1. Chapter 8
Audit Planning 1

2. Learning Objectives Discuss why adequate audit planning is essential.
Make client acceptance decisions and perform initial audit planning.
Gain an understanding of the client’s business and industry.
Assess client business risk.

3. Learning Objectives Perform preliminary analytical procedures.
State the purposes of analytical procedures and the timing of each purpose.
Select the most appropriate analytical procedure from among the five major types.
Compute common financial ratios.

4. Discuss why adequate audit planning is essential.1
Discuss why adequate audit planning is essential.

5. Three Main Reasons for Planning
1. To obtain sufficient appropriate evidence
for the circumstances
To help keep audit costs reasonable
To avoid misunderstanding with the client
Obtaining sufficient appropriate evidence is essential if the CPA firm is to minimize legal liability and maintain a good reputation.
Up front and regular communications with the client is a way to avoid misunderstandings and keep costs under control.

6. Three Main Reasons for Planning

7. Risk Terms Acceptable audit risk Inherent risk
Acceptable audit risk is a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued.
Inherent risk is a measure of the auditor’s assessment of the likelihood that there are material misstatements in an account balance before considering the effectiveness of internal control.
If inherent risk is high, more evidence will be accumulated in the audit of inventory and more experienced staff will be assigned to perform testing in this area.

8. Make client acceptance decisions and perform initial audit planning.2
Make client acceptance decisions and perform initial audit planning.

9. Initial Audit Planning
Client acceptance and continuance
Identify client’s reasons for audit
Obtain an understanding with the client
Develop overall audit strategy
The auditor decides whether to accept a new client or continue serving an existing one.
Identifying the reasons for the audit is likely to affect the remaining parts of the planning process.
The auditor also needs to obtain an understanding with the client about the terms of the engagement.
The auditor develops an overall strategy for the audit including engagement staffing and any required audit specialists.

10. Client Acceptance and Continuance
New client investigations
If previously audited, the new auditor is
required to communicate with the
predecessor auditor
Client permission required
It is better to have no work than high risk, “bad work”.
Annual client evaluations is the time to critically and honestly assess whether to continue associating with a particular client. Engagement risk, audit risk, detection risk and inherent risk are all factors that need to be considered.
Continuing clients
Annual evaluations whether to continue
based on issues, fees, and client integrity

11. Identify Reasons for the Audit
Two major factors affecting acceptable risk
Likely statement users
Intended uses of the statements
Likely to accumulate more evidence for
companies that are
Publicly held
Have extreme indebtedness
Likely to be sold

12. Obtaining an Understanding with the Client
Engagement terms should be understood
between CPA and client.
Standards require an engagement letter
describing:
objectives
responsibilities of auditor and management
schedules and fees
Informs client that auditor cannot guarantee
all acts of fraud will be discovered
See figure 8-2

13. Develop Overall Audit Strategy
Preliminary audit strategy should consider
client’s business and industry
material misstatement risk areas
number of client locations
past effectiveness of controls
Preliminary strategy helps auditor determine
resource requirements and staffing
staff continuity
need for specialists

14. Gain an understanding of the client’s business and industry.3
Gain an understanding of the client’s business and industry.

15. Understanding of the Client’s Business and Industry
Client business risk is the risk
that the client will fail to meet
its objectives.
Declines in economic conditions
Information technology
Global operations
Human capital

16. Understanding of the Client’s Business and Industry

17. Industry and External Environment
Reasons for obtaining an 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
3. Unique accounting requirements
Business and industry risk may even affect the auditor’s decision against accepting engagements in riskier industries such as financial services or health insurance.
Risks common to a particular industry may include inventory obsolescence, accounts receivable collection risk, reserve for losses in the casualty insurance industry.
Unique accounting requirements are found in government entities, not-for-profit organizations, and railroads.

18. Business Operations and Processes
Factors the auditor should understand:
Major sources of revenue
Key customers and suppliers
Sources of financing
Information about related parties

19. Tour the Plant and Offices
Touring the physical facilities
enables the auditor to assess
asset safeguards and interpret
accounting data related to assets.

20. Identify Related Parties
Affiliated companies
Principal owners of the client
Any other party with which the client deals
A party who can influence management or
client policies
A related party is defined as an affiliated company, a principal owner of the client
company, or any other party with which the client deals, where one of the parties
can influence the management or policies of the other.

21. Management and Governance
Governance includes:
Organizational
structure
Board activities
Audit committee
activities.
Governance insights:
Corporate charter
and bylaws
Code of ethics
Meeting minutes
Effective boards ensure the company takes only appropriate risks while the audit committee, through oversight of financial reporting, can reduce the likelihood of overly aggressive accounting.
To gain an understanding of the client's governance system, the auditor should understand how the board and audit committee exercise oversight along with the following:
The corporate charter
Code of ethics
Meeting minutes
Management establishes the strategies and
processes followed by the client’s business.

22. 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.

23. Client Objectives and Strategies
Strategies are approaches followed by the
entity to achieve organizational objectives.
Auditors should understand client objectives.
Financial reporting reliability
Effectiveness and efficiency of operations
Compliance with laws and regulations

24. 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.

25. Assess client business risk.4
Assess client business risk.

26. 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
Auditor’s assessment of client business risk considers the industry and other external factors as well as the client’s business strategies processes and other internal factors.

27. Client’s Business, Risk, and Risk of Material Misstatement

28. Sarbanes-Oxley Act Management must certify it has designed
disclosure controls and procedures to
ensure that material information about
business risks is made known to them.
The Sarbanes-Oxley Act requires that 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.
Management must certify it has informed
the auditor and audit committee of any
significant control deficiencies.

29. Perform preliminary analytical procedures.5
Perform preliminary analytical procedures.

30. Preliminary Analytical Procedures
Comparison of client ratios to industry
or competitor benchmarks provides an
indication of the company’s performance.
Preliminary tests can reveal unusual
changes in ratios.
Auditors perform preliminary analytical procedures to better understand the client’s business and to assess client business risk.

31. Examples of Planning Analytical Procedures

32. Summary of the Parts of Auditing Planning
A major purpose is to gain an understanding
of the client’s business and industry.
A major purpose is to gain an understanding of the client’s business and industry which is used to assess acceptable audit risk, client business risk and the risk of material misstatements in the financial statements.

33. 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 strategy and audit program

34. 6
State the purposes of analytical procedures and the timing of each procedure.

35. Analytical Procedures
Analytical procedures may be performed
at any of three times during an
engagement.
Required in the planning phase
Often done during the testing phase
Required during the completion phase
Analytical procedures are defined by auditing standards as evaluations of financial information made by a study of plausible relationships among financial and nonfinancial data involving comparisons of recorded amounts to expectations developed by the auditor.
Required in the planning phase to assist in determining the nature extent and timing of audit procedures.
Analytical procedures are often done during the testing phase of the audit as a substantive test in support of account balances.
Analytical procedures are also required during the completion phase of the audit. Typically, a senior partner with extensive knowledge of the client’s business conducts the analytical procedures during the final review of the audit files to identify possible oversights in an audit.

36. Timing and Purposes of Analytical Procedures

37. 7
Select the most appropriate analytical procedure from among the five major types.

38. Five Types of Analytical Procedures
Compare client data with:
1. Industry data
2. Similar prior-period data
3. Client-determined expected results
4. Auditor-determined expected results
5. Expected results using nonfinancial data.

39. Compare Client and Industry Data
2014
2013
2014
2013
Inventory turnover
Gross margin % 26.4% 27.3% 26.2%
The most important benefit of industry comparison are to aid in understanding the client's business and as an indication of the likelihood of financial failure.

40. Internal Comparisons

41. Compare Client Data with Similar Prior Period Data
2014
2013
(000)
Prelim.
% of
Net sales
(000)
Prelim.
% of
Net sales
Net 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,

42. Compute common financial ratios.8
Compute common financial ratios.

43. Common Financial Ratios
Short-term debt-paying ability
Liquidity activity ratios
Ability to meet long-term debt obligations
Profitability ratios
Activity ratios for accounts receivable and inventory are useful to auditors who often use trends in the accounts receivable turnover ratio to assess the reasonableness of the allowance for uncollectible accounts. Same concept applies to inventory turnover ratios and potentially obsolete inventory.

44. 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

45. Liquidity Activity Ratios
Accounts receivable
turnover =
Net sales
Average gross receivables
Days to collect
receivable =
365 days
Accounts receivable
turnover
Inventory
turnover =
Cost of goods sold
Average inventory
Days to sell
inventory =
365 days
Inventory turnover

46. Ability to Meet Long-term Debt Obligation
Debt to equity =
Total liabilities
Total equity
Times interest
earned =
Operating income
Interest expense

47. 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

48. Average stockholders’ equity
Profitability Ratios
Return on
assets =
Income before taxes
Average total assets
Return on
common
equity =
(Income before taxes
– Preferred dividends)
Average stockholders’ equity

49. Summary of Analytical Procedures
Compare ratios of recorded amounts to
auditor expectations.
Used in planning to understand client’s
business and industry.
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.
Used throughout the audit
to identify possible misstatements
reduce detailed tests
assess going-concern issues.

50. Are there any questions?

51. Copyright
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