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Chapter 8--Audit Planning and Analytical

Procedures
8-1 The Need for Adequate Audit Planning
Your text points out three reasons why proper planning of an engagement is crucial: 1)
to obtain sufficient competent evidence, 2) to keep audit costs reasonable, and 3) to
avoid misunderstandings with the client. Ultimately, planning the audit pays off in
minimizing legal entanglements and maintaining good relations with your customer--
the client.

Audit planning consists of eight steps, illustrated in Table 8-1:

1. Accept the client and perform initial audit planning

2. Understand the client's business and industry

3. Assess client business risk

4. Perform preliminary analytical procedures

5. Set materiality and assess acceptable audit risk and inherent risk

6. Understand internal control and assess control risk

7. Gather information to assess fraud risks

8. Develop overall audit plan and program

Only the first four of the steps listed above are covered in this chapter.

The author points out two types of risk that the auditor must consider: acceptable audit
risk and inherent risk. Acceptable audit risk measures how willing the auditor is to
accept that the financial statements may be materially misstated at completion of the
audit. Inherent risk measures the likelihood of a material misstatement before
considering the effectiveness of internal control. These two measures of risk are
important in determining the quantity of evidence that must be accumulated. The
higher the risk, the more evidence it is necessary to acquire.
8-2 Make Client Acceptance Decisions and Perform Initial
Audit Planning
This first step can be broken down in to four tasks:

Client Acceptance and Continuance: Not every client is acceptable. The auditor
must consider the client's integrity, as well as the industry in which the client operates.
In short, the audit risk must be measured against the auditor's threshhold. The CPA
firm should conduct an investigation of a company to assess its desirability as a client.
If the would-be client has been audited previously by another CPA firm, that firm
must be contacted, with the client's permission. The auditor may even go further in the
investigation by contacting other entities that have had dealings with the client, in
order to further assess the client's situation.

For a continuing client, the auditor must reflect upon previous relations with the
client, evidence of the client's integrity, whether the audit fees have been paid (which
could introduce an independence violation if the fees are one year or more in arrears),
and the industry in which the client operates.

Identify the Client's Reasons for an Audit: Two factors will affect audit risk--the
likely statement users and their intended use of the statements. If the statements are to
be used widely, the auditor will need to amass more information in the audit.

Obtain an Understanding with the Client: The auditor must document the
understanding of the engagement by submitting an engagement letter to the client. A
good example of an engagement letter is shown in Figure 8-2. The engagement letter
will carefully specify what work the auditor will perform (audit, compilation, review,
tax return preparation) and should indicate that there is no guarantee of fraud
discovery. You should be aware of the stipulation by the Sarbanes-Oxley Act that it is
the audit committee of the firm being audited that is considered the client.

Select Staff for the Engagement: The staffing of the audit must meet the first general
standard of the Generally Accepted Auditing Standards relating to adequate technical
training and proficiency. Additional specialists should also be considered, if
appropriate. SAS 73 (AU 336) sets requirements for selecting and reviewing the work
of specialists. Also, continuity of personnel from year to year may help to improve
efficiency of the audit.

8-3 Understand the Client's Business and Industry


An auditor must have a thorough knowledge of the client's business and industry. This
need has been accentuated by the prevalence of information processing systems,
global operations, intangible asset complexities, as well as to provide consulting or
other services to the client.

The author of your text refers to the strategic systems approach to understanding the
client's business. This approach examines a number of dimensions:

1. Industry and the external environment

2. Business operations and processes

3. Management and governance

4. Objectives and strategies

5. Measurements and performance

Industry and the external environment: There are risks associated with certain
industries; there are risks associated to all clients in certain industries. Additionally,
there are varying accounting requirements that the auditor must take into account in
assessing whether or not to serve a particular client. The auditor must also consider
the external environment in which a company operates--the economic situation,
regulatory requirements, and other factors.

Business operations and processes: The auditor must strive to understand how the
business works--how revenue is generated, how the company is financed, who the
customers are, etc. A company tour is a step toward getting some familiarity,
particularly if questions can be directed to some of the employees. Additionally,
identifying transactions with related parties is a necessary step in understanding the
business, and may involve examination of SEC filings, conversations with
management, and reading through stockholder lists. The Sarbanes-Oxley Act prohibits
related party personal loans to executives; the auditor should be on the lookout for
such illegal loans.

Management and governance: The auditor should become familiar with the
company's organization chart, as well as the corporate charter and bylaws. The SEC
requires public companies to establish a code of ethics; assuming such a code exists, it
should be reviewed by the auditor for any changes or waivers taking place. Corporate
minutes taken at board meetings or stockholders' meetings should be reviewed by the
auditor, to determine if actions required of management have been executed.
Client objectives and strategies: Auditors should be aware of client objectives
related to reliability of financial reporting, effectiveness and efficiency of operations,
and compliance with laws and regulations. Various contracts, debts, pension plans,
leases, and other legal documents should be reviewed with the purpose of evaluating
the client's legal compliance.

Measurement and performance: The auditor should be knowledgeable regarding the


client's performance measures by making those same calculations.

8-4 Assess Client Business Risk


Figure 8-4 shows how the Strategic Systems approach provides information for
evaluating the client's business risk, and provides a basis for the auditor's assessment
of risk of material misstatement. Additionally, the Sarbanes-Oxley Act requires
management to certify that 1) it has designed disclosure controls and procedures to
ensure that material information about business risks is made known to them, and that
2) management has informed the auditor and audit committee of any significant
deficiencies in internal control, including material weaknesses.

8-5 Perform Preliminary Analytical Procedures


The fourth step in the audit planning process is to perform preliminary analytical
procedures. This step involves comparison of the client's ratios to industry standard
ratios, both to see how the client compares to its industry, as well as to determine if
the client's ratios have changed from previous years. Table 8-1 shows a comparison of
Hillsburg Hardware Company's raios, with industry standards, as well as Hillsburg's
ratios for the previous year. Note that the ratios include several categories--short term
debt-paying ability, liquidity activity ratios, ability to meet long term obligations, and
profitability ratios.

In Figure 8-5, the author presents a comprehensive example of how the steps in this
chapter could be applied to the Hillsburg Company example. The steps are listed,
along with the substeps, to the left, with the results stated on the right side of the
figure. Also, remember that in this chapter, only the first four steps are presented, and
that the other four steps will be introduced later.

8-6 State the Purposes of Analytical Procedures and Timing


of Each
You will remember that analytical procedures are one of the seven types of evidence
discussed in chapter 7. Your text defines analytical procedures as "evaluations of
financial information made by a study of plausible relationships among financial and
nonfinancial data...involving comparisons of recorded amounts to expectations
developed by the auditor." In other words, do the ratios and balances calculated appear
to be reasonable?

Analytical procedures are performed at three stages of the audit: 1) in the planning
phase, 2) during the testing phase, and 3) during the completion phase of the audit.
The purposes fo analytical procedures in different phases are illustrated in Figure 8-6.

8-7 Select the Most Appropriate Analytical Procedures from


Among the Five Types
It is vital that the auditor develop an expectation of what the calculations should look
like, based on information from prior periods, industry trends, and other information.
The auditor will use one or more of the following analytical procedures:

1. Compare client with industry data

2. Compare client data with similar prior-period data

3. Compare client data with client-determined expected results

4. Compare client data with auditor-determined expected results

5. Compare client data with expected results, using nonfinancial data

The author discusses each of these analytical procedures in some detail.

8-8 Compute Common Financial Ratios


In this final section, the text presents some common ratios used to measure company
performance. These measures are summarized as follows.

Short Term Debt Paying Ability

1. Cash Ratio

2. Quick Ratio

3. Current Ratio

Liquidity Activity Ratios


1. Accounts Receivable Turnover

2. Days to Collect Receivables

3. Inventory Turnover

4. Days to Sell Inventory

Ability to Meet Long-term Debt Obligations

1. Debt to Equity Ratio

2. Times Interest Earned

Profitability Ratios

1. Earnings per Share

2. Gross Profit Percentage

3. Profit Margin

4. Return on Assets

5. Return on Common Equity