Chapter 8Audit Planning and Analytical

Procedures

J. Smith, CPAAudit Plan

Presentation Outline

I. Accept Client and Perform Initial Audit PlanningII. Understand the Client’s Business and Industry

III. Assess Client Business RiskIV. Perform Preliminary Analytical Procedures

I. Accept Client and Perform Initial Planning

A. Client Acceptance and Continuance

B. Identify Client’s Reasons for Audit

C. Obtain an Understanding with the Client

D. Select Staff for the Engagement

E. Evaluate Need for Outside Specialist

Acceptable Audit Risk - how willing the auditor is to accept that the financial statements may be materially misstated when an unqualified opinion is issued.

A. Client Continuance and Acceptance

Association with client’s who lack integrity can cause significant

problems.SAS 84 requires a successor

auditor to communicate with the predecessor auditor. Predecessor must obtain permission from client before responding. Response may

be limited.Lawsuits between the CPA and

client or unpaid fees for services performed more than 1 year

previously, will prohibit acceptance of the audit client.

B. Identify Client’s Reasons for Audit

Two major factors affecting acceptable audit risk are

likely statement users and their intended uses of the statements. More

evidence may be necessary when the statements are to be

used extensively.

The most likely uses can be determined from previous experience with the client

and discussion with management.

C. Obtaining an Understanding with the Client

SAS 83 requires auditors to document their understanding of the engagement in the audit files.

Although not required, an engagement letter is normally

used to establish the agreement.Auditors of public companies

should establish the understanding with the audit

committee.

Contents of Engagement Letter Services to be provided

Any restrictions on the auditors’ work

Deadlines for completing the work Assistance to be provided by

client personnel Inform client that fraud may not be

discovered May include fees

D. Select Staff for the Engagement

Staff should be knowledgeable of the client’s industry.

Continuity of staff helps the CPA firm maintain familiarity with technical requirements.

E. Evaluate Need for Outside Specialists

If an audit client requires specialized knowledge, it may

be necessary to consult a specialist.

Auditor should evaluate the specialist’s qualifications and understand the objectives and

scope of their work. Auditor should also consider

specialist’s relationship to client that could impair

objectivity.

II. Understand the Client’s Business and Industry

A. Major Reasons for Understanding Client Industry and External Environment

B. Business Operations and Processes C. Management and Governance

D. Client Objectives and StrategiesE. Measurement and Performance

The nature of the client’s business and industry affects client business risk and the risk of material misstatements in the financial

statements.

A. Major Reasons for UnderstandingClient Industry and External Environment

1. There may be risks associated with the client and the specific industry in which

it operates.2. Many industries have unique

accounting requirements that the auditor must understand.

B. Business Operations and Processes

Tour the plant and offices to better understand client operations and meet key personnel.

Identify related parties for purposes of disclosure. Related parties include an affiliated company, a

principal owner of client, and others who can influence the management or operating policies of the other.

Sarbanes-Oxley prohibits personal loans to client executives, except for normal loans by banks using

market rates.

C. Management and Governance

Management philosophy and operating style significantly influence the risk of material misstatement in the financial

statements. Sarbanes-Oxley requires public

companies to disclose whether they have adopted a code of

ethics for senior management. If not, they must state why.

Corporate minutes should be read by the auditor to identify

various authorizations that must be complied with.

D. Client Objectives and Strategies

Strategies are approaches followed by the entity to achieve organizational

objectives. Auditor should understand client strategies

regarding:Reliability of financial

reportingEffectiveness and efficiency of

operationsCompliance with laws and

regulations

E. Measurement and Performance

The risk of financial misstatements may be

increased if the client has set unreasonable objectives or if the

performance measurement system

encourages aggressive accounting.

III. Assess Client Business RiskClient business risk is the risk that the client will fail to achieve its

objectives. Sources include competitors, new technology, industry condition, and regulatory environment. Could influence client to

misstate the financial statements.Sarbanes-Oxley requires management to certify it has designed disclosure controls and procedures to ensure that they are made

aware of material information about business risks. Sarbanes-Oxley also requires management to certify that it has

informed the auditor and audit committee of any significant deficiencies in internal control.

IV. Perform Preliminary Analytical Procedures

A. Defining Analytical Procedures

B. Short-term Debt-Paying Ability

C. Liquidity Activity Ratios

D. Ability to Meet Long-term Debt Obligation

E. Profitability Ratios

A. Defining Analytical Procedures

Evaluations of financial information made by a study of plausible relationships among financial and non-financial data.

See purpose of procedures during audit phases in Figure 8-6 on page 209.

B. 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

C. 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

C. Liquidity Activity Ratios (Continued)

Days to sell inventory:365 days ÷ inventory turnover

D. Ability to Meet Long-term Debt Obligation

Debt to equity:Total liabilities ÷ Total equity

Times interest earned:Operating income ÷ Interest expense

E. Profitability Ratios

Earnings per share:Net income ÷ Average commons shares outstanding

Gross profit percent:(Net sales – Cost of goods sold) ÷ Net sales

Profit margin:Operating income ÷ Net sales

E. Profitability Ratios (Continued)

Return on assets:Income before taxes ÷ Average total assets

Return on common equity:(Income before taxes – Preferred dividends)

÷ Average stockholders’ equity

Initial Audit Planning

Accept client andperform initial audit

planning

Understand the client’sbusiness and industry

Assess client business risk

Perform preliminary analytical procedures