Three stages, two of them required
| Stage | Required? | Purpose |
|---|---|---|
| Planning (risk assessment) | Required | Identify unusual relationships and areas of higher risk |
| Substantive testing | Optional | Obtain evidence about an assertion directly |
| Final review | Required | Overall conclusion — do the statements make sense as a whole? |
The four steps of a substantive analytical procedure
- Develop an expectation — the more precise and independent, the better
- Define a tolerable difference — how much variance is acceptable without investigation
- Compare the expectation to the recorded amount
- Investigate significant differences and corroborate management's explanations with evidence
IMPORTANT: Management's explanation for a fluctuation is never sufficient by itself — the auditor must corroborate it with other evidence.
What makes analytics effective
- The relationship is plausible and predictable (e.g., commissions to sales, payroll to headcount, interest expense to average debt)
- Data is reliable — external or subject to effective controls
- Income statement relationships are generally more predictable than balance sheet relationships (they cover a period rather than a point in time)
- Stable, mature businesses are more predictable than volatile or rapidly changing ones
EXAMPLE: Sales rose 30% but the gross margin percentage was unchanged and receivable days jumped from 45 to 78. That combination is a classic signal of possible fictitious revenue or channel stuffing — the auditor should extend testing rather than accept a general management explanation.