Analytical review is a crucial process in the preparation of financial statements, ensuring that the financial information presented is accurate, compliant, and transparent. Although accountants are not required to provide formal assurance on financial statements, they must ensure that the information is 'fairly presented'. Analytical reviews are a straightforward method for accountants to verify that the financial statements accurately reflect the company's financial status. This involves ensuring that accounting policies are applied consistently, that financial records are complete and precise, and that all necessary details and assumptions are clearly disclosed.

Understanding Analytical Review

Analytical review is defined in the accounting profession as:

"the evaluation of financial information through analysis of plausible relationships among both financial and non-financial data."

The analytical review assumes that stable relationships, or expected patterns, should exist among the data. Accountants use analytical procedures to identify deviations from expected patterns based on historical performance, industry norms, or known events within the company.

For example, by comparing a client’s financial data to previous years' figures, industry standards, and budgetary projections, accountants can detect anomalies that may suggest underlying issues. This not only highlights inconsistencies but also helps in understanding broader financial implications for the business.

The following example illustrates how accountants can use analytical review procedures to detect and investigate inconsistencies by analysing the relationships between financial and non-financial data.

Steps in performing an analytical review

Performing an analytical review is a methodical process that helps accountants and auditors assess the consistency and plausibility of financial data. Here's a step-by-step approach to conducting an analytical review:

Step 1: Define the Purpose and Scope of the Review

Begin by clarifying the objectives of the analytical review. Determine which financial statements or specific accounts will be examined. This step sets the direction and focus of the analysis, whether it's for a routine check, a specific anomaly investigation, or as part of an annual audit.

Step 2: Gather and Prepare Data

Collect the necessary financial data, which may include current period financial statements, budgetary forecasts, and historical financial data for comparison. Prepare the data by ensuring it is complete, accurate, and formatted appropriately for analysis.

Step 3: Develop Expectations

Based on an understanding of the business, industry norms, and historical trends, develop expectations for financial ratios, trends, and other key metrics. Expectations serve as benchmarks against which the actual results will be compared. For instance, if analyzing sales, an expectation might be set based on seasonal trends observed in previous years.

Step 4: Perform Initial Analysis

Conduct the initial analysis by comparing actual results against your expectations. This can involve calculating financial ratios, performing trend analysis, and using reasonableness tests. Identify any significant variances that deviate from expected values by a substantial margin.

Step 5: Investigate Variances

For any significant deviations identified, perform a deeper investigation to understand the reasons behind these variances. This may involve:

• Inquiring with management about any known business changes or external factors that could have impacted the financial results.

• Reviewing transaction details to verify accuracy and completeness.

• Comparing with industry performance to determine if the variance is consistent with broader market trends.

Step 6: Evaluate the Findings

Assess the explanations received and the additional information gathered to determine whether the variances are justified or if they indicate potential issues such as errors or fraudulent activity. Consider the impact of these findings on the overall financial presentation.

Step 7: Document the Review Process

Thoroughly document each step of the process, including the data used, expectations set, analysis performed, inquiries made, and conclusions reached. This documentation is crucial for transparency and for supporting the conclusions drawn from the review.

Key Techniques in Analytical Reviews

1.    Ratio Analysis

Ratio analysis is a fundamental tool in financial analysis that provides insights into various aspects of a company's financial health.

Current Ratio

The current ratio indicates liquidity by measuring a company’s ability to pay off short-term obligations with current assets. If a company's current ratio drops from 1.8 to 1.2 within a year, it indicates a potential liquidity problem. The ratio is calculated by dividing current assets by current liabilities. A lower ratio might suggest that the company is not well positioned to cover its short-term obligations, which could lead to cash flow issues.

Return on Assets (ROA)

The ROA indicates how efficiently a company is using its assets to generate earnings. For instance, if it decreases from 8% to 5%, it could imply that the company is not utilising its assets effectively, possibly due to outdated equipment or poor asset management.

Debt-to-Equity Ratio

Shows the relative proportions of shareholders' equity and debt used to finance a company's assets. For example, A company traditionally maintains a debt-to-equity ratio of around 0.6. A sudden jump to 1.2 suggests an increased reliance on debt, elevating financial risk due to potential interest rate hikes or repayment challenges.

Gross Profit Margin

Reflects the financial health of core operations by showing the percentage of revenue that exceeds the cost of goods sold.

2.    Trend Analysis

Trend analysis helps in spotting financial changes over time, providing insights into patterns that could indicate emerging risks. When analysing trends or year-over-year figures, any variation over 10% is typically significant enough to warrant further investigation. However, the sensitivity might vary based on the industry norms and the specific financial condition of the company. For instance, a 10% increase in the cost of goods sold without a corresponding increase in sales should trigger a deeper review.

Another useful procedure is to ensure that there are 12 transactions recorded for monthly expenses, such as rent, leases or telephone costs. Exceptions noted would be due to new or terminated agreements.  

3.    Year-over-Year Comparisons

This analysis is crucial for identifying significant changes in financial statements. For example, a company’s year-over-year administrative expenses increase by more than 15%. This is beyond the typical 10% threshold and should prompt an inquiry to understand the reasons for such an increase, such as new hires, increased rent, or higher consultancy fees.

Using analytical procedures in reviews and audits

In financial audits and reviews, analytical procedures are indispensable tools for auditors and reviewers. During an audit, these procedures are crucial at both the planning and final review stages, helping to form an overall opinion on the financial statements. They allow auditors to detect unusual fluctuations that might indicate errors or potential fraud, enhancing the rigor of the audit.

In reviews, which typically provide a lower level of assurance than audits, analytical procedures play an even more critical role. They are used primarily to gain a limited assurance that no material modifications need to be made to the financial statements for them to be in conformity with the applicable financial reporting framework. By comparing current data to previous years, budgeted figures, or industry averages, reviewers can quickly identify discrepancies that may require deeper investigation. This process not only supports the integrity of financial reporting but also aids in the effective communication of financial health and operational insights to stakeholders.

Example: Analysing Fuel Costs in a Transportation Company

XYZ Logistics is a transport company that operates a fleet of trucks for cargo delivery services across South Africa. The company's fuel costs are a significant operational expense and are closely monitored each financial period.

Data and Relationships: In a typical analytical review, the accountant would expect a stable relationship between the number of kilometers driven (a non-financial data point) and the fuel costs (a financial data point). This relationship is predictable because fuel consumption directly correlates with distance traveled.

Analytical Procedure: At the end of the financial period, the accountant reviews the fuel costs. They notice that although the total kilometers driven by the fleet has remained consistent with the previous period, the fuel costs have increased by 20%.

Evaluation Through Plausible Relationships:

• Historical Performance: Historically, the fuel costs of XYZ Logistics have shown a stable ratio to kilometers driven. Any significant deviation from this ratio without a change in kilometers driven warrants further investigation.

• Industry Norms: The accountant also considers industry norms, such as average fuel costs per kilometer for logistics companies in South Africa. If the industry norm has not changed significantly, this strengthens the suspicion that the increase in fuel costs may not be related to general market conditions (like nationwide fuel price increases).

• Known Events: The accountant checks for any known events that could have influenced fuel usage or costs, such as the purchase of less fuel-efficient trucks, changes in route efficiencies, or the implementation of new regulations requiring different fuel types.

Action: Given the unusual increase in fuel costs despite stable kilometers driven and no significant changes in industry fuel prices, the accountant decides to investigate further. They would start by:

1. Inquiring with management about any changes in routes, truck maintenance issues, or changes in fuel suppliers or types of fuel used.

2. Reviewing fuel purchase invoices to check for anomalies such as higher prices paid per liter or higher volumes purchased than necessary.

3. Assessing internal controls around fuel logs and purchase protocols to ensure no fraudulent activities are occurring, such as theft.

Learn more about analytical reviews by enrolling to CIBA Management Excellence 3-in-1 CPD course

What you will learn

After attending this webinar you will:

• Attain an understanding of the purpose and significance of the three primary financial statements: income statement, balance sheet, and cash flow statement.

• Understand and be able to assess the financial health of an organisation through the use of essential financial ratios.  

• Possess thorough understanding of business valuation and know when to apply its various methods.

• Understand the definition of diligence and its role in assessing the risks and opportunities in a business transaction.

• Get an Illustration of the interconnectedness of financial statement analysis, business valuations, and due diligence in the context of making informed business decisions.