Page 182 - COSO Guidance Book

Expectation formulation

AU-C section 520 requires the auditor to form an expectation whenever substantive analytical procedures
are performed. The more precise the expectation (the closer the auditor’s expectation is to the correct
balance or relationship), the more effective the procedure will be in identifying potential misstatements.
The effectiveness of the procedure is a function of the following:

 The nature of the account or assertion and the auditor’s assessment of the risk of material
misstatement — For example, if controls over payroll processing are deficient, the auditor may need
to perform more extensive tests of details for assertions related to compensation expense. The
auditor considers factors such as product mix, stability of the environment, accounting changes, and
economic and industry factors in predicting the balance of an account. Increasing the number of
relevant factors increases the precision of the expectation. For example, an expectation of new car
sales that considers interest rates, unemployment rates, and average age of used cars would be
more precise than one for which only unemployment rates were considered in its formulation.
Precision is also enhanced if expectations are made under stable economic conditions. Expectations
for income statement accounts are more precise than those formed from balance sheet accounts;
income statement relationships are often more predictable.
 Characteristics of the data — The more disaggregated the data, the more precise the expectation (for
example, weekly versus annual sales data or product category of inventory versus total inventory
data). Data developed under a strong system of internal control is more reliable than data developed
under a weak system of internal control. Data from independent sources is more reliable than internal
data. Also, reliable nonfinancial data (such as retail store square footage) and data that has been
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subjected to auditing procedures improve precision.
 Types of expectations — These include trend analysis, ratio analysis, reasonableness testing, and
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regression analysis.

Trend analysis
Trend analysis is the analysis of changes in account balances over time. This technique is appropriate
in a stable environment when the account or relationship is fairly predictable. Trend analysis on a
disaggregated level is more precise. It has been found that using only the prior-year balance as the
expectation reduces the effectiveness of this procedure to identify high-risk areas. One use of this
method would be to predict current-year interest income for a financial institution based on last year’s
total interest income; this assumes no changes in interest rates or loan mix and gives effect to the
increase or decrease in the prior-year total loan balance. A more effective use of this method in this
example would be to base the expectation on calculations made on changes in the total monthly loan
balance. The revised expectation would be based on desegregated data consisting of 12 calculations and
would be considered more precise.

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The reliability of data used for performing analytical procedures also considers whether the data was developed
under a reliable system with effectively designed (and, for high reliance on analytical procedures, operating)
controls. This means the auditor will likely test the operating effectiveness of related controls to rely on the data.
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See the AICPA Audit Guide Analytical Procedures for additional guidance on analytical procedures
(http://www.aicpastore.com/AST/PricingStructureAssortments/Educator/Pricing_Educator/PRDOVR~PC-
012551/PC-012551.jsp). This guide is used as a primary source for this section.

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