AS 1095 Requirements for Substantive Analytical Procedures

Auditing Standard 2305 is a rule from the Public Company Accounting Oversight Board (PCAOB) that guides auditors of public companies on using substantive analytical procedures. These procedures are a type of test used to gather evidence about the accuracy of financial information by comparing recorded data to expectations developed by the auditor. The standard is based on the premise that plausible relationships among data are expected to exist and continue unless specific conditions cause them to change. Auditors use this framework to identify potential misstatements and ensure the evidence gathered is both relevant and reliable.

Developing a Plausible Expectation

The initial step in performing a substantive analytical procedure is developing a plausible expectation. This is the auditor’s prediction of a company’s recorded account balance or ratio, and it must be formed before looking at the company’s actual numbers. The objective is to create a benchmark precise enough to identify a difference that could signal a material misstatement, which is an error significant enough to influence a user’s decisions.

To form this expectation, auditors draw upon various information sources. This includes analyzing financial information from prior periods to identify trends, while considering known business changes like acquisitions. Auditors also use company-prepared information like budgets and forecasts, comparing them to historical performance and industry trends. The process must be independent, as auditors cannot simply use the company’s recorded amount as their starting point.

A part of developing a robust expectation involves linking financial data to relevant nonfinancial information. For instance, an auditor might develop an expectation for revenue by analyzing the number of units produced or shipped and multiplying that by the average sales price. Similarly, for a company with debt, an auditor could calculate an expected interest expense by applying interest rates to the outstanding principal balances.

The effectiveness of the procedure hinges on the quality of this expectation. The standard requires the auditor to have a sufficient basis for believing the relationship used to form the prediction is both plausible and predictable. This involves a deep understanding of the company, its operations, and the broader economic environment.

Assessing the Reliability of Data

The quality of evidence from an analytical procedure depends on the reliability of the underlying data used to form the expectation. Auditors must formally assess this data to ensure it is accurate, complete, and relevant before performing their calculations.

The source of the data is a primary consideration. Information from independent, external sources, like government economic data, is more reliable than data generated internally by the company. When using client-produced data, auditors must evaluate the internal controls over its preparation to ensure its integrity.

Auditors also consider the comparability of the information. When using historical data, the auditor must assess if changes in business operations, accounting principles, or the economy make past results an unreliable predictor. The information must also logically relate to the account being tested.

Finally, the auditor must understand how the data was captured and processed. This may involve testing the controls over the company’s information technology systems to ensure they function correctly and produce complete data. Without this assurance, the resulting analytical procedure is less persuasive.

Investigating Significant Differences

Once the auditor has developed an expectation and compared it to the company’s recorded amount, the focus shifts to investigating any significant differences. The process begins by determining the threshold for what constitutes a “significant difference,” often called the tolerable difference. This amount is set during the planning phase and is influenced by the overall materiality for the audit, with any variance exceeding it requiring investigation.

The investigation begins with inquiries directed at company management. The auditor will ask management to provide explanations for the observed difference, as they are closest to the operations and can provide context for unexpected fluctuations. For example, if revenues were significantly higher than expected, management might explain that a large, one-time sale occurred.

Management’s explanations alone are not sufficient audit evidence. The standard requires the auditor to obtain corroborating evidence to support the reasons provided. Following the previous example, the auditor would need to examine the sales contract, shipping documents, and subsequent cash receipts to confirm the transaction was legitimate and recorded correctly.

If management is unable to provide a reasonable explanation, or if the corroborating evidence does not support their explanation, the auditor must consider the possibility of a misstatement. The unexplained difference itself could represent an error. In this situation, the auditor would expand testing, potentially performing more detailed tests of the underlying transactions to quantify any potential misstatement and determine its impact on the overall financial statements.

Required Audit Documentation

To comply with AS 2305, auditors must maintain specific documentation in their audit workpapers for any substantive analytical procedure performed. This documentation serves as the primary record of the work done and the conclusions reached, allowing for review by others. The standard is explicit about what must be recorded to ensure the procedure is properly supported.

The workpapers must clearly state the expectation developed by the auditor, including the specific factors and data used in its development. This includes identifying data sources and the rationale for why the relationships were considered plausible.

The documentation must also show the results of the comparison between the auditor’s expectation and the client’s recorded amount. This includes the actual amounts for both values and the calculated difference between them. If the comparison resulted in a significant difference, the auditor must document the additional auditing procedures performed in response, including the ultimate conclusion that resolved the matter.