2. 8 - 1 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Audit Planning and Analytical Procedures Chapter 8

3. 8 - 2 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 1 Discuss why adequate audit planning is essential.

4. 8 - 3 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Three Main Reasons for Planning To obtain sufficient competent evidence for the circumstances To help keep audit costs reasonable To avoid misunderstanding with the client

5. 8 - 4 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Risk Terms Acceptable audit risk Inherent risk

6. 8 - 5 ©2006 Prentice Hall Business Publishing, Auditing 11/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.

7. 8 - 6 ©2006 Prentice Hall Business Publishing, Auditing 11/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.

8. 8 - 7 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 2 Make client acceptance decisions and perform initial audit planning.

9. 8 - 8 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Initial Audit Planning Get client acceptance and continuance. Identify client’s reasons for audit. Obtain an understanding with the client. Select staff for the engagement. Evaluate need for outside specialists.

10. 8 - 9 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 3 Gain an understanding of the client’s business and industry.

11. 8 - 10 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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? Global operations Information technology Human capital

12. 8 - 11 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Understanding of the Client’s Business and Industry Industry and external environment Industry and external environment Business operations and processes Management and governance Objectives and strategies Measurement and performance Understand client’s business and industry.

13. 8 - 12 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Industry and External Environment What are some reasons for obtaining an understanding of the client’s industry 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 certain industries 3.Unique accounting requirements

14. 8 - 13 ©2006 Prentice Hall Business Publishing, Auditing 11/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 – Ability to obtain financing

15. 8 - 14 ©2006 Prentice Hall Business Publishing, Auditing 11/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

16. 8 - 15 ©2006 Prentice Hall Business Publishing, Auditing 11/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.

17. 8 - 16 ©2006 Prentice Hall Business Publishing, Auditing 11/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

18. 8 - 17 ©2006 Prentice Hall Business Publishing, Auditing 11/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.

19. 8 - 18 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 4 Assess client business risk.

20. 8 - 19 ©2006 Prentice Hall Business Publishing, Auditing 11/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

21. 8 - 20 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Assess Client Business Risk The Sarbanes-Oxley Act requires that management certify it has designed 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.

22. 8 - 21 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder The Client’s Business, Risk, and Auditor’s Risk Assessment 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. 8 - 22 ©2006 Prentice Hall Business Publishing, Auditing 11/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. What’s a paradigm? Go look it up!

24. 8 - 23 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 5 Perform preliminary analytical procedures.

25. 8 - 24 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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.

26. 8 - 25 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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. 8 - 26 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Summary of the Purposes of Auditing Planning A major purpose is to gain an understanding of the client’s business and industry.

28. 8 - 27 ©2006 Prentice Hall Business Publishing, Auditing 11/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

29. 8 - 28 ©2006 Prentice Hall Business Publishing, Auditing 11/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

30. 8 - 29 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Key Parts of Planning Assess client business risk Assess client business risk Evaluate management controls affecting business risk Assess risk of material misstatements

31. 8 - 30 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Key Parts of Planning Perform preliminary analytical procedures

32. 8 - 31 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 6 State the purposes of analytical procedures and the timing of each purpose.

33. 8 - 32 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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.

34. 8 - 33 ©2006 Prentice Hall Business Publishing, Auditing 11/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

35. 8 - 34 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Timing and Purposes of Analytical Procedures Testing Phase Purpose Understand client’s industry and business Assess going concern Indicate possible misstatements (attention directing) Secondary purpose Reduce detailed tests Primary purpose

36. 8 - 35 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Timing and Purposes of Analytical Procedures (Required) Completion Phase Purpose Understand client’s industry and business Assess going concern Secondary purpose Indicate possible misstatements (attention directing) Primary purpose Reduce detailed tests

37. 8 - 36 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 7 Select the most appropriate analytical procedure from among the five major types.

38. 8 - 37 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Five Types of Analytical Procedures 1.Compare client and industry data. 2.Compare client data with similar prior period data. prior period data. 3.Compare client data with client-determined expected results. client-determined expected results. 4.Compare client data with auditor-determined expected results. auditor-determined expected results. 5.Compare client data with expected results, using nonfinancial data. results, using nonfinancial data.

39. 8 - 38 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Compare Client and Industry Data Inventory turnover 3.4 3.5 3.9 3.4 Gross margin26.3%26.4%27.3%26.2% ClientIndustry2005200420052004

40. 8 - 39 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Compare Client Data with Similar Prior Period Data Net sales$143,086100.0$131,226100.0 Cost of goods sold 103,241 72.1 94,876 72.3 Gross profit$ 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 2004(000)Prelim. % of Net sales 2003(000)Prelim. % of Net sales

41. 8 - 40 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 8 Compute common financial ratios.

42. 8 - 41 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Common Financial Ratios Short-term debt-paying ability Liquidity activity ratios Ability to meet long-term debt obligations Profitability ratios

43. 8 - 42 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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

44. 8 - 43 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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

45. 8 - 44 ©2006 Prentice Hall Business Publishing, Auditing 11/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

46. 8 - 45 ©2006 Prentice Hall Business Publishing, Auditing 11/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

47. 8 - 46 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Profitability Ratios Return on assets: Income before taxes ÷ Average total assets Income before taxes ÷ Average total assets Return on common equity: (Income before taxes – Preferred dividends) ÷ Average stockholders’ equity

48. 8 - 47 ©2006 Prentice Hall Business Publishing, Auditing 11/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.

49. 8 - 48 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder End of Chapter 8