What is Analytical Procedure. How any business and auditor can benefit from this.

Do you know how Analytical procedure help financial auditor as well as finance department of entity to make financial decision and help making controls on their financial system. Lets explore how vast the world of Analytical procedure is:

Analytical procedure are formula and processes that compare financial and non financial data in order to determine relationships between the two. It also investigate identified fluctuations and relationship that are inconsistent with other relevant information or deviate significantly from expected amount. 

Nature and purpose of Analytical procedure:

1. Consideration of comparisons of entity’s Financial information with:

• • Comparable information for prior periods,
  • Anticipated results of entity, such as budgets or forecasts, or expectations of auditor, such as estimation of depreciation
  • Similar industry information,

2. Consideration of relationships:

• Among elements of financial information that would be expected to conform to a predictable pattern based on entity’s experience, such as gross margin percent
•  Between financial information & relevant non financial information, such as payroll costs to number of employees.

Various methods may be used in performing above audit procedures. These ranges from simple comparision to complex analysis using advanced statistical techniques.

Some examples of analytical procedure method are:

• Efficiency ratio analysis: It is comparing line item of financial statement to assess them as for liquidity, profitability & efficiency. Auditor calculates ratios & map them over an extended period. This helps them identify trends, ensuring whether any aspect of financial statement remained stable or not.  

For example: Comparing clients asset and liabilities for the most recent fiscal year with those reported by his clients during 5 years period. 
If clients liabilities and assets followed trends established during the previous years, it can be confirmed that these aspects of company’s finances remained stable.
If significant change is noticed from previous years then auditor or business has to assess how these changes happen. 
These changes can happen if there is for eg: recent change in accounting policy, if significant changes in current year are due to those factor then there may not be misstatements.

•  Industry compliance ratio: Here we calculate same ratio for companies in same industry to ensure their client’s value are similar or higher than other companies. It helps in ensuring good financial health. It also helps to know that how entity performs in certain economic condition. 

• Other ratio analysis methods: Here are other types of ratio analysis methods auditors use:

1. 1. Coverage ratio:  This method determines the ability of a company to cover debts
   2. Leverage ratio: This technique determines the debt load the business has incurred.
   3. Market value ratios: This approach assesses the current share price of the company’s stock.
   4. Liquidity ratio: This method measures the ability of a company to pay off short term debts.
   5.  Profitability ratios: This approach measures the ability of a company to earn a profit.

• •  Revenue and cost trend analysis: Auditors can use trend analysis using revenue and cost analysis. They use this process internally to create a trend line that reveals whether the company’s revenue and costs have remained consistent.
    Depending on distribution of data points, auditors can identify potential problems & help their client resolve them. Such as using revenue and cost analysis to create a trend line for client. Recording revenue over previous 5 years & revealed that sale had remained steady.
                   Example of its uses are:
    a) Analysing growth or decline of revenue and its percentage, trend analysis increasing or decreasing trend, its correlation.
    b) Comparing revenue and cost of company with economic condition. How it performs on certain economic condition. 
    c) Analysing how revenue reacts with price of product, income rate, inflation rate. 
    d) Estimating future results for budgeting purpose 
    e) Assessing trends in sales by customer or target market
    f) Checking for expenditures that requires investigation

Investment trend analysis: The other types of trend analysis, is more a part of investment strategy than an auditing method, but it still affects the company’s financial decisions. Investment analysis tracks company’s stock prices to see if investors can determine a cause for increases and decreases in the cost. Auditors may use investment analysis to assess an overall financial strategy for a client. 

Reasonableness test: Auditors conduct reasonableness tests to confirm the validity of company’s transaction, balances & other financial events. They determine reasonableness based on information provided on two or more sources of data. If auditor notices possible inaccuracies, they address them with client.

Eg: Using reasonable test to make sure clients cost of goods reflects their revenue. He found his client has a significant higher revenue that its cost of goods, so work should be put to find the cause discrepancy. 

Regression analysis: Auditor use regression analysis to determine how two sets of variables relate to each other. This type of analysis requires the dependence of one variable on the other. Using this, auditor can determine how one variable affects the other over an established time period. They can then use this information to predict certain financial elements, such as account balances.

Example: Performing repression analysis on past financial statements to determine how client’s debts, revenue and cost of goods affected their account balance. Based on correlation between two factors and reported account balance in years prior, auditor can use current debts, revenue and cost of goods to predict their account balance. 

Before performing AP, auditor should develop expectation of results of AP based on understanding of entity based on his understanding of entity & its environment & the accounts, balances & transaction recorded in FS.

In order to form a conclusion based in AP, auditor must compare expectation to actual results of AP & investigate any differences or unexpected fluctuations.

Illustration on using expectation: 

Following discussions with management during course of the year, review of management accounts and an understanding of business environment in which an audit client operates, auditor is expecting current year’s results to be lower than those of previous year.

However, according to draft financial statement, not only revenue has increased, but gross profit percentage has also improved. The auditor would need to gather addtitional audit evidence to determine why the result of AP is not consistent with expectation. 

In reasonable