Auditors often perform inspections of their clients’ financial statements and tax filings, known as audits, to identify errors and ensure accuracy. Analytical procedures guide them through the auditing process and help them determine whether the documents have the correct information. These tests point out potential problems and help auditors take steps to resolve them. In this article, we discuss analytical procedures in accounting and list seven types and examples of analytical procedures auditors use to confirm the precision of figures and calculations.
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What are analytical procedures in accounting?
Analytical procedures are formulas and processes that compare financial data to non-financial data in order to determine relationships between the two. Examples of non-financial data that can affect an organization’s financial statements and taxes include contract compliance, energy consumption and the percentage of women in leadership positions. Companies can benefit from tax breaks if they meet certain qualifications regarding these issues, and they must follow specific protocols to maintain eligibility.
Analytical procedures also help auditors investigate variations in figures that have shown consistency in the past or do not correlate with other values. If a long-term client, for instance, reports a substantial change in income, the auditor may research the origin of the additional funding to make sure it comes from a legitimate source and reflects valid information about the client’s financial state. Auditors use three types of analytical procedures, and each serves a different purpose. They include:
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Preliminary analytical review: Auditors conduct risk assessments, known as preliminary analytical reviews, to plan and time their strategies for conducting an initial analysis.
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Substantive analytical procedures: Auditors use substantive analytical procedures to gather information and determine if they need to conduct substantive testing. Sometimes, they can use analytical methods alone to come to a conclusion.
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Final analytical review: Auditors use final analytical reviews at the end of the audit to review their work and check for inaccuracies. If they find errors, they complete the risk assessment process again.
7 examples of analytical procedure methods
Here are some methods auditors use during analytical procedures:
1. Efficiency ratio analysis
One type of ratio analysis involves comparing line items on a financial statement to assess them for concerns such as liquidity, profitability and efficiency. Auditors calculate ratios and map them over an extended period. This helps them identify trends and view the organization’s financial status over several years or fiscal periods so that they can ensure a consistent financial status. If the auditor notices that financial reports during a single period fall above or below the trend, they can research further to identify and resolve the issue.
Example: Brian compared his clients’ assets and liabilities for the most recent fiscal year with those reported by his clients during the five years prior. The first client’s liabilities and assets followed the trend established during the previous years, so Brian confirmed that these aspects of the company’s finances remained stable. When analyzing his second client, he noticed a significant change in their assets and liabilities from previous years. However, he knows that the company recently changed their accounts receivable policies, so he expected the change.
2. Industry comparison ratio analysis
Auditors also use another type of ratio analysis, called industry comparison, to examine these ratios. This process involves the calculation of the same ratios for companies in the same industry to ensure their client’s values are similar or higher than other companies.
Example: Brian wanted to make sure a retail client’s finances compared to other companies of the same size in the retail industry. He performed an industry comparison and found that the elements of his client’s financial status closely matched those of the others, which indicated good financial health.
3. Other ratio analysis methods
Here are other types of ratio analysis methods auditors use:
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Coverage ratios: This method determines the ability of a company to cover its debts.
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Leverage ratios: This technique determines the debt load the business has incurred.
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Market value ratios: This approach assesses the current share price of the company’s stock.
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Liquidity ratios: This method measures the ability of a company to pay off short-term debts.
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Profitability ratios: This approach measures the ability of a company to earn a profit.
4. 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 the distribution of the data points, auditors can identify potential problems and help their clients resolve them.
Example: Brian used revenue and cost analysis to create a trend line for his client. The trend line recorded revenue over the previous five years and revealed that sales had remained steady.
Other reasons to conduct revenue and cost analysis include:
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Estimating future results for budgeting purposes
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Assessing trends in sales by customer or target market
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Checking for expenditures that require investigation
5. Investment trend analysis
The other type of trend analysis, called investment analysis, is more a part of investment strategy than an auditing method, but it can still affect a company’s financial decisions. Investment analysis tracks the 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.
6. Reasonableness test
Auditors conduct reasonableness tests to confirm the validity of a company’s transactions, balances and other financial events. They determine reasonableness based on the information provided on two or more sources of data. If the auditor notices possible inaccuracies, they address them with the client.
Example: Brian used the reasonableness test to make sure his client’s cost of goods reflects their revenue. He found his client had a significantly higher revenue compared to their cost of goods and goods sold, so he worked with the client to determine the cause of the discrepancy. Further auditing revealed an error on the company’s financial statement, which Brian fixed.
7. Regression analysis
Auditors 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, auditors 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: Brian performed a regression analysis on past financial statements to determine how a client’s debts, revenue and cost of goods affected their account balance. Based on the correlation between these factors and the reported account balance in years prior, Brian could use the client’s current debts, revenue and cost of goods to predict their account balance.
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