Audit Planning and Analytical Procedures

Audit Planning and
Analytical Procedures
Chapter 8
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley
8-1
Learning Objective 1
Discuss why adequate audit
planning is essential.
8-2
Three Main Reasons for

Planning
1. To obtain sufficient appropriate evidence
for the circumstances
2. To help keep audit costs reasonable

3. To avoid misunderstanding with the client
8-3
Risk Terms
Acceptable audit risk
Inherent risk
8-4
Planning an Audit and

Designing an Audit Approach
Accept client and perform initial audit planning.
Understand the clients business and industry.
Assess client business risk.
Perform preliminary analytical procedures.
8-5
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.
8-6
Make client acceptance decisions
and perform initial audit planning.
8-7
Initial Audit Planning

1. Client acceptance and continuance
2. Identify clients reasons for audit
3. Obtain an understanding with the client
4. Develop overall audit strategy
8-8
Gain an understanding of the
clients business and industry.
8-9
Understanding of the Clients

Business and Industry
Factors that have increased the
importance of understanding the
clients business and industry:
Information technology
Global operations
Human capital
8 - 10
Understanding of the Clients

Business and Industry
Understand clients business and industry
Industry and external environment
Business operations and processes
Management and governance
Objectives and strategies
Measurement and performance
8 - 11
Industry and External

Environment
Reasons for obtaining an understanding of the
clients industry and external environment:
1. Risks associated with specific industries
2. Inherent risks common to all clients in
certain industries
3. Unique accounting requirements
8 - 12
Business Operations
and Processes
Factors the auditor should understand:
Major sources of revenue
Key customers and suppliers
Sources of financing
Information about related parties
8 - 13
Tour the Plant and Offices

By viewing the physical facilities,
the auditor can asses physical
safeguards over assets and interpret
accounting data related to assets.
8 - 14
Identify Related Parties

A related party is defined as an affiliated
company, a principal owner of the client
company, or any other party with which
the client deals, where one of the parties
can influence the management or
policies of the other.
8 - 15
Management and Governance

Management establishes the strategies and
processes followed by the clients business.
Governance includes the clients organizational
structure, as well as the activities of the board
of directors and the audit committee.
Corporate charter and bylaws
Code of ethics
Meeting minutes
8 - 16
Code of Ethics
In response to the Sarbanes-Oxley Act, the SEC
now requires each public company to disclose
whether is has adopted a code of ethics that
applies to senior management.
The SEC also requires companies to disclose
amendments and waivers to the code of ethics.
8 - 17
Client Objectives and Strategies

Strategies are approaches followed by the
entity to achieve organizational objectives.
Auditors should understand client objectives.
Financial reporting reliability
Effectiveness and efficiency of operations

Compliance with laws and regulations
8 - 18
Measurement and Performance

The clients performance measurement system
includes 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 analysis

and benchmarking against key competitors.
8 - 19
Assess client business risk.
8 - 20
Assess Client Business Risk

Client business risk is the risk that the
client will fail to achieve its objectives.
What is the auditors primary concern?

Material misstatements in the financial
statements due to client business risk
8 - 21
Clients Business, Risk, and

Risk of Material Misstatement
Industry and external environment
Understand clients
business and industry
Assess client business

risk
Business operations and processes

Management and governance
Objectives and strategies
Assess risk of material

misstatements
Measurement and performance
8 - 22
Sarbanes-Oxley Act
The Sarbanes-Oxley Act requires that
management certify it has designed
disclosure controls and procedures to
ensure that material information about
business risks is made known to them.
It also requires that management certify
it has informed the auditor and audit
committee of any significant deficiencies
in internal control.
8 - 23
Perform preliminary analytical
procedures.
8 - 24
Preliminary Analytical
Procedures
Comparison of client ratios to industry
or competitor benchmarks provides an
indication of the companys performance.
Preliminary tests can reveal unusual

changes in ratios.
8 - 25
Examples of Planning Analytical

Procedures
Selected Ratios
Client Industry
Short-term debt-paying ability:

Current ratio
3.86
5.20
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
0.07
0.05
8 - 26
Summary of the Parts

of Auditing Planning
A major purpose is to gain an understanding
of the clients business and industry.
8 - 27
Key Parts of Planning

Accept client and perform initial planning
New client acceptance and continuance
Identify clients reasons for audit
Obtain an understanding with client
Staff the engagement
8 - 28

Understand the clients business and industry
Understand clients industry and external
environment
Understand clients operations, strategies,
and performance system
8 - 29

Assess client business risk
Evaluate management controls
affecting business risk
Assess risk of material misstatements
8 - 30

Perform preliminary analytical procedures
8 - 31
State the purposes of analytical
procedures and the timing
of each purpose.
8 - 32
AU 329 emphasizes the expectations
developed by the auditor.
1. Required in the planning phase
2. Often done during the testing phase
3. Required during the completion phase
8 - 33
Timing and Purposes of

Purpose
(Required)
Planning
Phase
Understand clients
industry and business
Primary
purpose
Assess going concern
Secondary
purpose
Indicate possible
misstatements
(attention directing)
Reduce detailed tests
Primary
purpose
Testing
Phase
(Required)
Completion
Phase
Secondary
purpose
Secondary Primary
purpose
purpose
Secondary Primary
purpose
purpose
8 - 34
Select the most appropriate
analytical procedure from
among the five major types.
8 - 35
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.
8 - 36
Compare Client and Industry

Data
Client
Inventory turnover
Gross margin
Industry
2009
2008
2009
2008
3.4
26.3%
3.5
26.4%
3.9
27.3%
3.4
26.2%
8 - 37
Compare Client Data with

Similar Prior Period Data
2009
Net sales
Cost of goods sold
Gross profit
Selling expense
Administrative expense
Other
Earnings before taxes
Income taxes
Net income
(000)
Prelim.
% of
Net sales
$143,086
103,241
$ 39,845
14,810
17,665
1,689
$ 5,681
1,747
$ 3,934
100.0
72.1
27.9
10.3
12.4
1.2
4.0
1.2
2.8
2008
(000)
% of
Prelim. Net sales
$131,226
94,876
$ 36,350
12,899
16,757
2,035
$ 4,659
1,465
$ 3,194
100.0
72.3
27.7
9.8
12.8
1.6
3.5
1.1
2.4
8 - 38
Compute common financial ratios.
8 - 39
Common Financial Ratios

Short-term debt-paying ability
Liquidity activity ratios

Ability to meet long-term debt obligations
Profitability ratios
8 - 40
Short-term Debt-paying Ability

Cash ratio
(Cash + Marketable securities)

=
Current liabilities
Quick ratio
(Cash + Marketable securities

=
+ Net accounts receivable)
Current liabilities
Current assets
Current ratio =
Current liabilities
8 - 41
Liquidity Activity Ratios

Accounts receivable
Net sales
=
turnover
Average gross receivables
Days to collect
receivable
365 days
=
Accounts receivable turnover
Inventory
turnover
Cost of goods sold

=
Average inventory
Days to sell
inventory
365 days
=
Inventory turnover
8 - 42
Ability to Meet Long-term Debt

Obligation
Debt to equity =
Total liabilities
Total equity
Times interest
=
earned
Operating income
Interest expense
8 - 43
Profitability Ratios
Earnings
per share
Gross profit
percent
Net income
Average common shares outstanding
(Net sales Cost of goods sold)

Net sales
Profit margin =
Operating income
Net sales
8 - 44
Profitability Ratios
Return on
=
assets
Income before taxes

Average total assets
Return on
common
=
equity
(Income before taxes

Preferred dividends)
Average stockholders equity
8 - 45
Summary of Analytical
Procedures
They involve the computation of ratios
and other comparisons of recorded
amounts to auditor expectations.
They are used in planning to understand
the clients business and industry.
They are used throughout the audit to identify
possible misstatements, reduce detailed tests,
and to assess going-concern issues.
8 - 46
End of Chapter 8
8 - 47

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Audit Planning and

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Three Main Reasons for

2. To help keep audit costs reasonable

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Planning an Audit and

Perform preliminary analytical procedures.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Planning an Audit and

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Initial Audit Planning

4. Develop overall audit strategy

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Understanding of the Clients

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Understanding of the Clients

Industry and External

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Tour the Plant and Offices

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Identify Related Parties

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Management and Governance

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Client Objectives and Strategies

Effectiveness and efficiency of operations

Measurement and Performance

Web site visitors

Performance measurement includes ratio analysis

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Assess Client Business Risk

What is the auditors primary concern?

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Clients Business, Risk, and

Assess client business

Business operations and processes

Assess risk of material

Measurement and performance

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Preliminary tests can reveal unusual

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Examples of Planning Analytical

Short-term debt-paying ability:

Liquidity activity ratio:

Ability to meet long-term obligations:

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Summary of the Parts

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Key Parts of Planning

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Key Parts of Planning

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Key Parts of Planning

Assess risk of material misstatements

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Key Parts of Planning

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley