12/1/2023

Three Main Reasons for Planning

1. To obtain sufficient appropriate evidence
for the circumstances

2. To help keep audit costs reasonable

3. To avoid misunderstanding with the client

Materiality

Risk Terms It is a major consideration in determining

the appropriate audit report to issue.
 Acceptable audit risk

 Inherent risk
The auditor’s responsibility is to determine
whether financial statements are
materially misstated.

If there is a material misstatement, the auditor will

bring it to the client’s attention so that a correction
can be made.

3 4

Steps in Applying Materiality

1. Set Preliminary Judgment About
1. Set preliminary judgment
Planning
Materiality
about materiality
extent Auditors decide early in the audit
2. Allocate preliminary judgment
of tests the combined amount of misstatements
about materiality to segments of the financial statements that would
be considered material.

3. Estimate total misstatement

in segment This preliminary judgment is the maximum
Evaluating amount by which the auditor believes the
4. Estimate the combined
results statements could be misstated and still not
misstatement
5. Compare combined estimate affect the decisions of reasonable users.
with judgment about materiality
5 6

1
 12/1/2023

Factors Affecting Judgment Guidelines

Materiality is a relative rather Accounting and auditing standards
than an absolute concept. do not provide specific materiality
guidelines to practitioners.
Bases are needed for
evaluating materiality.
Professional judgment is to be used
at all times in setting and applying
Qualitative factors also materiality guidelines.
affect materiality.

7 8

2. Allocate Preliminary Judgment 3. Estimated Total Misstatement and

About Materiality to Segments Preliminary Judgment
Estimated Misstatement Amount
This is necessary because evidence is Known
Misstatement
accumulated by segments rather than Tolerable and Direct Sampling
for the financial statements as a whole. Account Misstatement Projection Error Total

Cash $ 4,000 $ 2,000 $ N/A $ 2,000

Accounts receivable 20,000 12,000 6,000 18,000
Most practitioners allocate materiality Inventory 36,000 31,500 15,750 47,250
to balance sheet accounts. Total estimated
misstatement amount $45,500 $16,800 $62,300
Preliminary judgment
about materiality $50,000

N/A = Not applicable

Cash audited 100 percent
9 10

Illustration of Differing Evidence Among Illustration of Differing Evidence Among

Cycles Cycles
Sales and Acquisition Payroll and Inventory and Capital acquisition
collection and payment personnel warehousing and repayment
cycle cycle cycle cycle cycle
Inherent Inherent
A Medium High Low A High Low
risk risk
Control Control
B Medium Low Low B High Medium
risk risk
Acceptable Acceptable
C Low Low Low C Low Low
audit risk audit risk
Planned Planned
D Medium Medium High D Low Medium
detection risk detection risk

11 12

2
 12/1/2023

Further Audit Procedures

and the Audit Risk Model
Audit Risk Model for Planning
PDR = AAR ÷ (IR × CR) Audit risk AAR
model = PDR
IR × CR
where: PDR = Planned detection risk

AAR = Acceptable audit risk

Sufficient
Tests of Substantive Analytical Tests of
appropriate
IR = Inherent risk controls + tests of + procedures + details of =
evidence
transactions balances
per GASS
CR = Control risk
Further audit procedures

13 14

Impact of Engagement Risk on

Acceptable Audit Risk Factors Affecting Acceptable Audit Risk
Auditors decide engagement risk and use  The degree to which external users
that risk to modify acceptable audit risk. rely on the statements

 The likelihood that a client will have

Engagement risk closely relates to client financial difficulties after the
business risk. audit report is issued

 The auditor’s evaluation of

management’s integrity

15 16

Methods Practitioners Use to Assess Methods Practitioners Use to Assess

Acceptable Audit Risk Acceptable Audit Risk
Methods Used to Assess Methods Used to Assess
Factors Acceptable Audit Risk Factors Acceptable Audit Risk
External users’  Examine financial statements Likelihood  Analyze financial statements
reliance on  Read minutes of the board of financial for difficulties using ratios
financial  Examine form 10K difficulties  Examine inflows and outflows
statements  Discuss financing plans of cash flow statements
with management
Management  See Chapter 8 for client
integrity acceptance and continuance

17 18

3
 12/1/2023

Relationship of Factors Influencing Risks

Factors Affecting Inherent Risk to Risks and Risks to Planned Evidence
 Nature of the client’s business  Auditors can change the audit
 Results of previous audits to respond to risks
 Initial versus repeat engagement
 Related parties  The engagement may require
 Nonroutine transactions more experienced staff
 Judgment required to correctly record
account balances and transactions  The engagement will be reviewed
 Makeup of the population more carefully than usual
 Factors related to fraudulent financial reporting
 Factors related to misappropriation of assets
19 20

Tolerable Misstatement, Risks,

Audit Risk for Segments and Balance-related Audit Objectives
Both control risk and inherent risk are  It is common to assess inherent and control
typically set for each cycle, each risk for each balance-related audit objective
account, and often even each audit
objective, not for the overall audit.  It is not common to allocate materiality
to objectives

21 22

Measurement Limitations Relationships of Risk to Evidence

One major limitation in the application of the AcceptableInherent Control
Planned Amount of
detection evidence
audit risk model is the difficulty of measuring Situation audit risk risk risk risk required
the components of the model. 1 High Low Low High Low
2 Low Low Low Medium Medium
3 Low High High Low High
4 Medium Medium Medium Medium Medium
5 High Low Medium Medium Medium

23 24

4
 12/1/2023

Tests of Details of Balances Evidence

Planning Worksheet Revising Risks and Evidence
Auditors develop various types of worksheets The auditor must revise the original
to aid in relating the considerations affecting assessment of the appropriate risk.
audit evidence to the appropriate
evidence to accumulate. The auditor should consider the effect
of the revision on evidence requirements,
without the use of the audit risk model.

25 26

Risk Risk and Evidence

Auditors accept some level of risk Auditors gain an understanding of the
in performing the audit. client’s business and industry and
assess client business risk.
An effective auditor recognizes that
risks exist, are difficult to measure, Auditors use the audit risk model to further
and require careful thought to respond. identify the potential for misstatements
and where they are most likely to occur.
Responding to risks properly is critical
to achieving a high-quality audit.

27 28

Planning an Audit and Designing an Planning an Audit and Designing an

Audit Approach Audit Approach
Accept client and perform initial audit planning. Set materiality and assess acceptable audit risk
and inherent risk.
Understand the client’s business and industry.
Understand internal control and assess control risk.
Assess client business risk.
Gather information to assess fraud risks.
Perform preliminary analytical procedures.
Develop overall audit plan and audit program.

29 30

5
 12/1/2023

Understanding of the Client’s Business

Initial Audit Planning and Industry
1. Client acceptance and continuance Factors that have increased the
importance of understanding the
2. Identify client’s reasons for audit client’s business and industry:

3. Obtain an understanding with the client  Information technology

 Global operations
4. Develop overall audit strategy
 Human capital

31 32

Understanding of the Client’s Business

and Industry Industry and External Environment
Understand client’s business and industry Reasons for obtaining an understanding of the
client’s industry and external environment:
Industry and external environment
1. Risks associated with specific industries
Business operations and processes
2. Inherent risks common to all clients in
Management and governance certain industries
3. Unique accounting requirements
Objectives and strategies

Measurement and performance

33 34

Business Operations
and Processes Tour the Plant and Offices
Factors the auditor should understand: By viewing the physical facilities,
the auditor can asses physical
safeguards over assets and interpret
 Major sources of revenue accounting data related to assets.
 Key customers and suppliers
 Sources of financing
 Information about related parties

35 36

6
 12/1/2023

Identify Related Parties Management and Governance

Management establishes the strategies and
A related party is defined as an affiliated processes followed by the client’s business.
company, a principal owner of the client
company, or any other party with which
Governance includes the client’s organizational
the client deals, where one of the parties
structure, as well as the activities of the board
can influence the management or
of directors and the audit committee.
policies of the other.
 Corporate charter and bylaws
 Code of ethics
 Meeting minutes

37 38

Code of Ethics Client Objectives and Strategies

In response to the Sarbanes-Oxley Act, the SEC Strategies are approaches followed by the
now requires each public company to disclose entity to achieve organizational objectives.
whether is has adopted a code of ethics that
applies to senior management. Auditors should understand client objectives.

 Financial reporting reliability

The SEC also requires companies to disclose
amendments and waivers to the code of ethics.  Effectiveness and efficiency of operations
 Compliance with laws and regulations

39 40

Measurement and Performance Assess Client Business Risk

The client’s performance measurement system Client business risk is the risk that the
includes key performance indicators. Examples: client will fail to achieve its objectives.

 market share  Web site visitors  What is the auditor’s primary concern?
 sales per employee  same-store sales
 unit sales growth  sales/square foot  Material misstatements in the financial
statements due to client business risk
Performance measurement includes ratio analysis
and benchmarking against key competitors.

41 42

7
 12/1/2023

Client’s Business, Risk, and Sarbanes-Oxley Act

Risk of Material Misstatement The Sarbanes-Oxley Act requires that
Industry and external environment
Understand client’s management certify it has designed
business and industry
Business operations and processes
disclosure controls and procedures to
ensure that material information about
Management and governance business risks is made known to them.
Assess client business
risk
Objectives and strategies It also requires that management certify
it has informed the auditor and audit
Assess risk of material Measurement and performance
misstatements committee of any significant deficiencies
in internal control.

43 44

Examples of Planning Analytical

Preliminary Analytical Procedures Procedures
Selected Ratios Client Industry
Comparison of client ratios to industry
or competitor benchmarks provides an Short-term debt-paying ability:
indication of the company’s performance. Current ratio 3.86 5.20
Liquidity activity ratio:
Inventory turnover 3.36 5.20
Preliminary tests can reveal unusual
Ability to meet long-term obligations:
changes in ratios.
Debt to equity 1.73 2.51
Profitability ratio:
Profit margin 0.05 0.07

45 46

Summary of the Parts

of Auditing Planning Key Parts of Planning
A major purpose is to gain an understanding Accept client and perform initial planning
of the client’s business and industry.
 New client acceptance and continuance

 Identify client’s reasons for audit

 Obtain an understanding with client

 Staff the engagement

47 48

8
 12/1/2023

Key Parts of Planning Key Parts of Planning

Understand the client’s business and industry
 Assess client business risk
 Understand client’s industry and external  Evaluate management controls
environment affecting business risk

 Understand client’s operations, strategies,  Assess risk of material misstatements

and performance system

49 50

Key Parts of Planning Analytical Procedures

Perform preliminary analytical procedures AU 329 emphasizes the expectations
developed by the auditor.

1. Required in the planning phase

2. Often done during the testing phase
3. Required during the completion phase

51 52

Timing and Purposes of Analytical

Procedures Five Types of Analytical Procedures
(Required) (Required)
Planning Testing Completion Compare client data with:
Purpose Phase Phase Phase
Understand client’s Primary 1. Industry data
industry and business purpose 2. Similar prior-period data
Assess going concern Secondary Secondary
purpose purpose
3. Client-determined expected results
Indicate possible Primary Secondary Primary
4. Auditor-determined expected results
misstatements
(attention directing) purpose purpose purpose 5. Expected results using nonfinancial data.
Reduce detailed tests Secondary Primary
purpose purpose

53 54

9
 12/1/2023

Compare Client Data with Similar Prior

Compare Client and Industry Data Period Data
2009 2008
Client Industry
(000) % of (000) % of
2009 2008 2009 2008 Prelim. Net sales Prelim. Net sales

Inventory turnover 3.4 3.5 3.9 3.4 Net sales $143,086 100.0 $131,226 100.0
Cost of goods sold 103,241 72.1 94,876 72.3
Gross margin 26.3% 26.4% 27.3% 26.2% 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

55 56

Common Financial Ratios Short-term Debt-paying Ability

 Short-term debt-paying ability (Cash + Marketable securities)
Cash ratio =
Current liabilities
 Liquidity activity ratios (Cash + Marketable securities
Quick ratio = + Net accounts receivable)
 Ability to meet long-term debt obligations Current liabilities

Current assets
 Profitability ratios Current ratio =
Current liabilities

57 58

Ability to Meet Long-term Debt

Liquidity Activity Ratios Obligation
Accounts receivable Net sales Total liabilities
= Debt to equity =
turnover Average gross receivables Total equity
Days to collect 365 days
= Times interest Operating income
receivable Accounts receivable turnover =
earned Interest expense
Inventory Cost of goods sold
=
turnover Average inventory
Days to sell 365 days
=
inventory Inventory turnover

59 60

10
 12/1/2023

Profitability Ratios Profitability Ratios

Earnings Net income Return on Income before taxes
= =
per share Average common shares outstanding assets Average total assets

Return on (Income before taxes

Gross profit (Net sales – Cost of goods sold) common = – Preferred dividends)
=
percent Net sales equity Average stockholders’ equity

Operating income
Profit margin =
Net sales

61 62

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.

63

11