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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Audit Planning andAnalytical Procedures
Chapter 7
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 1
Discuss why adequate audit
planning is essential.
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©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
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Planning an Audit andDesigning an Approach
Accept client and
perform initial
audit planning
Understand the
client’s business
and industry
Assess client
business risk
Perform preliminary
analytical procedures
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Planning an Audit andDesigning 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
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©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.
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©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.
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©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.
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Understanding of the Client’sBusiness 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
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Understanding of the Client’sBusiness 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
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©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
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Business Operationsand 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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©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
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Client Objectivesand 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
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©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
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 4
Assess client business risk.
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©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
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
The Client’s Business, Risk, andAuditor’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
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 5
Perform preliminary
analytical procedures.
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©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.
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Examples of PlanningAnalytical Procedures
Liquidity Activity Ratio
Inventory turnover
3.46
5.20
Ability to Meet Long-Term Obligations
Debt to equity
1.73
2.51
Profitability
Return on assets
0.09
0.09
Client
Industry
Short-Term Debt-Paying Ability
Current ratio
3.86
5.20
Selected Ratios
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©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
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©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
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©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
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Key Parts of Planning
Perform Preliminary
Analytical Procedures
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Summary of the Purposesof Auditing Planning
A major purpose is to gain an understanding
of the client’s business and industry.
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©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.
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©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.
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Timing and Purpose ofAnalytical 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
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Timing and Purpose ofAnalytical 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
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Timing and Purpose ofAnalytical 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
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©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.
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Five Major Types ofAnalytical Procedures
1.Compare client and industry data.
2.Compare client data with similarprior-period data.
3.Compare client data withclient-determined expected results.
4.Compare client data withauditor-determined expected results.
5.Compare client data with expectedresults, using nonfinancial data.
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Compare Clientand 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%
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Compare Client Data WithSimilar 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
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 8
Compute common
financial ratios.
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©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
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Short-termDebt-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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©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
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Liquidity Activity Ratios
Days to sell inventory:
365 days ÷ inventory turnover
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Ability to Meet Long-termDebt Obligation
Debt to equity:
Total liabilities ÷ Total equity
Times interest earned:
Operating income ÷ Interest expense
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©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.
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©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
End of Chapter 7