Audit Planning and Analytical Procedures

Chapter 8

2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley

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Planning
The work is to be adequately planned, and assistants, if any, are to be properly supervised.

Acceptable audit risk how willing is auditor to accept F/S may be materially misstated after the audit is completed & the opinion is issued.

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Planning
Inherent risk assessment of likelihood that there are material misstatements in accounts before considering effectiveness of internal controls.

Control risk assessment of likelihood that misstatements exceeding a tolerable amount in accounts will not be prevented or detected by the clients internal controls.

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Planning an Audit and Designing an Approach

I. Accept client and perform initial audit planning II. Understand the clients business and industry III. Assess client business risk

IV. Perform preliminary Analytical procedures

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2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley

Planning an Audit and Designing an Approach

V. Set materiality, and assess acceptable audit risk and inherent risk VI. Understand internal control and assess control risk VII. Develop overall audit plan and audit program
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Initial Audit Planning

Should the auditor accept a new client? Identify why the client wants or needs an audit. Obtain an understanding with the client. Select staff for the engagement.

2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley

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II. Understanding of the Clients Business and Industry

A. Understand Clients Business and Industry B. Industry and External Environment

C. Business Operations and Processes

D. Management and Governance E. Objectives and Strategies F. Measurement and Performance
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A. Understanding of the Clients Business and Industry

What are some factors that have increased the importance of understanding the clients business and industry?
Information technology Global operations Human capital

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B. Industry and External Environment

What are some reasons for obtaining an understanding of the clients industry and external environment?

Risks associated with specific industries

Inherent risks common to all clients in certain industries

Unique accounting requirements

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C. 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
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D. Management and Governance

Management establishes the strategies and processes followed by the clients business. Governance includes the clients organizational structure, as well as the activities of the board of directors and the audit committee. Corporate charter and bylaws Minutes of meetings
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E. 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
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F. Measurement and Performance

The clients performance measurement system includes key performance indicators. Examples: market share sales per employee

unit sales growth

same-store sales

Web site visitors

sales/square foot

Performance measurement includes ratio analysis and benchmarking against key competitors.
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III. Assess Client Business Risk

Client business risk is the risk that the client will fail to achieve its objectives. What is the auditors primary concern? material misstatement of the financial statements due to client business risk
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The Clients Business Risk, and Auditors Risk Assessment

Industry and External Environment

Understand Clients Business and Industry

Business Operations and Processes Management and Governance Objectives and Strategies

Assess Client Business Risk

Measurement and Performance

Assess Risk of Material Misstatements

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IV. Perform Analytical Procedures

First, analytical procedures use comparison of client ratios to industry or competitor benchmarks to provide an indication of the companys performance.
Second, analytical procedures use comparisons and relationships to assess whether account balances or other data appear reasonable. SAS 56
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Timing and Purpose of Analytical Procedures

Purpose Understand clients industry and business Assess going concern

(Required) Planning Phase

Primary purpose Secondary purpose

Indicate possible misstatements Primary purpose (attention directing) Reduce detailed tests Secondary purpose
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Timing and Purpose of Analytical Procedures

Purpose Understand clients industry and business Assess going concern Indicate possible misstatements Secondary purpose (attention directing) Reduce detailed tests Primary purpose
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Testing Phase

Timing and Purpose of Analytical Procedures

Purpose Understand clients industry and business Access going concern Indicate possible misstatements (attention directing) Reduce detailed tests

(Required) Completion Phase

Secondary purpose Primary purpose

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Five Major Types of Analytical Procedures

1.

2.
3. 4.

5.

Compare client and industry data. Compare client data with similar prior-period data. Compare client data with client-determined expected results. Compare client data with auditor-determined expected results. Compare client data with expected results, using nonfinancial data.
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Common Financial Ratios

Short-term debt-paying ability
Liquidity activity ratios Ability to meet long-term debt obligations Profitability ratios

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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

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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

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Liquidity Activity Ratios

Days to sell inventory: 365 days inventory turnover

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Ability to Meet Long-term Debt Obligation

Debt to equity: Total liabilities Total equity Times interest earned: Operating income Interest expense

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Profitability Ratios
Return on equity: Net Income Average (or Total) equity Return on assets: Net income Average total assets Profit Margin: Net income Net Sales
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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 clients business and industry. They are used throughout the audit to identify possible misstatements, reduce detailed tests, and to assess going-concern issues.
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Summary of the Purposes of Audit Planning

Gain an understanding of the clients business and industry.
Assess risks business risk, inherent risk, control risk, and acceptable audit risk. Set materiality and develop overall audit plan and audit program.

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Key Parts of Planning

Accept Client and Perform Initial Planning New client acceptance and continuance Identify clients reasons for the audit Obtain an understanding with client Staff the engagement
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2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley

Key Parts of Planning

Understand the Clients Business and Industry

Understand clients industry and external environment

Understand clients operations, strategies, and performance system

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2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley

Key Parts of Planning

Assess Client Business Risk Assess client business risk

Assess risk of material misstatements

Evaluate management business controls affecting business risk

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Key Parts of Planning

Perform Preliminary Analytical Procedures

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End of Chapter 8

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