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Preliminary Analytical Review Procedures in a Financial Statement Audit
6 Key Things You Need to Know!
If you’re responsible for conducting audits of privately-held entities under auditing standards generally accepted in the United States of America (U.S. GAAS), there are some key considerations pertaining to performing preliminary analytical review procedures during planning.
Keep in mind that AU-C Section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement, specifies that our risk assessment activities should include analytical procedures.
Well-designed preliminary analytical review procedures are based on appropriate expectations of plausible relationships can be very effective in identifying risks of material misstatement (RMM) during the risk assessment process in audit planning. However, because preliminary analytical review procedures are ideally performed early in the process, the analytical procedures may use information that is aggregated at a relatively high-level (i.e., recent interim financial statements or, if financial statements are not available, a general ledger or trial balance). Information aggregated at a relatively high-level is appropriate at this stage of the audit because the intent of the audit engagement team is to identify potential audit issues or risks, and not reach a conclusion on the reasonableness of a specific balance. Accordingly, audit engagement teams need to consider the results of preliminary analytical review procedures along with other information gathered in identifying the risks of material misstatement.
Here are six factors to be aware of:
Prior Knowledge of the Client’s Industry and Business Operations
Knowledge of audit clients’ operations and the industry in which they operate in is strongly linked to the effective use of analytical procedures for audit planning and assessing risk.
Engagement teams are expected to understand a client's business and industry and to know what relationships could be expected to exist, what relationships would be considered unusual or unlikely, and what plausible explanations might exist for observed relationships, prior to performing preliminary analytics.
Preliminary analytical review procedures might include reviewing changes in account balances from the prior to the current year using the client’s internal financial statements or a grouped trial balance or analysis of ratios or trends related to profitability, liquidity, solvency, and activity.
Identification of Potential Risks in an Audit
Analytical review procedures, among other procedures used in the planning stage only need to be designed to identify audit areas with unusual or unexpected relationships that may be indicative of potential risks and material misstatements, thus needing linkage and consideration of impact on the audit plan by the engagement team. In the audit of companies with simple operations, simple comparisons and ratios are ordinarily effective, whereas in more complex engagements the engagement team may need to make use of complex mathematical or statistical models such as ratio or trend analysis.
Consideration of Revenue
In addition to the requirement in AU-C 315 to perform analytical procedures as part of risk assessment procedures, AU-C 240, Consideration of Fraud in a Financial Statement Audit, requires that, to the extent they are not already included, analytical procedures should include procedures related to revenue recognition. Audit engagement teams perform preliminary analytical review procedures related to revenue to identify unusual or unexpected relationships that may indicate fraudulent financial reporting.
Use of Interim Financial Information
When audit engagement teams are using interim financial information for their preliminary analytical review, keep in mind certain factors, such as seasonal trends, that might be considered in making comparisons. For example, if the audit engagement team is using information as of the end of November and the client's business is highly seasonal with substantial activity in December; a straight annualization of interim information will not provide a meaningful comparison. Sometimes, particular accounting methods may make comparisons less meaningful such as if the client uses the LIFO inventory method; comparison of gross profit ratios might be improved by restoring LIFO reserves before computing the ratio. Audit engagement teams should also be aware of the possibility of events such as strikes or changes in production methods that influence comparability.
Bring Professional Skepticism to the Assessment
Audit engagement teams should avoid making mechanical computations and comparisons when documenting their preliminary analytical review. We encourage audit professionals to bring in as much skepticism, creativity and insight to the assessment as possible.
In the audits of most recurring clients, audit engagement teams likely have a sufficient understanding of the client and its operations to judgmentally consider the expected relationships. The audit engagement team will need to document these expectations based on their knowledge of the client, the industry, the economy and current discussions with management.
Included below are some examples of unusual or unexpected relationships and possible risks that may exist for audit engagement teams to consider:
| Unusual or Unexpected Relationships | Potential Implications to the Audit |
|---|---|
| Increased sales with decreased inventories | Improper revenue recognition, theft of inventory, inventory valuation issues, physical inventory observation errors, etc. |
| Decreased sales with increased receivables | Uncollectible receivables |
| Decreased compensation expense with increase in sales | Payroll accrual recognition issues, improper cost allocation issues, etc. |
| Increased net income with decreased cash flows | Uncollectible receivables, going concern issues, sales or expense cut-off issues, etc. |
| Increased payables with decreased inventory | Going concern issues, payable defalcation schemes, physical inventory observation errors, theft of inventory, etc. |
| Unusual increases in miscellaneous income | Revenue classification issues, improper revenue recognition or customer deposits, etc. |
| Unusual items in operating expenses | Issues in expense classification, improper expensing of capital acquistions, missappropriation of assets, etc. |
Documentation Requirements
Documentation of preliminary analytical review procedures must be sufficient to provide linkage to the audit engagement team's risk assessment. The results of the preliminary analytical review ordinarily are documented using a narrative memorandum, comparative carry forward schedule, or other combination thereof. The documentation should address how the engagement team: (a) developed their expectations, (b) compared their expectations to the client’s actual amounts to see if they were met or not, and (c) selected which balance sheet and income statement accounts require audit attention. One common form of documentation is referred to as a “flux analysis.” A flux analysis is a narrative explanation by financial statement caption or line item of the change in the amount from the prior period and of any unusual or unexpected relationships to other financial statement line items in the current period. Although a flux analysis is not required by standards, it’s recommended as a convenient means of documenting the thought process of the audit engagement team.
Collemi Consulting has significant expertise with respect to the performance of preliminary analytical review procedures in a financial statement audit. Contact us so we can assist with the process and help ensure that you’ll able to comply withProfessional Standards.
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