Nature and Purpose: Since routine checks cannot be depended upon to disclose all the mistakes or manipulation that may exist in accounts, certain other procedures also have to be applied. These collectively are known as overall tests. As stated earlier, with the passage of tests, analytical procedures have acquired lot of significance as substantive audit procedure. AAS-14 on Analytical Procedures discusses the application of analytical procedures during an audit. “Analytical procedures” means the analysis of significant ratios and trends, including the resulting investigation of fluctuations and relationships that are inconsistent with other relevant information or which deviate from predicted amounts. Analytical procedures include the consideration of comparisons of the entity’s financial information with, for example:

  •  Comparable information for prior periods.
  • Anticipated results of the entity, such as budgets or forecasts.
  • Predictive estimates prepared the auditor, such as an estimation of depreciation charge for the year.
  •  Similar industry information, such as a comparison of the entity’s ratio of sales to trade debtors with industry averages, or with other entities of comparable size in the same industry.

Analytical procedures also include consideration of relationships:

  •  Among elements of financial information that would be expected to conform to a predictable pattern based on the entity’s experience, such as gross margin percentages.
  • Between financial information and relevant non-financial information, such as payroll costs to number of employees.Various methods may be used in performing the above procedures. These range from simple comparisons to complex analyses using advanced statistical techniques. Analytical procedures may be applied to consolidated financial statements, financial statements of components (such as subsidiaries, divisions or segments) and individual elements of financial information. The auditor’s choice of procedures, methods and level of application is a matter of professional judgement. Analytical procedures are used for the following purposes:
  1.  to assist the auditor in planning the nature, timing and extent of other audit procedures;
  2. as substantive procedures when their use can be more effective or efficient than tests of details in reducing detection risk for specific financial statement assertions; and
  3.  as an overall review of the financial statements in the final review stage of the audit.

For instance, establishing the relationship that exists between certain balances included in the Balance Sheet and the Profit and Loss Account and comparing them with those that existed between the same set of balances in the previous years reconciling the physical balances of assets with the relevant financial record; obtaining of account from the bankers, customers and creditors and reconciling with relevant balances in books of account; confirming amounts of outstanding income and expenses preparing reconciliation statements, etc. These are helpful in the detection of unusual state of affairs and mistakes in accounts. For example if on comparison of the gross profit ratio with that of the previous year, it is discovered that there has been fall in the ratio, it would be necessary for the auditor to make further enquiries. These may reveal that this was the result of pilferage of stocks, misappropriation of a part of the sale proceeds or a change in the cost of sales without a corresponding increase in the sales price.

Likewise, on verifying the balances of sundry debtors and creditors obtaining the confirmation of their statements of account, it will be possible for the auditor to find out whether the discrepancy in the balance of a debtor is due to the failure to debit his account with the cost of goods supplied to him or is the result of non-adjustment of a remittance received from him. Also whether in the case of a creditor, the discrepancy is due to failure to afford him credit for one or more consignments of goods supplied him or failure to debit him with an amount of remittance. Similarly, taking stocks of raw materials and stores at the end of the year any excesses or shortages therein shall be detected. The investigation of their causes might disclose that the shortages were the result of a misappropriation of stock or that the excess were due to requisitions having been entered before the stocks were issued.

Similarly, reconciling the amounts of interest and dividends collected with the amounts which had accrued due and that which are outstanding for payment, the mistake, if any, in the adjustment of such an income would be detected. The overall tests can be extended for making a inter-firm and intra-firm comparison of trading results. For example, if balances included in the trading account of an entity are compared with those contained in the trading account for the same period of another entity engaged in the same trade and working under similar circumstances, it would be possible to find out the cause of the variation in the rate of profitability that exists. Similarly, it would also be possible to compare the balances on the trading account with that of the previous period, it would be possible to find out the reasons for increase or decrease in the amount of profits of those years. By setting up certain expenses ratios on the basis of balances included in the trading account, for the year under audit, comparing them with the same ratios for the previous year, it is possible to ascertain the extent of increase or decrease in various items of expenditure in relation to sales and that of gross profit in relation to sales. If differences are found to be material, the auditor would ascertain the reasons thereof and assess whether the accounts have been
manipulated to inflate or suppress profits.

An abnormal fall in the cost of manufacture or that in the administrative cost, apart from economy in expenses, there could be no provision or less provision for expenses incurred in the year. When it is suspected, the auditor should compare the entries in the outstanding book with those in the previous year. He must also check the vouchers for one month immediately before the close of the following years. To verify that none of the expenses in the accounts under audit have been charged to the accounts of the following years. Often it is possible to independently verify the correctness of some of the items of expenses included in the trading account. For instance the cost of importing goods which are subjected to an ad valorem duty at uniform rate can be verified from the amount of duty paid. Similarly, a quantity of sugar a mill sold can be verified independently from the amount of excise duty paid. Similarly, the amount of any income or expenses which has a direct relationship with the amount of profits or that of sales can be verified independently, e.g., commission paid to a manager calculated on the basis of net profits, commission paid to a selling agent as percentage of sales, etc. Such calculation of ratios, trends and comparisons is also termed as analytical review.

Analytical Procedures in Planning the Audit: The auditor should apply analytical procedures at the planning stage to assist in understanding the business and in identifying areas of potential risk. Application of analytical procedures may indicate aspects of the business of which the auditor was unaware and will assist in determining the nature, timing and extent of other audit procedures. Analytical procedures in planning the audit use both financial and non-financial information, for example, the relationship between sales and square footage of selling space or volume of goods sold. Analytical Procedures in the Overall Review at the End of the Audit: The auditor should apply analytical procedures at or near the end of the audit when forming an overall conclusion as to whether the financial statements as a whole are consistent with the auditor’s knowledge of the business. The conclusions drawn from the results of such procedures are intended to corroborate conclusions formed during the audit of individual components or elements of the financial statements and assist in arriving at the overall conclusion as to the reasonableness of the financial statements. However, in some cases, as a result of application of analytical procedures, the auditor may identify areas where further procedures need to be applied before the auditor can form an overall conclusion about the financial statements.

Extent of Reliance on Analytical Procedures: The application of analytical procedures is based on the expectation that relationships among data exist and continue in the absence of known conditions to the contrary. The presence of these relationships provides audit evidence as to the completeness, accuracy and validity of the data produced the accounting system. However, reliance on the results of analytical procedures will depend on the auditor’s assessment of the risk that the analytical procedures may identify relationships as expected when, in fact, a material misstatement exists.
The extent of reliance that the auditor places on the results of analytical procedures depends on the following factors:

  1.  materiality of the items involved, for example, when inventory balances are material, the auditor does not rely only on analytical procedures in forming conclusions. However, the auditor may rely solely on analytical procedures for certain income and expense items when they are not individually material;
  2.  other audit procedures directed toward the same audit objectives, for example, other procedures performed the auditor in reviewing the collectibility of accounts receivable, such as the review of subsequent cash receipts, might confirm or dispel questions raised from the application of analytical procedures to an ageing schedule of customers’ accounts;
  3.  accuracy with which the expected results of analytical procedures can be predicted. For example, the auditor will ordinarily expect greater consistency in comparing gross profit margins from one period to another than in comparing discretionary expenses, such as research or advertising; and
  4.  assessments of inherent and control risks, for example, if internal control over sales order processing is weak and, therefore, control risk is high, more reliance on tests of details of transactions and balances than on analytical procedures in drawing conclusions on receivables may be required.

The auditor will need to consider testing the controls, if any, over the preparation of information used in applying analytical procedures. When such controls are effective, the auditor will have greater confidence in the reliability of the information and, therefore, in the results of analytical procedures. The controls over non-financial information can often be tested in conjunction with tests of accountingrelated controls. For example, an entity in establishing controls over the processing of sales invoices may include controls over the recording of unit sales. In these circumstances, the auditor could test the controls over the recording of unit sales in conjunction with tests of the controls over the processing of sales invoices.

Investigating Unusual Items: When analytical procedures identify significant fluctuations or relationships that are inconsistent with other relevant information or that deviate from predicted amounts, the auditor should investigate and obtain adequate explanations and appropriate corroborative evidence. The investigation of unusual fluctuations and relationships ordinarily begins with inquiries of management, followed by:

  1.  corroboration of management’s responses, for example, comparing them with the auditor’s knowledge of the business and other evidence obtained during the course of the audit; and
  2.  consideration of the need to apply other audit procedures based on the results of such inquiries, if management is unable to provide an explanation or if the explanation is not considered adequate.
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