Substantive analytical procedures: expectation, threshold and investigation

• Apply the four AU-C 520.05 requirements to a substantive analytical procedure
• Build an independent expectation precise enough to detect material misstatement
• Set the acceptable difference threshold from materiality and assessed risk
• Investigate differences and document results under AU-C 520.07-.08

Analytics that count as evidence

An analytical procedure is an evaluation of financial information through analysis of plausible relationships among financial and nonfinancial data. Used as a substantive procedure, it can replace or reduce tests of details. But a comparison of this year with last year, with "reasonable" written next to it, is not a substantive analytical procedure. AU-C 520 sets four requirements.

The AU-C 520.05 requirements

When performing analytical procedures as substantive procedures, alone or with tests of details, the auditor should:

1. Determine suitability for the assertion, given the assessed risks and any tests of details. Analytics suit large volumes of transactions with predictable relationships, such as interest, payroll, rent and depreciation. They suit cutoff or existence of individual large items poorly.
2. Evaluate the reliability of the data used to develop the expectation, considering its source, comparability, nature and relevance, and the controls over its preparation. Nonfinancial data from operations, such as headcount, units shipped or square footage, needs its own testing.
3. Develop an expectation of recorded amounts or ratios, and evaluate whether it is precise enough to identify a misstatement that, alone or with others, could be material.
4. Determine the acceptable difference without further investigation, and compare recorded amounts with the expectation.

Precision

The application material explains what drives precision:

• Predictability. Gross margin from period to period is more predictable than discretionary spending such as advertising.
• Disaggregation. Monthly amounts are more effective than annual; by location or product line beats company-wide.
• Use with other procedures. A less precise expectation may be acceptable when the analytic is combined with tests of details. When the analytic is the only procedure for an assertion, a more precise expectation is necessary.

An expectation built from the client's budget, or from last year's balance alone, is weak. Build it from independent drivers: rate times volume, square footage times rent per square foot, average debt times rate.

The threshold

The amount of difference you accept without investigation depends on materiality and the desired level of assurance. As assessed risk rises, the acceptable difference falls. In practice firms set it as a portion of performance materiality, smaller for higher risk. Write the threshold down before you compute the difference, so the result does not shape the threshold.

Investigation and documentation

AU-C 520.07 requires the auditor to investigate differences above the threshold by inquiring of management and obtaining audit evidence relevant to the responses, and by performing other procedures as needed. Management's explanation is a lead, not evidence. If the explanation is "more overtime," look at overtime reports.

If you cannot explain the difference, it may be a misstatement, or your expectation may be wrong. Either way the analytic has not given you the assurance planned, and you need tests of details.

AU-C 520.08 requires documentation of the expectation and the factors used to develop it, the results of the comparison, and any additional procedures performed on differences and their results.

The analytical procedures expectation workpaper, the AU-C 520 summary and the guide on building expectations and thresholds support each step.

Common file findings

• Expectation equals prior year with no adjustment for known changes.
• No threshold, or a threshold set after the difference was known.
• Explanations accepted with no corroboration.
• Analytic used as the only procedure for a significant risk when no controls are tested, which AU-C 330.22 does not allow.

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