Risk Assessment: Analyzing Processes and Paperwork
For this part of risk assessment, you use analytical procedures to evaluate audit risk. Put simply, analytical procedures test to see whether plausible and expected relationships exist in both financial and nonfinancial data.
Obviously, the figures shown on a client’s financial statements are financial data. Nonfinancial data includes the client’s overall position in the industry. Another example is how the client goes about achieving company objectives such as marketing, staffing, and opening plants in new locations.
Here are common analytical procedures to do while assessing audit risk:
Trend analysis: You compare current financial figures (such as gross receipts) to the same figures in the prior year. You also compare actual figures to what was in the budget and assess how well the company is doing when compared to similar companies in the same industry.
Ratio analysis: You use ratios. Some common ones are the current ratio, which is Current assets / Current liabilities, and inventory turnover, which is Sales / Average inventory. A quick and easy way to figure average inventory is to add inventory at January 1 to inventory at December 31 and divide the number by two.
Reasonableness: Does what you’re seeing make sense in the light of other facts? For example, does the depreciation expense appear accurate when you consider the book value of all fixed assets on the balance sheet?
Or, if the company has five leased vehicles with a total lease payment of $2,500 per month, would it be reasonable to see an auto lease expense for $50,000? At face value, the answer is no, because $2,500 times 12 months is only $30,000.
But you have to go beyond face value to find out whether any special events happened during the year to cause a legitimate increase in the auto lease expense. For example, maybe the client turned in a leased vehicle early and had to a pay a penalty.