Audit Planning Need an effective and efficient audit planNeed an effective and efficient audit plan Underaudit - see you in courtUnderaudit - see you in court Overaudit - loseOveraudit - lose clients to competitors clients to competitors

Planning 1.Accept client and perform initial planning 2.Understand client’s business and industry 3.Assess client business risk 4. Perform preliminary analytical procedures Note: Planning also includes fraud risk brainstorming required by SAS #99

Client Acceptance Do we want this client?Do we want this client? - Are we independent? - Are we technically competent? - Is client reputable? Who will use financial statements?Who will use financial statements? (Key part of acceptable audit risk - discussed in Ch. 9)

Communication With Predecessor Required by SAS #84Required by SAS #84 Purpose is to assess whether to accept clientPurpose is to assess whether to accept client Successor initiatesSuccessor initiates - predecessor needs client permission to release information permission to release information

Successor - Predecessor Communication Usually review prior auditor workpapersUsually review prior auditor workpapers –Determine whether problems exist that impact client acceptance –Support beginning asset balances (why?)

Multiple Choice #1 A successor auditor most likely would make specific inquiries of the predecessor auditor regarding: 1.Specialized accounting principles of the client’s industry. 2.The competency of the client’s internal audit staff. 3.The uncertainty inherent in applying sampling procedures. 4.Disagreements with management as to auditing procedures.

Understanding with Client Must obtain and document understanding (SAS #108)Must obtain and document understanding (SAS #108) Written engagement letter now requiredWritten engagement letter now required - Engagement objectives - Management responsibilities - Responsibilities of auditor - Limits of engagement

Specialists Used to address complex issues where auditor is not qualifiedUsed to address complex issues where auditor is not qualified May be hired by client or auditorMay be hired by client or auditor Auditor should evaluate qualifications, and relationship with clientAuditor should evaluate qualifications, and relationship with client May refer to specialist in audit report only when opinion is qualified or explanatory paragraph added based on specialist’s reportMay refer to specialist in audit report only when opinion is qualified or explanatory paragraph added based on specialist’s report

MC #2 An auditor may refer to the specialist in the auditor’s report if the: 1. Specialist’s findings provide the auditor greater assurance of reliability about greater assurance of reliability about management's representations. management's representations. 2. The auditor qualifies the opinion as a result of the specialist’s findings. result of the specialist’s findings. 3. Auditor’s use of the specialist’s findings is different from that of prior years. different from that of prior years. 4. Specialist is a related party whose findings fully corroborate management’s financial fully corroborate management’s financial statement assertions. statement assertions.

Understanding of the Client’s Business and Industry Understand Client’s Business and Industry Industry and External Environment Business Operations and Processes Management and Governance Objectives and Strategies Measurement and Performance

Related Parties Concern is that they are adequately disclosedConcern is that they are adequately disclosed By nature, are not arm’s lengthBy nature, are not arm’s length

MC #3 When auditing related party transactions, an auditor places primary emphasis on: 1. Confirming the existence of the related parties. parties. 2. Verifying the valuation of the related parties. parties. 3. Evaluating the disclosure of the related party transactions. party transactions. 4. Ascertaining the rights and obligations of the related parties. the related parties.

MC #3 When auditing related party transactions, an auditor places primary emphasis on: 1. Confirming the existence of the related parties. parties. 2. Verifying the valuation of the related parties. parties. 3. Evaluating the disclosure of the related party transactions. party transactions. 4. Ascertaining the rights and obligations of the related parties. the related parties.

PurposeCommon form of Test Understand client Comparison to industry businessusing broad ratios Going ConcernStatistical prediction model based on key ratios (plus auditor judgment) Attention directingComparison to prior year or expected value Reduce detail testsComparison using highly predictable relationships or nonfinancial data

Auditors try to identify predictable relationships when using analytical procedures. Relationships involving transactions from which of the following accounts most likely would yield the highest level of evidence? 1. Accounts payable 2. Advertising expense 2. Advertising expense 3. Accounts receivable 3. Accounts receivable 4. Interest expense 4. Interest expense

8-27(d) Which of the following situations has the best chance of being detected when a CPA compares 2009 revenues and expenses with the p/y, and investigates all changes exceeding a fixed %? 1. Increase in property tax rates has not been recognized in the 2009 accrual. been recognized in the 2009 accrual. 2. Cashier began lapping A/R in Because economy worsened, 2009 provision for bad debts is insufficient. provision for bad debts is insufficient. 4. Company changed capitalization for small tools in tools in 2009.

Materiality of Fluctuation 2009 Gross Margin 42% 2008 Gross Margin 40% 2009 Sales $20,000, Net Income $ 1,000,000 Materiality $ 50,000 Is the change material?

Change in gross margin (2009=49%, 2005=40%) 2% Sales$ 20,000,000 Dollar change $ 400,000 Change is material (> materiality of $50,000)

Materiality of Fluctuation 1. Determine fluctuation = Actual - Expected amount 2. Compare to net income or other base to determine if material base to determine if material For gross margin, change = change as % of sales

For balance sheet accounts, need to compute expected amount (alternate method % change in ratio) Predicted inventory if turnover constant: Inv. Turn (Cos/EI) COS/2008 Turn = 194,371/5.2 = Predicted inventory = 37,379 Recorded inventory = 59,864 Increase in inventory 22,485 Increase in inventory 22,485

Alternate method - % change in ratio For turnover ratios, can’t subtract ratio since involves B/S and I/S amounts – can computer dollar change as percentage change in ratio Inv. Turn (Cos/EI) % Change in turn = (2008 – 2009) /2008 = = 1.95/5.20 = 37.5 % x EI 59,864 x EI 59,864 Increase in inventory 22,449 Increase in inventory 22,449

Problem 8-33 Change in Gross Margin: ( ) x 14,211 = 128 Explanations: Industry GP decline Decrease % of sales from drugs

Problem 8-33 Explanations: Industry GP decline - True Decrease % of sales from drugs - True Our concern is not whether the statements are true, but whether they fully account for the decline in gross margin.

Total GP decline 128 Industry (.2% x 14,211) (28) Change in mix: 09 Drugs = 39% sales 08 Drugs = 36% (3% x 14,211) = 426 (decline in drug sales) drug sales) Drug - Nondrug GP = ( ) = 8.6 % (37) Unaccounted for 63

Problem 8-33: DrugsNondrugs % 32.0% % 32.0% % 32.0% % 32.0% % 31.9% % 31.9% % 31.8% % 31.8% The change in drug gross margin is much larger than for the industry, and appears to be material ([ ] x 5,126,000 = $82,000). (drug sales)

Assessment of Going Concern Auditor must assess whether client will continue in existence for a reasonable period of time. Required on all audit engagementsRequired on all audit engagements Reasonable period is usually one year from f/s dateReasonable period is usually one year from f/s date Auditor should consider management plans affect going concern statusAuditor should consider management plans affect going concern status