What are Analytical Procedures?

Analytical procedures are a type of evidence used during an audit. These procedures can indicate possible problems with the financial records of a client, which can then be investigated more thoroughly. Analytical procedures involve comparisons of different sets of financial and operational information, to see if historical relationships are continuing forward into the period under review. In most cases, these relationships should remain consistent over time. If not, it can imply that the client’s financial records are incorrect, possibly due to errors or fraudulent reporting activity.

Characteristics of Analytical Procedures

Here are the key characteristics of analytical procedures:

Comparison-based analysis. Analytical procedures often involve comparing current financial data with prior periods, industry averages, budgets, or other benchmarks. This comparison helps identify trends, inconsistencies, or anomalies that may indicate errors or areas requiring further analysis.
Focus on relationships. Analytical procedures emphasize understanding the relationships within financial data, such as the relationship between sales and cost of goods sold. By examining these relationships, auditors can detect inconsistencies or potential misstatements.
Risk assessment tool. Analytical procedures are commonly used in the planning phase of an audit to assess risk and determine areas of focus. They help auditors understand the business environment, identify significant transactions, and evaluate areas that may need additional scrutiny.
Efficient methodology. Analytical procedures can be a cost-effective method for identifying areas that require deeper analysis. By highlighting irregularities early, they can reduce the time and effort needed for a detailed audit, allowing auditors to focus resources where they’re needed most.

Analytical procedures are an integral part of the auditing process, especially useful in the planning and review stages, where they help auditors make informed decisions on risk areas, enhancing the effectiveness and efficiency of the audit.

Examples of Analytical Procedures

There are many examples of analytical procedures. We provide several below:

Compare the days sales outstanding metric to the amount for prior years. This relationship between receivables and sales should remain about the same over time, unless there have been changes in the customer base, the credit policy of the organization, or its collection practices. This is a form of ratio analysis.
Review the current ratio over several reporting periods. This comparison of current assets to current liabilities should be about the same over time, unless the entity has altered its policies related to accounts receivable, inventory, or accounts payable. This is a form of ratio analysis.
Compare the ending balances in the compensation expense account for several years. This amount should rise somewhat with inflation. Unusual spikes may indicate that fraudulent payments are being made to fake employees through the payroll system. This is a form of trend analysis.
Examine a trend line of bad debt expenses. This amount should vary in relation to sales. If not, management may not be correctly recognizing bad debts in a timely manner. This is a form of trend analysis.
Multiply the number of employees by average pay to estimate the total annual compensation, and then compare the result to the actual total compensation expense for the period. The client must explain any material difference from this amount, such as bonus payments or employee leave without pay. This is a form of reasonableness test.

The Materiality of Analytical Procedure Differences

Auditors need to consider the level of variability from expectations that will be accepted without taking matters to the client for an explanation. This level of allowable variability is driven by the amount of assurance that the auditors want to obtain from the procedures. When making this consideration, the auditor must consider whether a combination of misstatements in certain account balances could sum to a difference that is no longer acceptable.

Discussing Procedure Differences with the Client

When the results of analytical procedures are materially different from expectations, the auditor should discuss them with management. A certain amount of skepticism is needed when having this discussion, since management may not want to spend the time to delve into a detailed explanation, or may be hiding fraudulent behavior. Management responses should be documented, and could be valuable as a baseline when conducting the same analysis in the following year.