|Opinion and Editorial - Point of View|
|Thursday, 17 December 2009 14:53|
Analytical Review Importance and Risks
By Hermes Baticulon and Lenard Ibadlit
Analytical procedures are evaluations of financial information made by a study of plausible relationships between both financial and nonfinancial data. Analytical procedures are used in all stages of the audit including planning, substantive testing and final review stage. Auditing standards require the use of analytical review procedures in the planning and final review stages. It serves as a vital planning function in the entirety of the audit procedures.
During the planning stage, the analytical review procedure enhances the auditor’s understanding of the client’s business and helps in identifying significant transactions and events that have occurred since the last audit date. It also identifies unusual transactions and events, amounts, ratios, or trends that might be significant to the financial statements and may represent specific risks relevant to the audit.
Risk assessment procedure also includes understanding the entity and its environment. The whole process assists the auditor in planning the nature, extent and timing of other auditing procedures. Measuring risks to identify significant areas requiring the auditor’s attention is also covered here. Results of the analytical procedures performed during the planning stage helps identify risks that may, based on the auditor’s judgment, require special audit consideration. Examples of these are those that are considered as non-routine, unusual and complex transactions, business risks that may result in material misstatement, fraud risk, significant related party transactions, accounting estimates and principles.
Analytical procedures also must cover the review of data aggregated at high levels, such as comparing financial statements to budgeted or anticipated results. Generally, financial data are used, but relevant nonfinancial data (e.g. number of employees, square footage of selling space, or volume of good produced) may also be considered.
Analytical review procedures also include a review of the current and prior year’s financial statements and the current year’s budget. Comparisons are made between the current year’s actual and budgeted financial statements. There must also be an analysis to compare the current and previous year’s actual financial statements to test for internal consistency.
Auditors must develop independent expectations for comparison to recorded amounts. Examples of these expectations include financial information for comparable prior periods, anticipated results from budgets and forecasts, relationship among data within the current period, industry norms and relationships of financial data with nonfinancial information. Income statement accounts have more predictable relationships compared to balance sheet accounts. In addition, accounts based on management discretion such as bonus, other employee benefits and other related expenses are less predictable.
In performing analytical procedures, the auditor may also use financial analysis ratios which maybe classified as liquidity ratios, activity ratios, profitability ratios, investors ratios, and long-term debt paying ability ratios. Additional analyses, such as common size analysis (vertical and horizontal), analysis of industry statistics and trend analysis, may also be valuable depending on the nature of transactions.
In recent years, there has been an increased emphasis on the use of analytical procedures, as it helps identify significant audit risks. However, analytical review comparisons are based on expected plausible relationships among data. Limitations exist in the use of analytical procedures because differences noted do not necessarily indicate errors or fraud, but simply the need for further analysis and investigation. Changes in an account and in accounting principle, and inherent differences between industry norms and the client all contribute to fluctuations in expected amounts. Hence, the auditor needs to exercise professional judgment in analyzing the results.
Analytical procedures are usually designed to point out audit areas which are indicative of potential risks, need special emphasis or additional attention.
Effective and best practices for analytical procedures would adhere to the following principles:
Avoid mechanical computations and comparisons. Instead, determine trends, ratios and relationships that are most relevant to the business.
Develop expectations on plausible or predictable relationships based on historical patterns in the operation of the business. These will serve as benchmarks for comparisons to determine unusual or unexpected changes.
Unusual or unexpected relationships would be characterized by anything out-of-the-ordinary, or those that do not make sense or at odds with comparable industry data.
For nonprofit organizations, analytical procedures should lead to information regarding changes in programs, nature of activities, grantors, fund-raising events, political environment, and the impact of the economy in the collection of promises to give.
Some of the typical analytical procedures applied are:
Comparison of receipts from annual fund-raising drives to total support. This procedure could help detect improper revenue recognition.
Comparison of support and revenue by source for the past five years. This procedure may identify revenue sources that require increased attention.
Evaluation of the ratio of fund-raising expenses to contribution revenues. This could also help detect improper revenue recognition. If the expense is significantly lower than the amount needed to produce recorded revenue, it might indicate overstating of revenues. If there is little or no fundraising expense while reporting contribution revenue, this might indicate underreported expenses to maintain favorable expense ratios.
Scanning of financial information to identify unusual changes, unexpected relationships and major fluctuations which could indicate specific areas of risk of material misstatement. For example, a large increase in notes payable might indicate new loans acquired. Also, significant changes in total net assets or changes in net assets by class (unrestricted, temporarily restricted, permanently restricted) might indicate unfavorable trends or going concern problems.
Obtain information from prior audits. This enables the auditor to make preliminary judgments about the inherent and control risks about material accounts and to focus on substantive procedures to reduce the detection risk.
In summary, analytical procedures play an important part of the audit process. One significant aspect is that it enables the auditor to better understand the nature of the client’s business and helps the auditor in the responsibility for identifying risks that may be relevant to the audit. Consequently, it will assist the auditor to make a professional judgment on the nature, timing and extent of other auditing procedures that need to be pursued in view of this more comprehensive perception of the business.