Chapter 8 Audit Planning and Analytical Procedures

1. Chapter 8Audit Planning andAnalytical Procedures Dr. Mohamed A. Hamada Lecturer of AIS

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

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

4. Main phases of Audit Planning Acceptthe client and perform initial audit planning. Understand the client’s business and industry. Assessthe client business risk. Perform initial analyticalprocedures.

5. Main phases of Audit Planning Set materiality and assess acceptable audit risk and inherent risk. Understand internalcontroland assess control risk. Gather information to assess fraudrisks. Develop overall audit plan and audit program.

6. Risk Terms • Acceptable audit risk is a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued • Inherent risk is a measure of the auditor’s assessment of the probability that there are material misstatements in an account balance.

8. Initial Audit Planning 1. Clientacceptance and continuance 2. Identify client’s reasons for audit 3. Obtain an understanding with the client 4. Develop overall audit strategy

9. Understanding of the Client’s Business and Industry Understand client’s business and industry include Industry and external environment Business operations and processes Management and governance Objectives and strategies Measurement and performance

10. Business Operationsand Processes Factors the auditor should understand: • Major sources of revenue • Key customers and suppliers • Sources of financing • Information about related parties

11. Identify Related Parties • A related party transaction is any transaction between the client and a related party. • Common examples include sales or purchase transactions between a parent company and its subsidiary, • exchanges of equipment between two companies owned by the same person.

12. 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 • average revenue Also, Performance measurement includes ratio analysis and benchmarking against key competitors.

13. Client’s Business, Risk, andRisk of Material Misstatement Industry and external environment Understand client’s business and industry Business operations and processes Management and governance Assess client business risk Objectives and strategies Assess risk of material misstatements Measurement and performance

14. Learning Objective 5 Perform preliminary analytical procedures.

15. Analytical Procedures Comparison of client ratios to industry or competitor benchmarks provides an indication of the company’s performance. Auditors perform preliminary analytical procedures to better understand the client’s business and to assess client business risk.

17. 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 3.36 5.20 Ability to meet long-term obligations: Debt to equity 1.73 2.51 Profitability ratio: Profit margin 0.05 0.07

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

19. Analytical procedures may be performed at any of three times • Analytical procedures are required in the planning phase to assist in determining the nature, extent, and timing of audit procedures • Analytical procedures are often done during the testing phase of the audit as a substantive test in support of account balances • Analytical procedures are also required during the completion phase of the audit

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

21. Five Types of Analytical Procedures Compare client data with: 1. Industry data 2. Similar prior-period data 3. Client-determined expected results 4. Auditor-determined expected results 5. Expected results using nonfinancial data.

22. Compare Client and Industry Data Client Industry 2009 2008 2009 2008 Inventory turnover 3.4 3.5 3.9 3.4 Gross margin 26.3% 26.4% 27.3% 26.2%

23. Compare Client Data with Similar Prior Period Data 2009 2008 (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 1,6891.22,0351.6 Earnings before taxes $ 5,681 4.0 $ 4,659 3.5 Income taxes 1,7471.2 1,4651.1 Net income $ 3,934 2.8 $ 3,194 2.4

24. Example • Suppose that the gross margin percentage between 26 and 27 percent for each of the past 4 years but has dropped to 23 percent in the current year. • This decline in gross margin should be a concern to the auditor if a decline is not expected. • The cause of the decline could be a change in economic conditions. • But, it could also be caused by misstatements in the financial statements, such as sales or purchase cutoff errors, unrecorded sales, overstated accounts payable, or inventory costing errors.

26. End of Chapter 8