1. 7 - 1 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Audit Planning and Analytical Procedures Chapter 7

2. 7 - 2 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 1 Discuss why adequate audit planning is essential.

3. 7 - 3 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Planning The work is to be adequately planned, and assistants, if any, are to be properly supervised. Acceptable audit risk Inherent risk

4. 7 - 4 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Planning an Audit and Designing an Approach Accept client and perform initial audit planning Understand the client’s business and industry Assess client business risk Perform preliminary analytical procedures

5. 7 - 5 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Planning an Audit and Designing an Approach Set materiality, and assess acceptable audit risk and inherent risk Develop overall audit plan and audit program Understand internal control and assess control risk

6. 7 - 6 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 2 Make client acceptance decisions and perform initial audit planning.

7. 7 - 7 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Initial Audit Planning Client acceptance and continuation Identify client’s reasons for audit. Obtain an understanding with the client. Select staff for the engagement.

8. 7 - 8 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 3 Gain an understanding of the client’s business and industry.

9. 7 - 9 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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

10. 7 - 10 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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

11. 7 - 11 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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 Inherent risks common to all clients in certain industries Unique accounting requirements

12. 7 - 12 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Business Operations and Processes Factors the auditor should understand: – major sources of revenue – sources of revenue – key customers and suppliers – sources of financing – information about related parties – ability to obtain financing

13. 7 - 13 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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 meetings

14. 7 - 14 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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

15. 7 - 15 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Measurement and Performance The client’s performance measurement system includes key performance indicators. Examples: Performance measurement includes ratio analysis and benchmarking against key competitors. – market share– sales per employee – unit sales growth– Web site visitors – same-store sales– sales/square foot

16. 7 - 16 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 4 Assess client business risk.

17. 7 - 17 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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 misstatement of the financial statements due to client business risk

18. 7 - 18 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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 Assess Risk of Material Misstatements

19. 7 - 19 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 5 Perform preliminary analytical procedures.

20. 7 - 20 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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.

21. 7 - 21 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Examples of Planning Analytical Procedures Liquidity Activity Ratio Inventory turnover 3.465.20 Ability to Meet Long-Term Obligations Debt to equity 1.732.51 Profitability Return on assets 0.09 ClientIndustry Short-Term Debt-Paying Ability Current ratio 3.865.20 Selected Ratios

22. 7 - 22 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Key Parts of Planning Accept Client and Perform Initial Planning New client acceptance and continuance Obtain an understanding with client Identify client’s reasons for the audit Staff the engagement

23. 7 - 23 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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

24. 7 - 24 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Key Parts of Planning Assess Client Business Risk Evaluate management business controls affecting business risk Assess client business risk Assess risk of material misstatements

25. 7 - 25 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Key Parts of Planning Perform Preliminary Analytical Procedures

26. 7 - 26 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Summary of the Purposes of Auditing Planning A major purpose is to gain an understanding of the client’s business and industry.

27. 7 - 27 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 6 State the purposes of analytical procedures and the timing of each purpose.

28. 7 - 28 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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.

29. 7 - 29 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Timing and Purpose of Analytical Procedures (Required) Planning Phase Purpose Understand client’s industry and business Primary purpose Assess going concernSecondary purposeIndicate possible misstatements (attention directing) Primary purpose Reduce detailed testsSecondary purpose

30. 7 - 30 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Timing and Purpose of Analytical Procedures Testing Phase Purpose Understand client’s industry and business Assess going concernIndicate possible misstatements (attention directing) Secondary purpose Reduce detailed testsPrimary purpose

31. 7 - 31 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Timing and Purpose of Analytical Procedures (Required) Completion Phase Purpose Understand client’s industry and business Assess going concernSecondary purposeIndicate possible misstatements (attention directing) Primary purpose Reduce detailed tests

32. 7 - 32 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 7 Select the most appropriate analytical procedure from among the five major types.

33. 7 - 33 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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. 4. Compare client data with auditor-determined expected results. 5. Compare client data with expected results, using nonfinancial data.

34. 7 - 34 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Compare Client and Industry Data Client Industry 2002200120022001 Inventory turnover 3.4 3.5 3.9 3.4 Gross margin percent26.3%26.4%27.3%26.2%

35. 7 - 35 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Compare Client Data With Similar Prior-period Data 2002 2001 (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

36. 7 - 36 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 8 Compute common financial ratios.

37. 7 - 37 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Common Financial Ratios Short-term debt-paying ability Liquidity activity ratios Ability to meet long-term debt obligations Profitability ratios

38. 7 - 38 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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

39. 7 - 39 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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

40. 7 - 40 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Liquidity Activity Ratios Days to sell inventory: 365 days ÷ inventory turnover

41. 7 - 41 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Ability to Meet Long-term Debt Obligation Debt to equity: Total liabilities ÷ Total equity Times interest earned: Operating income ÷ Interest expense

42. 7 - 42 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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.

43. 7 - 43 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley End of Chapter 7