Chapter Eleven – Analytical Procedures

Summary

This Chapter discusses when and how analytical procedures should be used
during the audit.

Introduction
11.01 “Analytical procedures” is the term applied to a variety of techniques used by the
audit team to study plausible relationships, financial and non-financial, between
both internal and external data. Analytical procedures can be used to help
identify possible material misstatements by indicating whether account balances
and relationships appear reasonable in relation to expectations developed from
past results, expected results, or other trends.

11.02 Examples of analytical procedures include a:

 comparison of the changes in a given account balance, item, or element over
prior accounting periods with expectations for the current period
 comparison of financial information with anticipated results (for example,
budgets and other prospective information)
 study of the relationship between account balances over time or among
entities in a given industry
 comparison of simple computations or a series of computations, which
develop an estimate for a given account balance, item, or element
(reasonableness tests)
 study of the relationship of financial information with non-financial information

11.03 The basic premise underlying the application of analytical procedures is that
relationships between data may reasonably be expected to exist and to continue
in the absence of known conditions to the contrary. Particular conditions that can
cause variations in these relationships include unusual transactions or events,
accounting changes, business changes, random fluctuations or misstatements.

11.04 Analytical procedures are used to:

 obtain an understanding of the entity and its environment
 assess risks to determine the nature, timing and extent of audit procedures
 assist in the identification of material fraud
 evaluate risk that the entity may not be able to continue as a going concern
 effectively and efficiently respond to risks
 corroborate conclusions formed
 assist in arriving at the overall conclusion as to the reasonableness of the
financial statements
 Uses of Analytical Procedures
11.05 The type of analytical procedure used and the response to the results of those
procedures will vary depending on purpose for which they are performed.
Analytical procedures are used for the following purposes:
 as risk assessment procedures
 as substantive procedures
 as concluding procedures

As Risk Assessment Procedures

11.06 Analytical procedures are required by professional standards to be done as part

of the risk assessment process. As risk assessment procedures, analytical
procedures assist in:
 understanding the client’s business
 understanding the client’s present financial position
 identifying risks
 identifying unusual transactions and amounts, including those related to fraud
 developing expectations for year-end values and ratios
These procedures assist the audit team in assessing risks of material
misstatement to determine the nature, timing and extent of further audit
procedures necessary.

11.07 To accomplish this objective, various analytical techniques are used to examine
financial liquidity and the entity’s ability to continue as a going concern and to
identify specific risks, accounts, transaction cycles, subsidiaries, divisions, or
locations requiring audit attention because of unusual relationships (those
outside the audit team’s expectations).

11.08 During the risk assessment phase, analytical procedures are usually focused on
account balances aggregated at the financial statement level and relationships
between account balances. Accordingly, trend and ratio analysis are the most
common analytical methods used. Although corroboration of the management’s
explanations of fluctuations is not ordinarily required, significant fluctuations or
anomalies should be documented, along with the audit team’s planned response
(how they will be addressed by further audit procedures).

11.09 In performing analytical procedures as part of assessing risks, the audit team
considers:
 significant events that occurred during the year that could affect gross profit
(e.g., changes in pricing, costs, volumes, etc.). For service businesses,
consider direct costs as a percentage of sales.
 the relationship of significant financial statement items (e.g., payroll, selling
expense, etc.) with respect to sales/production that changed during the year
  changes in credit practices or customer profiles during the year. Consider the
effect credit granting and collection experiences may have on expected aging
and turnover of accounts receivable.
 changes in the expected monetary value of inventory and inventory turnover.
Consider whether these trends indicate an increased risk of inventory
obsolescence.
 difficulty experienced by the entity in meeting its short-term and long-term
obligations as payments become due and satisfying loan covenant
requirements
 whether unusual relationships exist in revenue accounts that may indicate
fraudulent financial reporting
 how financial statements are expected to change because of significant
events or other matters, including:
– economic, legislative or industry changes
– major expansion or closure of plants, divisions, etc.
– changes in product lines
– significant financing
– loss of a major supplier or customer

11.10 In addition, these considerations should be reflected in the inherent risk indicator
applicability assessments and when assessing inherent risk at the assertion
level. Professional standards require documentation of the assessed risks as a
result of these risk assessment procedures and how the audit team responds to
those risks in performing the audit (e.g., procedures in the audit program).

11.11 When comprehensive financial data is not available, the audit team should
perform whatever planning analytical procedures are useful. For example, review
of the gross profit margin, days sales in accounts receivable, current ratio,
inventory turnover, and the acid test ratio will aid in our understanding of the
entity necessary to assess risks and direct audit attention to those areas of risk.

As Substantive Procedures

11.12 As substantive procedures, analytical procedures provide evidence about one or

more assertions related to account balances or classes of transactions. At this
stage, analytical procedures provide all or a portion of the evidence required to
respond to a risk. Voyager suggests different types of analytical procedures
depending on the achieved control reliance and the assessed inherent risk.

11.13 Substantive analytical procedures may be appropriate when:

 the balance involves a large volume of transactions that are predictable over
time. In this case, there is evidence to support the completeness, accuracy,
and occurrence of transactions.
 additional evidence is necessary to support evidence obtained from
performing tests of details
 they provide assurance relating to several different assertions
  potential misstatements may not be apparent from detailed tests (e.g.,
completeness of sales)
 the risk of misstatement is such that analytical procedures alone provide
sufficient evidence that a material misstatement is not likely
 reliable data is available to perform relevant analytical procedures, including
disaggregated information
 the amount can be reasonably predicted

11.14 In contrast to the use of analytical procedures as risk assessment procedures,

those applied as substantive procedures involve more extensive data gathering,
analysis, and evaluation. These tests tend to be more well-defined and structured
and the judgments involved are more objective than the analytical procedures
performed during risk assessment.

11.15 When an analytical procedure is used as the principal substantive test for a risk,
the audit team should document the following:
 the expectation and the factors considered in its development
 results of the comparison between the expectation and the entity’s recorded
amount
 any additional auditing procedures performed in response to significant
unexpected differences and the results of those procedures
 any corroborating evidence obtained to support any large or unusual
variances between expectations

11.16 As part of the auditor’s responsibility to detect material fraud, substantive

analytical procedures should be performed to identify material fraud related to
revenue recognition. An example of such an analytical procedure is a
comparison of sales volume, as determined from recorded revenue amounts,
with production capacity. An excess of sales volume over production capacity
may be indicative of recording fictitious sales. Another example is trend analysis
of revenues by month and sales returns by month which may indicate
undisclosed side agreements with customers to return goods. The procedures
may be performed at an interim date and updated through the end of the
reporting period.

As Concluding Procedures
11.17 Analytical procedures are required at the concluding stage of the audit. The
procedures used are often similar to the ones used as risk assessment
procedures, but at this stage their objective is to assess (1) whether there are
significant fluctuations or unusual items in the audited financial statements that
have not been sufficiently explained and (2) that the financial statements and
disclosures are consistent with the results of the audit procedures performed and
the audit team’s understanding of the entity and its environment. For example,
changes in cash, receivables, inventory and payables might have appeared
reasonable when audited individually, but in combination, result in a significant
 working capital fluctuation that has not really been explained. Accordingly,
analytical procedures can help provide assurance that the financial statements
make sense.

11.18 Analytical procedures as risk assessment procedures and as concluding

procedures should consider financial liquidity, and the expectation of remaining a
going concern, when such risk is present. Typical ratios used are the:
 acid test ratio
 current ratio
 debt to equity
 interest coverage ratio
 other key performance indicators, as appropriate
Various other measures of identifying increasing distress have been developed,
based on the measure of a total of various financial statement ratios. These can
also be useful as indicators of going concern problems.

11.19 In concluding the audit, the audit team reads the final financial statements
(including disclosures) and considers:
 the adequacy of the audit evidence gathered with respect to unusual or
unexpected balances identified in performing risk assessment procedures or
during the course of the audit
 unusual or unexpected balances or relationships that have not previously
been identified
 whether the current year's financial statements are comparable to the prior
year, considering the understanding of the entity and its environment
This final review integrates the results of all the audit work performed and gives
added assurance that there is a low risk of the financial statements being
materially misstated because of undetected misstatements.

Other Considerations

11.20 All understanding of the entity and its environment, including risk assessments,
should enter in the audit team’s design of analytical procedures. This has staffing
implications. Such work cannot be delegated to a team member who does not
have an understanding of the entity and business in which the entity operates.

11.21 The personal experience and knowledge of the entity and the entity's business
and of the key indicators of that business often enable the audit team to develop
and apply more informal procedures. The effectiveness of analytical procedures
relates to the audit team’s ability to detect potential misstatements, and well-
conceived informal procedures can be very effective, especially in smaller
entities.

11.22 The reliability of data for audit purposes may be influenced by a number of
factors, including:
  whether the data is obtained from independent sources outside the entity, or
from client sources
 whether information provided by client personnel are independent of those
who are responsible for the amount being audited
 whether the data was developed under a reliable system with adequate
internal control
In practice, data developed outside the accounting function (for example, by
sales personnel) can provide independent information, because the compiler has
different motivations than the accounting staff.

11.23 Some accounts are more predictable than others. Relationships involving income
statement accounts are usually more predictable than those for balance sheet
amounts. The former represent transactions over a period of time; the latter
represent amounts at a point in time, which are residual effects of those
transactions. Therefore, analytical procedures tend to be directed to the income
statement.

11.24 In performing analytical procedures, the most useful and valid results are usually
obtained when the analysis is performed using disaggregated data (i.e., analyses
of sales by product line, etc.). Similarly, applying analytical procedures to
consolidated financial statements may not be as effective or efficient as applying
the same procedures to individual subsidiaries or divisions.

Performing Analytical Procedures

11.25 Performing analytical procedures is a process that consists of four phases that
are discussed further in the following paragraphs:
 expectation formation
 identification
 investigation
 evaluation

The Expectation-Formation Phase

11.26 Forming an expectation is the most important part of the analytical review
process. To form an expectation, the audit team uses one of the expectation
methods that include:
 trend analysis
 ratio analysis
 reasonableness tests
 regression analysis
 Trend Analysis

11.27 Trend analysis compares balances in a single account or financial statement line
to prior periods, budgeted amounts or industry data. Although trend analysis can
be used as a substantive test, it is typically more useful as a risk assessment
procedure or a concluding procedure, where lower levels of precision are
acceptable.

11.28 Trend analysis is relatively easy to perform and the audit team is not required to
form an explicit expectation. With trend analysis, it is presumed that the balances
should be comparable with the prior periods or with the industry average; and
therefore, expectations are implicit.

11.29 Trend analysis can be as simple as comparing last year’s account balance to the
current year balance. In this example, the implicit expectation is the prior year
amount. It is not necessary to document the expectation when using trend
analysis because it is implicit.

11.30 The number of years used in the trend analysis is a function of the stability of
operations. The more stable the entity’s operations over time, the more
predictable the relationships and the more appropriate is the use of multiple
years in identifying trends. It is important to understand the volatility of the entity’s
environment related to the amounts being tested. For example, except in
situations in which the environment has remained stable relative to the prior year,
using only the prior-year balance as the expectation reduces the effectiveness of
analytical procedures to identify potential high-risk areas. In fact, using only the
prior-year balance without considering whether it is the most appropriate
expectation can lead to a bias toward accepting the current data that has not
been subject to auditing procedures as fairly stated, even when they are
misstated.

11.31 Trend analysis typically produces the most effective results when performed on
disaggregated data, because aggregate level analyses are relatively imprecise.
Trend analysis is less effective in situations where the entity experienced
significant operating or accounting changes during any of the periods being
analyzed. It is also less effective in detecting situations where amounts should
have changed and did not.

11.32 The effectiveness of using budgeted data depends on the rigor and
appropriateness of the client’s budgeting process. If, for example, budgets are
prepared on an overly optimistic basis, the budget value will not represent the
most probable expected results. Also, budgets are set before economic events
occur and expectations developed a year ago may not have appropriately
accounted for the environmental events that occurred during the year. Therefore,
the audit team should obtain an understanding of the budgeting procedures
before utilizing budgets or forecasts as their expectations.
 Ratio Analysis

11.33 Ratio analysis involves comparing:

 relationships between financial statement accounts (e.g., sales divided by
accounts receivable)
 an account with nonfinancial data (e.g., rent income divided by units available
for rent)
 relationships between entities operating within the same industry
Ratio analysis on account balances is useful for those relationships expected
to be stable (over time) or comparable (across entities in the same industry or
locations in the same entity). Once a ratio is determined, it is compared with
the ratio for prior periods or others in the same industry during the same
period.

11.34 The use of financial ratios as substantive procedures may have limitations:
 ratios assume that all elements of financial information are completely
variable and do not recognize the fixed or semi-variable nature of certain
items. For example, ratios based upon sales fail to recognize that expenses
such as rent or interest are either fixed or vary with factors other than sales
 the possible bias or lack of comparability of industry data, due to different
accounting methods, product lines, etc.
 external factors (e.g., labor strikes, changes in regulations) and internal
factors (e.g., changes in product mix, pricing strategies, subsidiary entities)
can cause distortions
 ratios can be easily misinterpreted. For example, by assuming a simple linear
relationship, a current ratio of 1.0 may be considered "twice as bad" as a ratio
of 2.0, when actually, it is many times worse

11.35 Notwithstanding these concerns, ratio analysis can be an important indicator of

potential financial statement problems. For example, financial ratio analysis can
be used to identify possible aging problems for accounts receivable, inventory,
and accounts payable.”

11.36 Accordingly, the audit team should exercise caution in the use of ratios, but also
recognize that financial ratio analysis can be a useful audit tool. Because the
relationships underlying various important ratios tend to be relatively stable, such
ratios can be valuable indicators of distorted financial information.

11.37 As with trend analysis, the expectation for ratio analysis is implicit. The
expectation is the compared item (i.e., prior year ratio). Because it is implicit, the
audit team need not document the expectation when performing ratio analysis.
 Reasonableness Tests

11.38 Reasonableness tests involve developing an independent expectation based on

financial and nonfinancial data, frequently by a computation or series of
computations using the audit team's knowledge of the entity and its business.
Reasonableness tests provide the opportunity for tailoring the test to include all
relevant factors that may explain fluctuations. Therefore, it is potentially the most
powerful and well-focused test.

11.39 Because income statement accounts tend to be more predictable than balance
sheet amounts, reasonableness tests are best suited to income statement
balances. Possible applications include payroll expense, sales commissions,
payroll taxes, depreciation and amortization expense, rent income, rent expense,
investment income and interest expense.

11.40 Further, reasonableness tests can be sufficiently precise to provide the principal
evidence for a particular risk.

11.41 One example of a reasonableness test is using the number of employees hired
and terminated, the timing of pay changes and the effect of vacation and sick
days to develop a model that could predict the change in payroll expense from
the previous year(s) to the current period. Another example is estimating interest
expense using the average balance of debt outstanding, the average interest rate
and the average time outstanding during the period.

11.42 When performing reasonableness tests, the independent amount or ratio

computed by the audit team is the audit team’s expectation. Therefore, the
computed amount is the audit team’s documentation of the expectation.

Regression Analysis

11.43 Regression analysis uses statistical models to quantify the audit team’s
expectation in monetary terms, with measurable risk and precision levels. For
example, an expectation for sales may be developed based on management’s
sales forecast, commission expense, and changes in advertising expenditures.

11.44 Regression analysis is similar to reasonableness testing in that there is an

explicit prediction using the audit team’s understanding of the factors that affect
the account balances to develop a model of the account balance. The model is
most effective when the data are disaggregated and are from an accounting
system with effective internal controls.

Selecting an Expectation Method

11.45 The effectiveness of the method used is a function of three factors related to the
precision with which the expectation is developed:
  the nature of the account or risk
 the reliability of the data
 the inherent precision of the expectation method used

11.46 When considering the nature of the account or risk, the audit team considers
whether:
 the amount is determined subjectively
 significant events occurred during the period that would impact the precision
of the test
 other events or changes impact the comparability of balances between
periods
 the stability of the environment (did events occur that lead the audit team to
believe that previous relationships between data no longer exist)

11.47 The reliability of data used in the analysis is an important factor in determining
the effectiveness of the analytical procedure. The following factors help the audit
team determine the reliability of data:
More precise Less precise
Disaggregated data Financial statement-level data
External data Internal data
Strong internal control Weak internal control
Non-financial data Financial data
Audited data Unaudited data

11.48 When the entity operates in a stable environment, the audit team can use
previous years’ data to develop an expected value for a given ratio. For example,
the audit team could analyze the change in a ratio over the previous four audited
years by adding to the prior year's ratio the average change in the ratio over the
previous four years. For example, if last year's current ratio (current assets to
current liabilities) is 1.31 and the average change in the ratio is +0.03, then the
expected ratio, in the absence of unusual activity, would be 1.34. If the entity’s
environment is not stable, emphasis should be placed on more recent data and
events.

11.49 If only two prior years of audited information are available, the average change
should be based on the change between those two years, unless that change is
believed not to be representative. If no prior year audited information is available,
the expectation should be developed based on the audit team’s understanding of
the entity and its environment.

11.50 The audit team should select the expectation method by considering the level of
assurance required by the procedure. Determining which type of expectation
method is a matter of professional judgment. Trend analysis generally provides
the least precision because it does not consider the factors that affect the
account (e.g., product mix). Regression analysis, in contrast, is the most precise
because it measures precision mathematically. Ratio analysis and
reasonableness tests fall somewhere in between; however, reasonableness tests
 are ordinarily more precise because they involve the formation of explicit
expectations.

11.51 The audit team may identify risks where the risk of material misstatement is so
low that analytical procedures alone will provide an appropriate response to the
risks identified. When an analytical procedure is used as the primary substantive
test of a risk, the audit team should document all of the following:
 the expectation, unless it is apparent from the documentation of the work
performed, and factors considered in its development
 results of the comparison to recorded amounts or ratios developed from
recorded amounts
 additional auditing procedures performed in response to the significant
unexpected differences arising from the analytical procedure and the results
of such other procedures
 corroborating evidence obtained to support unexpected variances

The Identification Phase

11.52 The identification phase begins by comparing the audit team’s expected value
with the recorded value. Since the audit team developed the expectation with a
particular materiality threshold in mind, the differences between the expected
value and the recorded value should be compared to that threshold.

11.53 As a reminder, Horizon requires that tolerable error be used to drive the scope of
audit procedures. Tolerable error is defined as 60% of materiality (see Chapter
7). Horizon allows tolerable error to be lowered for a particular test if, in the audit
team’s judgment, a lower threshold is appropriate. In those situations, the lower
tolerable error should be documented together with the factors the audit team
considered in lowering tolerable error.

11.54 The identification phase includes identifying deviations when fluctuations that
were expected did not occur. For example, sales in the current period have
grown in line with previous trends, but a larger increase was expected because
of the introduction of a new product line.

11.55 Acceptance ranges help the audit team to decide whether further investigation is
necessary. The wider the acceptance range, the less confidence the audit team
has that the procedure is effective in detecting material misstatements. However,
narrowing the acceptance range too much to improve the effectiveness of the
procedure may result in unnecessarily investigating immaterial fluctuations and
over auditing.

11.56 Determining an appropriate acceptance range is a matter of judgment. It may be

tempting to simplify this judgment by using standard practices such as
investigating deviations greater than 10% from the previous year’s balance.
However, this approach frequently results in focusing too much attention on small
 or low-risk accounts and unnecessary audit work, and could detract attention
away from larger or higher risk accounts that may be more sensitive to much
smaller fluctuations.

11.57 Acceptance ranges can be expressed on monetary amounts or a percentage.

Tolerable error is the starting point in developing acceptance ranges. For ratios,
one way of calculating the acceptance range is by determining the effect that an
error of the amount of tolerable error in one of the components would have on
the ratio under review.

11.58 When the expectation and amounts recorded are not comparable, the audit team
should reconsider the validity of the expectation. For example, was there a
change in the entity or its environment that was not reflected in the expected
amount? Was a variable cost model applied to fixed cost items?

The Investigation Phase

11.59 In the investigation phase, the audit team considers the possible explanations for
the differences. The greater the precision of the procedure, the greater the
likelihood that the difference between the expectation and the recorded amount
is due to a misstatement rather than other causes. When the precision of the
procedure is less, the greater the likelihood that the difference between the
expected amount and the recorded amount is due to causes such as using
imprecise or less reliable data.

11.60 If the audit team believes the difference is more likely due to factors related to the
precision of the expectation, they should consider whether a more precise
expectation can be developed cost-effectively. If so, the audit team should
perform the more precise procedure.

11.61 The audit team may believe the expectation is sufficiently precise and determine
that the difference could indicate a misstatement. If so, the audit team uses their
understanding of the entity and its environment to identify likely causes of the
difference and identify plausible explanations.

11.62 Plausible explanations usually relate to changes in the business and unusual
events or transactions. In evaluating the plausibility of explanations for
differences, the audit team considers the consistency of the explanation with their
understanding of the entity and its environment and the audit evidence obtained
in other areas. The plausibility of the explanation may also be evaluated by:
 management and board reports containing explanations of significant
variances between budgeted and actual results
 review of minutes of those charged with governance
 information on unusual events occurring in prior years
11.63 When the analytical procedure serves as a primary substantive procedure, the
audit team should corroborate explanations for significant differences by
obtaining sufficient audit evidence. The evidence should be of the same quality
as evidence supporting tests of details. To corroborate an explanation, one or
more of the following techniques may be used:
 inquire of persons outside the entity (e.g., confirm discounts with a major
supplier or agree changes in security valuations to exchange prices or
published reports)
 inquire of independent persons inside the organization (e.g., corroborate an
explanation received from the controller with the marketing director)
 consider evidence from other auditing procedures (e.g., those performed on
the data used to develop an expectation)
 examine supporting evidence (e.g., if the increase in cost of sales was
represented as the result of an unusually large sales contract, the audit team
could examine the sales contract)

11.64 Particular attention should be given to explanations that appear contradictory to

other evidence or that do not seem to make sense in light of the surrounding
circumstances. In many of the documented cases of the profession's past audit
failures, auditors were aware of significant unusual fluctuations in the financial
statements being audited, but accepted client explanations without evaluation or
verification. Accordingly, the importance of subjecting client explanations to
professional skepticism, analysis, verification and appropriately documenting the
work performed cannot be overemphasized.

The Evaluation Phase

11.65 When an analytical procedure provides evidence that an account may be
misstated, further procedures should be applied to determine the amount of the
misstatement. If the audit team performs a very precise analytical procedure and
uses it to develop a range of acceptable values, an audit difference is identified if
the actual value (recorded amount) falls outside the acceptance range. The
difference between the actual value and the nearest acceptable value in an
acceptance range usually is the amount of the audit difference. To illustrate: if an
entity’s depreciation provision is being tested for reasonableness by using a
precise analytical procedure to estimate the provision based upon asset
balances and depreciation rates, the amount recorded by the entity should be
compared to the acceptance range developed by the audit team. (If the predicted
provision is $500,000, the audit team might establish an acceptance range at
$475,000 to $525,000). Accordingly, if the recorded amount is $440,000, the
audit team should consider the audit difference to be $35,000; the difference
between the recorded amount and the nearest acceptable value in the range. (If
the recorded amount falls within the acceptance range (e.g., $480,000 in this
example), there would be no audit difference).
11.66 As a reminder, audit differences should be added to the Summary of Unrecorded
Misstatements. In addition, misstatements identified by the audit team are direct
evidence that the internal controls failed to prevent an error. The audit team
should identify the underlying control deficiency, add it to the appropriate Design
Effectiveness tool in Voyager, and evaluate its severity. As discussed in Chapter
10, a misstatement is at least a significant deficiency and a strong indicator of a
material weakness.

Recommended Analytical Techniques

Comparison of Account Balances

11.67 Perhaps the most fundamental analytical procedure is comparison of account

balances with those of a comparable period (e.g., with previous months or
quarters, or with the prior year). In making such comparisons, the audit team
should not be concerned with items not considered significant to the financial
statements. In some circumstances, comparisons of interim (quarterly or
monthly) balances to prior year may be useful. In general, the more detailed the
basis of comparison, the more likely that significant fluctuations or unusual items
will be identified.

Ratios to Sales

11.68 Because many revenue and expense accounts tend to bear a direct relationship
to sales, the comparison of ratios to sales from period to period can be useful.
Such comparisons affect various risks. For example, variations in the returns and
allowances ratio may indicate problems with the existence of recorded sales. Not
all revenue and expense items would be expected to bear a stable relationship
with sales, (for example administrative expenses) so the comparisons should be
made with forethought.

Reasonableness Tests of Account Balances

11.69 Certain analytical procedures give such a high level of assurance that they can
be used to provide all the necessary evidence for a particular risk. The most
common examples of this type of test are reasonableness tests of an account
balance or class of transaction. This is a particularly efficient procedure.

11.70 This type of reasonableness test is used to estimate the total of an account
balance or class of transactions either by determining in total from independent
confirmation or computing from independent information. For this test to be
effective there needs to be a stable relationship between the factors and the data
used needs to be reliable. The extent to which an analysis actually provides proof
of the amount depends on its precision. Examples of areas where this test may
be appropriate include:
  sales commissions
 depreciation
 salaries
 sales and production amounts
 payroll taxes
 interest income and expenses
 rental income and expense

Comparisons with Other Related Accounts

11.71 Certain revenue and expense accounts are closely related to particular asset
accounts, or to other expense accounts, so that the relationship between
accounts is meaningful and can be usefully compared over time. This is a form of
ratio analysis.

11.72 Examples of the relationship of income and expense accounts to assets include:
 investment income to average investments
 interest expense to average debt
 depreciation expense to depreciable assets
It may be necessary to apply certain of these tests on a more detailed basis
and to disaggregate the expense and related asset (for example, where
certain investments have substantially different returns than others or where
the mix of the depreciation categories of assets has significantly changed).

11.73 Another type of comparison useful for certain expense accounts is the ratio of
such expenses to other related expense accounts (for example, payroll taxes to
payroll expense). These ratios have stable, predictable patterns and significant
deviations not resulting from changes in tax rates or management benefit policies
might indicate a potential accounting error.

Comparisons Based on Non-Accounting Data

11.74 For audit purposes, other information generated by the client, but from outside
the accounting system (e.g., production statistics, units purchased, number of
employees) may have greater value and reliability than material produced from
within the accounting records (for example, in reviewing sales, consideration
might be given to production records and delivery charges). In a retail entity,
comparisons might be made to sales per employee and sales per departmental
square foot. The independence from the accounting function of the person
compiling the data may give that data added credibility.
 Use of Industry Statistics

11.75 In most audit situations, extensive reliance on comparison with published

industry financial ratios or similar data as a means of identifying possible
misstatements in the financial statements is not appropriate. This is because the
differences between the client's financial information or method of compiling such
information, and the reported industry results may be so great that audit
comparisons may be invalid or may require excessive work to identify the
reasons for fluctuations. Also, the client's circumstances are unique and may not
reflect the industry norm.

11.76 In certain industries, however, various well-known, non-financial statistics are

widely used to measure or compare financial performance. For example, in the
real estate industry, using the cost per foot statistics for similar types of
construction in the same geographical area might test the reasonableness of
construction costs. Similarly, department store sales can be tested by reference
to industry data for sales per square meter, etc. Such data can be most
appropriate for analytical purposes.

Commonly Used Financial Ratios

11.77 Financial analysts commonly use the following financial ratios. Audit teams will
not investigate all of them on most audits, although the liquidity ratios and gross
margin ratio are useful for most audits. The insights given by these and some
other ratios are as follows:
1. Liquidity ratios:
 the current ratio identifies working capital shortages or going concern
problems
 the quick or acid test ratio is a more conservative measure of liquidity and
gives an indication of the company's ability to pay short-term obligations
without liquidating inventory
2. Profitability ratios:
 gross margin (profit) measures the rate of return on sales that can be
compared with previous periods and industry norms
 the operating margin measures operating profitability and the extent it can
pay operating expenses from net sales
 return on total assets measures the income generated by the assets utilized
 return on equity indicates the rate of return to shareholders
3. Leverage or solvency ratios:
 debt to equity measures the extent the entity finances its operations from
long-term debt versus equity
 fixed assets to long-term debt shows the extent to which long-term financing
is used for fixed assets
 times interest earned shows the degree that earnings can decrease and still
allow the entity to make its interest payments
4. Activity ratios:
 the number of days sales in accounts receivable (debtor days) indicates
potential cash flow and working capital problems, or bad debt considerations
inventory turnover highlights overstocking of inventory and slow moving or
obsolete items
 average age of inventory shows the number of days of inventory is held at the
end of the period. It may also highlight overstocking of inventory, or unusual
purchase transactions at the end of the period
 receivable turnover provides an approximate measure of how many times per
year receivables are collected. If the turnover rate is low, the longer the period
of time receivables are held and the less likely they will be collected

Description Formula
Liquidity Ratios
Current ratio Current assets/current liabilities
Acid test Quick assets/current liabilities
Days sales in receivables Accounts receivable/(credit sales/
360 days)
Inventory turnover Cost of sales/average inventory
Working capital to total assets (Current assets – current liabilities)/
total assets
Movement of Current Assets
Receivable turnover Credit sales/average accounts receivables
Average days to collect 360 days/receivable turnover
Days sales in inventory Ending inventory / (cost of goods sold / 360
days)

Operating cycle Average days to collect + average days to sell

Leverage or Solvency Ratios
Debt to equity
Long-term debt to equity
Fixed assets to equity
Times interest earned
Creditors equity to total assets
Fixed assets to long-term debt
Profitability ratios
Return on total assets
Return on equity
Gross margin
Operating margin
Pretax income to sales
Net earnings to sales
Asset Utilization Ratios
Sales to cash
Sales to accounts receivable
Sales to inventories
Total liabilities/shareholders equity
Long-term debt/shareholders equity
(Fixed assets – accumulated
depreciation)/shareholders equity
Income before interest and taxes/interest
expense
Total liabilities/total assets
(Fixed assets – accumulated
depreciation)/long-term debt
(Net earnings + interest expense x
(1 – tax rate))/average total assets
Net earnings/average shareholders’ equity
Gross profit/total sales
Operating income/total sales
Pretax income/total sales
Net earnings/total sales
Total sales/cash
Total sales/accounts receivable
Total sales/inventories
Sales to working capital Total sales/working capital
Sales to fixed assets Sales/(fixed assets – accumulated
depreciation)
Sales to other assets Sales/other assets
Sales to total assets Sales/total assets
Market Measures
Price to earnings ratio Market price per share/(net earnings/number of
common shares)
Dividend yield Dividends per share/market price per share
Dividend payout ratio Dividends per share/earnings per share
 Exhibit 11.1 – Practical Applications
11.500 This exhibit includes practical applications for performing analytical procedures
on an engagement. In almost every cycle, Voyager already includes analytical
procedures. Therefore, this exhibit does not list the procedures, rather it gives
practical considerations the audit team should follow when performing
analytics. Each engagement varies due to the client’s operations, industry, and
environmental factors. As a result, audit teams may need to further tailor any
procedures for the specific situation.

Interest Expense Reasonableness Test

11.501 Reasonableness tests are often the most powerful and precise way to test
interest expense. The audit team computes an expected estimate and then
compares this expectation to the company’s account balance.

11.502 There are some practical considerations for performing a reasonableness test
over interest expense. To perform such a test, the audit team obtains a
calculation of the average loan balance from the client. This calculation should
be disaggregated by month or quarter, as appropriate. The audit team then
should test the validity of the underlying data. This testing varies depending on
the company’s records, but in most cases is possible by tracing the data to
audited general ledger or sub-ledger detail.

11.503 Next, the audit team obtains the applicable interest rate for the interest
expense calculation from the source loan agreement or the prior year
workpapers. Then, the audit team should determine the actual interest rate of
the period from an independent source. If the rate is not verified, the remaining
analytical procedures are invalid.

11.504 The final step is to recalculate the interest expense using the average loan
balance and the verified interest rate. The result is the audit team’s
expectation of the interest expense balance. The audit team compares the
expectation and the balance. If there are any differences, the audit team
should investigate them, including obtaining corroborating evidence and
asking probing question.

Revenue Trend Analysis

11.505 The standards require the audit team to presume that improper revenue
recognition is a fraud risk that must be addressed. An effective way to respond
to this risk is to perform trend analysis analytics.
11.506 To perform these procedures, the audit team should first determine the proper
data to analyze. The more disaggregated the data, the greater the test’s
precision. Examples of ways to disaggregate revenue data are by month,
product line, domestic versus foreign, or all of the above. Then, the auditor
should test the data’s validity. The analytical procedures will not be effective if
the underlying data is skewed, fabricated, or inapplicable. To test the validity
of data, the audit team should either test controls involved in the preparation of
the data (in most cases this is already done as a response to other risks) or
test the schedules themselves by selecting items to verify.

11.507 The team should then develop and document expectations for the current year
balances. When trend analysis is used as a risk assessment procedure, it is
not necessary to document the audit team’s expectations because the implicit
expectation is that the distribution of amounts between periods will remain
constant (i.e., the audit team’s expectation is that the current period trend will
follow the prior period trend). When trend analysis is used as a substantive
procedure, the audit team should document its expectations.

11.508 The audit team should next document the comparison between the
expectation and the entity’s recorded amount. If this comparison isolates
unexpected anomalies, the audit team should perform and document the
additional auditing procedures performed and the results of those procedures.

11.509 Remember, the objective of this test is to overcome the presumption of the risk
of fraud in revenue recognition. As a result, the audit team should corroborate
management’s explanations of anomalies with supporting documentation. This
evidence should be as specific as any other support obtained when performing
revenue procedures. Further, the audit team should also address all of the
anomalies noted. For example, only verifying items above a set scope or
range is not sufficient. Testing a portion of the items identified will not
sufficiently support the assumption that fraud is not present.