Audit Planning and Analytical Procedures

1. Audit Planning andAnalytical Procedures Chapter 8

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

3. To obtain sufficient competent evidence for the circumstances 1 To help keep audit costs reasonable 2 To avoid misunderstanding with the client 3 Three Main Reasons for Planning

4. Risk Terms Acceptable audit risk Inherent risk

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

6. Gather information to assess fraud risks. Understand internal control and assess control risk. Develop overall audit plan and audit program. Planning an Audit and Designing an Audit Approach Set materiality and assess acceptable audit risk and inherent risk.

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

8. Initial Audit Planning Get client acceptance and continuance. Identify client’s reasons for audit. Obtain an understanding with the client. Select staff for the engagement. Evaluate need for outside specialists.

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

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. 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

12. Industry and External Environment What are some 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

13. Business Operationsand Processes Factors the auditor should understand: – Major sources of revenue – Key customers and suppliers – Sources of financing – Information about related parties – Ability to obtain financing

14. 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 Code of ethics Meeting minutes

15. 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.

16. 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

17. 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.

18. Learning Objective 4 • Assess client business risk.

19. 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

20. Assess Client Business Risk 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.

21. Assess client business risk. Assess risk of material misstatements. 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 Measurement and performance

22. Go look it up! What’s a paradigm? Enterprise Risk Management Enterprise risk management (ERM) has emerged as a new paradigm for managing risk. ERM integrates and coordinates risk management across the entire enterprise.

23. Learning Objective 5 • Perform preliminary analytical • procedures.

24. 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.

25. Selected Ratios Client Industry Short-term debt-paying ability: Current ratio 3.86 5.20 Examples of Planning Analytical Procedures Liquidity activity ratio: Inventory turnover 3.36 5.20 Ability to meet long-term obligations: Debt to equity 1.73 2.51 Profitability ratio: Profit margin 0.05 0.07

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

27. New client acceptance and continuance Obtain an understanding with client Identify client’s reasons for audit Staff the engagement Key Parts of Planning Accept client and perform initial planning

28. Understand client’s industry and external environment Understand client’s operations, strategies, and performance system Key Parts of Planning Understand the client’s business and industry

29. Assess client business risk Assess risk of material misstatements Evaluate management controls affecting business risk Key Parts of Planning Assess client business risk

30. Key Parts of Planning Perform preliminary analytical procedures

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

32. 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.

33. 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 Timing and Purposes of Analytical Procedures

34. Timing and Purposes 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

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

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

37. Five Types of Analytical Procedures 1. Compare client and industry data. 2. Compare client data with similar prior period data. 3. Compare client data with client-determined expected results. 4. Compare client data with auditor-determined expected results. 5. Compare client data with expected results, using nonfinancial data.

38. Client Industry 2005 2004 2005 2004 Inventory turnover 3.4 3.5 3.9 3.4 Gross margin 26.3% 26.4% 27.3% 26.2% Compare Client and Industry Data

39. 2004 2003 (000) Prelim. % of Net sales (000) Prelim. % of Net sales Net sales $143,086 100 .0 $131,226 100.0 Cost of goods sold 103,241 72.1 94,876 72.3 Gross profit $ 39,845 27.9 $ 36,350 27.7 Selling expense 14,810 10 .3 12,899 9.8 Administrative expense 17,665 12.4 16,757 12.8 Other 1,689 1.2 2,035 1.6 Earnings before taxes $ 5,681 4.0 $ 4,659 3.5 Income taxes 1,747 1.2 1,465 1.1 Net income $ 3,934 2.8 $ 3,194 2.4 Compare Client Data with Similar Prior Period Data

40. Learning Objective 8 • Compute common financial ratios.

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

42. 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

43. 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 Days to sell inventory: 365 days ÷ Inventory turnover

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

45. 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

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

47. 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.

48. End of Chapter 8