Audit Planning and Analytical Procedures

Audit Planning and
Analytical Procedures
Chapter 8
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©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8-1

Learning Objective 1
Discuss why adequate audit planning is

essential.

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

Three Main Reasons for
Planning

Risk Terms
 Acceptable audit risk
 Inherent risk

Make client acceptance decisions and

perform initial audit planning.

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

Client Acceptance and
Continuance
New client investigations
If previously audited, the new auditor is
required to communicate with the
predecessor auditor
Client permission required
Continuing clients
Annual evaluations whether to continue
based on issues, fees, and client integrity
Identify Reasons for the Audit
Two major factors affecting acceptable risk

Likely statement users
Intended uses of the statements
Likely to accumulate more evidence for

companies that are
Publicly held
Have extreme indebtedness
Likely to be sold
Obtaining an Understanding
with the Client
Engagement terms should be understood
between CPA and client.
Standards require an engagement letter
describing:
objectives
responsibilities of auditor and management
schedules and fees
Informs client that auditor cannot guarantee
all acts of fraud will be discovered
See figure 8-2
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 10
Develop Overall Audit Strategy
Preliminary audit strategy should consider

client’s business and industry
material misstatement risk areas
number of client locations
past effectiveness of controls
Preliminary strategy helps auditor determine
resource requirements and staffing
staff continuity
need for specialists
Gain an understanding of the client’s

business and industry.

Understanding of the Client’s
Business and Industry
Client business risk is the risk
that the client will fail to meet
its objectives.
 Information technology
Global operations
Human capital

Understanding of the Client’s
Business and Industry

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

Business Operations
and Processes
Factors the auditor should understand:
 Major sources of revenue

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

Tour the Plant and Offices
Touring the physical facilities

enables the auditor to assess
asset safeguards and interpret
accounting data related to assets.

Identify Related Parties
Affiliated companies
Principal owners of the client
Any other party with which the client deals
A party who can influence management or

client policies

Management and Governance
Governance includes:
Governance insights:
Organizational
Corporate charter
structure
and bylaws
Board activities
Code of ethics
Audit committee
Meeting minutes
activities.
Management establishes the strategies and

processes followed by the client’s business.
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.

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

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.

Assess client business risk.

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

Client’s Business, Risk, and
Risk of Material Misstatement

Sarbanes-Oxley Act
Management must certify it has designed

disclosure controls and procedures to
ensure that material information about
business risks is made known to them.
Management must certify it has informed

the auditor and audit committee of any
significant control deficiencies.

Perform preliminary analytical procedures.

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.

Examples of Planning Analytical
Procedures

Summary of the Parts
of Auditing Planning
A major purpose is to gain an understanding
of the client’s business and industry.

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

State the purposes of analytical procedures

and the timing of each procedure.

AU 329 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

Timing and Purposes of

Select the most appropriate analytical

procedure from among the five major
types.

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.

Compare Client and Industry
Data
Client Industry
2009 2008 2009 2008
Inventory turnover 3.4 3.5 3.9 3.4
Gross margin 26.3% 26.4% 27.3% 26.2%

Internal Comparisons

Compare Client Data with
Similar Prior Period Data
2009 2008
(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

Compute common financial ratios.

Common Financial Ratios
 Short-term debt-paying ability
Liquidity activity ratios
Ability to meet long-term debt obligations
Profitability ratios

Short-term Debt-paying Ability
(Cash + Marketable securities)

Cash ratio =
Current liabilities
(Cash + Marketable securities

Quick ratio = + Net accounts receivable)
Current liabilities
Current assets
Current ratio =
Current liabilities

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
Ability to Meet Long-term Debt
Obligation
Total liabilities
Debt to equity =
Total equity
Times interest Operating income

=
earned Interest expense

Profitability Ratios
Earnings Net income

=
per share Average common shares outstanding
Gross profit (Net sales – Cost of goods sold)

=
percent Net sales
Profit Operating income

=
margin Net sales

Profitability Ratios
Return on Income before taxes

=
assets Average total assets
Return on (Income before taxes

common = – Preferred dividends)
equity Average stockholders’ equity

Summary of Analytical
Procedures
Compare ratios of recorded amounts to
auditor expectations.
Used in planning to understand client’s

business and industry.
Used throughout the audit

to identify possible misstatements
reduce detailed tests
assess going-concern issues.

End of Chapter 8

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Audit Planning and

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8-1

Discuss why adequate audit planning is

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8-2

2. To help keep audit costs reasonable

3. To avoid misunderstanding with the client

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8-3

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8-4

 Acceptable audit risk

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8-5

Make client acceptance decisions and

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8-6

1. Client acceptance and continuance

2. Identify client’s reasons for audit

3. Obtain an understanding with the client

4. Develop overall audit strategy

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8-7

Two major factors affecting acceptable risk

Likely to accumulate more evidence for

Preliminary audit strategy should consider

Gain an understanding of the client’s

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 12

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 13

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 14

1. Risks associated with specific industries

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 15

 Major sources of revenue

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 16

Touring the physical facilities

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 17

Principal owners of the client

Any other party with which the client deals

A party who can influence management or

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 18

Management establishes the strategies and

In response to the Sarbanes-Oxley Act, the SEC

The SEC also requires companies to disclose

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 20

Strategies are approaches followed by the

Auditors should understand client objectives.

Financial reporting reliability

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 21

The client’s performance measurement system

 market share  Web site visitors

Performance measurement includes ratio analysis

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 22

Assess client business risk.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 23

Client business risk is the risk that the

 What is the auditor’s primary concern?

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 24

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 25

Management must certify it has designed

Management must certify it has informed

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 26

Perform preliminary analytical procedures.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 27

Preliminary tests can reveal unusual

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 8 - 28