1. Electronic Presentations in Microsoft ® PowerPoint ® Prepared by Brad MacDonald SIAST © 2003 McGraw-Hill Ryerson Limited

2. Copyright © 2003 McGraw-Hill Ryerson Limited Chapte r 5 2 Audit Planning with Analytical Procedures, Risks, and Materiality

3. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 3 Audit Planning After pre-engagement procedures are complete, the auditor has certain planning tools to guide and direct the audit. Preliminary analytical procedures Preliminary materiality decisions Preliminary risk assessment –Audit planning tools are used to design the audit programs.

4. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 4 Preliminary Analytical Procedures Standards require analytical procedures at the start of the audit. Five types of procedures: –Compare current-year account balances to prior year account balances (comparatives). –Compare actual results to anticipated results found in the company’s budgets and forecasts. –Evaluate of the relationship to other current-year balances for conformity with predictable patterns. –Compare results with similar information for the industry in which the company operates. –Study the relationships of the current-year account balances with relevant non-financial information.

5. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 5 Preliminary Analytical Procedures Purposes of preliminary analytical procedures is –to alert the audit team to problems in the accounts and disclosures, and –effectively uncover misstatements

6. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 6 Learning Objective 1 Perform analytical procedures using un- audited financial statements to identify potential problems in the accounts.

7. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 7 Analysis of Unaudited Financial Statements Analysis is gaining importance in current auditing. –Auditors look for relationships in accounts as indicators of problems and to plan further audit work. –Horizontal analysis: examination of numbers and ratios across two or more years. –Vertical analysis: examination of amounts expressed each year as proportions of a base (sales or total assets).

8. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 8 Analysis of Unaudited Financial Statements Preliminary analytical procedures: –are attention-directing: Assist the auditor in identifying potential problem areas –provide for an organized approach: A standard starting point, analytical procedures provide considerable familiarity with client’s business. –describe financial activities: Identify relationships and changes in data.

9. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 9 Analysis of Unaudited Financial Statements Ask relevant questions: –What could be wrong? –What errors or irregularities could account for these results? Funds flow analysis: –A statement of cash flow should be reviewed. –This provides crucial information of funds flow. Timing: (beginning and end of audit) –Standards require analysis at beginning and end of the audit.

10. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 10 Learning Objective 2 Describe how auditors decide upon a maximum amount of misstatement (planning materiality) acceptable in a company’s financial statements.

11. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 11 Preliminary Assessment of Planning Materiality Financial statement materiality: –Information is material and should be disclosed if it is likely to influence the economic decisions of financial statement users. –Accounting numbers are not perfectly accurate because of the nature of accounting. Estimates are used, and honest mistakes happen.

12. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 12 Materiality Judgement Criteria Auditors are generally left without definite, quantitative guidelines to determine materiality. –Rules of thumb : 5 to 10% of income before tax ½ to1% of assets ½ to 1% of equity ½ to 1% of revenue ½ to 1% of gross profit

13. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 13 Materiality Judgement Criteria Common factors used in making materiality judgments: –absolute size –relative size –nature of the item or issue –circumstances –cumulative effects of errors

14. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 14 Materiality Judgement Criteria Under SEC regulations, otherwise small misstatements are now considered material. –intentional misstatements –intentional violation of the law –intentional earnings management

15. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 15 Learning Objective 3 Describe the relationship of an overall planning materiality amount to the tolerable misstatement amounts for particular accounts.

16. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 16 Materiality Allocation To plan the audit of various accounts, auditors assign part of the planning materiality to each account. –Assigned amount is tolerable misstatement. The amount by which an account may be misstated and yet not cause the financial statements taken as a whole to be materially misleading.

17. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 17 Materiality Allocation Overall planning materiality can be allocated to accounts in amounts: that add up to twice the overall materiality that the square root of the sum of the squared tolerable misstatements is equal to overall materiality, or that exactly add up to materiality –Or, the auditor can use the same overall materiality for the entire audit.

18. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 18 Materiality and Planning Uses of materiality: –guide for planning audit program (efficiency and effectiveness) Develop a program that will detect material errors without over auditing –guide for evaluation of evidence –guide for making decisions about audit report

19. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 19 Learning Objective 4 Describe the conceptual audit risk model and explain the meaning and importance of its components in terms of professional judgement and audit planning.

20. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 20 Basic Goal of the Audit Since the basic goal of the audit is defined in terms of audit assurance, it is not an exaggeration to say that the reason for the existence of the auditing profession is to control risk.

21. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 21 Components of Audit Risk AR = Audit Risk –probability of material error in F/S remaining undetected after the audit. This will occur if the following three events occur. IR = Inherent Risk CR = Control Risk DR = Detection Risk

22. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 22 Inherent Risk The probability of material misstatement occurring in transactions entering the accounting system or being in the account balances is inherent risk. –Auditors do not create or control inherent risk. Auditors only try to assess its magnitude based on prior experience, management bias, and nature of the transactions. The auditor will consider the characteristics of the client’s business, types of transactions, and effectiveness of accountants.

23. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 23 Control Risk The risk that the client’s internal control system will not prevent or detect a material misstatement is control risk. –Auditors do not create or control control risk; they simply evaluate or assess probability of failure to detect material misstatements. This assessment of effectiveness may be tested by the auditor in the audit. –Assessment is based on study and evaluation of the company’s control system.

24. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 24 Detection Risk The risk that any material misstatement that has not been corrected by the client’s internal control will not be detected by the auditor is detection risk. –Auditors can control this risk by conducting substantive (balance audit) tests. Substantive tests include audit of details of transactions and balances, and analytical procedures applied to dollar amounts in the accounts.

25. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 25 Audit Risk The probability that an auditor will fail to express a reservation that financial statements are materially misstated is audit risk. –Audit risk is greater if there is poor planning or poor execution of the audit. –Audit risk is inversely proportionate to risk of getting sued. –Audit risk is dependent on user reliance. –Audit risk is also applied to individual account balances and disclosures.

26. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 26 Risk Model AR = IR x CR x DR Audit risk will occur when –A material misstatement has been made in the transactions or balances (inherent risk), –and internal controls fail to detect or correct the misstatement (control risk), and –audit procedures also fail to detect the misstatement (detection risk). Auditors usually like to limit audit risk to less than 5%.

27. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 27 Planning Memorandum The planning memorandum is a summarization of the preliminary analytical review and the materiality assessment with specific directions about the effect on the audit. All planning becomes the basis for the audit program. –The audit program specifies procedures the auditor will use to guide the work of inherent control and control risk assessment and to obtain sufficient competent evidence as a basis for the audit report

28. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 28 Learning Objective 5 Describe the content and purpose of audit programs.

29. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 29 Content and Purpose of the Audit Programs Internal control program: –A specification of procedures for obtaining and understanding the client’s business and control systems (assess IR and CR). Balance-audit program: –A specification of substantive procedures for gathering direct evidence on assertions about dollar amounts and accounts.

30. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 30 Selected Financial Ratios (Appendix 5A) Balance sheet ratios: –current ratio = CA / CL –days’ sales in receivables –doubtful account ratio –days’ sales in inventory –debit ratio

31. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 31 Selected Financial Ratios (Appendix 5A) Operations ratios: –receivables turnover –inventory turnover –cost of goods sold ratio –gross margin ratio –return on beginning equity

32. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 32 Selected Financial Ratios (Appendix 5A) Financial distress ratios (Altman, 1968) –Working capital / total assets –Retained earnings / total assets –Earnings before interest & taxes Total assets –Market value of equity Total assets – Net sales Total assets –Discriminant Z score

33. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 33 Strategic Systems Approach (SSA) to Auditing (Appendix 5B) Audit planning is not viewed as separate phase of audit. –Assurance propositions on client’s F/S are based on deep knowledge of client based on: strategic analysis analysis of business processes continuous business risk assessment business measurement analysis –Propositions are continually assessed against management assertions.

34. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 5 34 SSA (Appendix 5B) Questions asked by strategic analysis: –What is client strategy? –Is it sustainable? –What are the business risks/threats to client? –How does the client manage those risks? –What are the gaps in the client’s risk management approach? –Do those gaps affect the financial statements? Answers help to assess: –That business risks reflected in F/S. –That business processes are in place to attempt to control business risk.