Audit Planning and

Analytical
Procedures (ISA 300)

Chapter 8

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8-1

 Three Main Reasons for Planning

To obtain sufficient competent evidence

for the circumstances

To help keep audit costs reasonable

To avoid misunderstanding with the client

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8-2

 Steps in 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.
• 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.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8-3

 Initial Audit Planning
Get client acceptance and continuance.

Identify client’s reasons for audit.

Obtain an understanding with the client

(Engagement Letter).

Select staff for the engagement.

Evaluate need for outside specialists.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8-4

 Understanding of the Client’s
Business and Industry
What are some factors that have increased
the importance of understanding the
client’s business and industry?

Information technology- photograph industry

Global operations - outsourcing

Human capital -
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8-6
 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

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8-7

 The Client’s Business, Risk, and
Auditor’s Risk Assessment
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.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8-8

 Perform Preliminary Analytical
Procedures)

Comparison of client ratios to industry

or competitor benchmarks provides an
indication of the company’s performance.

Analytical procedures are also an important

part of testing throughout the audit.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8-9

 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
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8 - 10
 Analytical Procedures

• The purposes of analytical

procedures and
• the timing of each purpose.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8 - 11

 Analytical Procedures

Analytical procedures use comparisons and

relationships to assess whether account
balances or other data appear reasonable.

ISA 520 emphasizes the expectations

developed by the auditor.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8 - 12

 Timing and Purposes of Analytical
Procedures (refer figure 8-6, pg 204)
(Required)
Purpose Planning Phase
Understand client’s
industry and business Primary purpose

Assess going concern Secondary purpose

Indicate possible misstatements
(attention directing) Primary purpose

Reduce detailed tests Secondary purpose

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8 - 13

 Five Types of Analytical
Procedures
1. Compare client and industry data.
2. Compare client data with similar
prior period data.
3. Compare client data with
client-determined expected results.
4. Compare client data with
auditor-determined expected results.
5. Compare client data with expected
results, using nonfinancial data.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8 - 14

 Compare Client and Industry Data

Client Industry
2005 2004 2005 2004

Inventory turnover 3.4 3.5 3.9 3.4

Gross margin 26.3% 26.4% 27.3% 26.2%

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8 - 15

 Compare Client Data with Similar
Prior Period Data
2004 2003
(000) % of (000) % of
Prelim. Net sales Prelim. Net sales

Net sales $143,086 100 .0 $131,226 100.0

Cost of goods sold 103,241 72 .1 94,876 72.3
Gross profit $ 39,845 27.9 $ 36,350 27.7
Selling expense 14,810 10 .3 12,899 9.8
Administrative expense 17,665 12.4 16,757 12.8
Other 1,689 1 .2 2,035 1.6
Earnings before taxes $ 5,681 4.0 $ 4,659 3.5
Income taxes 1,747 1.2 1,465 1.1
Net income $ 3,934 2.8 $ 3,194 2.4

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8 - 16

 Common Financial Ratios

Short-term debt-paying ability

Liquidity activity ratios

Ability to meet long-term debt obligations

Profitability ratios

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 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

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8 - 18

 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

Days to sell inventory:

365 days ÷ Inventory turnover
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8 - 19
 Ability to Meet Long-term Debt
Obligation

Debt to equity:
Total liabilities ÷ Total equity

Times interest earned:

Operating income ÷ Interest expense

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 Profitability Ratios

Earnings per share:

Net income ÷ Average common shares outstanding

Gross profit percent:

(Net sales – Cost of goods sold) ÷ Net sales

Profit margin:
Operating income ÷ Net sales

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8 - 21

 Profitability Ratios

Return on assets:
Income before taxes ÷ Average total assets

Return on common equity:

(Income before taxes – Preferred dividends)
÷ Average stockholders’ equity

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8 - 22

 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.
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 8 - 23