An auditor does significant legwork before starting field work. During the audit planning phase, he or she reviews the preliminary financials and compares the current year’s results to last year and industry benchmarks. Here’s a closer look at what happens behind the scenes — and why you might want to implement a similar approach internally.
Preliminary analytics start with a horizontal comparison. That is, auditors compare internally prepared financial statements for the current year to last year’s audited results. Usually, changes are shown as a dollar amount and percentage.
The amount of change that warrants additional attention depends on the “materiality” threshold the auditor sets. For example, an auditor of a small business may decide to inquire about any line item that changes by, say, $10,000 or 10% and then possibly incorporate additional testing for questionable line items. A higher dollar amount threshold may apply for a larger company.
Accountants also may use a vertical or “common-size” approach when planning an audit. This technique shows each line item as a percentage of sales or total assets.
For example, a common-size income statement — which shows expenses as a percentage of sales — explains how each dollar of sales is distributed between costs, expenses and profits. Changes in a company’s financial statements over time can highlight trends and operating inefficiencies that warrant closer scrutiny.
Additionally, auditors calculate ratios to capture the relationships between various items on a company’s financial statements. For example:
• Profit margin = net income / sales.
• Total asset turnover = sales / total assets.
Ratios are helpful when benchmarking a company against competitors (which may be bigger or smaller) or in comparison with industry averages. What’s good or bad for a particular ratio depends on the industry in which the company operates.
Significant variances from year to year and from industry norms can help auditors decide where to focus. Owners can adopt similar analytical procedures to anticipate the questions that will be asked during audit field work and improve audit efficiency.
More important, however, using a similar type of analysis in-house can help owners monitor the company’s performance throughout the year and catch mistakes early. Contact us for a detailed explanation of how to think like an auditor and perform an interim financial analysis of your company.