Audit Planning and Analytical Procedures

Acceptance of Clients Juan M. Garcia Merced

First Standard of Field Work The work is to be adequately planned, and assistants, if any, are to be properly supervised.

Obtaining Clients Through: Acquisitions Business contacts Social contacts Advertising

Auditor’s Business Risk A thoroughly investigation of prospective clients should be made.

Submitting a Proposal Should include: Nature of services Qualifications Fees & other information Audit committee

Communication with Predecessor Auditor The successor auditor must ask management to authorize the predecessor to respond fully. Key issue in deciding whether to accept the engagement.

Auditor inquiries will include: Disagreements with management over accounting principles or scope limitations The predecessor’s understanding for the change in auditors The integrity of management Communications with audit committees regarding important audit issues

Items Included in Engagement Letters Name of the entity Management responsibilities Financial statements Establishing effective internal control over financial reporting Compliance with laws and regulations Making records available to the auditors Providing written representations at end of the audit, including that adjustments discovered by the auditors and not recorded to the financials are not material Auditor responsibilities Conducting an audit in accordance with GAAS Obtaining an understanding of internal control to plan audit and to determine the nature, timing and extent of procedures Making communications required by GAAS 2 2

Engagement Letters--Optional Items Arrangements regarding Conduct of the audit (e.g., timing, client assistance) Use of specialists or internal auditors Obtaining information from predecessor auditors Fees and billing Other services to be provided, such as examination of internal control over financial reporting Limitation of or other arrangements regarding liability of auditors or client Conditions under which access to the auditors’ working papers may be granted to others 3

ENGAGEMENT LETTER Required!!!!!!!!!!!!!!!

Generally Accepted Auditing Standards Technical training and efficiency Independence Due professional care Field Work Planning and supervision Internal control Evidence Reporting GAAP Disclosure Opinion Consistency

Audit Planning Gain an understanding of the client’s business and industry.

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

Tour the Plant and Offices By viewing the physical facilities, the auditor can asses physical safeguards over assets and interpret accounting data related to assets.

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

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.

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

Perform preliminary analytical procedures.

Preliminary Analytical Procedures Comparison of client ratios to industry or competitor benchmarks provides an indication of the company’s performance. Preliminary tests can reveal unusual changes in ratios.

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

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

Key Parts of Planning Perform preliminary analytical procedures

Analytical Procedures SAS 56 emphasizes the expectations developed by the auditor. Required in the planning phase Often done during the testing phase Required during the completion phase

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.

Compare Client and Industry Data 2007 2006 2007 2006 Inventory turnover 3.4 3.5 3.9 3.4 Gross margin 26.3% 26.4% 27.3% 26.2%

Compare Client Data with Similar Prior Period Data 2007 2006 (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

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

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

Liquidity Activity Ratios Accounts receivable turnover = Net sales Average gross receivables Days to collect receivable = 365 days Accounts receivable turnover Inventory turnover = Cost of goods sold Average inventory Days to sell inventory = 365 days Inventory turnover

Ability to Meet Long-term Debt Obligation Debt to equity = Total liabilities Total equity Times interest earned = Operating income Interest expense

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

Profitability Ratios Return on assets = Income before taxes Average total assets Return on common equity = (Income before taxes – Preferred dividends) Average stockholders’ equity

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.

End of Chapter