Analytical review can be defined as the study of relationships between element of financial information expected to conform to a predictable pattern based on the organization’s experience and between financial information and non-financial information.
Under analytical review information is compared with comparable information for prior records with anticipated results and with information relating to similar organizations.
In an actual case, analytical review can be applied by examining: -
- Increases in magnitude corresponding to inflation
- Changes in amounts consequent on changes in output levels
- Comparison with previous periods
- Trends and ratios
- Comparisons with budgets and forecasts
- Comparisons with other similar organizations e.g. inter-firm comparison
The Timing of Analytical Review Techniques
This will be applied throughout the audit but the specific occasions will include:
- At the planning stage: at this stage the auditors will hope to identify areas of potential risk or new developments so that he can plan his other audit procedures in these areas.
- During the audit as a substantive procedure for obtaining audit evidence: modern audits with their emphasis on efficiency and economy depend heavily on analytical review as a valid audit technique used alone on in conjunction with the internal control reliance and substantive testing. It can be reasonable to obtain assurance of the completeness, accuracy and validity of transactions and balances by analytical review as by other types of audit evidence. E.g. if the relative amounts under different expense headings repeat the pattern of previous years, the auditor will have evidence of the accuracy of expense invoice coding.
- At the final review stage of the audit: analytical review techniques can provide support for the conclusions arrived at as a result of other work. E.g. indications from external sources that profit margins have declined by 10% may support the declined profit figure in a segment of the company whose figures have audited by other means and found to be correct. The techniques are also used to assess the overall reasonableness of the financial statements taken as a whole.
Extent of use analytical review procedures
The factors which might affect the extent of use of analytical review include:
- The nature of the entity and its operations: e.g. a long established chain of similar shops which changed little in the period under review will offer many opportunities for analytical review to be used as a primary source of audit evidence. Conversely a newly established manufacturer of high-tech products will not provide such an opportunity.
- Knowledge gained from previous audits of the enterprise: the auditors will have experience of those areas where errors and difficulties arose and those areas of greatest audit risk.
- Management’s own use of analytical review procedures: if management has a reliable system of budgetary control then the auditors will have already made source of explanation for variances. If management uses information that has been subjected to internal audit review, the reliability of that information is enhanced. If the staff who produce the information are competent and have integrity again the reliability of information is enhanced.
Availability of non-financial information to back up financial information
- The cost effectiveness of the use of analytical review in relation to other forms of evidence: in general analytical review is cheap but requires high quality staff. Some techniques can be expensive if they involve statistical techniques.
- Availability of staff: analytical review requires high quality staff with much intelligence, experience and training.
The auditor’s procedures:
- Identify the factors likely to have an effect on items in the accounts
- Ascertain or assess the probable relationship between these factors and the items.
- Predict the value of the item in the light of the factors.
- Compare the predicted value with the actual recorded amount.
- Consider the implications of significant fluctuations, unusual items, or relationships that are unexpected or inconsistent with evidence from other sources. Similarly consider the implications or predicted fluctuations that fail to occur.
- Discuss with management any significant variations therefore management will usually have an explanation for the variation. Seek independent evidence to support management explanations.
- React to significant fluctuations or unexpected values. The auditors reaction depends on the stage of the audit at which he is carrying out analytical review. If at the planning stage- plan suitable detailed substantive tests. If during the audit-then further audit tests will be indicated. All fluctuations and unexpected values must be fully indicted and sufficient audit evidence obtained.
- As with all audit work analytical review procedures should be fully documented in the working papers. Files should include:-
- The information examined with detailed calculations and explanations ofinfluences expected.
- The management explanation of significant fluctuation
- The verification of these explanations
- The conclusions drawn by the auditor
- Details of further tests if any
Please note the following:
- Any relationship perceived between variables must be plausible ie the relationship found should be reasonable and relevant to audit objectives. E.g. debtors and sales have a plausible relationship but there’s no plausible relationship between selling expenses and work in progress (W.I.P.) in a manufacturing account.
- Also note that the nature of analytical review includes the comparison over time and the use of past experience on the audit therefore it is desirable for the auditor to build up a picture of the organisation and the relationship between magnitudes in the permanent audit files.
- Materiality is very important thus those areas not judged to be material, the auditor will very often rely wholly on analytical review to conclude. But material areas require a combination of compliance testing, analytical review and detailed substantive testing.
Analytical review in practice:
- The auditor will always establish a trend analysis most common trend analysis being a 5-year side-by-side balance sheet and detailed profit and loss account.
- A trend analysis of key profit and loss figures within the year under review such as a monthly summary of the sales and related expenses.
- Ratio analysis: for the profit and loss account growth in percentage terms of key figures will be worked out.
The figures will also be compared with the budget with variations being expressed maybe in percentage terms. The previous years figures may also be put alongside. Gross profit margin is also a figure that is worked out along the same lines. Gross profit margin will be compared to that of the previous year and that of the budget usually the Gross profit margin is expected to be steady. If it has fluctuated significantly then the components that make up the Gross profit figure particularly sales, purchases and closing stocks are further investigated.
The proportion to sales of those items that have a plausible relationship with sales is worked out. These could include selling and distribution expenses such as advertising and motor vehicle running expenses.
If industry averages are available the organisation’s figures are also compared to those averages.
Balance sheet ratios that are usually considered:-
- Fixed Assets (FA):
(i) The utilisation of FA’s is usually worked out. This is: Turnover
To determine how much sales are generated for every shilling invested in FA’s. It is normally called the FA turnover ratio.
(ii) Global depreciation ratio is also worked out which involves taking the NBV of the FA’s divided by the depreciation charge in the profit and loss account. The resultant figure gives a rough estimate of the average remaining useful life of the assets. Too big a figure indicating that maybe the rates of depreciation used are too low.
The percentage increase is calculated and is compared with the corresponding percentage increases in purchases. If the two increases do not correspond, it may indicate that the provision for obsolescence is inadequate.
The stock turnover ratio is also worked out. To ensure that we’re comparing like with like, the cost of sales figure is used and not the sales figure. A slowing down turnover ratio may also indicate that the provision for obsolescence is also inadequate therefore it would appear that the demand for the products of the organisation may be diminishing.
The percentage increase in debtors is worked out and this is compared with the percentage increase in turnover. It is usually being expected that an increase in turnover ordinarily should have a corresponding increase in debtors. Debtors to sales ratio is also worked out to determine the number of days sales in debtors. This number of days is compared with the normal allowed credit period. It measures the effectiveness of credit control and consequently the adequacy provision for bad and doubtful debts.
- Liquidity ratios are then worked out, the most common of which are:
- The current ratio
- The acid test ratioFor cash at bank an additional measure is consideration of the overdraft limit for trade creditors. The percentage increase is worked out and compared with the increase in the cost of sales. Also the number of days purchases in creditors worked out to measure the difference between credit taken and credit allowed by suppliers.
- The gearing ratio is worked out to measure the company’s exposure or the cost of external capital to the organisation.