Analytical Procedures Used In Planning An Audit Should Focus On

Analytical Procedures Used in Planning an Audit Should Focus On: Identifying Risks and Forming Expectations

Analytical procedures are a crucial component of the audit planning process. They are not merely a post-audit review technique; rather, they are a powerful tool used early on to understand the client's business, identify potential risks, and form reliable expectations against which subsequent audit evidence will be evaluated. The focus of these planning-stage analytical procedures should be on risk assessment and developing sound expectations. This article will delve into the specifics of how to effectively utilize analytical procedures during the audit planning phase, emphasizing their critical role in a successful and efficient audit.

Understanding the Purpose of Analytical Procedures in Audit Planning

Before diving into specifics, it's essential to clarify the purpose of analytical procedures in the planning phase. Unlike substantive analytical procedures performed later in the audit, those used during planning are primarily designed to:

• Gain an understanding of the client's business: This involves analyzing financial and non-financial data to identify trends, unusual fluctuations, and potential areas of risk. Understanding the client’s industry, economic environment, and business model is paramount to effectively assessing risks.
• Identify significant risks: By analyzing data, auditors can pinpoint areas where material misstatements are more likely to occur. This informs the overall audit strategy and resource allocation.
• Develop expectations for substantive procedures: The analytical procedures provide a benchmark – a preliminary expectation – against which the auditor will compare the results of detailed substantive testing. Large discrepancies between the expectation and actual results signal potential problems requiring further investigation.
• Enhance the overall effectiveness and efficiency of the audit: By pinpointing potential problem areas upfront, the audit team can focus its resources where they are most needed. This makes the audit process more efficient and cost-effective.

Key Steps in Applying Analytical Procedures During Audit Planning

The effective application of analytical procedures in audit planning involves several key steps:

1. Develop an Understanding of the Client and its Environment

This is the foundational step. The auditor must thoroughly understand the client's business, its industry, its operating environment, and its financial reporting processes. This understanding informs the selection of appropriate analytical procedures and the interpretation of the results. Consider:

• Industry benchmarks: Comparing the client's performance to industry averages provides context and helps identify potential outliers.
• Economic conditions: Macroeconomic factors like inflation, interest rates, and recessionary pressures can significantly impact a company's financial performance. The auditor must consider these external factors.
• Client’s business model: How does the company generate revenue? What are its key success factors? Understanding the business model is crucial to assessing the inherent risks.
• Internal controls: While a detailed review of internal controls comes later, a preliminary understanding of the client’s control environment is beneficial in shaping analytical procedures.

2. Identify Potential Areas of Risk

Based on the understanding gained in the previous step, the auditor identifies potential areas of risk. This is a crucial step because it helps to focus the analytical procedures on areas where material misstatements are most likely to occur. Consider focusing on:

• Unusual fluctuations: Significant changes in key financial ratios or account balances compared to prior periods or industry averages warrant further investigation.
• Industry-specific risks: Certain industries are more prone to specific types of fraud or errors. For example, inventory obsolescence is a significant risk for retailers.
• Changes in the client's business: Major changes like mergers, acquisitions, or new product launches can introduce new risks.
• Management incentives: Are there any management incentives that could increase the likelihood of financial statement manipulation?

3. Select Appropriate Analytical Procedures

The auditor selects analytical procedures that are appropriate to the specific circumstances of the client and the identified risks. The choice depends on several factors, including the availability of reliable data, the nature of the account balances, and the auditor's understanding of the client's business. Examples of commonly used analytical procedures include:

• Trend analysis: Comparing financial data over several periods to identify trends and fluctuations.
• Ratio analysis: Analyzing ratios such as profitability, liquidity, and solvency ratios to assess the client's financial health.
• Comparison to prior periods: Comparing current year data to data from previous years can reveal significant changes.
• Comparison to budgets and forecasts: Comparing actual results to budgets and forecasts can identify variances that require further scrutiny.
• Common-size financial statements: Expressing financial statement items as percentages of a base amount (e.g., sales or total assets) helps in identifying unusual patterns.

4. Develop Expectations

Once the analytical procedures are performed, the auditor develops expectations for key financial statement balances and ratios. This expectation serves as a benchmark against which subsequent audit evidence will be evaluated. The expectation should be:

• Predictable: Based on reliable data and reasonable assumptions.
• Precise: As precise as possible, given the inherent limitations of analytical procedures.
• Justified: The auditor should be able to justify the chosen expectation based on their understanding of the client and the procedures performed.

5. Investigate Significant Deviations

Any significant deviations between the auditor's expectations and the actual results should be investigated thoroughly. The investigation may involve further analytical procedures, detailed testing of underlying transactions, or inquiries with management. The goal is to determine the cause of the deviation and whether it represents a material misstatement.

6. Document the Procedures and Results

All analytical procedures performed during the planning phase, including the methods used, the data analyzed, the expectations developed, and the results obtained, should be meticulously documented. This documentation is crucial for demonstrating the auditor's compliance with auditing standards. The documentation should also clearly demonstrate the auditor's consideration of risks identified.

Types of Analytical Procedures Used in Audit Planning

While numerous procedures exist, some are particularly relevant during planning:

• Horizontal analysis: Comparing financial data across multiple periods to identify trends and fluctuations. This helps in pinpointing unusual changes that may warrant further investigation. For example, a sudden spike in accounts receivable could signal potential issues with collections.
• Vertical analysis: Expressing financial statement items as a percentage of a base figure, such as total assets or total revenue. This helps in identifying unusual proportions or relationships between different accounts. For instance, a significantly high cost of goods sold as a percentage of sales might indicate inefficiencies in operations.
• Ratio analysis: Computing financial ratios to assess the company’s financial health and performance. Common ratios include profitability ratios (gross profit margin, net profit margin), liquidity ratios (current ratio, quick ratio), and solvency ratios (debt-to-equity ratio). Significant deviations from historical ratios or industry benchmarks may indicate risks.
• Cross-sectional analysis: Comparing a client's financial data with similar entities in the same industry. This helps to identify outliers and potentially problematic areas. For example, comparing a client’s profit margin to its competitors can reveal potential underperformance.
• Regression analysis: A statistical technique to analyze relationships between variables. This can help in predicting future performance and identifying potential anomalies. For example, regression can be used to predict sales based on historical data and identify outliers.

Importance of Documentation

Detailed documentation is paramount. Auditing standards require auditors to document their work, and this is particularly true for analytical procedures. The documentation should clearly outline:

• The procedures performed: Specific analytical procedures used, including the data sources and methods employed.
• The expectations developed: Clearly stated expectations for key financial statement balances and ratios, along with the rationale for those expectations.
• The results obtained: The actual results of the analytical procedures, including any significant deviations from expectations.
• The conclusions reached: The auditor's conclusions based on the results of the analytical procedures, including any identified risks and the impact on the overall audit strategy.

Conclusion

Analytical procedures are indispensable during audit planning. Their effective use facilitates a more targeted and efficient audit, mitigating risks and enhancing the quality of the audit report. By focusing on identifying risks and developing sound expectations, auditors can leverage analytical procedures to improve the overall effectiveness and reliability of their audit work. The key takeaway is that analytical procedures, applied thoughtfully and documented meticulously, are not merely a supplementary audit technique; they are a cornerstone of a well-planned and robust audit engagement. This proactive approach allows auditors to focus their efforts where they are most needed, resulting in a more efficient and effective audit process.