Chapter 8 Audit Planning and Analytical Procedures J. Smith, CPA Audit Plan

Presentation Outline Accept Client and Perform Initial Audit Planning Understand the Client’s Business and Industry Assess Client Business Risk Perform Preliminary Analytical Procedures

I. Accept Client and Perform Initial Planning 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 Specialist Acceptable Audit Risk - how willing the auditor is to accept that the financial statements may be materially misstated when an unqualified opinion is issued.

A. Client Continuance and Acceptance Association with client’s who lack integrity can cause significant problems. SAS 84 requires a successor auditor to communicate with the predecessor auditor. Predecessor must obtain permission from client before responding. Response may be limited. Lawsuits between the CPA and client or unpaid fees for services performed more than 1 year previously, will prohibit acceptance of the audit client.

B. Identify Client’s Reasons for Audit Two major factors affecting acceptable audit risk are likely statement users and their intended uses of the statements. More evidence may be necessary when the statements are to be used extensively. The most likely uses can be determined from previous experience with the client and discussion with management.

C. Obtaining an Understanding with the Client Contents of Engagement Letter Services to be provided Any restrictions on the auditors’ work Deadlines for completing the work Assistance to be provided by client personnel Inform client that fraud may not be discovered May include fees SAS 83 requires auditors to document their understanding of the engagement in the audit files. Although not required, an engagement letter is normally used to establish the agreement. Auditors of public companies should establish the understanding with the audit committee.

D. Select Staff for the Engagement Staff should be knowledgeable of the client’s industry. Continuity of staff helps the CPA firm maintain familiarity with technical requirements.

E. Evaluate Need for Outside Specialists If an audit client requires specialized knowledge, it may be necessary to consult a specialist. Auditor should evaluate the specialist’s qualifications and understand the objectives and scope of their work. Auditor should also consider specialist’s relationship to client that could impair objectivity.

II. Understand the Client’s Business and Industry The nature of the client’s business and industry affects client business risk and the risk of material misstatements in the financial statements. Major Reasons for Understanding Client Industry and External Environment Business Operations and Processes Management and Governance Client Objectives and Strategies Measurement and Performance

Major Reasons for Understanding Client Industry and External Environment There may be risks associated with the client and the specific industry in which it operates. Many industries have unique accounting requirements that the auditor must understand.

B. Business Operations and Processes Tour the plant and offices to better understand client operations and meet key personnel. Identify related parties for purposes of disclosure. Related parties include an affiliated company, a principal owner of client, and others who can influence the management or operating policies of the other. Sarbanes-Oxley prohibits personal loans to client executives, except for normal loans by banks using market rates.

C. Management and Governance Management philosophy and operating style significantly influence the risk of material misstatement in the financial statements. Sarbanes-Oxley requires public companies to disclose whether they have adopted a code of ethics for senior management. If not, they must state why. Corporate minutes should be read by the auditor to identify various authorizations that must be complied with.

D. Client Objectives and Strategies Strategies are approaches followed by the entity to achieve organizational objectives. Auditor should understand client strategies regarding: Reliability of financial reporting Effectiveness and efficiency of operations Compliance with laws and regulations

E. Measurement and Performance The risk of financial misstatements may be increased if the client has set unreasonable objectives or if the performance measurement system encourages aggressive accounting.

III. Assess Client Business Risk Client business risk is the risk that the client will fail to achieve its objectives. Sources include competitors, new technology, industry condition, and regulatory environment. Could influence client to misstate the financial statements. Sarbanes-Oxley requires management to certify it has designed disclosure controls and procedures to ensure that they are made aware of material information about business risks. Sarbanes-Oxley also requires management to certify that it has informed the auditor and audit committee of any significant deficiencies in internal control.

IV. Perform Preliminary Analytical Procedures Defining Analytical Procedures Short-term Debt-Paying Ability Liquidity Activity Ratios Ability to Meet Long-term Debt Obligation Profitability Ratios

A. Defining Analytical Procedures Evaluations of financial information made by a study of plausible relationships among financial and non-financial data. See purpose of procedures during audit phases in Figure 8-6 on page 209.

B. 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

C. 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

C. Liquidity Activity Ratios (Continued) Days to sell inventory: 365 days ÷ inventory turnover

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

E. Profitability Ratios Earnings per share: Net income ÷ Average commons shares outstanding Gross profit percent: (Net sales – Cost of goods sold) ÷ Net sales Profit margin: Operating income ÷ Net sales

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

Initial Audit Planning Accept client and perform initial audit planning Understand the client’s business and industry Assess client business risk Perform preliminary analytical procedures