Chapter 8
Audit Planning
There are three primary benefits from planning audits:
it helps the auditor obtain sufficient appropriate evidence for the
circumstances, helps keep audit costs reasonable, and helps avoid
misunderstandings with the client.
Audit planning Audit evidence Audit reporting
Eight major steps in planning audits are:
1. Accept client and perform initial 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.
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6. Understand internal control and assess control risk.
7. Gather information to assess fraud risks
8. Develop overall audit strategy and audit program.
Important Information:
Auditing standards require auditors to document their
understanding of the terms of the engagement with the client in
an engagement letter.
The engagement letter:
is an agreement between the CPA firm and the client concerning
the conduct of the audit and related services? It should state what
services will be provided, whether any restrictions will be imposed
on the auditor’s work, deadlines for completing the audit, and
assistance to be provided by client personnel. The engagement
letter may also include the auditor’s fees.
It should include the engagement’s objectives, the
responsibilities of the auditor and management, and the
engagement’s limitations.
2-The five major aspects of understanding the client’s business
and industry, along with potential sources of information that
auditors commonly used for each of the five areas, are as
follows:
1. Industry and External Environment:
– Read industry trade publications, AICPA Industry Audit Guides,
and regulatory requirements.
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2. Business Operations and Processes:
– Tour the plant and offices, identify related parties, and inquire
of management.
3. Management and Governance:
– Read the corporate charter and bylaws, read minutes of board
of directors and stockholders, and inquire of management.
Management Governance
• establishes the strategies and • includes the client’s
processes followed by the organizational structure, as
client’s business well as the activities of the
board of directors and the
audit committee
4. Client Objectives and Strategies:
– Inquire of management regarding their objectives for the
reliability of financial reporting, effectiveness and efficiency of
operations, and compliance with laws and regulations; read
contracts and other legal documents, such as those for notes and
bonds payable, stock options, and pension plans.
5. Measurement and Performance:
– Read financial statements, perform ratio analysis, and inquire of
management about key performance indicators that management
uses to measure progress toward its objectives.
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During the plant tour, the CPA will obtain a perspective of the
client’s business, which will contribute to the auditor’s
understanding of the entity and its environment.
Information in the client’s minutes that is likely to be relevant to
the auditor includes the following:
1. Declaration of dividends
2. Authorized compensation of officers
3. Acceptance of contracts and agreements
4. Authorization for the acquisition of property
5. Approval of mergers
6. Authorization of long-term loans
7. Approval to pledge securities
8. Authorization of individuals to sign checks
9. Reports on the progress of operations
10. Discussion about outstanding litigation and other
contingencies
3- Assess client business risk:
(is the risk that the client will fail to meet its objectives)
• Sources of client business risk include any of the factors
affecting the client and its environment, including
competitor performance, new technology, industry
conditions, and the regulatory environment.
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• The auditor’s primary concern when evaluating client
business risk is the risk of material misstatements in the
financial statements due to client business risk.
• For example, if the client’s industry is experiencing a
significant and unexpected downturn, client business risk
increases. This increase would most likely increase the risk
of material misstatements in the financial statements. The
auditor’s assessment of the risk of material misstatements is
then used to classify risks using the audit risk model to
determine the appropriate extent of audit evidence.
4- Perform Preliminary analytical Procedures:
(Comparison of client ratios to industry or competitor benchmarks
provides an indication of the company’s performance)
Analytical procedures are performed during the planning phase of
an engagement to assist the auditor in determining the nature,
extent, and timing of work to be performed.
Five Types of Analytical Procedures
Compare client data with:
1- Industry data
2-Similar prior-period data
3-Client-determined expected results
4-Auditor-determined expected results
5-Expected results using nonfinancial data.
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The four categories of financial ratios and examples of ratios in
each category are as follows:
1. Short-term debt-paying ability
(Cash ratio, quick ratio, and current ratio).
2. Liquidity activity
(Accounts receivable turnover, days to collect receivables,
inventory turnover, and days to sell inventory).
3-Ability to meet long-term debt obligations
(Debt to equity and times interest earned)
3. Profitability
(Earnings per share, gross profit percent, profit margin,
return on assets, and return on common equity)
5- Set materiality, and assess acceptable audit risk and
inherent risk:
Inherent Risk:
The susceptibility of an assertion about a class of transaction,
account balance or disclosure to a misstatement that could be
material, either individually or when aggregated with other
misstatements before consideration of any related controls.
Good Luck