Audit Planning and
Analytical
Procedures
Chapter 8
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
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Learning Objective 1
Discuss why adequate audit
planning is essential.
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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
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Risk Terms
Acceptable audit risk
Inherent risk
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Planning an Audit and Designing
an Audit Approach
Accept client and
perform initial
audit planning.
Assess client business
risk.
Understand the client’s
business and industry.
Perform preliminary
analytical procedures.
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Planning an Audit and Designing
an Audit Approach
Set materiality and
assess acceptable audit
risk and inherent risk.
Gather information to
assess fraud risks.
Understand internal
control and assess
control risk.
Develop overall audit
plan and audit program.
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Learning Objective 2
Make client acceptance decisions
and perform initial audit planning.
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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.
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Learning Objective 3
Gain an understanding of the
client’s business and industry.
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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?
Information technology
Global operations
Human capital
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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
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Industry and External
Environment
What are some 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
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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
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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
Code of ethics
Meeting minutes
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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.
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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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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.
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Learning Objective 4
Assess client business risk.
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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
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Assess Client Business Risk
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.
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The Client’s Business, Risk, and
Auditor’s Risk Assessment
Industry and external environment
Understand client’s
business and industry.
Assess client business
risk.
Business operations and processes
Management and governance
Objectives and strategies
Assess risk of material
misstatements.
Measurement and performance
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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?
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
Go look
it up!
8 - 22
Learning Objective 5
Perform preliminary analytical
procedures.
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8 - 23
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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8 - 24
Examples of Planning Analytical
Procedures
Selected Ratios
Client
Industry
Short-term debt-paying ability:
Current ratio
3.86
5.20
Liquidity activity ratio:
Inventory turnover
3.36
5.20
Ability to meet long-term obligations:
Debt to equity
1.73
2.51
Profitability ratio:
Profit margin
0.05
0.07
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8 - 25
Summary of the Purposes
of Auditing Planning
A major purpose is to gain an understanding
of the client’s business and industry.
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8 - 26
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 audit
Staff the
engagement
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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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8 - 28
Key Parts of Planning
Assess client business risk
Assess client
business risk
Assess risk
of material
misstatements
Evaluate management controls
affecting business risk
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8 - 29
Key Parts of Planning
Perform preliminary analytical procedures
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8 - 30
Learning Objective 6
State the purposes of analytical
procedures and the timing
of each purpose.
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8 - 31
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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8 - 32
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
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8 - 33
Timing and Purposes of Analytical
Procedures
Purpose
Understand client’s
industry and business
Testing Phase
Assess going concern
Indicate possible misstatements
(attention directing)
Secondary purpose
Reduce detailed tests
Primary purpose
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8 - 34
Timing and Purposes of Analytical
Procedures
Purpose
Understand client’s
industry and business
(Required)
Completion Phase
Assess going concern
Secondary purpose
Indicate possible misstatements
(attention directing)
Primary purpose
Reduce detailed tests
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8 - 35
Learning Objective 7
Select the most appropriate
analytical procedure from
among the five major types.
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8 - 36
Five 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.
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8 - 37
Compare Client and Industry Data
Client
2005
2004
Inventory turnover
Gross margin
3.4
26.3%
3.5
26.4%
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Industry
2005
2004
3.9
27.3%
3.4
26.2%
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Compare Client Data with Similar
Prior Period Data
2004
(000)
% of
Prelim. Net sales
Net sales
Cost of goods sold
Gross profit
Selling expense
Administrative expense
Other
Earnings before taxes
Income taxes
Net income
$143,086
103,241
$ 39,845
14,810
17,665
1,689
$ 5,681
1,747
$ 3,934
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100 .0
72 .1
27.9
10 .3
12.4
1 .2
4.0
1.2
2.8
2003
(000)
% of
Prelim. Net sales
$131,226
94,876
$ 36,350
12,899
16,757
2,035
$ 4,659
1,465
$ 3,194
100.0
72.3
27.7
9.8
12.8
1.6
3.5
1.1
2.4
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Learning Objective 8
Compute common financial ratios.
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8 - 40
Common Financial Ratios
Short-term debt-paying ability
Liquidity activity ratios
Ability to meet long-term debt obligations
Profitability ratios
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8 - 41
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
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
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
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Profitability Ratios
Return on assets:
Income before taxes ÷ Average total assets
Return on common equity:
(Income before taxes – Preferred dividends)
÷ Average stockholders’ equity
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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 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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End of Chapter 8
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