Page 183 - COSO Guidance Book

Trend analysis is considered the least precise of the four methods presented because it does not
consider specific factors that affect the account balance. It also includes an implicit expectation that
does not consider changing current-year conditions (such as changes in interest rates).

Ratio analysis
Ratio analysis is the comparison of relationships between accounts (between periods, such as current-
and preceding-year amounts); the comparison of an account with nonfinancial data (number of miles
flown by an airline and average fuel cost per mile to formulate an expectation of total fuel costs); or the
comparison of information between firms in an industry (such as common-size income statements).
Ratio analysis is appropriate when the relationship between accounts is stable and fairly predictable
(such as sales and cost of goods sold). Ratio analysis can be more effective than trend analysis because
comparisons between the balance sheet and income statement can reveal unusual fluctuations that an
analysis of individual accounts would not (such as a comparison of bad debts expense with average
accounts-receivable balances). Ratio analysis is the third-most precise of the four methods presented.
It is more reliable than trend analysis because trend analysis does not compare relationships between
financial and nonfinancial data, between firms, or between financial statement accounts. Trend analysis
uses one predictor; ratio analysis uses two.

Reasonableness testing
Reasonableness testing is an analysis of account balances or changes in account balances that is based
on financial data, nonfinancial data, or both. Unlike trend and ratio analyses, which assume stable
relationships, reasonableness testing uses current information and accounts for changes in the
environment to develop an explicit prediction of the account balance or relationship. This is the second-
most precise method because explicit expectations are formed and there can be two or more predictors.

In reasonableness testing, a manager or auditor uses current-year data and knowledge of factors to
estimate the account balance. To compute gross sales at a car wash, for instance, the manager or
auditor could multiply current-year water usage (from utility bills, an independent source) by the
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average dollar amount of revenue per gallon of water used. Because some areas of the country have
experienced drought, many municipalities have imposed bans on washing cars at home. If, however, the
option of using a car wash is generally still available, it can be expected that car owners would opt to use
a car wash rather than to cease washing their cars altogether. If the manager or auditor chose to use
trend analysis to predict this year’s revenue based on last year’s sales — a year when people could wash
their cars at home — then the difference between the expectation and the recorded amount could result
from using an inappropriate procedure to formulate the expectation. This is because trend analysis
assumes a stable environment and does not incorporate current information, such as regulatory
mandates, in formulating expectations.

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Water usage would not be a predictor for car washes that recycle water.

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