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 - SET Inherent risk - ASSESSED

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 (specialization) Perform preliminary analytical procedures/review

5. Planning an Audit and Designing an Approach Set materiality, set acceptable audit risk and assess inherent risk (Ch 9) Gather information to assess fraud risks (Ch. 11) Understand internal control and assess control risk (Ch 10) Develop overall audit plan and audit program (Ch 13)

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

7. Initial Audit Planning Should the auditor accept a new client? Or re-accept one? Research on mitigators of risk. SOX – Big firms trimming down clients → 2nd tier Small firms, public clients, SOX 404, and PCAOB fees Identify why the client wants or needs an audit. Why? Obtain an understanding with the client. Engagement Letter SOX – signed by audit committee Select staff for the engagement → NSTE Specialists?

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. 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 High Tech: Inventory, A/R Retail: Competition Real Estate: LSL Unique accounting requirements: GAAP

11. Business Operationsand Processes Factors the auditor should understand: – major sources of revenue – how inputs changed to outputs – key customers and suppliers – sources of financing – information about related parties – ability to obtain financing – changes since the PY

12. 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 SOX – Code of Ethics – really do anything? Objectivity and competence of IA, whistleblowers Minutes of BOD meetings

13. Client Objectivesand Strategies Strategies are approaches followed by the entity to achieve organizational objectives. Auditors should understand client objectives. Financial reporting reliability Opportunities Effectiveness and efficiency of operations BR Compliance with laws and regulations Attitudes

14. Measurement and Performance The client’s performance measurement system includes key performance indicators. Examples: – market share – sales per employee – budgets: NI, Sales, etc. – Bonuses – stock price/stock options – EPS forecasts Performance Measurement = Incentives! “Follow the money”

15. Learning Objective 4 Assess client business risk.

16. Assess Client Business Risk Client business risk is the risk that the client will fail to achieve IT’S objectives. What is the auditor’s primary concern? Material misstatement of the financial statements (fraud or error) or bankruptcy due to client business risk. COSO’s ERM Framework

17. 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 PAP (could provide more BR info!) and then→Set Materiality and AR / Assess IR (next chapter)

18. Learning Objective 5 Perform preliminary analytical procedures.

19. Preliminary Analytical Procedures Comparisonof client ratios or balances to industry or competitor benchmarks provides an indication of the company’s performance. Comparison to PY = significant changes at the client Analytical procedures are also an important part of testing throughout the audit.

20. 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

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

22. 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 (source objectivity).

23. Timing and Purpose of Analytical Procedures Purpose (Required) PlanningPhase Understand client’s industry and business Primary purpose Assess going concern Secondary purpose Indicate possible misstatements (attention directing) Primary purpose

24. Timing and Purpose of Analytical Procedures Purpose Testing Phase Understand client’s industry and business Assess going concern Indicate possible misstatements (get an explanation and test) Secondary purpose Reduce costly detailed tests Primary purpose

25. Timing and Purpose of Analytical Procedures Purpose (Required) Completion Phase Understand client’s industry and business Access going concern Secondary purpose Indicate possible misstatements (did we test it adequately?) Primary purpose Reduce detailed tests

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

27. 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 (Budget). Compare client data with auditor-determined expected results. Compare client data with expected results, using quantitative, nonfinancial data. What does research tell us: preferences, areas for improvement, getting more sophisticated

28. Compare Clientand Industry Data ClientIndustry 2009200820092008 Inventory turnover 3.4 3.5 3.9 3.4 Gross margin percent 26.3% 26.4% 27.3% 26.2%

29. Compare Client Data With Similar Prior-period Data 2009 2008 (audited) (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

30. Compare Client Data With Non-financial data Research Findings: NFMs = employees, patents, squ. footage of facilities, retail outlets. Financial = Revenue (why). Change in Rev – Change in NFM = DIFF Fraud firm DIFF = 30% Non-fraud firm DIFF = 11% Why NFMs so valuable (vs. other sources) related to fraud. Do auditors use them? Do investors use them? Short-sellers and a tool.

31. Learning Objective 8 Compute common financial ratios.

32. Common Financial Ratios Short-term debt-paying ability Liquidity activity ratios Ability to meet long-term debt obligations Profitability ratios-EPS, Return on assets, etc.

33. 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

34. 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

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

36. End of Chapter 8