Electronic
Presentations
in Microsoft®
PowerPoint®
Prepared by
Brad MacDonald
SIAST
© 2003 McGraw-Hill
Ryerson Limited
Chapte
r
5
Audit Planning with
Analytical Procedures,
Risks, and Materiality
Copyright © 2003 McGraw-Hill Ryerson Limited
2
Audit Planning
After pre-engagement procedures are
complete, the auditor has certain planning
tools to guide and direct the audit.
• Preliminary analytical procedures
• Preliminary materiality decisions
• Preliminary risk assessment
– Audit planning tools are used to design the
audit programs.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
3
Preliminary Analytical
Procedures
Standards require analytical procedures at the
start of the audit. Five types of procedures:
– Compare current-year account balances to prior year
account balances (comparatives).
– Compare actual results to anticipated results found in
the company’s budgets and forecasts.
– Evaluate of the relationship to other current-year
balances for conformity with predictable patterns.
– Compare results with similar information for the
industry in which the company operates.
– Study the relationships of the current-year account
balances with relevant non-financial information.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
4
Preliminary Analytical
Procedures
Purposes of preliminary analytical
procedures is
– to alert the audit team to problems in the
accounts and disclosures, and
– effectively uncover misstatements
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
5
Learning Objective 1
Perform analytical procedures using unaudited financial statements to identify
potential problems in the accounts.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
6
Analysis of Unaudited
Financial Statements
Analysis is gaining importance in current
auditing.
– Auditors look for relationships in accounts as
indicators of problems and to plan further
audit work.
– Horizontal analysis: examination of numbers
and ratios across two or more years.
– Vertical analysis: examination of amounts
expressed each year as proportions of a
base (sales or total assets).
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
7
Analysis of Unaudited
Financial Statements
Preliminary analytical procedures:
– are attention-directing:
• Assist the auditor in identifying potential
problem areas
– provide for an organized approach:
• A standard starting point, analytical
procedures provide considerable familiarity
with client’s business.
– describe financial activities:
• Identify relationships and changes in data.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
8
Analysis of Unaudited
Financial Statements
Ask relevant questions:
– What could be wrong?
– What errors or irregularities could account for these
results?
Funds flow analysis:
– A statement of cash flow should be reviewed.
– This provides crucial information of funds flow.
Timing: (beginning and end of audit)
– Standards require analysis at beginning and end of
the audit.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
9
Learning Objective 2
Describe how auditors decide upon a
maximum amount of misstatement
(planning materiality) acceptable in a
company’s financial statements.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
10
Preliminary Assessment of
Planning Materiality
Financial statement materiality:
– Information is material and should be
disclosed if it is likely to influence the
economic decisions of financial statement
users.
– Accounting numbers are not perfectly
accurate because of the nature of
accounting.
• Estimates are used, and honest mistakes
happen.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
11
Materiality Judgement Criteria
Auditors are generally left without definite,
quantitative guidelines to determine
materiality.
– Rules of thumb :
• 5 to 10% of income before tax
• ½ to1% of assets
• ½ to 1% of equity
• ½ to 1% of revenue
• ½ to 1% of gross profit
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
12
Materiality Judgement Criteria
Common factors used in making materiality
judgments:
– absolute size
– relative size
– nature of the item or issue
– circumstances
– cumulative effects of errors
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
13
Materiality Judgement Criteria
Under SEC regulations, otherwise small
misstatements are now considered material.
– intentional misstatements
– intentional violation of the law
– intentional earnings management
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
14
Learning Objective 3
Describe the relationship of an overall
planning materiality amount to the tolerable
misstatement amounts for particular
accounts.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
15
Materiality Allocation
To plan the audit of various accounts,
auditors assign part of the planning
materiality to each account.
– Assigned amount is tolerable misstatement.
• The amount by which an account may be
misstated and yet not cause the financial
statements taken as a whole to be
materially misleading.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
16
Materiality Allocation
Overall planning materiality can be allocated
to accounts in amounts:
• that add up to twice the overall materiality
• that the square root of the sum of the
squared tolerable misstatements is
equal to overall materiality, or
• that exactly add up to materiality
– Or, the auditor can use the same overall
materiality for the entire audit.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
17
Materiality and Planning
Uses of materiality:
– guide for planning audit program (efficiency
and effectiveness)
• Develop a program that will detect material
errors without over auditing
– guide for evaluation of evidence
– guide for making decisions about audit report
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
18
Learning Objective 4
Describe the conceptual audit risk model
and explain the meaning and importance of
its components in terms of professional
judgement and audit planning.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
19
Basic Goal of the Audit
Since the basic goal of the audit is defined
in terms of audit assurance, it is not an
exaggeration to say that the reason for the
existence of the auditing profession is to
control risk.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
20
Components of Audit Risk
AR = Audit Risk
– probability of material error in F/S remaining
undetected after the audit. This will occur if
the following three events occur.
IR = Inherent Risk
CR = Control Risk
DR = Detection Risk
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
21
Inherent Risk
The probability of material misstatement
occurring in transactions entering the accounting
system or being in the account balances is
inherent risk.
– Auditors do not create or control inherent risk.
• Auditors only try to assess its magnitude based on
prior experience, management bias, and nature of
the transactions.
• The auditor will consider the characteristics of the
client’s business, types of transactions, and
effectiveness of accountants.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
22
Control Risk
The risk that the client’s internal control
system will not prevent or detect a material
misstatement is control risk.
– Auditors do not create or control control risk;
they simply evaluate or assess probability of
failure to detect material misstatements.
• This assessment of effectiveness may be
tested by the auditor in the audit.
– Assessment is based on study and evaluation
of the company’s control system.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
23
Detection Risk
The risk that any material misstatement that
has not been corrected by the client’s
internal control will not be detected by the
auditor is detection risk.
– Auditors can control this risk by conducting
substantive (balance audit) tests.
• Substantive tests include audit of details of
transactions and balances, and analytical
procedures applied to dollar amounts in
the accounts.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
24
Audit Risk
The probability that an auditor will fail to express a
reservation that financial statements are materially
misstated is audit risk.
– Audit risk is greater if there is poor planning
or poor execution of the audit.
– Audit risk is inversely proportionate to risk of
getting sued.
– Audit risk is dependent on user reliance.
– Audit risk is also applied to individual account
balances and disclosures.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
25
Risk Model
AR = IR x CR x DR
Audit risk will occur when
– A material misstatement has been made in
the transactions or balances (inherent risk),
– and internal controls fail to detect or correct
the misstatement (control risk), and
– audit procedures also fail to detect the
misstatement (detection risk).
• Auditors usually like to limit audit risk to
less than 5%.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
26
Planning Memorandum
The planning memorandum is a summarization of
the preliminary analytical review and the
materiality assessment with specific directions
about the effect on the audit.
All planning becomes the basis for the audit
program.
– The audit program specifies procedures the auditor
will use to guide the work of inherent control and
control risk assessment and to obtain sufficient
competent evidence as a basis for the audit report
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
27
Learning Objective 5
Describe the content and purpose of audit
programs.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
28
Content and Purpose of the
Audit Programs
Internal control program:
– A specification of procedures for obtaining
and understanding the client’s business and
control systems (assess IR and CR).
Balance-audit program:
– A specification of substantive procedures for
gathering direct evidence on assertions about
dollar amounts and accounts.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
29
Selected Financial Ratios
(Appendix 5A)
Balance sheet ratios:
– current ratio = CA / CL
– days’ sales in receivables
– doubtful account ratio
– days’ sales in inventory
– debit ratio
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
30
Selected Financial Ratios
(Appendix 5A)
Operations ratios:
– receivables turnover
– inventory turnover
– cost of goods sold ratio
– gross margin ratio
– return on beginning equity
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
31
Selected Financial Ratios
(Appendix 5A)
Financial distress ratios (Altman, 1968)
– Working capital / total assets
– Retained earnings / total assets
– Earnings before interest & taxes
Total assets
– Market value of equity
Total assets
– Net sales
Total assets
– Discriminant Z score
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
32
Strategic Systems Approach (SSA)
to Auditing (Appendix 5B)
Audit planning is not viewed as separate
phase of audit.
– Assurance propositions on client’s F/S are
based on deep knowledge of client based on:
• strategic analysis
• analysis of business processes
• continuous business risk assessment
• business measurement analysis
– Propositions are continually assessed against
management assertions.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
33
SSA (Appendix 5B)
Questions asked by strategic analysis:
– What is client strategy?
– Is it sustainable?
– What are the business risks/threats to client?
– How does the client manage those risks?
– What are the gaps in the client’s risk management
approach?
– Do those gaps affect the financial statements?
Answers help to assess:
– That business risks reflected in F/S.
– That business processes are in place to attempt to
control business risk.
Chapter 5
Copyright © 2003 McGraw-Hill Ryerson Limited
34