When accountants are engaged to review financial statements, the guidance provided by SSARS 1 indicates that analytical procedures should be designed to idenrify relationships and individual items that appear to be unusual, and consist of reviewing financial statements for comparable prior period(s), comparing financial statements with anticipated results, if available, and a study of the relationships of the elements of the financial statements that would be expected to conform to a predictable pattern based on the entity's experience.

Analytical procedures vary depending on the industry of the client, the nature and materiality of the accounts involved, financial data available, and the auditor's or accountant's experience with the client. However, judgment is always a factor and is required in selecting the data to be used, identifying relationships, and reaching conclusions.

The Nature of Analytical

Procedures

Analytical procedures consist of evaluations of financial information, which are made by studying plausible relationships among financial and non-financial data, and range from simple comparisons to the use of complex models involving many relationships and elements of data. Analytical procedures involve comparisons of recorded amount, or ratios developed from recorded amounts, and expectations developed by the auditor and accountant. Sources of information for developing expectations in engagements, either individuality or as a combination of factors, are as follows:

* Financial information for comparable prior period(s) giving consideration to known changes. Expectations can be established of current year's income and expenses based on prior year historical data, adjusted for any anticipated or known increases or decreases, compared with current year data.

* Anticipated results--the comparison of the financial statements with expected results. Expectations could be developed from budgets or forecasts, including extrapolations from interim or annual data and compared to recorded results.

* Relationships among elements of financial information within the period. For example, the accountant might consider the interaction of related accounts, such as property, plant, and equipment and depreciation expense, and other accounts such as maintenance and repairs.

* Information regarding the industry in which the client operates. Expectations of gross margin could be developed using industry-wide statistics for particular product lines, which are then compared to financial results for the year.

* Relationship of financial information with relevant nonfinancial information. Expectations can be developed utilizing square footage of selling space, volume of goods produced, labor costs related to labor hours worked, and similar information for application of the relationships.

SAS 56 does not require the use of any specific analytical procedures. It states that for some entities procedures may consist of reviewing changes in account balances from prior to current year using the general ledger or the auditor's preliminary or unadjusted trial balance. For other entities, procedures may involve an extensive analysis of quarterly financial statements. The sophistication, extent and timing of the procedures used are based on the auditor's judgment, and may vary depending on the size and complexity of the client. SAS 56 also indicates that analytical procedures are used in the various stages of an audit, and in the following manner:

* During the planning stage analytical procedures are used to assist the auditor in planning the nature, timing, and extent of other auditing procedures that will be used to obtain evidential matter for specific account balances or classes of transactions. The analytical procedures used in planning the audit should focus on enhancing the auditor's understanding of the client's business and the transactions and events that have occurred since the last audit date, and in identifying areas that may represent specific risks relevant to the audit. Thus, the objective of analytical procedures is to identify the existence of unusual transactions and events, and amounts, ratios and trends that might indicate matters that have financial statement and audit planning ramifications.

* During the conduct of substantive tests, analytical procedures are used to obtain evidential matter about particular assertions related to account balances or classes of transactions. The decision to utilize analytical procedures to achieve a particular audit objective is based on an auditor's judgment of the expected effectiveness and efficiency of the available procedures. The expected effectiveness and efficiency of an analytical procedure in identifying potential misstatements depends on, among other things:

1. The nature of the assertion;

2. The plausibility and predictability of the relationship;

3. The availability and reliability of data used to develop the expectations; and

4. The precision of the expectation.

In planning the analytical procedures in substantive testing, consideration should be given to the amount of differences from the expectation that can be accepted without further investigation, after establishing materiality and consistent levels of assurance desired from the procedures. Significant unexpected differences should be evaluated and corroborated with management's responses to inquiries. If explanations cannot be obtained, then sufficient evidence about the assertion should be obtained by performing other procedures to determine whether the difference is a likely misstatement; recognizing that such unexplained differences may indicate an increased risk or material misstatement.

Using analytical procedures as part of substantive testing should not be misconstrued as obtaining some overall comfort level that there are no material errors in the financial statements. SAS 56 makes it quite clear that analytical procedures in the substantive phase are to be specifically designed to be effective in detecting errors in amounts that would be material to the financial statements.

* During the final review stage of an audit, analytical procedures are used as an overall review to assist the auditor in assessing the conclusions reached and in the evaluation of the overall financial statement presentation. A wide variety of analytical procedures may be useful for this purpose. The overall review generally includes reading financial statements and the notes thereto, in addition to considering:

1. The adequacy of evidence gathered in response to unusual or unexpected balances identified in planning the audit or in the course of the audit; and

2. Unusual or unexpected balances or relationships that were not previously identified. Results of an overall review may indicate that additional evidence may be needed.

Utilizing analytical procedures provides knowledge of existing conditions and events and identifies possible misstatements by highlighting unusual or unexpected amounts. In small business engagements simple comparisons and ratios are generally effective. The objective is to identify the absence of expected relationship or the presence of unexpected relationships. The results of analytical procedures performed are generally evaluated against an entity's prior historical information and against industry averages. Various analytical procedures are utilized and some examples follow.

Trends. Analyzing account fluctuations by comparing current year to prior year information and, also, to information derived over several years.

Reasonablesness. Test are made by reviewing the relationship of certain account balances to other balances for reasonableness of amounts. Examples of accounts that may be reasonably tested are:

1. Interest expense against interest bearing obligations;

2. Sales discounts and commissions against sales volume; and

3. Rental revenues based on occupancy of premises.

Ratios. Analysis by computation of ratios includes the study of relationships between financial statement amounts. Common ratios are used for the following:

1. Elements of income or loss as a percentage of sales;

2. Gross profit;

3. Accounts receivable;

4. Inventory;

5. Profitability, leverage, and liquidity.

Once analytical procedures are used, results may turn up unfavorable. If that is the case, the auditor is required to apply additional procedures, and make further inquiry of management, which should then be corroborated with other evidential matter. Accounting schedules and or analyses for the explanations of the fluctuations should be completed to satisfy the auditor or accountant as to whether the differences are a likely misstatement. Documentation of those procedures performed should be made to support the conclusions reached.