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A424: Chapter 8 Audit Planning and Analytical Procedures I. Audit Planning A.

Reasons for planning: to obtain sufficient appropriate evidence for the circumstances: industry, personnel, audit alerts, etc. to keep audit cost reasonable to avoid misunderstandings with the client to evaluate acceptable audit risk: a measure of how willing the auditor is to accept that he/she may erroneously issue an unqualified report. to evaluate inherent risk: a measure of the likelihood that there are material misstatements in an account balance. Preparation Question: How does the potential for material misstatements relate to acceptable audit risk in decisions about evidence gathering?

B. Accept client and perform initial planning 1. New client acceptance and continuance SAS 84 requires that old and new auditors communicate. Preparation Question: Who is responsible for initiating communication? Predecessor Must have client permission to respond openly (client confidentiality) Required to respond, even if to say no information will be provided. Communicate with other entities (attorneys, banks, other CPAs, etc.). Investigate backgrounds of management. Consider amount of risk for a failed audit (litigation). Previous conflicts on the report or fees. Evidence for lack of integrity. Pending lawsuit with client. Unpaid fees.

2. Identify clients reasons for audit SEC/SOX State regulation Other regulation Loan requirements Shareholders Plans for future (IPO) In general, more users more evidence

3. Obtain an understanding with the client Preparation Question: Is it required to document an understanding with the client? Preparation Question: Is an engagement letter required? Engagement letter (p. 212) Clarify responsibilities services, timing, who does what, $. Limit legal risks Forms a contract with client Preparation Question: How does the engagement letter form a contract with the client? Preparation Question: For a publicly traded company, with whom does the auditor work out an understanding about the engagement?

4. Develop an overall strategy A. Resource needs - nature of client - risk of significant misstatements - number of locations - internal control quality history B. Staff the engagement GAAS general standard #1 continuity advantages and disadvantages experience industry specialization outside specialists (SAS 73)

Goal to Identify: 1) potential problems/solutions and 2) types of evidence available

C. Understand the clients business and industry Client business risk risk that the client will fail to meet its objectives. 1. Industry and external environment specific industry risks audit alerts, typical knowledge 7 years to restaurant success where is the client in the life-cycle of the business. read industry publications. consider impact of general economic factors inherent risks - very nature of what is done, such as handling cash

know unique accounting principles/policies/practices review permanent and last years current file. industry audit guides.

2. Clients operations and processes Identify major sources of revenue, sources of financing Identify major customers and suppliers Identify joint ventures and strategic alliances Identify related parties: any party where one party can influence the management or operating policies of the other (SAS 45); permanent file, affiliated companies, principal owner, other party that influences. Tour facilities Evaluate use and quality of information technology Preparation Question: What are the GAAP disclosure requirements for related party transactions?

Preparation Question: What type of related party transaction does SOX specifically prohibit?

3. Clients management and governance Management philosophy and operating style Organizational structure, board of directors, audit committee Corporate charter and bylaws Code of ethics Minutes of meetings of board of directors 4. Clients objectives and strategies Reliability of financial reporting Effectiveness and efficiency of operations Compliance with laws and regulations 5. Clients measurement and performance Identify key indicators used to evaluate objectives D. Assess client business risk 1. Assess client business risk Defined: The risk that the client will fail to achieve its objectives. 2. Evaluate management controls affecting business risk 3. Assess risk of material misstatements

E. Perform preliminary analytical procedures A. Required for preliminary and final phases of the audit. B. Purpose (Figure 8-6, p. 224) 1. Understand the client's industry and business 2. Assess going concern 3. Indicate possible misstatements (attention directing) 4. Reduce detailed tests C. Types of comparisons - client with 1. industry data 2. similar prior-period data. 3. client-determined expected results (budgets). 4. auditor-determined expected results. 5. expected results, using nonfinancial data.

Goal is to look for anomalies balances that just dont seem right.

V. Set Materiality and Acceptable Risk Levels (Chapter 9) VI. Understand Internal Controls (Chapter 10) VII. Develop an Overall Plan and Audit Program (Chapter 13)

Preparation Question: Use of Ratio Analysis For each ratio listed below 1. Indicate whether it is primarily A. an indicator of financial failure B. an indicator of potential misstatements C. both 2. For each "A" answer, is it primarily Short-term (ST) Long-term (LT) 3. For each "B" and "C" answer, state the potential misstatement.
Question 1 (A, B, or C) Question 2 (for As only) ST or LT Question 3 (for B and C only) Potential misstatement

Ratio Quick ratio Sales commission / sales Gross margin % Debt / equity Average days to collect receivables Interest expense / average interest-bearing debt outstanding Current ratio Inventory turnover Profit / tangible operating assets Manufacturing repair and maintenance / manufacturing fixed assets

ALPHA COMPANY PRELIMINARY ANALYTICAL PROCEDURES

2005 Balance Income Sales (net) Cost of goods sold Gross margin General expenses Depreciation Operating expenses Interest expense Income taxes Net income Assets Cash Accounts Receivable Allowance for doubtful accounts Inventory Total current assets Equipment Accumulated depreciation Total assets Liabilities and Equity Accounts payable Bank loans Accrued interest Total current liabilities Long-term debt Total liabilities Capital Stock Retained earnings Total liabilities and equity Common size 100.00% 75.00 25.00 17.67 3.33 4.00 0.67 1.33 2.00% 14.78% 12.32 (0.99) 36.95 63.05 73.89 (36.95) 100.00% 12.32% 0.00 1.48 13.79 14.78 28.57 49.26 22.17 100.00% Balance

2006 Common size

Change Amount Percent change

9,000,000 6,750,000 2,250,000 1,590,000 300,000 360,000 60,000 120,000 180,000 600,000 500,000 (40,000) 1,500,000 2,560,000 3,000,000 (1,500,000) 4,060,000 500,000 0 60,000 560,000 600,000 1,160,000 2,000,000 900,000 4,060,000

9,900,000 7,200,000 2,700,000 1,734,000 300,000 666,000 40,000 256,000 370,000 200,000 900,000 (50,000) 1,600,000 2,650,000 4,000,000 (1,800,000) 4,850,000 400,000 750,000 40,000 1,190,000 400,000 1,590,000 2,000,000 1,260,000 4,850,000 4.12% 18.56 (1.03) 32.99 54.63 82.47 (37.11) 100.00% 8.25% 15.46 0.82 24.53 8.25 32.78 41.24 25.98 100.00% (400,000) 400,000 (10,000) 100,000 90,000 1,000,000 (300,000) 790,000 (100,000) 750,000 (20,000) 630,000 (200,000) 430,000 0 360,000 790,000 (66.67)% 80.00 25.00 6.67 3.52 33.33 20.00 19.46% (20.00)% (33.33) 112.50 (33.33) 37.07 0.00 40.00 19.46%

ALPHA COMPANY PRELIMINARY ANALYTICAL PROCEDURES SELECTED FINANCIAL RATIOS 2005 Balance Sheet Ratios Current ratio Days sales in receivables Doubtful accounts ratio Days sales in inventory Debt/equity ratio Operations Ratio Receivable turnover Inventory turnover Cost of goods sold/sales Gross margin percentage Return on beginning equity Financial Distress Ratios Working capital/total assets Retained earnings/total assets EBIT/Total assets Market value of equity/total debt Net sales/total assets Discriminant Z score 4.57 18.40 0.0800 80.00 0.40 2006 2.23 30.91 0.0556 80.00 0.49 Percent Change

19.57 4.50 75.00% 25.00% 6.62%

11.65 4.50 72.73% 27.27% 12.76%

(40.47) 0.00 (3.03) 9.09 92.80

0.49 0.22 0.09 2.59 2.22 4.96

0.30 0.26 0.14 1.89 2.04 4.35

(38.89) 17.20 54.87 (27.04) (7.92) (12.32)