©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Audit Planning and Analytical Procedures Chapter 8

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 1 Discuss why adequate audit planning is essential.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Planning The work is to be adequately planned, and assistants, if any, are to be properly supervised. Acceptable audit risk Inherent risk

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Planning an Audit and Designing an Approach Accept client and perform initial audit planning Understand the client’s business and industry Assess client business risk Perform preliminary analytical procedures

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Planning an Audit and Designing an Approach Set materiality, and assess acceptable audit risk and inherent risk Understand internal control and assess control risk Develop overall audit plan and audit program

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 2 Make client acceptance decisions and perform initial audit planning.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Initial Audit Planning Should the auditor accept a new client? Identify why the client wants or needs an audit. Obtain an understanding with the client. Select staff for the engagement.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 3 Gain an understanding of the client’s business and industry.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 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

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 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 Global operations Human capital

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Industry and External Environment What are some reasons for obtaining an understanding of the client’s industry and external environment? Risks associated with specific industries Inherent risks common to all clients in certain industries Unique accounting requirements

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Business Operations and Processes Factors the auditor should understand: – major sources of revenue – sources of revenue – key customers and suppliers – sources of financing – information about related parties – ability to obtain financing

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 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 Minutes of meetings

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 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

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Measurement and Performance The client’s performance measurement system includes key performance indicators. Examples: Performance measurement includes ratio analysis and benchmarking against key competitors. – market share– sales per employee – unit sales growth– Web site visitors – same-store sales– sales/square foot

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 4 Assess client business risk.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 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 misstatement of the financial statements due to client business risk

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley The Client’s Business, Risk, and Auditor’s Risk Assessment Industry and External Environment Business Operations and Processes Management and Governance Objectives and Strategies Measurement and Performance Understand Client’s Business and Industry Assess Client Business Risk Assess Risk of Material Misstatements

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 5 Perform preliminary analytical procedures.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 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.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Examples of Planning Analytical Procedures ClientIndustry Short-Term Debt-Paying Ability Current ratio Liquidity Activity Ratio Inventory turnover Ability to Meet Long-Term Obligations Debt to equity Profitability Return on assets Selected Ratios

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Summary of the Purposes of Auditing Planning A major purpose is to gain an understanding of the client’s business and industry.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Key Parts of Planning Accept Client and Perform Initial Planning New client acceptance and continuance Identify client’s reasons for the audit Obtain an understanding with client Staff the engagement

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Key Parts of Planning Understand the Client’s Business and Industry Understand client’s industry and external environment Understand client’s operations, strategies, and performance system

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Key Parts of Planning Assess Client Business Risk Assess client business risk Evaluate management business controls affecting business risk Assess risk of material misstatements

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Key Parts of Planning Perform Preliminary Analytical Procedures

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 6 State the purposes of analytical procedures and the timing of each purpose.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Analytical Procedures Analytical procedures use comparisons and relationships to assess whether account balances or other data appear reasonable. SAS 56 emphasizes the expectations developed by the auditor.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Timing and Purpose of Analytical Procedures (Required) Planning Phase Purpose Understand client’s industry and business Assess going concern Indicate possible misstatements (attention directing) Reduce detailed tests Primary purpose Secondary purpose Primary purpose Secondary purpose

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Timing and Purpose of Analytical Procedures Testing Phase Purpose Understand client’s industry and business Assess going concern Indicate possible misstatements (attention directing) Reduce detailed tests Secondary purpose Primary purpose

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Timing and Purpose of Analytical Procedures (Required) Completion Phase Purpose Understand client’s industry and business Access going concern Indicate possible misstatements (attention directing) Reduce detailed tests Secondary purpose Primary purpose

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 7 Select the most appropriate analytical procedure from among the five major types.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Five Major 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.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Compare Client and Industry Data Client Industry Inventory turnover Gross margin percent26.3%26.4%27.3%26.2%

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Compare Client Data With Similar Prior-period Data (000,000) % of (000,000) % of PreliminaryNet Sales Audited Net Sales Net sales Cost of goods sold Gross profit S & A Other Net income

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 8 Compute common financial ratios.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Common Financial Ratios Short-term debt-paying ability Liquidity activity ratios Ability to meet long-term debt obligations Profitability ratios

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 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

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 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

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Liquidity Activity Ratios Days to sell inventory: 365 days ÷ inventory turnover

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Ability to Meet Long-term Debt Obligation Debt to equity: Total liabilities ÷ Total equity Times interest earned: Operating income ÷ Interest expense

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 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.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley End of Chapter 8