2. Presentation Outline
I. Accept Client and Perform Initial Audit Planning
II. Understand the Client’s Business and Industry
III. Assess Client Business Risk
IV. Perform Preliminary Analytical Procedures
3. I. Accept Client and Perform Initial
Planning
B. Client Acceptance and
Continuance
C. Identify Client’s Reasons
for Audit
D. Obtain an Understanding
with the Client
E. Select Staff for the
Engagement
F. Evaluate Need for Outside
Specialist
Acceptable Audit Risk - how willing the auditor is to accept that the financial statements
may be materially misstated when an unqualified opinion is issued.
4. A. Client Continuance and Acceptance
• Association with client’s
who lack integrity can
cause significant
problems.
• Lawsuits between the
CA and client or unpaid
fees for services
performed more than 1
year previously, will
prohibit acceptance of
the audit client.
5. B. Identify Client’s Reasons for
Audit
Two major factors
affecting acceptable
audit risk are likely
statement users and
The most likely uses can
their intended uses of
be determined from
the statements. More
previous experience with
evidence may be
the client and discussion
necessary when the
with management.
statements are to be
used extensively.
6. C. Obtaining an Understanding with the
Client
Contents of Engagement Letter
Services to be provided
• Although not required, an Any restrictions on the auditors’
engagement letter is work
normally used to establish Deadlines for completing the
the agreement. work
• Auditors of public Assistance to be provided by
client personnel
companies should establish
Inform client that fraud may not
the understanding with the be discovered
audit committee. May include fees
7. D. Select Staff for the Engagement
• Staff should be
knowledgeable of
the client’s industry.
• Continuity of staff
helps the CA firm
maintain familiarity
with technical
requirements.
8. E. Evaluate Need for Outside
Specialists
If an audit client requires
specialized knowledge, it may
be necessary to consult a
specialist.
Auditor should evaluate the
specialist’s qualifications and
understand the objectives
and scope of their work.
Auditor should also consider
specialist’s relationship to
client that could impair
objectivity.
9. II. Understand the Client’s Business and
Industry
The nature of the client’s business and industry
affects client business risk and the risk of
material misstatements in the financial
statements.
A. Major Reasons for Understanding Client
Industry and External Environment
B. Business Operations and Processes
C. Management and Governance
D. Client Objectives and Strategies
E. Measurement and Performance
10. A. Major Reasons for
Understanding
Client Industry and External
Environment
1. There may be risks associated
with the client and the specific
industry in which it operates.
2. Many industries have unique
accounting requirements that the
auditor must understand.
11. B. Business Operations and
Processes
• Tour the plant and offices to better
understand client operations and meet key
personnel.
• Identify related parties for purposes of
disclosure. Related parties include an
affiliated company, a principal owner of
client, and others who can influence the
management or operating policies of the
other.
12. C. Management and
Governance
Management philosophy and
operating style significantly
influence the risk of material
misstatement in the financial
statements.
Law requires public
companies to disclose whether
they have adopted a code of
ethics for senior management.
If not, they must state why.
Corporate minutes should be
read by the auditor to identify
various authorizations that
must be complied with.
13. D. Client Objectives and Strategies
Strategies are approaches
followed by the entity to
achieve organizational
objectives. Auditor
should understand client
strategies regarding:
• Reliability of financial
reporting
• Effectiveness and
efficiency of operations
• Compliance with laws
and regulations
14. E. Measurement and
Performance
The risk of financial
misstatements may
be increased if the
client has set
unreasonable
objectives or if the
performance
measurement system
encourages
aggressive
accounting.
15. III. Assess Client Business Risk
• Client business risk is the risk that the client will fail to achieve its
objectives. Sources include competitors, new technology, industry
condition, and regulatory environment. Could influence client to
misstate the financial statements.
• Law requires management to certify it has designed disclosure
controls and procedures to ensure that they are made aware of
material information about business risks.
• Law also requires management to certify that it has informed the
auditor and audit committee of any significant deficiencies in
internal control.
16. IV. Perform Preliminary
Analytical Procedures
A. Defining Analytical Procedures
B. Short-term Debt-Paying Ability
C. Liquidity Activity Ratios
D. Ability to Meet Long-term Debt
Obligation
E. Profitability Ratios
17. A. Defining Analytical Procedures
• Evaluations of financial
information made by a study
of plausible relationships
among financial and non-
financial data.
18. B. Short-term Debt-paying Ability
Cash ratio:
(Cash + Marketable securities) ÷ Current liabilities
Quick ratio:
(Cash + Marketable securities
+ Net accounts receivable) ÷ Current liabilities
Current ratio:
Current assets ÷ Current liabilities
19. C. Liquidity Activity Ratios
Accounts receivable turnover:
Net sales ÷ Average gross receivables
Days to collect receivables:
365 days ÷ Accounts receivable turnover
Inventory turnover:
Cost of goods sold ÷ Average inventory
20. C. Liquidity Activity Ratios (Continued)
Days to sell inventory:
365 days ÷ inventory turnover
21. D. Ability to Meet Long-term Debt
Obligation
Debt to equity:
Total liabilities ÷ Total equity
Times interest earned:
Operating income ÷ Interest expense
22. E. Profitability Ratios
Earnings per share:
Net income ÷ Average commons shares outstanding
Gross profit percent:
(Net sales – Cost of goods sold) ÷ Net sales
Profit margin:
Operating income ÷ Net sales
23. E. Profitability Ratios (Continued)
Return on assets:
Income before taxes ÷ Average total assets
Return on common equity:
(Income before taxes – Preferred dividends)
÷ Average stockholders’ equity
24. Initial Audit Planning
Accept client and
perform initial audit
planning
Understand the client’s
business and industry
Assess client business risk
Perform preliminary
analytical procedures
