AUDIT PLANNING

AND ANALYTICAL
PROCEDURES

CHAPTER 8
 8-1 Discuss Why Adequate Audit Planning is Essential.

8-2 Make Client Acceptance Decisions and Perform Initial Audit

Learning Planning.

8-3 Gain an Understanding of The Client’s Business and Industry.

Objective 8-4 Assess Client Business Risk.

8-5 Perform Preliminary Analytical Procedures.

s
8-6 State the Purposes of Analytical Procedures and The Timing
Of Each Purpose.
 There are three main reasons why the auditor
8.1 Why should properly plan engagements:
Adequate 1. to enable the auditor to obtain sufficient
Audit appropriate/ competent evidence for the
Planning Is circumstances,

Essential. 2. to help keep audit costs reasonable, and

3. to avoid misunderstandings with the client.
 ❑Client Business Risk—the risk that the client will fail to achieve its objectives
related to (1) reliability of financial reporting, (2) effectiveness and efficiency of
operations, and (3) compliance with laws and regulations

❑Acceptable Audit Risk—a measure of how willing the auditor is to accept that the

Risk financial statements may be materially misstated after the audit is completed and an
unqualified opinion has been issued
• When the auditor decides on a lower acceptable audit risk, it means that the auditor
wants to be more certain that the financial statements are not materially misstated.

Terms ❑Inherent Risk—a measure of the auditor’s assessment of the likelihood that there are
material misstatements in a segment before considering the effectiveness of internal
control
 If, for example, the auditor concludes that there is a high likelihood of material
misstatement in accounts receivable due to changing economic conditions, the
auditor concludes that the inherent risk for accounts receivable is high.
  Figure 8-1 Presents The Eight Major Parts Of Audit Planning

Audit
Planning
Step 1: Accept Client And
Perform Initial Audit
Planning.
 Initial audit planning involves four things:

Step 1: 1. The auditor decides whether to accept a new client or continue serving an
existing one.
Accept  New Client Investigation: Before accepting a new client, most CPA firms
investigate financial stability and communicate with their previous CPA firm.
Client And  Continuing Clients: Many CPA firms evaluate existing clients annually to

Perform determine whether there are reasons for not continuing to do the audit.

Initial Audit 2. The auditor identifies why the client wants or needs an audit.

3. To avoid misunderstandings, the auditor obtains an understanding with the client

Planning. about the terms of the engagement.

4. The auditor develops an overall strategy for the audit. Evaluate the need for
outside specialists.
 An agreement between the CPA firm and the
client as to the terms of the engagement for
the conduct of the audit and related services
Engagement
It includes the engagement’s objectives,
letter the responsibilities of the auditor and
management, and
the engagement’s limitations.
8.3 Step 2: Understand
The Client’s Business
And Industry.
 Step 2: The auditor must obtain a sufficient understanding of the entity
Understand and its external environment, including its internal control,
The Client’s  to assess the risk of material misstatement of the financial
Business statements whether due to error or fraud, and

And  to design the nature, timing, and extent of further audit

Industry. procedures.
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

Factors the auditor should understand:

– Major sources of revenue
– Key customers and suppliers
– Sources of financing
– Information about related parties
– Ability to obtain financing
• 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

The client’s performance measurement system includes key

performance indicators. Examples:

– market share – Web site visitors

– sales per employee – same-store sales
– unit sales growth – sales/square foot

Performance measurement includes ratio analysis and

benchmarking against key competitors.
 Step 3: Asses Client's
Business Risk
Learning Objective 4
 Step 3:
Asses  Client business risk is The risk that the client will
fail to achieve its objectives.
Client's  What is the auditor’s primary concern?
Business – material misstatements in the financial statements
due to client business risk

Risk
  Client business risk can arise from any of the factors

Step 3: affecting the client and its environment, such as

Asses  significant declines in the economy that threaten the

client’s cash flows (Economic Conditions),
Client's
 New technology eroding a client’s competitive
Business
advantage, or
Risk
 a client failing to execute its strategies as well as its
competitors.
 Step 4: Perform
Preliminary Analytical
Procedures
Learning Objective 5
  Auditors perform preliminary analytical procedures to better
understand the client’s business and to assess client business risk.
Step 4:  As compares client ratios to industry or competitor, and

Perform benchmarks to indicate the company’s performance

Preliminary  preliminary tests can reveal unusual changes in ratios

compared to prior years, or industry averages, and help the
Analytical auditor identify areas with increased risk of misstatements that
Procedures require further attention during the audit.

 Analytical procedures are also an important part of testing

throughout the audit.
 Selected Ratios Client Industry
Short-term debt-paying ability:
Examples of Current ratio 3.86 5.20
Planning
Liquidity activity ratio:
Analytical Inventory turnover 3.36 5.20
Procedures
Ability to meet long-term obligations:
Debt to equity 1.73 2.51

Profitability ratio:
Profit margin 0.05 0.07
  Analytical procedures use comparisons and
State the relationships to assess whether account balances or
Purposes Of other data appear reasonable.
Analytical  Analytical procedures may be performed at any of
Procedures three times during an engagement:
And The 1. required in the planning phase to assist in
determining the nature, extent, and timing of audit
Timing Of procedures
Each 2. often done during the testing phase of the audit as a
substantive test in support of account balances.
Purpose 3. required during the completion phase of the audit.
 The Purposes
Of Analytical
Procedures And
The Timing Of
Each Purpose.
Compute Common
Financial Ratios.
Learning Objective 8
Short-term Debt- Liquidity
paying Ability Activity Ratios

Cash ratio: Accounts receivable turnover:

(Cash + Marketable securities) ÷ Current Net sales ÷ Average gross
liabilities receivables

Quick ratio: Days to collect receivables:

(Cash + Marketable securities+ Net 365 days ÷ Accounts receivable
accounts receivable) ÷ Current liabilities turnover

Inventory Turnover:
Current ratio: Cost of goods sold ÷ Average
Current assets ÷ Current liabilities inventory

Days to sell Inventory:

365 days ÷ Inventory turnover
Ability to meet long-term
Profitability Ratios
Debt Obligations

Debt to equity: Total liabilities ÷ Earnings per share: Net income ÷ Average common shares
Total equity outstanding

Times interest Earned: Operating Gross profit percent:(Net sales – Cost of goods sold) ÷ Net
income ÷ Interest expense sales

Profit margin: Operating income ÷ Net sales

Return on assets: Income before taxes ÷ Average total assets

Return on common equity: (Income before taxes – Preferred

dividends) ÷ Average stockholders’ equity
Select the most
appropriate analytical
procedure from among the
five major types.
Learning Objective 7
 1. Compare client and industry data.
2. Compare client data with similar
prior period data.
Five Types of 3. Compare client data with

Analytical client-determined expected results.

4. Compare client data with
Procedures
auditor-determined expected results.
5. Compare client data with expected
results, using nonfinancial data.
 Client Industry

Compare 2005 2004 2005 2004

Client and Inventory turnover 3.4 3.5 3.9 3.4

Gross margin 26.3% 26.4% 27.3% 26.2%
Industry Data
 2004 2003
Compare (000) % of (000) % of
Prelim. Net sales Prelim. Net sales
Client Data Net sales $143,086 100 .0 $131,226 100.0
Cost of goods sold 103,241 72 .1 94,876 72.3
with Similar Gross profit
Selling expense
$ 39,845
14,810
27.9
10 .3
$ 36,350
12,899
27.7
9.8
Administrative expense 17,665 12.4 16,757 12.8
Prior Period 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
Data Net income $ 3,934 2.8 $ 3,194 2.4
 1) 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
is the:
A. inherent risk.
B. acceptable audit risk. Answer: B
C. statistical risk.
D. financial risk.

2) Initial audit planning involves four matters. Which of the following is not one of these?

Questions A. Develop an overall audit strategy.

B. Request that bank balances be confirmed.
C. Schedule engagement staff and audit specialists.
(Choose) D. Identify the client's reason for the audit.
Answer: B

3) Written communication that the auditor will provide reasonable assurance for the detection of
fraud is found in:
A. engagement letter.
B. representation letter.
C. responsibility letter.
Answer: A
D. client letter.
 4) A measure of the auditor's assessment of the likelihood that there are material
misstatements in an account before considering the effectiveness of the client's
internal control is called:
A. Control risk. Answer: D
B. Acceptable audit risk.
C. Statistical risk.
D. Inherent risk.

Questions 5) The auditor uses knowledge gained from the understanding of the client's
business and industry to assess:
Answer: A
(Choose) A.
B.
C.
client business risk.
control risk.
inherent risk.
D. audit risk.

6) The preliminary audit strategy:

A. is set before the auditor understands the client's reasons for the audit.
B. guides the development of the audit plan. Answer: B
C. is determined after the engagement staffing is set.
D. is the detailed steps to be followed for the substantive audit tests.
 4- Because of audit risk, some CPA firms now refuse any new clients in certain Answer: A
high-risk industries.
A) True
B) False

5- Many inherent risks are common to all clients in certain industries.

Answer: A
A) True
B) False.
Questions 6- Management is the primary source for identifying client business risks.
A) True
Answer: A

B) False.
(True and False) 7- Auditors perform preliminary analytical procedures to better understand the client's
business and to assess client business risk.
A) True Answer: A
B) False

8- In order to be meaningful, a company's ratios should be compared to their prior

year's ratios, not industry benchmarks.
A) True Answer: B
B) False