Audit Planning and
Analytical Procedures
Chapter 8
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8-1
Learning Objective 1
Discuss why adequate audit
planning is essential.
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Planning
The work is to be adequately planned, and
assistants, if any, are to be properly supervised.
Acceptable audit risk - SET
Inherent risk - ASSESSED
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8-3
Planning an Audit and
Designing an Approach
Accept client and
perform initial
audit planning
Assess client
business risk
Understand the
client’s business
and industry
(specialization)
Perform preliminary
analytical
procedures/review
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8-4
Planning an Audit and
Designing an Approach
Set materiality, set
acceptable audit
risk and assess inherent
risk (Ch 9)
Understand internal
control and assess
control risk (Ch 10)
Gather information
to assess fraud risks
(Ch. 11)
Develop overall
audit plan and
audit program
(Ch 13)
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8-5
Learning Objective 2
Make client acceptance
decisions and perform
initial audit planning.
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Initial Audit Planning
Should the auditor accept a new client?
Or re-accept one? Research on mitigators of risk.
SOX – Big firms trimming down clients → 2nd tier
Small firms, public clients, SOX 404, and PCAOB fees
Identify why the client wants or needs an audit. Why?
Obtain an understanding with the client.
Engagement Letter
SOX – signed by audit committee
Select staff for the engagement → NSTE
Specialists?
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8-7
Learning Objective 3
Gain an understanding of the
client’s business and industry.
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8-8
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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8-9
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
High Tech: Inventory, A/R
Retail: Competition
Real Estate: LSL
Unique accounting requirements: GAAP
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Business Operations
and Processes
Factors the auditor should understand:
– major sources of revenue
– how inputs changed to outputs
– key customers and suppliers
– sources of financing
– information about related parties
– ability to obtain financing
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– changes
since
the
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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
SOX – Code of Ethics – really do anything?
Objectivity and competence of IA, whistleblowers
Minutes of BOD meetings
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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
Opportunities
Effectiveness
and efficiency
of operations
BR
Compliance
with laws and
regulations
Attitudes
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Measurement and Performance
The client’s performance measurement system
includes key performance indicators. Examples:
– market share
– sales per employee
– budgets: NI, Sales, etc. – Bonuses
– EPS forecasts
– stock price/stock options
Performance Measurement = Incentives!
“Follow the money”
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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 IT’S objectives.
What is the auditor’s primary concern?
Material misstatement of the financial
statements (fraud or error) or bankruptcy
due to client business risk.
COSO’s ERM Framework
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The Client’s Business, Risk, and
Auditor’s Risk Assessment
Industry and External Environment
Understand Client’s
Business and Industry
Business Operations and Processes
Management and Governance
Objectives and Strategies
Assess Client
Business Risk
Measurement and Performance
PAP (could provide more BR info!)
and then→Set Materiality and AR / Assess IR (next chapter)
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Learning Objective 5
Perform preliminary
analytical procedures.
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Preliminary Analytical
Procedures
Comparison of client ratios or balances to industry
or competitor benchmarks provides an
indication of the company’s performance.
Comparison to PY = significant
changes at the client
Analytical procedures are also an important
part of testing throughout the audit.
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Examples of Planning
Analytical Procedures
Selected Ratios
Short-Term Debt-Paying Ability
Current ratio
Liquidity Activity Ratio
Inventory turnover
Ability to Meet Long-Term Obligations
Debt to equity
Profitability
Return on assets
Client
Industry
3.86
5.20
3.46
5.20
1.73
2.51
0.09
0.09
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Learning Objective 6
State the purposes of analytical
procedures and the timing of
each purpose.
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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 (source objectivity).
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Timing and Purpose of
Analytical Procedures
Purpose
Understand client’s
industry and business
Assess going concern
Indicate possible misstatements
(attention directing)
(Required)
Planning Phase
Primary purpose
Secondary purpose
Primary purpose
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Timing and Purpose of
Analytical Procedures
Purpose
Testing
Phase
Understand client’s
industry and business
Assess going concern
Indicate possible misstatements
Secondary purpose
(get an explanation and test)
Reduce costly detailed tests
Primary purpose
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Timing and Purpose of
Analytical Procedures
Purpose
Understand client’s
industry and business
Access going concern
Indicate possible misstatements
(did we test it adequately?)
Reduce detailed tests
(Required)
Completion Phase
Secondary purpose
Primary purpose
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Learning Objective 7
Select the most appropriate
analytical procedure from
among the five major types.
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Five Major Types of
Analytical Procedures
Compare client and industry data.
2. Compare client data with similar prior-period
data.
3. Compare client data with client-determined
expected results (Budget).
4. Compare client data with auditor-determined
expected results.
5. Compare client data with expected results, using
quantitative, nonfinancial data.
What does research tell us: preferences, areas for
improvement,
getting
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1.
Compare Client
and Industry Data
Inventory turnover
Gross margin percent
Client
Industry
2009 2008 2009 2008
3.4
3.5
3.9
3.4
26.3% 26.4% 27.3% 26.2%
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Compare Client Data With
Similar Prior-period Data
2009
(000,000)
% of
Preliminary Net Sales
Net sales
143
100
Cost of goods sold 103
72
Gross profit
40
28
S &A
32
22
Other
4
3
Net income
4
3
2008 (audited)
(000,000) % of
Audited Net Sales
131
100
95
72
36
28
30
23
3
3
3
2
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Compare Client Data With
Non-financial data
Research Findings: NFMs = employees, patents, squ. footage
of facilities, retail outlets. Financial = Revenue (why).
Change in Rev – Change in NFM = DIFF
Fraud firm DIFF = 30%
Non-fraud firm DIFF = 11%
Why NFMs so valuable (vs. other sources) related to fraud.
Do auditors use them?
Do investors use them? Short-sellers and a tool.
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Learning Objective 8
Compute common
financial ratios.
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Common Financial Ratios
Short-term debt-paying ability
Liquidity activity ratios
Ability to meet long-term debt obligations
Profitability ratios-EPS, Return on assets, etc.
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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
Days to sell inventory:
365 days ÷ inventory turnover
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Ability to Meet Long-term
Debt Obligation
Debt to equity:
Total liabilities or LT liabilities ÷ Total equity
Times interest earned:
Operating income ÷ Interest expense
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End of Chapter 8
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