7034 Best practices to overcome potential pitfalls in applying analytical procedures

Dec-2011

OAG Guidance

Enhancing precision of the expectation

When developing an expectation, the further disaggregated that data is, the easier it will be to develop an expectation. For instance, if performing substantive analytics over profit and loss accounts, disaggregation can generally be achieved by looking at revenues/expenses by business unit, product, location, geography, and/or over time (i.e., sales per day or quarter). At some entities it would be possible to disaggregate by all of the factors mentioned above. Typically, financial statement data can be disaggregated by department in the case of payroll, type of inventory (raw materials, WIP, finished goods) fixed asset category, expansion or replacement Property Plant and Equipment, type of debt in the case of interest payable. Continually determine how to further disaggregate the data. After disaggregation occurs, and the information is looked at over a significant amount of time (some period over 3 years or 12 quarters) generally it will be easier to develop an expectation, as patterns are more apparent.

The type of analytical procedure can also be changed to improve precision. A trend analysis provides the least amount of precision. However, even a trend analysis can be improved by increasing the number of periods reviewed, (which typically consists of a two-year flux review) to a greater number, such as five years. Also consider using ratios as part of the trend review. Ratios are based on predictable relationships between data elements and have greater precision than trends of account balances. See OAG Audit 7035 for a list of common ratios.

Obtain an external perspective with financial benchmarking

When performing analytical procedures, gaining an external perspective by including data from peer companies, industry statistics or specified competitors can improve the precision of our expectations; provide us corroborating evidence with respect to an entity’s financial performance and highlight significant anomalies in an entity’s data which is followed up. See OAG Audit 7035 for an overview of benchmarking and some practical steps that can be followed to facilitate adding benchmarking to analytical procedures. Performing external research will help develop an independent expectation. Analytical procedures using only internal company data do not give the same degree of audit evidence.

Absorb existing knowledge in the audit team

Prior audit experience of the entity, its business, industry developments and the internal control structure, is important in identifying potential misstatements when applying analytical procedures. Therefore, sharing knowledge among our team is important. This sharing of knowledge can be achieved through regular taking stock meetings and effective coaching, in particular at time of changes in the team. Research is a part of every team member’s role, but is also shared across the engagement team.

Importance of performing steps in the right order

For substantive analytical procedures to be most effective, perform the steps in the right order. As an example, when the difference between the prior period balance and the current year recorded but unaudited balance is computed (Step 3) before considering whether the prior year amount is an appropriate expectation (Step 1) and before determining the threshold (Step 2), the computed difference can inappropriately influence or bias our judgment toward accepting the current unaudited balance as fairly stated, even when it is misstated. For example, a computed difference in gross margin percentage may seem "reasonable" at first glance because the difference represents only a relatively small increase over the prior year. However, the same difference might be considered significant if our expectation, before we computed the difference, was that gross margin would drop substantially due to heightened competition and industry-wide cost increases. Also, a peer-group benchmark analysis may affect our expectation.

Non-financial information

Non-financial information can be useful in the development of expectations. For example, if financial trends (e.g., increasing revenues) are inconsistent with trends in related operating data (e.g., decreasing production), investigate the cause of the difference. Sometimes, we underutilize and undervalue non-financial data because we are unfamiliar with it or are concerned that it may not come from reliable sources. However, management engaging in fraud frequently manage results and "smooth" financial trends and ratios. It is generally more difficult for management to manipulate operating data, and thus the combined analysis of financial and non-financial relationships can be a powerful diagnostic tool. Consider data reliability, as discussed above.

Entity explanations

Inquiry of the entity is frequently an important aspect of the investigation of differences. Nevertheless, management inquiry is not the sole support for an explanation without quantification and corroboration (in the case of risk assessment analytical procedures quantification and corroboration is not necessary at the time as unusual items will be subjected to further audit procedures in accordance with the audit plan).

There are three possible causes of significant differences: unknown economic or operating conditions or events, error, and fraud. When a significant difference is found, the entity may provide a plausible, yet ultimately untrue, business explanation. If the entity introduces new information to explain the difference, verify this information before considering its impact on explaining the difference. Thus, the effectiveness of analytical procedures in identifying material misstatements is enhanced when developing potential explanations before obtaining the entity’s explanation (see OAG Audit 7033.1). By doing this, we are better able to exercise appropriate professional skepticism and challenge the entity’s explanation, where necessary.

The development of potential explanations typically is not time consuming as a standalone activity, if it is an inherent part of all our audit processes, i.e., constantly consider what the entity’s numbers tell us in the context of our own, independent knowledge of the entity’s business and our point of view/expectations. Re-examine and understand the various relationships in the financial and non-financial data, and maintain an open mind and skeptical attitude regarding possible explanations so as to avoid focusing on only one possible explanation. The independent consideration of alternative explanations for differences is more important for more significant accounts and when a higher degree of assurance is desired from substantive analytical procedures.

It is also important to consider, particularly for substantive and overall conclusion analytical procedures, the sufficiency, not just the plausibility, of the entity’s explanation. Hence quantify and corroborate explanations.

Evaluation of outcome

Evaluate the effectiveness of an analytical procedure and the level of assurance based on the factors discussed in this section (e.g., the precision of the expectation and the threshold) and not on a seemingly “favorable” outcome. There is a tendency for “favorable” outcomes to inflate the perceived effectiveness of weak analytical procedures. An analytical procedure based on an imprecise expectation and unreliable data that yields a difference less than the threshold provides little to no assurance or attention directing information.

Interaction with entity analyses

Reports and analyses that are prepared and relied on by management may be useful in the selection and performance of analytical procedures.

Consider and test (if appropriate) the entity’s process for analyzing operating results, trends, fluctuations, and ratios in order to utilize this information where appropriate, just as with any other management control. Often the entity will have specific procedures to analyze performance against business objectives, and some of these procedures may prove to be powerful analytical procedures that we can use as a basis for additional analytical procedures. Identify relevant entity processes during discussions held with the entity for the purpose of understanding the business objectives and related risks and as part of developing or updating our understanding of internal control. However, entity analyses are expanded, if necessary, to develop an appropriate level of understanding of the business and the significant trends and events affecting the entity. Apply the appropriate degree of professional skepticism to entity analyses. Furthermore, entity analyses used in substantive analytical procedures may need to be expanded to obtain an appropriate level of precision, evidence, and assurance.