Chapter 8

Audit Planning and Analytical Procedures

Key objectives:
1.
2.
3.
4.
5.

Understand the importance of audit planning.

Perform initial audit planning, including client acceptance.
Gain an understanding of the clients business and industry.
Assess client business risk.
Know the nature and purpose and perform preliminary analytical
procedures.
6. Understand the purpose and timing of analytical procedures.
1. Importance of Topic
Adequate planning is required under the first
standard of fieldwork. Audit planning helps
facilitate an efficient audit plan.
A.

Audit Risk - Risk that auditor is willing to

take that financial statements are materially
misstated when an unqualified opinion is
issued.

Underauditing (too little evidence) Auditor assumes more risk than desired.
Overauditing (too much evidence) Audit risk is reduced, but audit is
inefficient.

Either result is undesirable in a litigious,

competitive environment.
Accordingly,
audits must be planned to obtain the
appropriate amount of evidence.
In addition, many audit failures have been
attributed to a failure to plan, and gain an
understanding of the client's industry.
2. Planning the Audit - The eight parts of
planning the audit are included in Figure 8-1 on
page 211 of the text. Our concern in this chapter
is with the first four phases.
1.

Accept client and perform initial planning

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2. Understand the clients business and

industry
3. Assess client business risk
4. Perform preliminary analytical procedures

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3. Accept client and initial planning

A.

Evaluate whether you want to do the audit.

As discussed in Chapter 5, this is increasingly
important to minimizing firm risk. This is
generally routine for continuing clients. A
thorough review is usually warranted for new
clients, including communication with the
predecessor auditor. Client acceptance also
includes determining that the firm is
independent from the client.
Communication with predecessor auditor
(AU 315) is required before accepting
engagement and is a key element in the new
client acceptance review.
Primary purpose is to learn whether
predecessor auditor has information that will
help the successor auditor determine
whether to accept the engagement (i.e.,
client-auditor disputes, etc.).

Successor initiates the communication

Needs client approval (Why?)

Successor often reviews predecessor's

working papers to supporting beginning
asset balances (Why?)

Sample Multiple Choice #1

A successor auditor most likely would make specific
inquiries of the predecessor auditor regarding:
1.
2.
3.
4.

Specialized accounting principles of the client's

industry.
The competency of the client's internal audit
staff.
The uncertaintly inherent in applying sampling
procedures.
Disagreements with management as to auditing
procedures.
B.

Determine why the client wants the audit and

who the likely users of the financial
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statements are.
The users of the financial statements affects
the risk of the engagement (recall discussion
of liability to third parties in Ch. 5), which
influences the amount of evidence needed.
The relationship between risk and evidence is
discussed more fully in Ch. 9.

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C.

Establish understanding with the client

AU 310 requires auditors to obtain an
understanding with the client and document
that understanding. For public companies,
Sarbanes-Oxley requires that the audit
committee be responsible for hiring,
establishing
the
compensation,
preapproving
non-audit
services,
and
supervising the work of the auditor.

Engagement letter - A written

engagement letter is now required to
document the agreement between the
auditor and client to minimize any
misunderstandings.

Four elements of understanding

1. Engagement objectives
2. Management responsibilities
3. Responsibilities of auditor
4. Limitations of engagement
Understanding may address other
matters, such as use of specialists or
internal auditors

D. Staff the engagement.

E.

Evaluate need for specialist (AU 336)

Specialists should be, but are not required

to be independent of the client.
Auditor may only refer to a specialists
report in the audit opinion if the
specialists report resulted in a
qualification or modification of the
opinion.

Sample Multiple Choice #2

An auditor who uses the work of a specialist may refer
to the specialist in the auditor's report if the:
1.

Specialist's findings provide the auditor greater

assurance of reliability about management's
representations.
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2.
3.
4.

4.

The auditor qualifies the opinion as a result of the

specialist's findings.
Auditor's use of the specialist's findings is
different from that of prior years.
Specialist is a related party whose findings fully
corroborate management's financial statement
assertions.
Understand Clients Business and Industry
Learn as much as possible about the client to
effectively plan the audit. We not only want an
efficient audit, but want to prevent any surprises.
A. Learn about the client's industry - auditors
must be knowledgeable about their client's
industry to be technically competent to serve
on the engagement. There are a number of
sources of such information, including
industry audit guides.
Firms are increasingly emphasizing
industry specialization
Many firms audit processes place heavy
emphasis on knowledge of the clients
business strategies and risks.

FIGURE 8-3
Strategic Systems Understanding of the Client's
Business and Industry

Understand Client's
Business and Industry

Industry and
External Environment
Business Operations
and Processes
Management and
Governance
Objectives and
Strategies
Measurement and
Performance

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Inquire as to related parties - risky audit area

that should be addressed early. Auditor concern
with related parties is with the adequacy of
disclosure.

By their nature, related party

transactions may not be at arm's
length.
Readers of financial statements need
information to evaluate the economic
effects of related party transactions.

Sample Multiple Choice #3

When auditing related party transactions, an auditor
places primary emphasis on:
1.
2.

Confirming the existence of the related parties.

Verifying the valuation of the related party
transactions.
3. Evaluating the disclosure of the related party
transactions.
Ascertaining the rights and obligations of the related parties.

5. Assess Client Business Risk

Risks identified in gaining an understanding of
the clients business and industry are used to
assess the risk that the company will not be
successful in achieving its business objectives.
This risk is then used to assess risk of material
misstatements in the financial statements.

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6.

Perform Preliminary Analytical Procedures

Analysis using broad ratios can further support
understanding of the clients business and
assessment of client business risk.
A. Further discussion of objectives and types of analytical
procedures

Purpose

Common form of
Test

Example

Understand
client business

Comparison to
industry using broad
ratios

Comparison of gross margin

percentage and inventory turnover
to similar competitors.(1)

Going Concern

Statistical prediction
model based on key
ratios

Altman Z-Score based on factors

such as net income and retained
earnings.(2)

Attention
directing

Comparison to prior
year or expected
value

Compare depreciation expense to

prior year or expected amount
considering depreciation methods
and changes in fixed assets.

Reduce detail
tests

Comparison using
highly predictable
relationships or
nonfinancial data

Compare recorded interest expense

to an estimate based on average
borrowings and interest rates.

(1) Comparison may be made to an industry composite, or similar size

competitors whose business is most similar the client's business.
Auditors often examine both the level and changes in the ratio.
These ratios can also be used to indicate possible errors. Specific
examples are discussed further in Ch. 16 and Ch. 21.
(2) Several statistical models perform very well in making bankruptcy
predictions. These models can be used to assist the auditor's
judgment.

Sample Multiple Choice #4

Auditors try to identify predictable relationships when
using analytical procedures. Relationships involving
transactions from which of the following accounts
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would yield the highest level of evidence?

1.
2.
3.
4.

Accounts payable.
Advertising expense.
Accounts receivable.
Interest expense.

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B.

Forms of Comparison
1.
2.
3.
4.
5.

Industry data
Prior period data
Budget
Auditor expected results
Nonfinancial data

Most analytical procedures involve comparisons

of current amounts to prior period data or
auditor expected results.
Prior period data may be in dollars (good for
fixed costs), or percentages (good for variable
costs). Auditor expectations are especially good
for mixed costs, or changing economic
conditions.
Multiple Choice 8-27 (d)
Which of the following situations has the best chance
of being detected when a CPA compares 2009
revenues and expenses with the prior year and
investigates all changes exceeding a fixed
percentage?
1.
2.
3.
4.

An increase in property tax rates has not been

recognized in the company's 2009 accrual.
The cashier began lapping accounts receivable
in 2009.
Because of worsening conditions, the 2009
provision for uncollectible accounts was
inadequate.
The company changed its capitalization policy
for small tools in 2009.
C.

Decision rules - Because materiality is in

dollar terms, you can't decide a change in a
ratio is immaterial unless you can convert it
to dollar materiality.
Example using gross profit percentage:
2009 Gross margin
2008 Gross margin
2009 Sales

42 %
40 %
$20,000,000
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2009 Net income

Materiality (5% of
NI)

$1,000,000
$50,000

Is the change in gross margin material?

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Example using inventory turnover:

2009 Inventory
2009 Cost of Sales
2009 Inv. turn
(COS/EI)
2008 Inv. turn

59,864
194,371
3.25
5.20

What is the unexpected change in inventory?

D.

Follow-up - Significant fluctuations need to

be documented and explained.
Investigation often starts with the client's
explanation for the fluctuation.

Client explanation should be

corroborated.
Should consider whether there are
alternative explanations, especially
those that involve errors.

Discussion of Regina Vacuum Case

7.

Going Concern - The auditor is required to

assess whether the entity will continue in
existence for a reasonable period beyond the
financial statement date.

Assessment is required on all audit

engagements.
Reasonable period of time usually one year
from date of financial statements.
The auditor must also consider
management plans that may affect the
ability to continue as a going concern.

Despite the predictability of bankruptcy, auditors

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often fail to issue going concern opinions prior to

a company entering bankruptcy. What may
account for the failure of auditors to issue going
concern opinions (in hindsight)? (Discussion)

Chapter 8
Additional Reading - SAS #59 (AU 341), The Auditor's Consideration of the
Entity's Ability to Continue as a Going Concern.
Discussion Case Regina Vacuum

Homework Problems
8-33
8-34 (If time permits, we will complete this problem in class)

Sample Multiple Choice (Text)

8-26 (a), (b), (c)
8-27 (a), (b), (c), (d)

Problem 8-33
a.

The client's explanation is true, but does not account for the total change
in gross profit. The following is the gross margin on the two product lines:

2009
2008
2007
2006

Drugs

Nondrugs

40.6%
42.2%
42.1%
42.3%

32.0%
32.0%
31.9%
31.8%

The change in drug gross margin is much larger than for the industry, and
appears to be material ([42.2 - 40.6] x 5,126,000 = $82,000).
b.

The auditor would focus on explanations that account for a decrease in

gross profit.
The auditor would probably first test competitive
explanations by examining the changes in cost and prices for drugs. Error
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explanations would focus on items leading to a decrease in gross profit,

such as an understatement or theft of inventory, or an understatement of
sales. A good place to start investigating is cutoff for sales and inventory.

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Problem 8-34
Condition

a. Significance

b. Follow-up

1.

Commission
expense percentage
increased

Possible overstatement
of expense

1. Estimate expense as Sales x Rate for past

two
years
2. Check monthly expense calculations

2.

Inventory turnover
decreasing

Possible obsolescence
Possible overstatement
of inventory

Examine subsequent sales for largest dollar

items

3.

Inventory % of
current assets
increasing

4.

Days sales in AR
increasing

5.

Allowance as % of
AR decreased

6.

Depreciation
expense lower than
preceding year

Examine gross margin percentage