Analytical procedures (ISA 520)

A client's sales fall by 20% as the budget expected, but cost of sales stays exactly where it was last year, and receivables double. No test of details has been done yet, and three red flags are already visible. That is what analytical procedures do: they use relationships in the figures to show where the auditor should look hard and where the figures look sound.

Used well, they save time at planning, give evidence during the audit and act as a safety net at the end.

This topic covers when analytical procedures are used, what ISA 520 says, the comparisons and relationships an auditor uses, the limits of ratio analysis, how to use analytical procedures as a substantive test, how to investigate unusual results, the common ratios, and how to answer an exam question on them. The previous topic covered substantive procedures in general, and the next applies them to non-current assets.

Key terms in plain English

Syllabus check

This topic is in syllabus area C, audit evidence and substantive procedures (25% of marks). It covers:

• analytical procedures: nature, purpose and use
• the application of ratios in audit planning, evidence and review
• investigation of unusual fluctuations

CAMA 2020 and analytical procedures

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.

The rules in more depth

When analytical procedures are used

1. At the planning stage (ISA 315), to gain a better understanding of the client and its business and to identify areas of high audit risk, so that audit procedures can be aimed at them.
2. At the end of the audit, in the overall review, to help the auditor form a conclusion on whether the financial statements are consistent with the auditor's understanding of the entity. ISA 520 requires this.
3. As a substantive procedure during the audit, in the work on the income statement and the statement of financial position, to look for misstatement during the audit instead of at the final review.

ISA 520 deals with the second and third uses.

The nature of analytical procedures

ISA 520 defines analytical procedures as evaluations of financial information through analysis of plausible relationships among both financial and non-financial data. They include the investigation of identified fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount. They include:

• Comparisons of the entity's financial information with: comparable information for prior periods; anticipated results, such as budgets or forecasts, or the auditor's own expectations, such as an estimate of depreciation; and similar industry information, such as the ratio of sales to receivables compared with industry averages or with similar-sized entities.
• Relationships among elements of financial information that should follow a predictable pattern based on experience, such as gross margin percentages, and between financial and non-financial information, such as payroll costs to the number of employees.

If a ratio is unusually high or low, or a trend changes unexpectedly, one of the two figures may be abnormally high or low. The oddity can be checked in more detail. If key ratios are close to expectations, the auditor may take that as evidence that the balances or transactions are reliable. If a ratio differs greatly from expectation, the auditor must find the reason.

There may be a good business reason, or there may be a misstatement.

The comparisons

After the calculations, the auditor looks for unexpected relationships and asks management for explanations.

Limitations of ratio analysis

• Its usefulness depends on the quality of the underlying information. The auditor usually calculates ratios from the management accounts, which are more detailed than the financial statements.
• Information must be calculated on a consistent basis for comparison.
• The two figures in a ratio must be logically related.
• The auditor must understand the client's business to see what a ratio means or why it differs, for example between one year and the next.

Using analytical procedures as substantive tests

ISA 520 requires the auditor to:

1. decide whether the analytical procedures are suitable for the assertions, that is, how well they would detect a particular kind of material misstatement;
2. develop an expectation of recorded amounts or ratios and judge whether the expectation is precise enough to identify a misstatement;
3. evaluate the reliability of the data used to develop the expectation; and
4. decide what difference from expected amounts is acceptable without further investigation.

Analytical procedures normally give supplementary evidence, and it is not normally appropriate to base the conclusion on them alone. They support, or possibly contradict, the results of other, more specific tests. The precision of an expectation depends on how predictable the relationship is.

A relationship in a stable, high-volume business with a steady cost structure, such as payroll against headcount, gives a more precise expectation than a comparison with last year's profit in a business that is changing. The more precise the expectation, the more assurance it gives. The more significant the risk, the less the auditor can rely on analytical procedures alone.

Investigating fluctuations and relationships

If the auditor finds fluctuations or relationships that are inconsistent with other information, or differences from expected amounts that are not acceptable, ISA 520 requires the auditor to ask management and verify the answers, and perform other audit procedures as needed. The calculations are only part of the process, and they point to where more work may be needed.

If the usual gross profit is 20% and nothing is expected to change, a 20% result needs no further work. But if the auditor knows the business has changed in a way that should change the margin, and the margin is still 20%, there must be an enquiry. The enquiries involve using other audit evidence to explain the result and asking management for explanations.

Because oral explanations are not very reliable evidence, they must be confirmed by further audit work.

Example: Numero

Planning the audit of Numero for the year ended 31 December 20X4, revenue was budgeted to fall by 20%. The information is: revenue ₦400,000 (20X3 ₦500,000); cost of sales ₦300,000 (₦300,000); expenses ₦20,000 (₦50,000); trade receivables ₦60,000 (₦30,000).

• Revenue fell by the expected 20%, so no unexpected movement.
• Cost of sales stayed constant although revenue fell. Cost of sales should move with revenue. Put another way, the gross profit percentage has dropped from 40% to 25%. This may mean cost of sales is overstated or revenue understated.
• Expenses fell by 60%. This could be due to the fall in revenue, or to a misallocation between cost of sales and expenses.
• Receivables days rose from 22 days to 55 days. This may show a change in credit terms to attract customers as sales fall, or that some debts are not recoverable and need an allowance.

Common ratios

Using particular ratios

Payroll. Look at total payroll cost each month and in the same months of previous years. Changes should be reasonable, allowing for pay rises, changes in workforce and starters and leavers. Or measure the average monthly or annual pay per employee and compare it with other months or years. Unexpected changes are investigated.

Other expenses. Compare expenses to revenue. Unusual changes in the ratio of cost of sales to sales, or of distribution, selling and administration costs to revenue, are investigated.

Working capital. Days' sales outstanding and the inventory turnover period help show whether receivables and inventory balances are reasonable, or whether sales and purchases figures look right.

Analytical procedures in the exam

A question may give draft figures and ask the candidate to carry out analytical procedures. It tests whether you can identify unusual features, suggest how to investigate them and give possible explanations.

The usual unusual items are:

• sales up sharply but cost of sales down
• a big change in gross profit margin
• a big movement in administrative expenses, selling and distribution costs, interest costs or investment income
• a big change in net profit margin

A good answer calculates the ratios, states the change, gives two possible explanations (one innocent, one a possible error) and says what the auditor would do.

Ratios as warning signs

Limits and good practice

Analytical procedures are cheap and can cover a whole account. But they are weaker than tests of details when the risk is high, when the relationship is unstable or when the data cannot be relied on. The auditor documents the expectation, the source and reliability of the data, the threshold for investigation, the comparison, the explanations and the work done to verify them.

Where the analysis relies on client data, the auditor tests it for completeness and accuracy first.

Worked examples

1. This year.
   120 ÷ 730 × 365 = 60 days.
   Last year: 70 ÷ 700 × 365 = 36.5 days.
2. The jump needs an explanation: a change in credit terms, slow payers needing an allowance, or inflated year-end sales.

1. Average pay per head moved from ₦50,000 to about ₦61,400, a rise of 23% for 5 more staff.
2. The auditor asks about overtime, bonus, arrears or a possible phantom employee, and checks the payroll to the records.

1. Expected ₦20 million; recorded ₦12 million, a shortfall of ₦8 million.
2. If the tolerable difference is ₦2 million, the gap is too big and needs investigation, such as fully depreciated vehicles or an error in the calculation.

1. The unchanged margin is itself unexpected.
2. The auditor checks sales mix, cost allocation and closing inventory instead of accepting the ratio.

How to score full marks

• Calculate before you comment, and show the figures.
• Give both an innocent and an error explanation.
• Say what the auditor would do next.
• Remember that analytical procedures support other evidence and do not replace it.

Common mistakes in the exam

• Listing ratios without interpretation.
• Relating figures that have no logical link.
• Accepting management's answer without verification.
• Saying analytical procedures alone are enough for a high-risk area.

Quick revision

• Planning, substantive, overall review.
• Compare to prior years, budgets, industry, branches.
• Expectation, reliability of data, acceptable difference.
• Enquire, verify, do other procedures.

Practice questions

Questions 1 to 10 are multiple choice. Questions 11 to 13 are written. Try each before opening the answer.

Model answers

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