Statement In Support of Substantive Analytical Procedures

Remarks as prepared for delivery

Thank you, Chair Williams.

I support issuing the proposal to revise Auditing Standard 2305.

Just as an architect seeks to design sound structures, an auditor should design and implement sound audit responses to appropriately address risks of material misstatements during an audit. Substantive analytical procedures have long been in use by auditors, but greater availability of information in electronic form, increased use of technology-based tools by auditors to analyze such information, and changes to other PCAOB standards, such as risk assessment and audit evidence, lead us to today’s proposal. Our standards must not maintain the status quo, in light of these advances.

Proposed Auditing Standard 2305, which is titled Designing and Performing Substantive Analytical Procedures, sets forth a principles-based approach to be responsive to the evolution in auditing and technology. Substantive analytical procedures must be designed and executed appropriately to be an effective audit tool. At their core, substantive analytical procedures allow auditors to compare recorded amounts in the company’s financial statements to an auditor-developed expectation based on plausible and predictable relationships. This proposal retains this fundamental blueprint of a substantive analytical procedure.

Our oversight activities suggest that modernizing and strengthening this standard may advance audit quality, which would better protect investors. Sound auditing practices build trust in the audit. As noted in the proposing release, the average number of technology-based tools used by U.S. GNF engagement teams increased by 38 percent from 2018 to 2023. The release further noted that recent inspection results across all of our inspection programs indicate that there continue to be deficiencies in certain aspects of designing and executing substantive analytical procedures. For example, when substantive analytical procedures are not based on sufficiently plausible and predictable relationships, have circular references, include thresholds too wide to precisely identify material misstatements, or involve differences outside of expectation that are not sufficiently evaluated, then material misstatements, whether due to error or fraud, can be missed. Given the continued challenge in applying substantive analytical procedures for some firms, this Board is taking action to drive better audit quality.

Let’s examine a couple of the components of this proposed standard. When designing a substantive analytical procedure, there are a few essential inputs that impact its efficacy. First is the relationship on which the auditor bases its expectation of the recorded amount. The auditor must therefore determine, through more than inquiry alone, whether the relationship to be used in the substantive analytical procedure is sufficiently plausible and predictable. This proposed requirement would strengthen this component in the substantive analytical procedure. The quality of the output from a substantive analytical procedure is dependent upon the sufficiency of the inputs – in this case the plausible and predictable relationship driving the auditor expectation.

When differences are identified between the auditor’s expectation and the company’s recorded amount, the next important input to a substantive analytical procedure is determining the threshold for evaluating differences. A threshold that is not sufficiently precise could result in unidentified material misstatements, both individually and in the aggregate. The threshold, as proposed, should be set at or below tolerable misstatement. This proposed standard also describes considerations in determining this threshold, including “taking into account the nature of the account or disclosure or, where applicable, the component of the account or balance.” While it prescribes that the threshold cannot be more than tolerable misstatement, the threshold can be set lower, which could provide more persuasive audit evidence. Taking into consideration the assessed risk of material misstatement and the objective of the substantive analytical procedures in setting the threshold, strengthens the requirements to include appropriate guardrails in developing a threshold based on the facts and circumstances of each audit.

Evaluation of any difference outside of the auditor-established threshold is one of the last inputs in a substantive analytical procedure but must be completed before an auditor concludes the audit. Differences that exceed an appropriately developed threshold should be evaluated by the auditor through more than inquiry alone. These differences can’t be ignored or explained away, but rather should be evaluated to determine whether there is a misstatement. 

All of these inputs built together are necessary to produce a reliable substantive analytical procedure. Any deficiency in these inputs to a substantive analytical procedure, could lead to an unsupported output, that is an unsupported audit opinion, which could put investors at risk.

Based on these aspects, I am in support of today’s proposal to modernize, strengthen, and clarify the requirements around substantive analytical procedures. I am particularly interested in hearing from all stakeholders on the various aspects of the revised standard given the increased prevalence of the use of technology in performing substantive analytical procedures. Our standards benefit from stakeholder input, and I look forward to hearing from commenters.

In the last two and half years, this Board has convincingly executed its commitment to modernize standards. Since 2022, this Board has issued ten proposals, including this one today. This is the largest number of proposals in any two-year period since the inception of the PCAOB. These efforts demonstrate our continued commitment to ensure our standards, many of which haven’t been updated since 2003, are fit for purpose.

To accomplish this feat, I would like to commend the unequivocally dedicated and technically gifted staff of the PCAOB. For this proposing release, I would like to thank in the Office of the Chief Auditor, Barb Vanich, Dima Andriyenko, Dominika Taraszkiewicz, Donna Silknitter, Karen Wiedemann, and Sarah Madris; from the Office of Economic and Risk Analysis, Martin Schmalz, John Cook, Erik Durbin, Carrie von Bose, and Dylan Rassier; and from the Office of the General Counsel, Katherine Kelly, Jennifer Williams, Connor Raso, and Katie Reilly. Thank you additionally to the individuals from the Division of Registration and Inspections and the Division of Enforcement and Investigation who informed the proposal in front of us today. Thank you to the SEC staff within the Office of the Chief Accountant for their input, as well as my fellow Board Members, their staff, and my staff.