©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Audit Planning and Analytical Procedures Chapter 8

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 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 Risk Terms  Acceptable audit risk  Inherent risk

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

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 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 Initial Audit Planning  Client acceptance and continuance  Identify client’s reasons for audit  Obtain an understanding with the client  Develop overall audit strategy

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Understanding of the Client’s Business and Industry Factors that have increased the importance of understanding the client’s business and industry:  Global operations  Information technology  Human capital

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Understanding of the Client’s Business and Industry Industry and external environment Business operations and processes Management and governance Objectives and strategies Measurement and performance Understand client’s business and industry

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

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 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 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 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 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  Meeting minutes  Code of ethics

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 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 Client Objectives and Strategies Strategies are approaches followed by the entity to achieve organizational objectives. Auditors should understand client objectives.  Effectiveness and efficiency of operations  Financial reporting reliability  Compliance with laws and regulations

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Measurement and Performance The client’s 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 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

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Client’s Business, Risk, and Risk of Material Misstatement Understand client’s business and industry Industry and external environment Business operations and processes Management and governance Objectives and strategies Measurement and performance Assess client business risk Assess risk of material misstatements

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

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Examples of Planning Analytical Procedures Liquidity activity ratio: Inventory turnover Ability to meet long-term obligations: Debt to equity Profitability ratio: Profit margin Short-term debt-paying ability: Current ratio ClientIndustry Selected Ratios

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Summary of the Parts of Auditing Planning A major purpose is to gain an understanding of the client’s business and industry.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Key Parts of Planning Accept client and perform initial planning  New client acceptance and continuance  Identify client’s reasons for audit  Obtain an understanding with client  Staff the engagement

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

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 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 Key Parts of Planning Perform preliminary analytical procedures

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Analytical Procedures 1.Required in the planning phase 2.Often done during the testing phase 3.Required during the completion phase SAS 56 emphasizes the expectations developed by the auditor.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Timing and Purposes of Analytical Procedures (Required) Planning Phase Purpose 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 Secondary purpose Primary purpose Secondary purpose Primary purpose Testing Phase (Required) Completion Phase

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 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 Compare Client and Industry Data Inventory turnover Gross margin26.3%26.4%27.3%26.2% ClientIndustry

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Compare Client Data with Similar Prior Period Data Net sales$143, $131, Cost of goods sold 103, , Gross profit$ 39, $ 36, Selling expense 14, , Administrative expense 17, , Other 1, , Earnings before taxes$ 5, $ 4, Income taxes 1, , Net income$ 3, $ 3, (000)Prelim. % of Net sales 2006 (000)Prelim. % of Net sales

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 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 Short-term Debt-paying Ability Current ratio Current assets Current liabilities = Cash ratio (Cash + Marketable securities) Current liabilities = Quick ratio (Cash + Marketable securities + Net accounts receivable) Current liabilities =

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Liquidity Activity Ratios Accounts receivable turnover Net sales Average gross receivables = Days to collect receivable 365 days Accounts receivable turnover = Inventory turnover Cost of goods sold Average inventory = Days to sell inventory 365 days Inventory turnover =

©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 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 =

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Profitability Ratios Return on common equity (Income before taxes – Preferred dividends) Average stockholders’ equity = Return on assets Income before taxes Average total assets =

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

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder End of Chapter 8