PERFORMANCE MEASUREMENT ENHANCES ANALYTICAL PROCEDURES

By Barbara A. Waddington, Keith A. Moreland, and Thomas Lillie

Performance measurement requires an understanding of a company’s goals, objectives, strategies, and operations in order to identify and evaluate measures that inform management about issues necessary to align its future activities with its strategies. The level of sophistication of the current management information system affects the design and implementation of performance measurement. This focus on developing, improving, and assuring the relevance and reliability of financial and nonfinancial measurements will contribute to the success of the business. These measures often constitute relevant nonfinancial information, an important source for developing analytical expectations according to SAS No. 56, Analytical Procedures. Often, such nonfinancial information provides alternative, independent measures of business or economic events that will be reflected in the financial statements.

The attention to detail given to creating hierarchical, or cascading, performance measures fosters a high level of precision in analytical procedures conducted at a later date. In cascading systems, measures at any level are supported by the aggregation of measures at the next level of detail. Familiarity with this system enhances projections for analytical review.

Audit Planning

Performance measurement promotes a thorough understanding of the business by identifying aspects of its operations that drive performance: purchasing, inventory management, production, sales and marketing, product or service quality and delivery, customer satisfaction, cash management, credit and collections, capital asset acquisition and maintenance, financing, and product and process development. This analysis reveals measurable activities and results, such as customer satisfaction rates, defect rates, productivity per unit of scarce resource, and sales backlog.

During the audit planning stage, focus on these measurable activities provides a systematic framework to identify specific audit risk areas. Measures of warranty claims, past-due customer accounts, machine down-time, value of inventory, and accounts receivable can identify areas of high audit risk.

Substantive Testing

Many of the measurable activities and results handled in performance measurement are closely related to financial statement amounts. Performance measurement provides an additional source for precise estimates of expected of financial statement amounts. SAS No. 56 makes clear that the effectiveness of analytical procedures in detecting existing misstatements improves with knowledge of the business and precise analytical expectations.

Moreover, the information used for developing analytical expectations increases in validity with direct knowledge of the performance measurement system’s reliability. A more reliable performance measurement system will provide more assurance that the information generated for analytical review is reliable. The result will be greater confidence in analytical review procedures, more precise analytical expectations, and increased likelihood of detecting existing misstatements.

To use information from performance measurement to develop precise expectations of an amount requires the identification and understanding of the relationships between measurable activities and financial statement amounts. For example, in a traditional income statement fluctuation analysis, the auditor might compare current year compensation expense with prior year compensation expense, investigating if the difference exceeds a predetermined dollar and percentage threshold. This analysis, however, does not detect an account balance change that should have occurred but did not. Regression or nonstatistical analysis could determine the financial and nonfinancial measures that impact compensation expense and could be used in a predictive model. Variables could include sales, compensation, benefits per employee, number of employees, employee turnover, and productivity by department.

Comparison of recorded compensation expense to the estimate generated by the model provides additional validity because the latter is created from information independent of the financial statement amount.

Overall Review

The comprehensiveness and precision of performance measurement facilitate the overall review of the financial statements. Analytical procedures in the overall review help 1) determine the adequacy of evidence gathered in response to previously identified amounts that are considered unusual and 2) detect other unexpected amounts. The review is integrative in nature: The reasonableness of recorded amounts is compared to other recorded amounts. For example, performance measurement information about a change in the product defect rate or the number of warranty claims, along with sales volume, could provide evidence regarding the reasonableness of an unexpected balance in a product warranty liability.

Financial Statement Reviews

Analytical procedures and management inquiries are the primary methods of gathering evidence for a financial statement review. The analytical procedures conducted in a review include—