ANALYTICAL REVIEW-ISA 520 - Financial Auditing - Business Writing Services

Analytical review can be defined as the study of relationships between element of financialinformation expected to conform to a predictable pattern based on the organization’s experienceand between financial information and non-financial information.

Under analytical review information is compared with comparable information for prior recordswith anticipated results and with information relating to similar organizations.

In an actual case, analytical review can be applied by examining: -

1. Increases in magnitude corresponding to inflation 2. Changes in amounts consequent on changes in output levels 3. Comparison with previous periods 4. Trends and ratios 5. Comparisons with budgets and forecasts 6. Comparisons with other similar organizations e.g. inter-firm comparison

The Timing of Analytical Review Techniques

This will be applied throughout the audit but the specific occasions will include:

1. At the planning stage: at this stage the auditors will hope to identify areas of potentialrisk or new developments so that he can plan his other audit procedures in these areas. 2. During the audit as a substantive procedure for obtaining audit evidence: modernaudits with their emphasis on efficiency and economy depend heavily on analytical review as avalid audit technique used alone on in conjunction with the internal control reliance andsubstantive testing. It can be reasonable to obtain assurance of the completeness, accuracyand validity of transactions and balances by analytical review as by other types of audit

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ANALYTICAL REVIEW-ISA 520 - Financial Auditing - Business Writing Services

evidence. E.g. if the relative amounts under different expense headings repeat the pattern ofprevious years, the auditor will have evidence of the accuracy of expense invoice coding. 3. At the final review stage of the audit: analytical review techniques can provide supportfor the conclusions arrived at as a result of other work. E.g. indications from external sourcesthat profit margins have declined by 10% may support the declined profit figure in a segment ofthe company whose figures have audited by other means and found to be correct. Thetechniques are also used to assess the overall reasonableness of the financial statements takenas a whole.

Extent of use analytical review procedures

The factors which might affect the extent of use of analytical review include:

1. The nature of the entity and its operations: e.g. a long established chain of similarshops which changed little in the period under review will offer many opportunities for analyticalreview to be used as a primary source of audit evidence. Conversely a newly establishedmanufacturer of high-tech products will not provide such an opportunity. 2. Knowledge gained from previous audits of the enterprise: the auditors will haveexperience of those areas where errors and difficulties arose and those areas of greatest auditrisk. 3. Management’s own use of analytical review procedures: if management has a reliablesystem of budgetary control then the auditors will have already made source of explanation forvariances. If management uses information that has been subjected to internal audit review, thereliability of that information is enhanced. If the staff who produce the information are competentand have integrity again the reliability of information is enhanced. 4.

Availability of non-financial information to back up financial information

5. The cost effectiveness of the use of analytical review in relation to other forms ofevidence : in general analytical review is cheap but requires high quality staff. Sometechniques can be expensive if they involve statistical techniques. 6. Availability of staff: analytical review requires high quality staff with much intelligence,experience and training.

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ANALYTICAL REVIEW-ISA 520 - Financial Auditing - Business Writing Services

The auditor’s procedures:

1. Identify the factors likely to have an effect on items in the accounts 2. Ascertain or assess the probable relationship between these factors and the items. 3. Predict the value of the item in the light of the factors. 4. Compare the predicted value with the actual recorded amount. 5. Consider the implications of significant fluctuations, unusual items, or relationships thatare unexpected or inconsistent with evidence from other sources. Similarly consider theimplications or predicted fluctuations that fail to occur. 6. Discuss with management any significant variations therefore management will usuallyhave an explanation for the variation. Seek independent evidence to support managementexplanations. 7. React to significant fluctuations or unexpected values. The auditors reaction depends onthe stage of the audit at which he is carrying out analytical review. If at the planning stage- plansuitable detailed substantive tests. If during the audit-then further audit tests will be indicated.All fluctuations and unexpected values must be fully indicted and sufficient audit evidenceobtained. 8. As with all audit work analytical review procedures should be fully documented in theworking papers. Files should include:-

1. The information examined with detailed calculations and explanations ofinfluencesexpected. 2. The management explanation of significant fluctuation 3. The verification of these explanations 4. The conclusions drawn by the auditor 5. Details of further tests if any

Please note the following:

- Any relationship perceived between variables must be plausible ie the relationship foundshould be reasonable and relevant to audit objectives. E.g. debtors and sales have a plausiblerelationship but there’s no plausible relationship between selling expenses and work in progress(W.I.P.) in a manufacturing account. - Also note that the nature of analytical review includes the comparison over time and theuse of past experience on the audit therefore it is desirable for the auditor to build up a pictureof the organisation and the relationship between magnitudes in the permanent audit files. - Materiality is very important thus those areas not judged to be material, the auditor willvery often rely wholly on analytical review to conclude. But material areas require a combinationof compliance testing, analytical review and detailed substantive testing.

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ANALYTICAL REVIEW-ISA 520 - Financial Auditing - Business Writing Services

Analytical review in practice:

1. The auditor will always establish a trend analysis most common trend analysis being a5-year side-by-side balance sheet and detailed profit and loss account. 2. A trend analysis of key profit and loss figures within the year under review such as amonthly summary of the sales and related expenses. 3. Ratio analysis: for the profit and loss account growth in percentage terms of key figureswill be worked out.

The figures will also be compared with the budget with variations being expressed maybe inpercentage terms. The previous years figures may also be put alongside. Gross profit margin isalso a figure that is worked out along the same lines. Gross profit margin will be compared tothat of the previous year and that of the budget usually the Gross profit margin is expected to besteady. If it has fluctuated significantly then the components that make up the Gross profit figureparticularly sales, purchases and closing stocks are further investigated.

The proportion to sales of those items that have a plausible relationship with sales is workedout. These could include selling and distribution expenses such as advertising and motorvehicle running expenses.

If industry averages are available the organisation’s figures are also compared to thoseaverages.

Balance sheet ratios that are usually considered:-

- Fixed Assets (FA):

(i) The utilisation of FA’s is usually worked out. This is: Turnover

                                                                                             FA (NBV)

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ANALYTICAL REVIEW-ISA 520 - Financial Auditing - Business Writing Services

To determine how much sales are generated for every shilling invested in FA’s. It is normallycalled the FA turnover ratio.

(ii) Global depreciation ratio is also worked out which involves taking the NBV of the FA’sdivided by the depreciation charge in the profit and loss account. The resultant figure gives arough estimate of the average remaining useful life of the assets. Too big a figure indicating thatmaybe the rates of depreciation used are too low.

- Stocks:

The percentage increase is calculated and is compared with the corresponding percentageincreases in purchases. If the two increases do not correspond, it may indicate that theprovision for obsolescence is inadequate.

The stock turnover ratio is also worked out. To ensure that we’re comparing like with like, thecost of sales figure is used and not the sales figure. A slowing down turnover ratio may alsoindicate that the provision for obsolescence is also inadequate therefore it would appear that thedemand for the products of the organisation may be diminishing.

- Debtors:

The percentage increase in debtors is worked out and this is compared with the percentageincrease in turnover. It is usually being expected that an increase in turnover ordinarily shouldhave a corresponding increase in debtors. Debtors to sales ratio is also worked out to determinethe number of days sales in debtors. This number of days is compared with the normal allowedcredit period. It measures the effectiveness of credit control and consequently the adequacyprovision for bad and doubtful debts.

- Liquidity ratios are then worked out, the most common of which are: - - The current ratio - The acid test ratioFor cash at bank an additional measure is consideration of the overdraft

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ANALYTICAL REVIEW-ISA 520 - Financial Auditing - Business Writing Services

limit for trade creditors. The percentage increase is worked out and compared with the increasein the cost of sales. Also the number of days purchases in creditors worked out to measure thedifference between credit taken and credit allowed by suppliers.

- The gearing ratio is worked out to measure the company’s exposure or the cost of externalcapital to the organisation.

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