Chapter 8 Audit Planning and Analytical Procedures

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Chapter 8Audit Planning and Analytical Procedures
J. Smith, CPA Audit Plan
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Presentation Outline

• Accept Client and Perform Initial Audit Planning
• Understand the Clients Business and Industry
• Assess Client Business Risk
• Perform Preliminary Analytical Procedures

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I. Accept Client and Perform Initial Planning

• Client Acceptance and Continuance
• Identify Clients Reasons for Audit
• Obtain an Understanding with the Client
• Select Staff for the Engagement
• Evaluate Need for Outside Specialist

Acceptable Audit Risk - how willing the auditor
is to accept that the financial statements may
be materially misstated when an unqualified
opinion is issued.
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A. Client Continuance and Acceptance

• Association with clients who lack integrity can
  cause significant problems.
• SAS 84 requires a successor auditor to
  communicate with the predecessor auditor.
  Predecessor must obtain permission from client
  before responding. Response may be limited.
• Lawsuits between the CPA and client or unpaid
  fees for services performed more than 1 year
  previously, will prohibit acceptance of the audit
  client.

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B. Identify Clients Reasons for Audit

• Two major factors affecting acceptable audit risk
  are likely statement users and their intended
  uses of the statements. More evidence may be
  necessary when the statements are to be used
  extensively.

• The most likely uses can be determined from
  previous experience with the client and
  discussion with management.

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C. Obtaining an Understanding with the Client

• Contents of Engagement Letter
• Services to be provided
• Any restrictions on the auditors work
• Deadlines for completing the work
• Assistance to be provided by client personnel
• Inform client that fraud may not be discovered
• May include fees

• SAS 83 requires auditors to document their
  understanding of the engagement in the audit
  files.
• Although not required, an engagement letter is
  normally used to establish the agreement.
• Auditors of public companies should establish the
  understanding with the audit committee.

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D. Select Staff for the Engagement

• Staff should be knowledgeable of the clients
  industry.
• Continuity of staff helps the CPA firm maintain
  familiarity with technical requirements.

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E. Evaluate Need for Outside Specialists

• If an audit client requires specialized
  knowledge, it may be necessary to consult a
  specialist.
• Auditor should evaluate the specialists
  qualifications and understand the objectives and
  scope of their work.
• Auditor should also consider specialists
  relationship to client that could impair
  objectivity.

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II. Understand the Clients Business and Industry
The nature of the clients business and industry
affects client business risk and the risk of
material misstatements in the financial
statements.

1. Major Reasons for Understanding Client Industry
   and External Environment
2. Business Operations and Processes
3. Management and Governance
4. Client Objectives and Strategies
5. Measurement and Performance

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Major Reasons for UnderstandingClient Industry
and External Environment

1. There may be risks associated with the client and
   the specific industry in which it operates.
2. Many industries have unique accounting
   requirements that the auditor must understand.

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B. Business Operations and Processes

• Tour the plant and offices to better understand
  client operations and meet key personnel.
• Identify related parties for purposes of
  disclosure. Related parties include an
  affiliated company, a principal owner of client,
  and others who can influence the management or
  operating policies of the other.
• Sarbanes-Oxley prohibits personal loans to client
  executives, except for normal loans by banks
  using market rates.

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C. Management and Governance

• Management philosophy and operating style
  significantly influence the risk of material
  misstatement in the financial statements.
• Sarbanes-Oxley requires public companies to
  disclose whether they have adopted a code of
  ethics for senior management. If not, they must
  state why.
• Corporate minutes should be read by the auditor
  to identify various authorizations that must be
  complied with.

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D. Client Objectives and Strategies

• Strategies are approaches followed by the entity
  to achieve organizational objectives. Auditor
  should understand client strategies regarding
• Reliability of financial reporting
• Effectiveness and efficiency of operations
• Compliance with laws and regulations

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E. Measurement and Performance

• The risk of financial misstatements may be
  increased if the client has set unreasonable
  objectives or if the performance measurement
  system encourages aggressive accounting.

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III. Assess Client Business Risk

• Client business risk is the risk that the client
  will fail to achieve its objectives. Sources
  include competitors, new technology, industry
  condition, and regulatory environment. Could
  influence client to misstate the financial
  statements.
• Sarbanes-Oxley requires management to certify it
  has designed disclosure controls and procedures
  to ensure that they are made aware of material
  information about business risks.
• Sarbanes-Oxley also requires management to
  certify that it has informed the auditor and
  audit committee of any significant deficiencies
  in internal control.

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IV. Perform Preliminary Analytical Procedures

1. Defining Analytical Procedures
2. Short-term Debt-Paying Ability
3. Liquidity Activity Ratios
4. Ability to Meet Long-term Debt Obligation
5. Profitability Ratios

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A. Defining Analytical Procedures

• Evaluations of financial information made by a
  study of plausible relationships among financial
  and non-financial data.
• See purpose of procedures during audit phases in
  Figure 8-6 on page 209.

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B. Short-term Debt-paying Ability
Cash ratio (Cash Marketable securities)
Current liabilities
Quick ratio (Cash Marketable securities Net
accounts receivable) Current liabilities
Current ratio Current assets Current
liabilities
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C. Liquidity Activity Ratios
Accounts receivable turnover Net sales Average
gross receivables
Days to collect receivables 365 days Accounts
receivable turnover
Inventory turnover Cost of goods sold Average
inventory
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C. Liquidity Activity Ratios (Continued)
Days to sell inventory 365 days inventory
turnover
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D. Ability to Meet Long-term Debt Obligation
Debt to equity Total liabilities Total equity
Times interest earned Operating income
Interest expense
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E. Profitability Ratios
Earnings per share Net income Average commons
shares outstanding
Gross profit percent (Net sales Cost of goods
sold) Net sales
Profit margin Operating income Net sales
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E. Profitability Ratios (Continued)
Return on assets Income before taxes Average
total assets
Return on common equity (Income before taxes
Preferred dividends) Average stockholders
equity
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Initial Audit Planning
Accept client and perform initial audit planning
Understand the clients business and industry
Assess client business risk
Perform preliminary analytical procedures