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

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-1

 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.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-2

 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.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-3

 Initial Audit Planning
1. Client acceptance and continuance

2. Identify client’s reasons for audit

3. Obtain an understanding with the client

4. Develop overall audit strategy

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-4

 Understanding of the Client’s
Business and Industry
Factors that have increased the
importance of understanding the
client’s business and industry:

 Information technology
 Global operations

 Human capital

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-5

 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

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-6
 Industry and External
Environment
Reasons for obtaining an understanding of the
client’s industry and external environment:

1. Risks associated with specific industries

2. Inherent risks common to all clients in
certain industries
3. Unique accounting requirements

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-7

 Business Operations
and Processes
Factors the auditor should understand:

 Major sources of revenue

 Key customers and suppliers
 Sources of financing
 Information about related parties

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-8

 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.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-9

 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.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 10

 Management and Governance
Management establishes the strategies and
processes followed by the client’s business.

Governance includes the client’s 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
©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 11
 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.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 12

 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

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 13

 Measurement and
Performance
The client’s performance measurement system
includes key performance indicators. Examples:

 market share  Web site visitors

 sales per employee  same-store sales
 unit sales growth  sales/square foot

Performance measurement includes ratio analysis

and benchmarking against key competitors.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 14

 Assess Client Business Risk
Client business risk is the risk that the
client will fail to achieve its objectives.

 What is the auditor’s primary concern?

 Material misstatements in the financial

statements due to client business risk

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 15

 Client’s Business, Risk, and
Risk of Material Misstatement
Industry and external environment
Understand client’s
business and industry
Business operations and processes

Management and governance

Assess client business
risk
Objectives and strategies

Assess risk of material Measurement and performance

misstatements

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 16

 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.
©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 17
 Preliminary Analytical
Procedures
Comparison of client ratios to industry
or competitor benchmarks provides an
indication of the company’s performance.

Preliminary tests can reveal unusual

changes in ratios.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 18

 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 0.05 0.07
©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 19
Key Parts of Planning
1. 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
2. Understand the client’s business and industry
 Understand client’s industry and external
environment
 Understand client’s operations, strategies,
and performance system
3. Assess client business risk
 Evaluate management controls
affecting business risk
 Assess risk of material misstatements
4. Perform preliminary analytical procedures

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 20

 Timing and Purposes of
Analytical Procedures
(Required) (Required)
Purpose Planning Testing Completion
Phase Phase Phase
Understand client’s Primary
industry and business purpose
Secondary Secondary
Assess going concern
purpose purpose
Indicate possible Primary Secondary Primary
misstatements purpose purpose purpose
(attention directing)
Secondary Primary
Reduce detailed tests purpose purpose

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 21

 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.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 22

 Common Financial Ratios
Short-term Debt-paying Ability
Cash ratio
(Cash + Marketable securities)
=
Current liabilities

(Cash + Marketable securities

Quick ratio = + Net accounts receivable)
Current liabilities

Current assets
Current ratio =
Current liabilities

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 23

 Liquidity Activity Ratios
Accounts receivable Net sales
=
turnover Average gross receivables
Days to collect 365 days
=
receivable Accounts receivable turnover
Inventory Cost of goods sold
=
turnover Average inventory
Days to sell 365 days
=
inventory Inventory turnover
©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 24
 Ability to Meet Long-term
Debt Obligation
Total liabilities
Debt to equity =
Total equity

Times interest Operating income

=
earned Interest expense

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 25

 Profitability Ratios
Earnings Net income
=
per share Average common shares outstanding

Gross profit (Net sales – Cost of goods sold)

=
percent Net sales

Operating income
Profit margin =
Net sales

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 26

 Profitability Ratios
Return on Income before taxes
=
assets Average total assets

Return on (Income before taxes

common = – Preferred dividends)
equity Average stockholders’ equity

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 27

 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 client’s business and industry.

They are used throughout the audit to identify

possible misstatements, reduce detailed tests,
and to assess going-concern issues.
©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 28