1. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 1 Audit Planning and Analytical Procedures Chapter 8

2. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 2 Learning Objective 1 Discuss why adequate audit planning is essential.

3. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 3 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

4. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 4 Risk Terms  Acceptable audit risk  Inherent risk

5. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 5 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.

6. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 6 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.

7. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 7 Learning Objective 2 Make client acceptance decisions and perform initial audit planning.

8. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 8 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

9. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 9 Learning Objective 3 Gain an understanding of the client’s business and industry.

10. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 10 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

11. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 11 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

12. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 12 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

13. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 13 Business Operations and Processes Factors the auditor should understand:  Major sources of revenue  Key customers and suppliers  Sources of financing  Information about related parties

14. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 14 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.

15. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 15 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.

16. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 16 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

17. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 17 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.

18. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 18 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

19. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 19 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.

20. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 20 Learning Objective 4 Assess client business risk.

21. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 21 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

22. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 22 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

23. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 23 Sarbanes-Oxley Act 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.

24. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 24 Learning Objective 5 Perform preliminary analytical procedures.

25. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 25 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.

26. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 26 Examples of Planning Analytical Procedures Liquidity activity ratio: Inventory turnover3.365.20 Ability to meet long-term obligations: Debt to equity1.732.51 Profitability ratio: Profit margin0.050.07 Short-term debt-paying ability: Current ratio3.865.20 ClientIndustry Selected Ratios

27. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 27 Summary of the Parts of Auditing Planning A major purpose is to gain an understanding of the client’s business and industry.

28. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 28 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

29. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 29 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

30. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 30 Key Parts of Planning  Assess client business risk  Evaluate management controls affecting business risk  Assess risk of material misstatements

31. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 31 Key Parts of Planning Perform preliminary analytical procedures

32. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 32 Learning Objective 6 State the purposes of analytical procedures and the timing of each purpose.

33. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 33 Analytical Procedures 1.Required in the planning phase 2.Often done during the testing phase 3.Required during the completion phase AU 329 emphasizes the expectations developed by the auditor.

34. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 34 Timing and Purposes of Analytical Procedures (Required) Planning Phase Purpose Understand client’s industry and business Assess going concern Indicate possible misstatements (attention directing) Reduce detailed tests Testing Phase (Required) Completion Phase Primary purpose Secondary purpose Primary purpose Secondary purpose Primary purpose Primary purpose Secondary purpose Secondary purpose

35. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 35 Learning Objective 7 Select the most appropriate analytical procedure from among the five major types.

36. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 36 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.

37. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 37 Compare Client and Industry Data Inventory turnover 3.4 3.5 3.9 3.4 Gross margin26.3%26.4%27.3%26.2% ClientIndustry 2009200820092008

38. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 38 Compare Client Data with Similar Prior Period Data Net sales$143,086 100.0$131,226100.0 Cost of goods sold 103,241 72.1 94,876 72.3 Gross profit$ 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 2009 (000)Prelim. % of Net sales 2008 (000)Prelim. % of Net sales

39. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 39 Learning Objective 8 Compute common financial ratios.

40. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 40 Common Financial Ratios  Short-term debt-paying ability  Liquidity activity ratios  Ability to meet long-term debt obligations  Profitability ratios

41. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 41 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 =

42. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 42 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 =

43. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 43 Ability to Meet Long-term Debt Obligation Debt to equity Total liabilities Total equity = Times interest earned Operating income Interest expense =

44. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 44 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 =

45. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 45 Profitability Ratios Return on common equity (Income before taxes – Preferred dividends) Average stockholders’ equity = Return on assets Income before taxes Average total assets =

46. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 46 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.

47. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 47 End of Chapter 8