ASA520 of the Australian Auditing Standards addresses Analytical Procedures (APs), noting APs are one auditor skill used to comprehend the clients business, plan audit procedures and identify potential risks. They compare financial data from budgets, prior periods, forecasts, consider payroll costs, financial, non financial information and gross profits. Information is sourced from budgets, banking records, financials, clients or board minutes (Arens, Best et al (2010).
Advantages of APs is they can be broken into five components: expectation development, explanation generation, information search and explanation evaluation, decision making, and documentation (Hirst and Koonce, (1996), making the audit useful for both management and investors, enabling managers to develop statistics and key ratios, monitoring business progress; whereas investors use APs to forecast future sales based on prior sales history and industry knowledge. APs are an integral part of the audit process (O'Reilly, McDonnell et al (1998).
Research indicates auditors relying on APs alone encounter obstacles in explanations for discrepancies and have difficulty generating a majority of plausible causes for unusual fluctuations during APs, due to their failure to understand the problem may not contain the discrepancy causes (Bierstaker, Bedard et al (1999).
Auditors must judge reliability of information when assessing explanations for unexpected fluctuations found during APs, explanations can differ in degree of reliability due to its source (e.g., a third party, another audit team member, client or a decision aid). The inferential value of evidence received should be considered in context to the source (Reimers and Fennema (1999).
Auditors perform APs in planning the timing, nature and extent of testing. The timing of procedures may be performed at any time during the audit engagement. The Planning aids in identifying matters needing special consideration, assisting in the understanding of client’s industry and business , discussed in ASA315(Pearson, 2010, p. 207), where the auditor’s responsibility is to obtain an understanding of the entity and it environment and ASA330 (Pearson, 2010, p. 293) to assess ongoing concerns and reduce detailed testing, followed by ASA500 (Pearson, 2010, p. 276) requiring the auditor to use assertions in assessing risk and designing audit procedures in response to those risks. Testing allows evaluation of possible misstatements and reduces detailed tests, while ASA700 (Pearson, 2010, p. 431) discusses the completion phase, where the auditor considers a final review of material misstatements or financial problems, and has a final ‘objective look’ at the evidence and financial statements (Arens, Best et al (2010, p. 190-191) giving an opinion of whether the financial report gives a true and fair view.
APs form an expectation of trend and ratio analyses, combined with model-based procedures to identify potential misstatement. Trend analysis relies on data from a single account, in contrast to ratio analysis incorporating direct expected relationships between two or more accounts. Model-based procedures differ in that expectation formation is implicit in trend and ratio analyses. Expectation formation is explicit in model-based procedures and they use operating and external data in addition to financial data to develop the expectation.
APs provide a tool to evaluate the “reasonableness” of financial disclosures by comparing a client’s reported performance to expectations gained through knowledge of the client based on past experience and developments within the company and its industry, by taking a broader view of an entity’s performance vis-à-vis its environment (Trompeter and Wright (2010) therefore affording a reasonable indicator of client performance, assisting management to identify how the business has performed internally and against their competitors.