Audit Planning and Analytical Procedures

1. Audit Planning andAnalytical Procedures Chapter 8

2. Learning Objective 1 Discuss why adequate audit planning is essential.

3. Planning The work is to be adequately planned, and assistants, if any, are to be properly supervised. Acceptable audit risk Inherent risk

4. Planning an Audit and Designing an Approach Assess client business risk Accept client and perform initial audit planning Understand the client’s business and industry Perform preliminary analytical procedures

5. Planning an Audit and Designing an Approach Set materiality, and assess acceptable audit risk and inherent risk Understand internal control and assess control risk Develop overall audit plan and audit program

6. Learning Objective 2 Make client acceptance decisions and perform initial audit planning.

7. Initial Audit Planning Should the auditor accept a new client? Identify why the client wants or needs an audit. Obtain an understanding with the client. Select staff for the engagement.

8. Learning Objective 3 Gain an understanding of the client’s business and industry.

9. 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

10. Understanding of the Client’s Business and Industry What are some factors that have increased the importance of understanding the client’s business and industry? Information technology Global operations Human capital

11. Industry and External Environment What are some reasons for obtaining an understanding of the client’s industry and external environment? Risks associated with specific industries Inherent risks common to all clients in certain industries Unique accounting requirements

12. Business Operationsand Processes Factors the auditor should understand: – major sources of revenue – sources of revenue – key customers and suppliers – sources of financing – information about related parties – ability to obtain financing

13. 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 Minutes of meetings

14. Client Objectivesand 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

15. 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.

16. Learning Objective 4 Assess client business risk.

17. 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 misstatement of the financial statements due to client business risk

18. The Client’s Business, Risk, andAuditor’s Risk Assessment Industry and External Environment Understand Client’s Business and Industry Business Operations and Processes Management and Governance Objectives and Strategies Assess Client Business Risk Measurement and Performance Assess Risk of Material Misstatements

19. Learning Objective 5 Perform preliminary analytical procedures.

20. 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.

21. Examples of Planning Analytical Procedures Selected Ratios Client Industry Short-Term Debt-Paying Ability Current ratio 3.86 5.20 Liquidity Activity Ratio Inventory turnover 3.46 5.20 Ability to Meet Long-Term Obligations Debt to equity 1.73 2.51 Profitability Return on assets 0.09 0.09

22. Summary of the Purposesof Auditing Planning A major purpose is to gain an understanding of the client’s business and industry.

23. Key Parts of Planning Accept Client and Perform Initial Planning New client acceptance and continuance Obtain an understanding with client Identify client’s reasons for the audit Staff the engagement

24. 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

25. Key Parts of Planning Assess Client Business Risk Assess client business risk Assess risk of material misstatements Evaluate management business controls affecting business risk

26. Key Parts of Planning Perform Preliminary Analytical Procedures

27. Learning Objective 6 State the purposes of analytical procedures and the timing of each purpose.

28. 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.

29. Timing and Purpose of Analytical Procedures Purpose (Required) Planning Phase Understand client’s industry and business Primary purpose Assess going concern Secondary purpose Indicate possible misstatements (attention directing) Primary purpose Reduce detailed tests Secondary purpose

30. Timing and Purpose of Analytical Procedures Purpose Testing Phase Understand client’s industry and business Assess going concern Indicate possible misstatements (attention directing) Secondary purpose Reduce detailed tests Primary purpose

31. Timing and Purpose of Analytical Procedures Purpose (Required) Completion Phase Understand client’s industry and business Access going concern Secondary purpose Indicate possible misstatements (attention directing) Primary purpose Reduce detailed tests

32. Learning Objective 7 Select the most appropriate analytical procedure from among the five major types.

33. Five Major Types ofAnalytical Procedures Compare client and industry data. Compare client data with similar prior-period data. Compare client data with client-determined expected results. Compare client data with auditor-determined expected results. Compare client data with expected results, using nonfinancial data.

34. Compare Clientand Industry Data ClientIndustry 2002200120022001 Inventory turnover 3.4 3.5 3.9 3.4 Gross margin percent 26.3% 26.4% 27.3% 26.2%

35. Compare Client Data With Similar Prior-period Data 2002 2001 (000,000) % of (000,000) % of PreliminaryNet SalesAuditedNet Sales Net sales 143 100 131 100 Cost of goods sold 103 72 95 72 Gross profit 40 28 36 28 S & A 32 22 30 23 Other 4 3 3 3 Net income 4 3 3 2

36. Learning Objective 8 Compute common financial ratios.

37. Common Financial Ratios Short-term debt-paying ability Liquidity activity ratios Ability to meet long-term debt obligations Profitability ratios

38. Short-termDebt-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

39. 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

40. Liquidity Activity Ratios Days to sell inventory: 365 days ÷ inventory turnover

41. Ability to Meet Long-term Debt Obligation Debt to equity: Total liabilities ÷ Total equity Times interest earned: Operating income ÷ Interest expense

42. 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.