A colleague of mine wrote this. I hope you find it informative -
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Applying Prospective Financial Analysis to the Preliminary Analytical Review
By Alex Vuchnich, CPA, CFE
http://www.profitcents.com
With the official release of SSARS No. 17, attest standards have once again reflected the trend that there is an increasing emphasis on what types of analytical procedures should be performed in a review engagement and how those procedures should be documented. Recently the risk assessment standards and SAS 99 have both placed increased emphasis on the need to perform more effective analytical techniques in both planning and performing the engagement. Traditional techniques used in preliminary analytical review have consisted primarily of period to period comparisons of account balances and key financial ratios. Firms that have developed niche practices typically will also identify the key drivers for their niche and use available economic or industry data to supplement the analytical review process. However this traditional analytical review framework is primarily founded on the concept that the prior year's results are an effective benchmark for developing expectations about current year financial activity.
Although I do not dispute the importance of scanning current year and prior year amounts on the trial balance and financial statements as a procedure to orient the auditor during planning, the question is whether this procedure alone is effective enough. If this is the main preliminary analytical technique performed during planning, then it is essential that it is highly effective not only in providing context for evaluating the account balances but also in developing expectations about relationships between financial statement accounts. Ratio analysis is intended to provide a simple means for relating financial statement elements, but with the emphasis on prior period comparison I believe the effectiveness of this technique has been impaired. The simplistic nature of ratio analysis can work against us. Many times we get caught up in trying to explain away a variance noted in comparing ratios for two periods and end up missing out on gaining an understanding of what financial statement relationship should be present. In order for the analysis to be effective, what we need to do is develop analytics that are predictive in nature (forward-looking) so that we can establish a reasonable basis for expectations about what the account balances should be. I propose that we need an analytical framework that incorporates prospective financial analysis into the historical trend analysis that has been the cornerstone of our analytical review process.
Traditional analytical review techniques are usually premised under the assumption that prior year activity is representative of current year expectations. In many cases this logic stands up. If there are no significant changes in a company's operations or external factors to consider, then expecting the status quo is reasonable. For companies that have reached maturity in their business life cycle, historical trend analysis can be a very effective tool for analytical review. Certain revenue and expense accounts also tend to exhibit behavior that is predictable based on historical trends. Again in mature companies, payroll expense may follow predictable trends, such as annual increases for raises, or the ever present increasing trend in the cost of health insurance. But all too often in practice we typically find ourselves looking at financial data that has changed dramatically from prior periods. In this situation a new model for analytical review needs to be applied in order to develop meaningful expectations about account balances.
In identifying an appropriate model for analysis, one place we can look to is our clients' internal financial management tools. The officers of a business regularly adjust their strategic and operational goals. In making these adjustments they must rely on forecasts and projections to understand the implications of policy changes to the enterprise. Underlying a forecast is the assumption that certain relationships in the financial statements should exist. There is a definite relationship between forecasts and ratio analysis. Ratio analysis attempts to express a financial relationship in a simplistic fashion, expressing the relationship as a single number. A forecast however, takes a known relationship and attempts to quantify an expectation based on the preparer's best judgment about what is likely to occur. A benefit of this type of analysis is that it is largely based on our own independent professional judgments. Essentially the auditor can develop an independent budget and sales forecast for the company based on their knowledge of financial accounting and then compare the results to actual. Although this approach does introduce subjectivity into the analytical review process, it is inherently a more systematic and objective approach to developing expectations about the financial statements when compared to period comparisons and horizontal financial analysis.
In order to systematically develop expectations using a forecast it is beneficial and necessary to have a model to work from. One method of developing this type of forecast is the sales growth driven model. To prepare a sales growth driven forecast, the accountant starts by developing an expectation about sales for the period. Historical time series analysis can be a good predictor for this. Also many industry specific drivers exist that can also be applied in making this initial assumption. The client's actual sales will also be an important factor here. Once an independent forecast has been developed the auditor needs to evaluate that in the context of actual sales reported by the client. Any major variances must be dealt with before proceeding with the remainder of the analysis. Since sales are the primary driver for the analysis, any significant variance here will result in a forecast that is no longer comparable to what is portrayed on the client's financials.
Once sales have been forecasted, cost of goods sold can be backed into based on gross margin percentage and trends in expense accounts can be developed. For the balance sheet, the relationship for many accounts will be tied directly to sales or cost of goods sold. Typically we expect certain turnover relationships between revenue and accounts receivable, inventory, fixed assets and payables. Once the capital needs associated with fixed assets have been identified we can develop expectations about what sort of financing would be needed to maintain the forecasted sales level. In many cases trend analysis can be applied to this approach in quantifying what the applicable driver for various relationships should be. For instance regression analysis can be applied to historical accounts receivable turnover in forecasting the accounts receivable expectation. Many other factors can be tied into this type of forecast such as principal and interest payment amounts from loan amortization schedules or depreciation expense from fixed asset software projections. Finally, cash can be calculated using the indirect cash flow method to determine the change in cash from the prior period.
One ramification to the audit process that must be considered when using this approach to analytical review is that revenues must be evaluated much earlier in the engagement than probably has been traditionally the case. Since revenues represent a key driver in much of the forecast, if there are any significant variances or unusual relationships noted here it will have a pervasive impact throughout the analysis. In many ways accelerating the analysis of material revenue accounts towards the earlier risk assessment stages of the engagement is a vast improvement over the practice of leaving this testing until the end of the engagement. The emphasis under this model is on understanding the risk and expectations around revenue recognition in the planning stages of the engagement. Testing of revenue can still be postponed until later in the fieldwork but any significant adjustments for revenue deferrals, receivables or other accruals needs to be fully considered up front and ideally estimated if the calculation cannot be made until a later point in the engagement.
By integrating this type of approach into your analytical review process, a thorough understanding of where unexpected or unusual relationships in the financial statements can be obtained. Although traditional historical comparisons are still necessary as a starting point for analytical review, applying a projection model to develop independent expectations is essential for properly planning a meaningful engagement.