What Are Substantive Analytical Procedures?

Substantive analytical procedures are audit tests used to evaluate financial information. They involve an auditor developing an expectation of what a financial account balance or transaction total should be and then comparing it to the company’s recorded amount. This process helps auditors identify potential misstatements by analyzing plausible relationships among both financial and non-financial data. Unlike checking individual transactions, this approach allows auditors to gain assurance that the financial statements do not contain significant inaccuracies and fairly represent the company’s financial position.

Purpose and Placement in an Audit

The purpose of substantive analytical procedures is to detect material misstatements at the assertion level. Management makes assertions, or claims, that their financial data is complete, accurate, and valid, and auditors use these procedures to test those claims. These procedures are one of two main types of substantive tests, the other being tests of details. A test of details involves examining individual transactions or account balances, such as verifying specific invoices or confirming account balances with third parties. In contrast, analytical procedures look at data in the aggregate to identify unusual fluctuations, and auditors may use them as a primary source of evidence or in conjunction with tests of details.

While analytical procedures are used at various stages of an audit, their role as a substantive test is distinct. They are used during the initial risk assessment to identify areas of potential risk and help design further audit procedures. They are also used in the final review stage to help form an overall conclusion on the financial statements.

Common Techniques Used

Auditors employ several techniques to perform substantive analytical procedures.

• Trend analysis compares current financial data with data from prior periods. An auditor might examine a company’s sales revenue on a monthly or quarterly basis for the past three years to identify any unusual spikes or dips in the current year that deviate from the historical trend.
• Ratio analysis compares key financial ratios to historical performance or industry benchmarks. An auditor could calculate the current year’s gross profit margin and compare it to the company’s prior-year margin and the industry average. A significant, unexplained decrease could suggest issues with inventory valuation or revenue completeness.
• Reasonableness testing develops an expectation for an account balance based on non-financial data. For instance, an auditor could estimate a hotel’s room revenue by multiplying the number of rooms by the average occupancy rate and room rate, then comparing that estimate to the recorded revenue.
• Regression analysis models the relationship between two or more variables to predict an outcome. An auditor might use this to predict a company’s sales expense based on its total revenue and the number of salespeople, creating a precise expectation to compare against the recorded amount.

The Auditor’s Execution Process

Executing a substantive analytical procedure follows a structured process.

• Develop an expectation. The auditor must first develop a precise expectation of the recorded amount or ratio before viewing the company’s actual value. The quality of this expectation depends on the auditor’s understanding of the client’s business and industry.
• Define a tolerable difference. The auditor sets the maximum acceptable deviation between their expectation and the company’s recorded number. This threshold is based on professional judgment and the overall materiality set for the audit.
• Compare the expectation to the recorded amount. The auditor directly compares the two figures to determine the variance and evaluates it against the tolerable difference.
• Investigate significant differences. If the identified difference exceeds the tolerable amount, the auditor must investigate. This begins with asking management for an explanation and then corroborating that explanation with other evidence or additional audit procedures, such as tests of details.

Assessing the Suitability and Reliability of Procedures

An auditor must assess if a substantive analytical procedure is suitable for testing a specific financial statement assertion. Some assertions are better tested with these procedures than others. For instance, predicting an entire account balance like revenue through a reasonableness test may be highly effective for the completeness assertion, while a simple trend analysis might be less so. The auditor considers the assessed risks of material misstatement to determine if an analytical procedure alone will provide sufficient evidence.

The procedure’s effectiveness also depends on the plausibility and predictability of the data relationships, which are more reliable in a stable operating environment. For example, the link between production volume and material costs is often predictable in a mature manufacturing business.

The reliability of the underlying data used to develop the expectation is another factor. Auditors must evaluate the source and nature of this information. Data from independent, external sources is considered more reliable than internal client data. If internal data is used, the auditor must consider the effectiveness of the company’s internal controls over that information.

Regulatory Developments

The standards governing these procedures are evolving. In June 2024, the Public Company Accounting Oversight Board (PCAOB) proposed a new standard, AS 2305, Designing and Performing Substantive Analytical Procedures, to replace the existing one. The proposal aims to strengthen and clarify auditor responsibilities. A point of emphasis in the proposed standard is reinforcing the requirement that an auditor develops a precise and independent expectation before comparing it to the company’s recorded amount. This measure is intended to prevent the company’s own numbers from improperly influencing the auditor’s expectation.