or if an account balance is h can be derived from substantive analytic reduced or even not achievable

Each of the five types uses a different m five types are defined below, with the fir highest in order of their inherent precisio from the other types of analytical proced search within accounts or other entity da

individual items, while the other types u information.

Following this is guidance on factors tha procedures that are considered during th procedures.

Benchmarking can also be considered fo can improve the rigor of the procedure. S information.

Further, there are two types of basic fina be useful as a stand-alone analytical pro types of analytical procedures discussed

1. Comparative financial statement comparisons of two or more peri analyze trends. Trends can be an benchmark information. 2. Common size financial statemen statement amounts into percentag for income statement items or eit sheet items, and performing com benchmark information to analyz financial statements. For more in please see PwC Audit 7035.

Types of analytical procedures PwC Guidance Trend analysis

This is the analysis of changes in an account over time. Simple trend or fluctuation analyses typically compare a p the current balance. Trend analysis can also encompass multiple time periods and includes comparing recorded tr benchmarking against competitor and industry information.

Trend analysis is most appropriate when the account or relationship is fairly predictable (e.g., sales or equipment effective when the entity has experienced significant changes. The number of time periods used in trend analysis operations. The more stable the operations over time, the more predictable the relationship and the more appropri Using more periods can increase the precision of the expectation.

The use of only the prior period balance as the expectation in trend analysis reduces the effectiveness of the analy where operations are stable, more than 2 periods are normally included in the analysis. When we incorporate mor analyses, it means we examine the past trends to develop an expectation for the current period. For example, if sa between 4 and 6 percent in each of the last 5 years, our expectation for sales in the current year when performing greater than the prior year.

Trend analysis at an aggregated level (e.g., on a consolidated basis) is relatively imprecise because a significant d relative to the natural variation (i.e. regular fluctuation of the balance) in an aggregated account balance. This sug analysis on a disaggregated level (e.g., by segment, product, location, or quarterly or monthly) where greater prec performing substantive analytical procedures.

Trend analysis can be performed using comparative financial statement analysis, where financial statement inform and/or common size financial statement analysis, where all financial statement components are converted to a per percentage of sales or total assets. For a further description of comparative and common size financial statement a

Because trend analysis relies on a single predictor (e.g., prior periods' data for an account balance), it does not inc potentially relevant financial and operating data, as the other types of analytical procedures can do. Trend analysis performed on lead schedules prepared for FSLIs may not typically be designed with the appropria substantive audit evidence akin to substantive analytical procedures, however we may prepare lead schedules foll seek audit evidence from such procedures. Benchmarking perspective:

All financial benchmarks could be relevant to Trend Analysis. Select ranges of key benchmarks and create a trend revenues and gross margins against the industry over a period of time (monthly, quarterly or yearly) to detect unu See PwC Audit 7035 for further guidance and available benchmarking knowledge tools. Ratio analysis

This is the comparison, across time or to an external benchmark, of relationships between financial statement acc between an account and non-financial data (e.g., cost per order or sales per square foot). Benchmarks for ratio ana or industry data (e.g., comparing the entity's gross profit margin with its competitors or industry aggregated data) across time, an entity's prior period performance is used as a benchmark.

Ratio analysis also includes common size analysis, where all financial statement components are converted to a p a percentage of sales or total assets. For a further description of common size analysis see PwC Audit 7035.

Like trend analysis, ratio analysis is more appropriate when the relationship between accounts is fairly predictable between sales and accounts receivable). Ratio analysis can be more effective than trend analysis because compari reveal unusual fluctuations that analysis of the individual accounts would not.

Benchmarking ratios with competitors or aggregated industry data are most useful when operating factors are com ratio analysis at an aggregated level (i.e., consolidated operating units or across product lines) is relatively imprec difference is often small relative to the natural variation in the ratios. Thus, when increased effectiveness is desire disaggregated level (e.g., by segment, product, or location).

See PwC Audit 7035 for a listing of common ratios used in ratio analysis. Also use ratios that are relevant to a sp revenue per click-through, revenue per barrel, cost per student). Benchmarking perspective:

Ratios, such as liquidity, activity, profitability could be benchmarked against competitors or industry aggregated example, comparison of sales and accounts receivable (e.g., Days Sales Outstanding or accounts receivable as a p compared to competitors or industry data, could indicate problems with revenue recognition if sales are growing f vice versa, valuation of accounts receivable if accounts receivable is growing faster than sales. See PwC Audit 7

knowledge tools. Reasonableness testing

This is the analysis of account balances, or changes in account balances between accounting periods, that involve form an expectation based on financial data, non-financial data, or both. In many cases, a simple model may be su expectation for hotel revenue may be developed using a model that includes the average occupancy rate and the a class of room. Similarly, to develop an expectation for payroll expense, we may use a model including number of termination dates, and overtime.

Reasonableness testing relies on our knowledge of the relationships and factors that affect the account balances. U assumptions for each of the key factors (e.g., industry and economic factors) to estimate the account balance. A re be formed by considering the number of units sold, the unit price by product line, different pricing structures, and trends during the period. Regression analysis

This is the use of statistical models to quantify our expectation, with measurable risk and precision levels. For exa expectation for sales by performing a regression analysis using model inputs such as management's sales forecast fixed percentage of sales), and advertising expenditures. Standard software packages, including Microsoft Excel, can be used to perform regression analysis.

Regression analysis is similar to reasonableness testing in that the model yields a specific explicit prediction using of the factors that affect the account balances. Regression analysis is most effective when data is disaggregated, f control, and has a strong predictable relationship between at least two data elements (e.g., retail sales for a clothin the store). Scanning analytics

This is the identification of anomalous individual items within account balances or other entity data through the s transaction listings, subsidiary ledgers, general ledger accounts, adjusting entries, suspense accounts, reconciliatio

Scanning analytics are different from other types of analytical procedures, which are used at a more macro level w analytics include searching for large or unusual or unexpected items in the accounting records (e.g., non-standard reviewing transaction data (e.g., suspense accounts, adjusting journal entries) for indications of errors that have o may be more prone to error. Scanning analytics may include the following types of tests (listing is not all-inclusive):

Unusual items scanning transaction listings or closing/adjusting entries or large and unusual items. Gaps identifying missing items by reference to sequential numbering or other consistent patterns as in re ledgers for missing items in the sequence. Duplicates identifying duplicate invoice numbers, payments, or payroll transactions to the same payee. Filters applying or comparing patterns to identify only items of interest as in identifying all new supplie accounts under dispute, transactions with related parties, inactive inventory, raw materials related to obsol period-end for specific accounts. Sorts categorizing data to identify specific items by e.g., sorting suspense account items in reverse date o to a specific vendor.

Statistics identifying items by specifying statistical differences such as identifying all vendor payments standard deviations from the mean. Aging ordering items by reference to date such as identifying all invoices over 90 days past due or ident Classifying identifying items by reference to a characteristic in such as identifying credit balances in acc Stratifying categorizing data by reference to a characteristic in the population, e.g., grouping customer a employees by overtime pay.

Comparison comparing data by reference to a second source as in comparing customer sales contracts per the sa tracking system for identification of duplicate, missing or different items. The expectation formed for scanning an the procedure. The expectation in scanning for large or unusual or unexpected items is based on our assessment o "expected".

While some scanning analytics may be performed manually (e.g., scanning closing or adjusting entries), others (e may require computer-assisted audit techniques using software packages like ACL (Audit Command Language). development and execution of scanning analytics using more complex computer-assisted audit techniques.

Suitable tests of details need to be designed to follow up on the anomalous items identified, in order to obtain suf as to whether there is a misstatement. Summary

All five types of analytical procedures can be used at any time in the audit; and the five types are not mutually ex analysis of ratios; however, certain types are more commonly used for one purpose than for the others (i.e., risk a conclusion). When to use the various types of analytical procedures is discussed in more detail as part of the discu

Trend and ratio analyses are less precise than reasonableness testing or regression analysis. To improve the precis highly reliable data (internal entity data that has been subjected to control testing or external data such as peer dat data from trade associations).

Reasonableness tests or regression analyses are more precise, but take care to verify the nature of the relationship (e.g., expected annual interest expense computed for aggregate debt where the debt portfolio contains different flo of changing interest rates is not as precise as using the individual debt instruments).

The appropriate level of precision needed for a particular analytical procedure is a matter of professional judgmen insufficiently precise for their intended purpose can reduce both effectiveness and efficiency. For example, the ef analytical procedures is reduced when the expectation is less able to highlight potential material misstatements (p misstatements in high-level account balances that mask true differences) or provide the necessary level of assuran expectations can also reduce efficiency by yielding "false" differences requiring follow-up and additional docume

In summary, there is a direct correlation between the type of analytical procedure selected and the precision it can precision inherent in an analytical procedure, the greater is the potential reliability of that procedure.

Financial statement analysis in analytical procedures

PwC Guidance Two types of basic financial statement analyses that may be useful as a stand-alone analytical procedure or in con

procedures include:

Comparative financial statement analysis Common size financial statement analysis

Comparative financial statement analysis

Comparative financial statement analysis, or horizontal analysis, results from side-by-side comparisons of two or statement followed by analysis of the changes (flux analysis). This analysis is performed to identify trends in the of this analysis is the additional information provided by understanding the direction, rate, and volatility of a tren trends. The more periods included in the trend, the more beneficial the analysis would generally be (e.g., a five ye Benchmarking and comparative financial statements

Comparative financial statements are useful for benchmarking a company to its competitors or industry statistics By comparing our knowledge of the business and trends with industry and competitor information a greatly enhan assessing risk and improving audit evidence will result. Benchmarking can be considered as an addition to analyt financial information. Please see PwC Audit 7035 for more information on using benchmarking. Common-size financial statement analysis

Common-size financial statement analysis, or vertical analysis, results from converting financial statement amoun total. This analysis is performed to enhance the analysis of the internal structure of the financial statements. The b additional information provided by understanding the proportion of lines items of a related total. Examples:

The balance sheet is generally common-sized by expressing individual line items on the balance sheet as a or sales. The profit and loss statement is generally common-sized by expressing all line items below the sales line i