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Analytical Procedures

if the analytical procedures are being performed as a sub- primary purpose of substantive analytical procedures is to
stantive test (method of obtaining corroborating evi- provide evidence as to the validity of an account balance.
dence) or during the final review phase of the audit, in The type and amount of corroboration for the explana-
addition to asking the client, auditors will often generate tion will vary based on factors such as the size of the unex-
their own explanation or ask other members of the audit pected difference, the significance of the difference to the
team for an explanation. overall financial statements, and the risks (e.g., internal
When developing an explanation for an unexpected control and inherent) associated with the account bal-
change in account balances, an auditor considers both ance(s) affected. As any of these factors increase, the relia-
error and nonerror explanations. Nonerror explanations bility of the information obtained in support of the
are sometimes referred to as environmental explanations, explanation should also increase. SAS No. 56 provides
since they refer to changes in the business environment in guidance for auditors in the evaluation of the reliability of
which the client operates. For example, an environmental data. Some of the factors to be considered by the auditors
explanation for an unexpected decline in gross profit (sales include the following:
revenue less cost of sales) may be that the client faces
• Data obtained from independent sources outside the
increasing foreign competition and has been forced to
reduce selling prices. An error explanation, on the other entity are more reliable than data obtained from
hand, might be that the client has failed to record a prof- sources within the entity.
itable sale to a major customer. If this mistake is uninten- • If data are obtained from within the entity, data
tional, then auditors refer to the mistake as an error. obtained from sources independent from the
However, if this mistake was intentional (i.e., the client amount being audited are more reliable.
failed to record the sale on purpose), auditors refer to the
• Data developed under a system with adequate con-
mistake as a fraud. Auditors are much more concerned trols are more reliable than data from a system with
about errors and fraud than changes resulting from envi- poor controls.
ronmental factors. In fact, auditors are most concerned
about fraud, since this raises doubts about the integrity of After an auditor gathers information for purposes of
the client as well as about the process of recording trans- evaluating an analytical procedures explanation, it is a
actions affecting other account balances. matter of professional judgment in determining whether
Once an auditor has a potential explanation, whether the evidence adequately supports the explanation. This is
self-generated or obtained from the client, the next step in one of the most important steps of the analytical proce-
the analytical procedures process is to search for informa- dures process and is referred to as the decision phase of the
tion that can be used to evaluate the adequacy of the process. Factors the auditor should consider in evaluating
explanation. Similar to the explanation generation phase the acceptability of an explanation include the materiality
of the process, the extent of information search and expla- of the unexpected difference, reliability of the evidence
nation evaluation depends on the type of analytical proce- obtained to support the explanation, and whether the
dures being performed. Hirst and Koonce (1996) found explanation is sufficient to explain a material, or signifi-
that during the planning phase of analytical procedures, cant, portion of the unexpected difference. If, after evalu-
auditors do little if any follow-up work to evaluate an ating the evidence, the auditor finds that the explanation
explanation. Instead, consistent with SAS No. 56, audi- being considered does not adequately explain the unex-
tors typically use analytical procedures at the planning pected difference, the auditor should return to the “expla-
stage to improve their understanding of the client’s busi- nation generation” phase of the process. If the auditor
ness and to develop the audit plan for the engagement. believes that the audit evidence obtained adequately sup-
For example, if analytical procedures performed on inven- ports the explanation, the auditor may proceed to the final
tory during audit planning indicated the inventory bal- step of the process, which is documentation. While the
ance was higher than expected, the auditor would most extent of written documentation will vary depending on
likely adjust the audit plan by increasing the number of the materiality of the unexpected difference, the audit
audit tests performed on inventory or assigning more work papers will generally include a written description of
experienced personnel to the audit of inventory. Thus, if material unexpected differences, an explanation for the
an error or fraud has occurred with inventory, the revised difference, evidence that corroborates the explanation,
audit plan for obtaining corroborating evidence will lead and the judgment of the auditor as to the adequacy of the
to detection of the error or fraud. explanation.
If analytical procedures are being performed as a sub- The purpose of this article has been to provide the
stantive test, the auditor will need to gather information reader with a basic understanding of analytical procedures.
to evaluate the explanation being considered, since the For more detailed information, refer to the Statement on

30 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION