Audit Planning and Analytical Procedures

Chapter 8

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8-1

Learning Objective 1
Discuss why adequate audit planning is essential.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8-2

Three Main Reasons for Planning

1. To obtain sufficient competent evidence for the circumstances

2. To help keep audit costs reasonable

3. To avoid misunderstanding with the client

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8-3

Risk Terms
Acceptable audit risk Inherent risk

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8-6

Learning Objective 2
Make client acceptance decisions and perform initial audit planning.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8-7

Initial Audit Planning

Client acceptance and continuance Identify clients reasons for audit Obtain an understanding with the client

Develop overall audit strategy

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8-8

Learning Objective 3
Gain an understanding of the clients business and industry.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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
2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 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

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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
2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 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.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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
2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 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.
2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 8 - 19

Learning Objective 4
Assess client business risk.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 21

Clients Business, Risk, and Risk of Material Misstatement

Industry and external environment Understand clients business and industry Business operations and processes Management and governance Objectives and strategies Assess risk of material misstatements Measurement and performance

Assess client business risk

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 22

Sarbanes-Oxley (new title)

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.
2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 8 - 23

Enterprise Risk Management

Enterprise risk management (ERM) has emerged as a new paradigm for managing risk. ERM integrates and coordinates risk management across the entire enterprise.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 24

Learning Objective 5
Perform preliminary analytical procedures.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 25

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.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 26

Examples of Planning Analytical Procedures

Selected Ratios
Short-term debt-paying ability: Current ratio

Client Industry
3.86 3.36 5.20 5.20

Liquidity activity ratio: Inventory turnover

Ability to meet long-term obligations: Debt to equity 1.73 Profitability ratio: Profit margin
2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

2.51
0.07
8 - 27

0.05

Summary of the Parts of Auditing Planning

A major purpose is to gain an understanding of the clients business and industry.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 28

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

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 29

Key Parts of Planning

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

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 30

Key Parts of Planning

Assess client business risk Evaluate management controls affecting business risk

Assess risk of material misstatements

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 31

Key Parts of Planning

Perform preliminary analytical procedures

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 32

Learning Objective 6
State the purposes of analytical procedures and the timing of each purpose.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 33

Analytical Procedures
SAS 56 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

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 34

Timing and Purposes of Analytical Procedures

Purpose
Understand clients industry and business Assess going concern Indicate possible misstatements (attention directing) Reduce detailed tests (Required) Planning Phase Primary purpose Secondary purpose Primary purpose Secondary purpose Secondary Primary purpose purpose Testing Phase (Required) Completion Phase

Secondary Primary purpose purpose

8 - 35

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

Learning Objective 7
Select the most appropriate analytical procedure from among the five major types.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 36

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.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 37

Compare Client and Industry Data

Client 2007 2006 Industry 2007 2006

Inventory turnover Gross margin

3.4 26.3%

3.5 26.4%

3.9 27.3%

3.4 26.2%

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 38

Compare Client Data with Similar Prior Period Data

2007 (000) Prelim. Net sales Cost of goods sold Gross profit Selling expense Administrative expense Other Earnings before taxes Income taxes Net income $143,086 103,241 $ 39,845 14,810 17,665 1,689 $ 5,681 1,747 $ 3,934 % of Net sales 100.0 72.1 27.9 10.3 12.4 1.2 4.0 1.2 2.8 2006 (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

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 39

Learning Objective 8
Compute common financial ratios.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 40

Common Financial Ratios

Short-term debt-paying ability

Liquidity activity ratios

Ability to meet long-term debt obligations Profitability ratios

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 41

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

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 42

Liquidity Activity Ratios

Accounts receivable Net sales = turnover Average gross receivables Days to collect receivable Inventory turnover Days to sell inventory 365 days = Accounts receivable turnover Cost of goods sold = Average inventory 365 days = Inventory turnover
8 - 43

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

Ability to Meet Long-term Debt Obligation

Debt to equity = Total liabilities Total equity

Times interest = earned

Operating income Interest expense

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 44

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

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 45

Profitability Ratios
Return on = assets Return on common = equity Income before taxes Average total assets (Income before taxes Preferred dividends) Average stockholders equity

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 46

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.
2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 8 - 47

End of Chapter 8

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

8 - 48