Audit Planning and Analytical Procedures Chapter 8
First Standard of Fieldwork (GAAS) The work is to be adequately planned and assistants, if any, are to be properly supervised.
Three Main Reasons for Planning To obtain sufficient competent evidence for the circumstances To help keep audit costs reasonable To avoid misunderstanding with the client
Managing Risk is an Important Aspect of Auditing Acceptable audit risk – level of risk the auditor will accept, that an unqualified opinion is mistakenly issued. Inherent risk – likelihood of material misstatements In accounts before I/C effectiveness is considered.
Planning an Audit and Designing an Audit Approach Accept client and perform initial audit planning. Understand the client’s business and industry. Assess client business risk. Perform preliminary analytical procedures.
Planning an Audit and Designing an Audit Approach Set materiality and assess acceptable audit risk and inherent risk. Understand internal control and assess control risk. Gather information to assess fraud risks. Develop overall audit plan and audit program.
The Engagement Letter Not required by GAAS, but is very useful. Not required by GAAS, but is very useful. GAAS does require a clear understanding of the terms of the engagement between auditor and client. GAAS does require a clear understanding of the terms of the engagement between auditor and client.
Understanding of the Client’s Business and Industry Industry and external environment Industry and external environment Business operations and processes Management and governance Objectives and strategies Measurement and performance Understand client’s business and industry.
Industry and External Environment What are some reasons for obtaining an understanding of the client’s industry understanding of the client’s industry and external environment? 1.Risks associated with specific industries 2.Inherent risks common to all clients in certain industries certain industries 3.Unique accounting requirements
Business Operations and Processes Factors the auditor should understand: – Major sources of revenue – Key customers and suppliers – Sources of financing – Information about related parties – Ability to obtain financing
Management and Governance Management establishes the strategies and processes followed by the client’s business. Governance includes the client’s organizational structure, as well as the activities of the board of directors and the audit committee. Corporate charter and bylaws Meeting minutes Code of ethics
Related Party Transactions It is important to identify related parties to the client. It is important to identify related parties to the client. GAAP requires disclosure of material related party transactions SOX prohibits loans to any director or executive officer of the company. Financial institution exceptions Financial institution exceptions
Code of Ethics In response to the Sarbanes-Oxley Act, the SEC now requires each public company to disclose whether is has adopted a code of ethics that applies to senior management. The SEC also requires companies to disclose amendments and waivers to the code of ethics.
Client Objectives and Strategies Strategies are approaches followed by the entity to achieve organizational objectives. Auditors should understand client objectives. Effectiveness and efficiency of operations Financial reporting reliability Compliance with laws and regulations
Measurement and Performance The client’s performance measurement system includes key performance indicators. Examples: – market share – sales per employee – unit sales growth – Web site visitors – same-store sales – sales/square foot Performance measurement includes ratio analysis and benchmarking against key competitors.
Assess Client Business Risk Client business risk is the risk that the client will fail to achieve its objectives. What is the auditor’s primary concern? – material misstatements in the financial statements due to client business risk
Assess Client Business Risk The Sarbanes-Oxley Act requires that management certify it has designed management certify it has designed disclosure controls and procedures to ensure that material information about business risks is made known to them. It also requires that management certify it has informed the auditor and audit committee of any significant deficiencies in internal control.
The Client’s Business, Risk, and Auditor’s Risk Assessment Understand client’s business and industry. Industry and external environment Business operations and processes Management and governance Objectives and strategies Measurement and performance Assess client business risk. Assess risk of material misstatements.
Enterprise Risk Management Enterprise risk management (ERM) has emerged as a new paradigm for managing risk. ERM integrates and coordinates risk management across the entire enterprise.
Preliminary Analytical Procedures Comparison of client ratios to industry or competitor benchmarks provides an indication of the company’s performance. Analytical procedures are also an important part of testing throughout the audit.
Examples of Planning Analytical Procedures Liquidity activity ratio: Inventory turnover3.365.20 Ability to meet long-term obligations: Debt to equity1.732.51 Profitability ratio: Profit margin0.050.07 Short-term debt-paying ability: Current ratio3.865.20 ClientIndustry Selected Ratios
Key Parts of Planning Accept client and perform initial planning New client acceptance and continuance Identify client’s reasons for audit Obtain an understanding with client Staff the engagement
Key Parts of Planning Understand the client’s business and industry Understand client’s industry and external environment Understand client’s operations, strategies, and performance system
Key Parts of Planning Assess client business risk Assess client business risk Evaluate management controls affecting business risk Assess risk of material misstatements
Key Parts of Planning Perform preliminary analytical procedures
Analytical Procedures Analytical procedures use comparisons and relationships to assess whether account balances or other data appear reasonable. SAS 56 emphasizes the expectations developed by the auditor.
Timing and Purposes of Analytical Procedures (p. 208)
Five Types of Analytical Procedures 1.Compare client and industry data. 2.Compare client data with similar prior period data. prior period data. 3.Compare client data with client-determined expected results. client-determined expected results. 4.Compare client data with auditor-determined expected results. auditor-determined expected results. 5.Compare client data with expected results, using nonfinancial data. results, using nonfinancial data.
Compare Client and Industry Data Inventory turnover 3.4 3.5 3.9 3.4 Gross margin26.3%26.4%27.3%26.2% ClientIndustry2005200420052004
Compare Client Data with Similar Prior Period Data Net sales$143,086100.0$131,226100.0 Cost of goods sold 103,241 72.1 94,876 72.3 Gross profit$ 39,845 27.9$ 36,350 27.7 Selling expense 14,810 10.3 12,899 9.8 Administrative expense 17,665 12.4 16,757 12.8 Other 1,689 1.2 2,035 1.6 Earnings before taxes$ 5,681 4.0$ 4,659 3.5 Income taxes 1,747 1.2 1,465 1.1 Net income$ 3,934 2.8$ 3,194 2.4 2004(000)Prelim. % of Net sales 2003(000)Prelim. % of Net sales
Common Financial Ratios Short-term debt-paying ability Liquidity activity ratios Ability to meet long-term debt obligations Profitability ratios
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
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 Days to sell inventory: 365 days ÷ Inventory turnover
Ability to Meet Long-term Debt Obligation Debt to equity: Total liabilities ÷ Total equity Times interest earned: Operating income ÷ Interest expense
Profitability Ratios Earnings per share: Net income ÷ Average common shares outstanding Gross profit percent: (Net sales – Cost of goods sold) ÷ Net sales Profit margin: Operating income ÷ Net sales
Profitability Ratios Return on assets: Income before taxes ÷ Average total assets Income before taxes ÷ Average total assets Return on common equity: (Income before taxes – Preferred dividends) ÷ Average stockholders’ equity
Summary of Analytical Procedures They involve the computation of ratios and other comparisons of recorded amounts to auditor expectations. They are used in planning to understand the client’s business and industry. They are used throughout the audit to identify possible misstatements, reduce detailed tests, and to assess going-concern issues.