Analytical procedures are essential tools in the auditing process, used to evaluate financial information by analyzing plausible relationships among both financial and non-financial data. When the results of these procedures reveal unexpected discrepancies or variances, auditors must investigate further to determine their cause. This investigation helps identify potential errors, fraud, or misstatements in financial statements. The International Standards on Auditing (ISA) 520 outlines the role of analytical procedures and provides guidance on how to investigate unusual findings. This article explores the steps involved in investigating the results of analytical procedures, common causes of discrepancies, and best practices for auditors in addressing these issues.
1. Understanding Analytical Procedures in Auditing
Analytical procedures involve comparing financial data against expectations derived from historical trends, industry benchmarks, or other relevant sources to identify unusual variations that may indicate potential issues.
A. Purpose of Analytical Procedures
- Risk Assessment: Analytical procedures are used during the planning phase to identify areas of potential risk and focus audit efforts.
- Substantive Testing: They are also used as substantive procedures to gather audit evidence regarding the accuracy of financial data.
- Final Review: Analytical procedures help auditors perform a final review of financial statements to ensure they are free from material misstatement.
- Example: An auditor compares current year revenue to prior years and notices an unexplained spike in sales for the last quarter, prompting further investigation.
B. Types of Analytical Procedures
- Trend Analysis: Comparing financial data across multiple periods to identify patterns or anomalies.
- Ratio Analysis: Examining relationships between financial statement items (e.g., gross margin, liquidity ratios) to detect inconsistencies.
- Reasonableness Tests: Developing expectations based on non-financial data or industry benchmarks and comparing them to recorded amounts.
- Example: The auditor performs ratio analysis on inventory turnover rates and notices a significant decline, prompting further review of inventory valuation procedures.
2. Steps for Investigating the Results of Analytical Procedures
When analytical procedures reveal unexpected variances or discrepancies, auditors must follow a structured approach to investigate and resolve these issues.
A. Identifying and Prioritizing Unusual Variances
- Determine Materiality: Assess whether the identified variance is material to the financial statements and warrants further investigation.
- Prioritize High-Risk Areas: Focus on variances in high-risk areas such as revenue recognition, inventory valuation, or related-party transactions.
- Example: The auditor identifies a material increase in accounts receivable turnover without a corresponding increase in revenue, indicating a potential issue with receivables management.
B. Developing Hypotheses for Discrepancies
- Consider Plausible Explanations: Develop potential explanations for the variance, such as changes in business operations, accounting policies, or external factors.
- Evaluate Internal Controls: Assess whether deficiencies in internal controls could have contributed to the discrepancy.
- Example: The auditor considers whether the unexpected drop in gross margin could be due to changes in supplier pricing, product mix, or accounting errors.
C. Gathering Additional Evidence
- Inquiry with Management: Discuss the variance with management and request explanations or supporting documentation.
- Substantive Testing: Perform additional substantive procedures, such as detailed transaction testing, to verify the accuracy of the financial data.
- Review Documentation: Examine supporting documents like contracts, invoices, or board meeting minutes to corroborate management’s explanations.
- Example: The auditor requests sales contracts and shipping documents to verify management’s explanation for the sudden increase in revenue.
D. Evaluating the Sufficiency and Appropriateness of Evidence
- Assess Reliability: Determine whether the evidence obtained is sufficient and reliable to support or refute the initial variance identified.
- Consider Alternative Explanations: If the evidence does not fully explain the discrepancy, consider alternative causes or perform further testing.
- Example: The auditor finds that management’s explanation for the increase in revenue is unsupported by documentation, prompting further investigation into potential revenue manipulation.
E. Documenting and Communicating Findings
- Document Investigation Procedures: Maintain detailed documentation of the analytical procedures performed, discrepancies identified, and investigative steps taken.
- Communicate with Management: Share findings with management and those charged with governance, particularly if discrepancies remain unresolved or indicate control deficiencies.
- Example: The auditor documents the investigation into unusual revenue growth and communicates concerns about revenue recognition practices to the audit committee.
3. Common Causes of Discrepancies Identified Through Analytical Procedures
Discrepancies identified through analytical procedures can arise from various sources, including legitimate business changes, accounting errors, or fraudulent activities.
A. Legitimate Business Changes
- Operational Changes: Changes in business operations, such as expansion into new markets or changes in product offerings, can cause expected variances.
- Economic Factors: External factors like market trends, inflation, or currency fluctuations can impact financial results.
- Example: A company’s revenue increases significantly due to the successful launch of a new product line, explaining the variance in sales growth.
B. Accounting Errors
- Data Entry Mistakes: Manual errors in recording transactions can lead to discrepancies in financial data.
- Incorrect Application of Accounting Standards: Misapplication of accounting principles, such as revenue recognition or expense capitalization, can result in financial misstatements.
- Example: The auditor discovers that a decline in gross margin is due to the incorrect classification of direct costs as operating expenses.
C. Fraudulent Activities
- Revenue Manipulation: Management may overstate revenue by recording fictitious sales or recognizing revenue prematurely.
- Expense Understatement: Deliberately understating expenses to inflate profits is a common form of financial statement fraud.
- Example: The auditor identifies inflated revenue figures due to the recording of sales to non-existent customers, prompting further investigation into potential fraud.
4. Best Practices for Investigating Analytical Procedure Results
To effectively investigate discrepancies identified through analytical procedures, auditors should adopt best practices that ensure thorough analysis and reliable conclusions.
A. Use Multiple Analytical Techniques
- Combine Different Procedures: Use a combination of trend analysis, ratio analysis, and reasonableness tests to gain a comprehensive understanding of financial data.
- Example: The auditor uses both trend analysis and ratio analysis to investigate unexpected changes in profitability and liquidity metrics.
B. Incorporate Non-Financial Data
- Cross-Check with Operational Data: Compare financial results with non-financial data, such as production volumes or customer satisfaction metrics, to identify inconsistencies.
- Example: The auditor compares sales revenue with shipping logs and inventory levels to verify that recorded sales correspond to actual deliveries.
C. Maintain Professional Skepticism
- Question Management Explanations: Approach management’s explanations with skepticism and seek corroborating evidence to support claims.
- Example: The auditor requests supporting documentation for management’s explanation of an increase in accounts receivable turnover, rather than accepting the explanation at face value.
D. Adjust Audit Approach Based on Findings
- Expand Substantive Testing: If analytical procedures reveal unexplained discrepancies, adjust the audit plan to include more detailed substantive procedures.
- Reassess Risk Assessment: Update the risk assessment and audit strategy based on the results of the investigation.
- Example: The auditor identifies unexpected variances in expense accounts and expands substantive testing to include a larger sample of transactions.
The Role of Investigating Analytical Procedure Results in Auditing
Investigating the results of analytical procedures is a critical step in the auditing process, helping auditors identify potential errors, fraud, or misstatements in financial reporting. By following a structured approach to investigating discrepancies, auditors can determine whether variances are due to legitimate business changes, accounting errors, or fraudulent activities. Best practices such as using multiple analytical techniques, incorporating non-financial data, and maintaining professional skepticism ensure that investigations are thorough and reliable. Ultimately, effective investigation of analytical procedure results supports accurate financial reporting, enhances audit quality, and strengthens the integrity of the financial statements.