1. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 1 Audit Planning and Analytical Procedures Chapter 8

2. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 2 Learning Objective 1 Discuss why adequate audit planning is essential.

3. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 3 Planning The work is to be adequately planned, and assistants, if any, are to be properly supervised. Acceptable audit risk - SET Inherent risk - ASSESSED

4. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 4 Planning an Audit and Designing an Approach Accept client and perform initial audit planning Understand the client’s business and industry (specialization) Assess client business risk Perform preliminary analytical procedures/review

5. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 5 Planning an Audit and Designing an Approach Set materiality, set acceptable audit risk and assess inherent risk (Ch 9) Understand internal control and assess control risk (Ch 10) Gather information to assess fraud risks (Ch. 11) Develop overall audit plan and audit program (Ch 13)

6. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 6 Learning Objective 2 Make client acceptance decisions and perform initial audit planning.

7. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 7 Initial Audit Planning Should the auditor accept a new client? Or re-accept one? Research on mitigators of risk. SOX – Big firms trimming down clients → 2 nd tier Small firms, public clients, SOX 404, and PCAOB fees Identify why the client wants or needs an audit. Why? Obtain an understanding with the client. Engagement Letter SOX – signed by audit committee Select staff for the engagement → NSTE Specialists?

8. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 8 Learning Objective 3 Gain an understanding of the client’s business and industry.

9. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 9 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

10. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 10 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 High Tech: Inventory, A/R Retail: Competition Real Estate: LSL Unique accounting requirements: GAAP

11. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 11 Business Operations and Processes Factors the auditor should understand: – major sources of revenue – how inputs changed to outputs – key customers and suppliers – sources of financing – information about related parties – ability to obtain financing – changes since the PY

12. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 12 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 BOD meetings SOX – Code of Ethics – really do anything? Objectivity and competence of IA, whistleblowers

13. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 13 Client Objectives and Strategies Strategies are approaches followed by the entity to achieve organizational objectives. Auditors should understand client objectives. Financial reporting reliability Opportunities Effectiveness and efficiency of operations BR Compliance with laws and regulations Attitudes

14. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 14 Measurement and Performance The client’s performance measurement system includes key performance indicators. Examples: Performance Measurement = Incentives! “Follow the money” – market share– sales per employee – budgets: NI, Sales, etc.– Bonuses – EPS forecasts – stock price/stock options

15. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 15 Learning Objective 4 Assess client business risk.

16. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 16 Assess Client Business Risk Client business risk is the risk that the client will fail to achieve IT’S objectives. What is the auditor’s primary concern? Material misstatement of the financial statements (fraud or error) or bankruptcy due to client business risk. COSO’s ERM Framework

17. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 17 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 PAP (could provide more BR info!) and then → Set Materiality and AR / Assess IR (next chapter)

18. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 18 Learning Objective 5 Perform preliminary analytical procedures.

19. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 19 Preliminary Analytical Procedures Comparison of client ratios or balances to industry or competitor benchmarks provides an indication of the company’s performance. Comparison to PY = significant changes at the client Analytical procedures are also an important part of testing throughout the audit.

20. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 20 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 3.865.20 3.465.20 1.732.51 0.09 Selected Ratios

21. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 21 Learning Objective 6 State the purposes of analytical procedures and the timing of each purpose.

22. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 22 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 (source objectivity).

23. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 23 Timing and Purpose of Analytical Procedures (Required) Planning Phase Purpose Understand client’s industry and business Assess going concern Indicate possible misstatements (attention directing) Primary purpose Secondary purpose Primary purpose

24. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 24 Timing and Purpose of Analytical Procedures Testing Phase Purpose Understand client’s industry and business Assess going concern Indicate possible misstatements (get an explanation and test) Reduce costly detailed tests Secondary purpose Primary purpose

25. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 25 Timing and Purpose of Analytical Procedures (Required) Completion Phase Purpose Understand client’s industry and business Access going concern Indicate possible misstatements (did we test it adequately?) Reduce detailed tests Secondary purpose Primary purpose

26. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 26 Learning Objective 7 Select the most appropriate analytical procedure from among the five major types.

27. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 27 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 (Budget). 4. Compare client data with auditor-determined expected results. 5. Compare client data with expected results, using quantitative, nonfinancial data. What does research tell us: preferences, areas for improvement, getting more sophisticated

28. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 28 Compare Client and Industry Data Client Industry 2009200820092008 Inventory turnover 3.4 3.5 3.9 3.4 Gross margin percent26.3%26.4%27.3%26.2%

29. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 29 Compare Client Data With Similar Prior-period Data 2009 2008 (audited) (000,000) % of (000,000) % of PreliminaryNet Sales Audited Net Sales Net sales143100131100 Cost of goods sold103 72 95 72 Gross profit 40 28 36 28 S & A 32 22 30 23 Other 4 3 3 3 Net income 4 3 3 2

30. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 30 Compare Client Data With Non-financial data Research Findings: NFMs = employees, patents, squ. footage of facilities, retail outlets. Financial = Revenue (why). Change in Rev – Change in NFM = DIFF Fraud firm DIFF = 30% Non-fraud firm DIFF = 11% Why NFMs so valuable (vs. other sources) related to fraud. Do auditors use them? Do investors use them? Short-sellers and a tool.

31. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 31 Learning Objective 8 Compute common financial ratios.

32. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 32 Common Financial Ratios Short-term debt-paying ability Liquidity activity ratios Ability to meet long-term debt obligations Profitability ratios-EPS, Return on assets, etc.

33. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 33 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

34. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 34 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

35. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 35 Ability to Meet Long-term Debt Obligation Debt to equity: Total liabilities or LT liabilities ÷ Total equity Times interest earned: Operating income ÷ Interest expense

36. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 8 - 36 End of Chapter 8