Chapter 7 Audit Planning and Analytical Procedures PDF

Audit Planning and Analytical Procedures with Materiality and Risk Chapter 7  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk Index Why Audit Planning is Essential.............................

Audit Planning and Analytical Procedures with Materiality and Risk Chapter 7  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk Index Why Audit Planning is Essential........................................................................................................... 4 Major Purpose of the Parts of Auditing Planning.................................................................................. 4 Initial Audit Planning............................................................................................................................. 5 Client Acceptance and Continuance........................................................................... 5 Obtain an Understanding with the Client................................................................... 6 Understanding of the Client’s Business and Industry................................................ 6 Develop Overall Audit Strategy................................................................................. 7 Preliminary Analytical Procedures........................................................................................................ 8 Summary of Analytical Procedures............................................................................ 9 Types of Analytical Procedures............................................................................................................. 9 Compare Client and Industry Data........................................................................... 10 Compare Client Data with Similar Prior Period Data.............................................. 10 Planning an Audit and Designing an Audit Approach......................................................................... 12 Audit Risk............................................................................................................................................ 12 Risk and Evidence................................................................................................................................ 13 Risk Assessment.................................................................................................................................. 13 Audit Risk Model for Planning............................................................................................................ 13 Audit Risk Model Components................................................................................ 14 Impact of Engagement Risk on Acceptable Audit Risk...................................................................... 15 What is Engagement Risk?....................................................................................... 15 Factors Affecting Acceptable Audit Risk................................................................ 15 Measurement Limitations in the Audit Risk Model................................................. 15 References............................................................................................................................................ 16 2  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk Objectives By the end of this lesson the student is expected to be able to: 1- Discuss why audit planning is essential. 2- Perform initial audit planning. 3- Apply preliminary analytical procedures. 4- Use the most appropriate analytical procedure from among the five major types. 5- Explain the concept of materiality to the audit. 6- Negotiate Risk assessment in auditing. 7- Describe the audit risk model and its components. 8- Discuss the impact of engagement risk on acceptable audit risk. 3  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk Why Audit Planning is Essential There are three main reasons why the auditor should properly plan engagements: 1. To obtain sufficient appropriate evidence for the circumstances. 2. To help keep audit costs reasonable that helps the firms remain competitive. 3. To avoid misunderstanding with the client is important for good client relations and also for facilitating high quality work at a reasonable cost. Major Purpose of the Parts of Auditing Planning A major purpose is to gain an understanding of the client’s business and industry. Much of the early planning of audits deals with obtaining information to help auditors assess these risks. There are two risks that significantly influence the conduct and cost of audits: - Acceptable risk. - Inherent risk. - Acceptable risk: is 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. 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. Zero risk is certainty, and a 100 percent risk is complete uncertainty. - Inherent risk: is a measure of the auditor’s assessment of the likelihood that there are material misstatements in an account balance before considering the effectiveness of internal control. 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 inherent risk for 4  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk accounts receivable is high. Assessing acceptable audit risk and inherent risk is an important part of audit planning. Initial Audit Planning Initial audit planning involves four points: Client Acceptance and Continuance a CPA firm must care in deciding which clients are acceptable. The firm’s legal and professional responsibilities are such that clients who lack integrity or argue constantly about the proper conduct of the audit and fees can cause more problems than they are worth. Regarding new client investigations ▪ If previously audited, the new auditor is required to communicate with the predecessor auditor. ▪ Client permission required. Continuing clients ▪ Annual evaluations whether to continue based on issues, fees, and client integrity. CPA firms investigate the company to determine its acceptability. They do this by examining, to the extent possible, the prospective client’s standing in the business community, financial stability, and relations with its previous CPA firm. 5  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk Many CPA firms evaluate existing clients annually to determine if there are reasons for not continuing to do the audit. Previous conflicts over the appropriate scope of the audit, the type of opinion to issue, unpaid fees, or other matters may cause the auditor to discontinue association. The auditor may also drop a client after determining the client lacks integrity. Obtain an Understanding with the Client A clear understanding of the terms of the engagement should exist between the client and the CPA firm. Auditing standards require that auditors document their understanding with the client in an engagement letter, including the engagement’s objectives, the responsibilities of the auditor and management, and the engagement’s limitations. In summary: Engagement terms should be understood between CPA and client. Standards require an engagement letter describing: ▪ Objectives. ▪ Responsibilities of auditor and management. ▪ Schedules and fees. Informs client that auditor cannot guarantee all acts of fraud will be discovered Understanding of the Client’s Business and Industry. Understanding the nature of the client’s business and industry and external envirnoment, including areas where there is a greater risk of significant misstatements. 6  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk The auditor also considers other factors such as the number of client locations and the past effectiveness of client controls in developing a preliminary approach to the audit. Factors the auditor should understand: Major sources of revenue. Key customers and suppliers. Sources of financing. Information about related parties. Industry and External Environment 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. Develop Overall Audit Strategy Preliminary audit strategy should consider ▪ Material misstatement risk areas. ▪ Number of client locations. ▪ Past effectiveness of controls. Preliminary strategy helps the auditor determine resource requirements and staffing ▪ Staff continuity. ▪ Need for specialists. 7  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk Preliminary Analytical Procedures Auditors perform preliminary analytical procedures to better understand the client’s business and to assess client business risk. One such procedure compares client ratios to industry or competitor benchmarks to provide an indication of the company’s performance. preliminary tests can reveal unusual changes in ratios compared to prior years, or to industry averages, and help the auditor identify areas with increased risk of misstatements that require further attention during the audit. Such comparison of client ratios to industry or competitor benchmarks provides an indication of the company’s performance. Table 1: represent examples of planning analytical procedures 8  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk Summary of Analytical Procedures - Compare ratios of recorded amounts to auditor expectations. - Used in planning to understand client’s business and industry. - Used throughout the audit: To identify possible misstatements Reduce detailed tests Assess going-concern issues. Types of Analytical Procedures There are five types of analytical procedures: Auditors develop an expectation of an account balance or ratio by considering information from prior periods, industry trends, client-prepared budgeted expectations, and nonfinancial information. The auditor typically compares the client’s balances and ratios with expected balances and ratios using one or more of the following types of analytical procedures. In each case, auditors 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. 9  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk Compare Client and Industry Data Suppose you have the following information: Client Industry ____________________ _____________________ 2021 2020 2021 2020 Inventory turnover 3.4 3.5 3.9 3.4 Gross margin percentage 26.3% 26.4% 27.3% 26.2% If we look to the client information for the two ratios shown, the company appears to be stable with no apparent indication of difficulties. However, if we use industry data to develop expectations about the two ratios for 2021, we should expect both ratios for the client to increase. Although these two ratios by themselves may not indicate significant problems, this data illustrates how developing expectations using industry data may provide useful information about the client’s performance and potential misstatements. Compare Client Data with Similar Prior Period Data For example, Suppose that the gross margin percentage for a company has been between 26 and 27% for each of the past 4 years but has dropped to 23% in the current year. This decline in gross margin should be a concern to the auditor if a decline is not expected. The cause of the decline could be a change in economic conditions. But, it could also be caused by misstatements in the financial statements, such as sales or purchase cutoff errors, unrecorded sales, overstated accounts payable, or inventory costing errors. The decline in gross margin is likely to result in an increase in evidence in one or more of the accounts that affect gross margin. The auditor needs to determine the 10  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk cause of the decline to be confident that the financial statements are not materially misstated. A wide variety of analytical procedures allow auditors to compare client data with similar data from one or more prior periods. Here are some common examples: - Compare the current year’s balance with that of the preceding year. - Compare the detail of a total balance with similar detail for the preceding year. - Compute ratios and percent relationships for comparison with previous years. 2021 2020 ____________________ _________________ (000) % of (000) % of Prelim. Net sales Prelim. Net sales 100.0 $131,226 100.0 $143,086 Net sales 72.3 94,876 72.1 103,241 Cost of goods sold 27.7 $ 36,350 27.9 $ 39,845 Gross profit 9.8 12,899 10.3 14,810 Selling expense 12.8 16,757 12.4 17,665 Administrative expense 1.6 2,035 1.2 1,689 Other 3.5 $ 4,659 4.0 $ 5,681 Earnings before taxes 1.1 1,465 1.2 1,747 Income taxes 2.4 $ 3,194 2.8 $ 3,934 Net income 11  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk Planning an Audit and Designing an Audit Approach Set materiality and assess acceptable audit risk and inherent risk. Understand internal control and assess control risk. Gather information to assess fraud risks. Develop overall audit plan and audit program. Materiality Major consideration in determining the appropriate audit report. What is meant by the term “material”? FASB Concept Statement 2 defines materiality as: The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement. - Auditor’s responsibility = determine whether financial statements are materially misstated. - Auditor will bring material misstatements to the client’s attention so corrections can be made. Audit Risk - Auditors accept some level of risk in performing the audit. - Risks exist, are difficult to measure, and require careful thought in response. 12  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk Risk and Evidence - Auditors need to understand the client’s business and assess business risk. - The audit risk model helps identify the potential and likelihood of misstatements. Risk Assessment Risk assessment procedures are performed to identify and assess the risk of material misstatement. Auditors must decide the appropriate acceptable audit risk for an audit, especially during audit planning. Inquiries of management. Analytical procedures. Observation and inspection. Discussion among engagement team members. discussions with predecessor auditor. Audit Risk Model for Planning The audit risk model helps auditors decide how much and what types of evidence to accumulate in each cycle. It is usually stated as follows: 13  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk Audit Risk Model Components - Planned Detection Risk: Is a measure of the risk that audit evidence for a segment will fail to detect misstatements exceeding the performance materiality amount. - Acceptable Audit Risk: Is a measure of how much risk the auditor is willing to take that the financial statements may be materially misstated after the audit is completed and an unqualified audit opinion has been issued. - Inherent Risk: Is a measure of the auditor's assessment of the likelihood that there are material misstatements before considering the effectiveness of internal control. - Control Risk: Is a measure of the auditor's assessment of the likelihood that misstatements exceeding a performance materiality in a segment will not be prevented or detected by the client's internal controls. Table 2: Illustrate relationships of risk to evidence 14  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk Impact of Engagement Risk on Acceptable Audit Risk What is Engagement Risk? - Auditors decide engagement risk and use that risk to modify acceptable audit risk. - Engagement risk closely relates to client business risk. Factors Affecting Acceptable Audit Risk The degree to which external users rely on the statements. The likelihood that a client will have financial difficulties after the audit report is issued. The auditor’s evaluation of management’s integrity. Measurement Limitations in the Audit Risk Model One major limitation of the audit risk model is the difficulty of measuring the components of the model. Known: Preliminary assessed level of risk. Unknown: Actual level of risk achieved on the audit. 15  Chapter 7 Audit Planning and Analytical Procedures with Materiality and Risk References - Auditing and Assurance Services: An Integrated Approach,14th Edition - Alvin A Arens, Randal J Elder, Mark S Beasley, ISBN-13: 978-0-13-257595-9. ISBN-10: 0-13-257595-7 - Auditing Cases, International Edition (9th Edition) by Michael C. Knapp, ISBN-10: 1133187900. ISBN-13: 978-1133187905 16