5 Auditor’s Business Risk A thoroughly investigation of prospective clients should be made.
6 Submitting a Proposal Should include: Nature of services QualificationsFees & other informationAudit committee
7 Communication with Predecessor Auditor The successor auditor must ask management to authorize the predecessor to respond fully.Key issue in deciding whether to accept the engagement.
8 Auditor inquiries will include: Disagreements with management over accounting principles or scope limitationsThe predecessor’s understanding for the change in auditorsThe integrity of managementCommunications with audit committees regarding important audit issues
9 Items Included in Engagement Letters Name of the entityManagement responsibilitiesFinancial statementsEstablishing effective internal control over financial reportingCompliance with laws and regulationsMaking records available to the auditorsProviding written representations at end of the audit, including that adjustments discovered by the auditors and not recorded to the financials are not materialAuditor responsibilitiesConducting an audit in accordance with GAASObtaining an understanding of internal control to plan audit and to determine the nature, timing and extent of proceduresMaking communications required by GAAS22
10 Engagement Letters--Optional Items Arrangements regardingConduct of the audit (e.g., timing, client assistance)Use of specialists or internal auditorsObtaining information from predecessor auditorsFees and billingOther services to be provided, such as examination of internal control over financial reportingLimitation of or other arrangements regarding liability of auditors or clientConditions under which access to the auditors’ working papers may be granted to others3
12 Generally Accepted Auditing Standards Technical training and efficiencyIndependenceDue professional careField WorkPlanning and supervisionInternal controlEvidenceReportingGAAPDisclosureOpinionConsistency
13 Audit Planning Gain an understanding of the client’s business and industry.
14 Business Operations and Processes Factors the auditor should understand:Major sources of revenueKey customers and suppliersSources of financingInformation about related parties
15 Tour the Plant and Offices By viewing the physical facilities,the auditor can asses physicalsafeguards over assets and interpretaccounting data related to assets.
16 Management and Governance Management establishes the strategies andprocesses followed by the client’s business.Governance includes the client’s organizationalstructure, as well as the activities of the boardof directors and the audit committee.Corporate charter and bylawsCode of ethicsMeeting minutes
17 Measurement and Performance The client’s performance measurement systemincludes key performance indicators. Examples:market sharesales per employeeunit sales growthWeb site visitorssame-store salessales/square footPerformance measurement includes ratio analysisand benchmarking against key competitors.
18 Assess Client Business Risk Client business risk is the risk that theclient will fail to achieve its objectives.What is the auditor’s primary concern?Material misstatements in the financialstatements due to client business risk
20 Preliminary Analytical Procedures Comparison of client ratios to industryor competitor benchmarks provides anindication of the company’s performance.Preliminary tests can reveal unusualchanges in ratios.
21 Examples of Planning Analytical Procedures Selected RatiosClientIndustryShort-term debt-paying ability:Current ratioLiquidity activity ratio:Inventory turnoverAbility to meet long-term obligations:Debt to equityProfitability ratio:Profit margin
22 Summary of the Parts of Auditing Planning A major purpose is to gain an understandingof the client’s business and industry.
23 Key Parts of PlanningPerform preliminary analytical procedures
24 Analytical Procedures SAS 56 emphasizes the expectationsdeveloped by the auditor.Required in the planning phaseOften done during the testing phaseRequired during the completion phase
25 Five Types of Analytical Procedures Compare client data with:1. Industry data2. Similar prior-period data3. Client-determined expected results4. Auditor-determined expected results5. Expected results using nonfinancial data.
26 Compare Client and Industry Data 2007200620072006Inventory turnoverGross margin % 26.4% 27.3% 26.2%
27 Compare Client Data with Similar Prior Period Data 20072006(000)Prelim.% ofNet sales(000)Prelim.% ofNet salesNet sales $143, $131,Cost of goods sold , ,Gross profit $ 39, $ 36,Selling expense , ,Administrative expense , ,Other , ,Earnings before taxes $ 5, $ 4,Income taxes , ,Net income $ 3, $ 3,
28 Common Financial Ratios Short-term debt-paying abilityLiquidity activity ratiosAbility to meet long-term debt obligationsProfitability ratios
30 Liquidity Activity Ratios Accounts receivableturnover=Net salesAverage gross receivablesDays to collectreceivable=365 daysAccounts receivable turnoverInventoryturnover=Cost of goods soldAverage inventoryDays to sellinventory=365 daysInventory turnover
31 Ability to Meet Long-term Debt Obligation Debt to equity=Total liabilitiesTotal equityTimes interestearned=Operating incomeInterest expense
32 Profitability Ratios Earnings per share = Net income Average common shares outstandingGross profitpercent=(Net sales – Cost of goods sold)Net salesProfit margin=Operating incomeNet sales
33 Profitability Ratios Return on assets = Income before taxes Average total assetsReturn oncommonequity=(Income before taxes– Preferred dividends)Average stockholders’ equity
34 Summary of Analytical Procedures They involve the computation of ratiosand other comparisons of recordedamounts to auditor expectations.They are used in planning to understandthe client’s business and industry.They are used throughout the audit to identifypossible misstatements, reduce detailed tests,and to assess going-concern issues.