Auditing II

Unit 1 : Audit Procedures

Unit 2: Audit of Limited Companies

Unit 3: Audit of Government

Companies

Unit 1: Audit Procedures

Learning Objective 1

Discuss why adequate audit

planning is essential.

Three Main Reasons for Planning

1. To obtain sufficient competent evidencefor the circumstances

2. To help keep audit costs reasonable

3. To avoid misunderstanding with the client

Risk Terms

Acceptable audit risk Acceptable audit risk

Inherent risk Inherent risk

Planning an Audit and Designing an Audit Approach

Accept client and perform initial audit planning.

Understand the client’s business and industry.

Assess client business risk.

Perform preliminary analytical procedures.

Planning an Audit and Designing an Audit Approach

Set materiality and assess acceptable audit riskand inherent risk.

Understand internal control and assess control risk.

Gather information to assess fraud risks.

Develop overall audit plan and audit program.

Learning Objective 2

Make client acceptance decisions

and perform initial audit planning.

Initial Audit Planning

Client acceptance and continuance

Identify client’s reasons for audit

Obtain an understanding with the client

Develop overall audit strategy

Learning Objective 3

Gain an understanding of the

client’s business and industry.

Understanding of the Client’s Business and Industry

Factors that have increased theimportance of understanding theclient’s business and industry:

Global operations

Information technology

Human capital

Understanding of the Client’s Business and Industry

Industry and external environmentIndustry and external environment

Business operations and processesBusiness operations and processes

Management and governanceManagement and governance

Objectives and strategiesObjectives and strategies

Measurement and performanceMeasurement and performance

Understand client’s business and industryUnderstand client’s business and industry

Industry and External Environment

Reasons for obtaining an understanding of theclient’s industry and external environment:

1. Risks associated with specific industries

2. Inherent risks common to all clients incertain industries

3. Unique accounting requirements

Business Operationsand Processes

Factors the auditor should understand:

Major sources of revenue Key customers and suppliers Sources of financing Information about related parties

Tour the Plant and Offices

By viewing the physical facilities, the auditor can asses physical safeguards over assets and interpretaccounting data related to assets.

Identify Related Parties

A related party is defined as an affiliatedcompany, a principal owner of the clientcompany, or any other party with whichthe client deals, where one of the partiescan influence the management orpolicies of the other.

Management and Governance

Management establishes the strategies andprocesses followed by the client’s business.

Governance includes the client’s organizationalstructure, as well as the activities of the boardof directors and the audit committee.

Corporate charter and bylaws

Meeting minutes

Code of ethics

Code of Ethics

In response to the Sarbanes-Oxley Act, the SECnow requires each public company to disclosewhether is has adopted a code of ethics thatapplies to senior management.

The SEC also requires companies to discloseamendments and waivers to the code of ethics.

Client Objectives and Strategies

Strategies are approaches followed by theentity to achieve organizational objectives.

Auditors should understand client objectives.

Effectiveness and efficiency of operations

Financial reporting reliability

Compliance with laws and regulations

Measurement and Performance

The client’s performance measurement systemincludes key performance indicators. Examples:

market share sales per employee unit sales growth

Web site visitors same-store sales sales/square foot

Performance measurement includes ratio analysisand benchmarking against key competitors.

Learning Objective 4

Assess client business risk.

Assess Client Business Risk

Client business risk is the risk that theclient will fail to achieve its objectives.

What is the auditor’s primary concern?

Material misstatements in the financialstatements due to client business risk

Client’s Business, Risk, andRisk of Material Misstatement

Understand client’sbusiness and industry

Industry and external environment

Business operations and processes

Management and governance

Objectives and strategies

Measurement and performance

Assess client businessrisk

Assess risk of materialmisstatements

Sarbanes-Oxley (new title)

The Sarbanes-Oxley Act requires thatmanagement certify it has designeddisclosure controls and procedures toensure that material information aboutbusiness risks is made known to them.

It also requires that management certifyit has informed the auditor and auditcommittee of any significant deficienciesin internal control.

Enterprise Risk Management

Enterprise risk management (ERM) hasemerged as a new paradigm for managing risk.

ERM integrates and coordinates riskmanagement across the entire enterprise.

Learning Objective 5

Perform preliminary analytical

procedures.

Preliminary Analytical Procedures

Comparison of client ratios to industryor competitor benchmarks provides anindication of the company’s performance.

Preliminary tests can reveal unusualchanges in ratios.

Examples of Planning Analytical Procedures

Liquidity activity ratio:Inventory turnover 3.36 5.20

Ability to meet long-term obligations:Debt to equity 1.73 2.51

Profitability ratio:Profit margin 0.05 0.07

Short-term debt-paying ability:Current ratio 3.86 5.20

ClientClient IndustryIndustrySelected RatiosSelected Ratios

Summary of the Partsof Auditing Planning

A major purpose is to gain an understanding of the client’s business and industry.

Key Parts of Planning

Accept client and perform initial planning

New client acceptance and continuance

Identify client’s reasons for audit

Obtain an understanding with client

Staff the engagement

Key Parts of Planning

Understand the client’s business and industry

Understand client’s industry and externalenvironment

Understand client’s operations, strategies,and performance system

Key Parts of Planning

Assess client business risk

Evaluate management controlsaffecting business risk

Assess risk of material misstatements

Key Parts of Planning

Perform preliminary analytical procedures

Learning Objective 6

State the purposes of analytical

procedures and the timing

of each purpose.

Analytical Procedures

1. Required in the planning phase

2. Often done during the testing phase

3. Required during the completion phase

SAS 56 emphasizes the expectationsdeveloped by the auditor.

Timing and Purposes of Analytical Procedures

(Required)Planning

PhasePurpose

Understand client’sindustry and business

Primarypurpose

Assess going concern Secondarypurpose

Indicate possiblemisstatements(attention directing)

Primarypurpose

Reduce detailed tests Secondarypurpose

Secondarypurpose

Primarypurpose

Secondarypurpose

Primarypurpose

TestingPhase

(Required)Completion

Phase

Learning Objective 7

Select the most appropriate

analytical procedure from

among the five major types.

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.

Compare Client and Industry Data

Inventory turnover 3.4 3.5 3.9 3.4Gross margin 26.3% 26.4% 27.3% 26.2%

ClientClient IndustryIndustry

2007 2006 2007 2006

Compare Client Data with Similar Prior Period Data

Net sales $143,086 100.0 $131,226 100.0Cost of goods sold 103,241 72.1 94,876 72.3Gross profit $ 39,845 27.9 $ 36,350 27.7Selling expense 14,810 10.3 12,899 9.8Administrative expense 17,665 12.4 16,757 12.8Other 1,689 1.2 2,035 1.6Earnings before taxes $ 5,681 4.0 $ 4,659 3.5Income taxes 1,747 1.2 1,465 1.1Net income $ 3,934 2.8 $ 3,194 2.4

20072007

(000)(000)Prelim.Prelim.

% of% ofNet salesNet sales

20062006

(000)(000)Prelim.Prelim.

% of% ofNet salesNet sales

Learning Objective 8

Compute common financial ratios.

Common Financial Ratios

Short-term debt-paying ability

Liquidity activity ratios

Ability to meet long-term debt obligations

Profitability ratios

Short-term Debt-paying Ability

Current ratioCurrent assets

Current liabilities=

Cash ratio(Cash + Marketable securities)

Current liabilities=

Quick ratio(Cash + Marketable securities

+ Net accounts receivable)Current liabilities

=

Liquidity Activity Ratios

Accounts receivableturnover

Net salesAverage gross receivables

=

Days to collectreceivable

365 days365 daysAccounts receivable turnover

=

Inventoryturnover

Cost of goods soldCost of goods soldAverage inventory

=

Days to sellinventory

365 days365 daysInventory turnover

=

Ability to Meet Long-term Debt Obligation

Debt to equityTotal liabilities

Total equity=

Times interestearned

Operating incomeInterest expense

=

Profitability Ratios

Earningsper share

Net incomeAverage common shares outstanding

=

Gross profitpercent

(Net sales – Cost of goods sold)Net sales

=

Profit marginOperating income

Net sales=

Profitability Ratios

Return oncommonequity

(Income before taxes– Preferred dividends)

Average stockholders’ equityAverage stockholders’ equity=

Return onassets

Income before taxesAverage total assets

=

Summary of Analytical Procedures

They involve the computation of ratiosand other comparisons of recordedamounts to auditor expectations.

They are used in planning to understandthe client’s business and industry.

They are used throughout the audit to identifypossible misstatements, reduce detailed tests,and to assess going-concern issues.

End of Chapter 8