Analytical Procedures

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Definition: Analytical Procedures

Analytical Procedures

Full Definition of Analytical Procedures

“Analytical Procedures” refers to a tool used by external auditors in public accounting.

There are 2 main approaches to audit methodology:

  • Test of controls, and
  • Substantive procedures (aka “Substantive tests”).

While it is generally considered more efficient and thus more favourable to rely on a test of controls method, the inability to gain confidence with respect to financial statement balances by using such a method will result in pointing the audit team toward substantive procedures. The two approaches are not mutually exclusive. It is general practice to perform a test of controls during the initial stages of the audit, especially with public companies (SEC-listed) which require an Auditor’s Report on Internal Controls of Public Companies in conjunction with the Auditor’s Report on Financial Statements i.e. 10-K. If a test of controls returns a less-than-perfect yet satisfactory result, it is not uncommon that the audit team will place a certain degree of reliance on those tests already performed. In such a case, the substantive procedures serve to bolster the previous tests. The audit team will likely lower the materiality threshold – i.e. the percentage of an account’s balance that is vouched for / the percentage variance in period-on-period account fluctuations for which the auditors will pass investigation – allowing a more efficient audit.

Substantive procedures are also employed independently of test of controls considerations.

There are 2 methods for executing substantive procedures:

  • Test of details, and
  • Analytical procedures

Test of details is a substantive test that aims to test each balance up to a certain amount, for which is determined during the planning stage of the audit. This approach is almost always more time-consuming and is commonly used if there is reason to doubt an account or class of transactions or if the auditors are dealing with the client (audited entity) for the first time. However, it is important to note that a test of details generally yields much more reliable evidence than a substantive test.

Analytical procedures aid the auditor in understanding the client’s business. If the entity is a recurring (maintained relationship from previous audit periods) client, the auditor can better understand changes in the business. Thus, the auditor may develop expectations by benchmark (trend analysis, ratio analysis) the company’s performance against both the company’s prior performance and the industry trends the client may be subject to. For example, given a commercial bank client, assume a stiff competitive environment reflective of increasing interest rates offered on deposit accounts. The auditor would expect some sort of decrease in the bank’s gross margin. A variance from expectations greater than the pre-determined materiality would prompt the auditor to conduct further investigation such as inquiry of management. Analytical procedures do not provide complete coverage of all transactions. But a simple ratio may glean information suggesting that a few significant entries were either omitted or added, intentionally or not. The key is not the ensuring of an exactly correct account balance, but a balance that is “free of material misstatement”. Through this process, the auditor will naturally identify potential areas of risk and further tailor the team’s audit procedures to match the calculated risk.

Analytical procedures include analysis of financial statement information with respect to:

  • Financial ratios
  • Industry trends
  • Prior periods / Historical data
  • Mark-to-market budgets produced by management
  • Forecasting

Analytical procedures have received much publicity, and the use of them has garnered much scrutiny in recent years by regulatory bodies such as the PCAOB. There are many financial reporting programs used by clients’ management and proprietary software used by auditors that monitor ratios and trends. However, it is important to note that this information is of little use without expectations developed prior to testing and a critical and appropriate evaluation by the auditors themselves to ensure that the results make sense.

The public accounting industry has evolved to exhibit a lower tolerance for potential misstatement of the financial statements. Many accounting firms require that client’s account or class transaction balances not be taken at face value. Materiality is not applied only to the analysis-produced variances. Materiality is applied as a percentage of an account’s balance. This means that either all transactions above a certain dollar amount will be traced to source documents or the largest items making up the account balance will be traced until a certain percentage of the total is reached.

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January 18, 2022
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Definition Sources

Definitions for Analytical Procedures are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 18th April, 2020 | 2 Views.