Audit Planning and
Analytical Procedures
Chapter 8
First Standard of Fieldwork (GAAS)
The work is to be adequately planned
and assistants, if any, are to be
properly supervised.
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
Managing Risk is an Important Aspect of
Auditing
Acceptable audit risk – level of risk the auditor
will accept, that an unqualified opinion is
mistakenly issued.
Inherent risk – likelihood of material misstatements
In accounts before I/C effectiveness is considered.
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.
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.
The Engagement Letter


Not required by GAAS, but is very useful.
GAAS does require a clear understanding of
the terms of the engagement between auditor
and client.
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
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
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
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
Related Party Transactions

It is important to identify related parties to the
client.
 GAAP
requires disclosure of material related party
transactions
 SOX prohibits loans to any director or executive
officer of the company.

Financial institution exceptions
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.
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
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.
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
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.
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
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.
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.
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
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
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
Key Parts of Planning
Assess client business risk
Assess client
business risk
Assess risk
of material
misstatements
Evaluate management controls
affecting business risk
Key Parts of Planning
Perform preliminary analytical procedures
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.
Timing and Purposes of Analytical
Procedures (p. 208)
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.
Compare Client and Industry Data
Client
2005
2004
Inventory turnover
Gross margin
3.4
26.3%
3.5
26.4%
Industry
2005
2004
3.9
27.3%
3.4
26.2%
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
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
Common Financial Ratios
Short-term debt-paying ability
Liquidity activity ratios
Ability to meet long-term debt obligations
Profitability ratios
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
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
Ability to Meet Long-term Debt Obligation
Debt to equity:
Total liabilities ÷ Total equity
Times interest earned:
Operating income ÷ Interest expense
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
Profitability Ratios
Return on assets:
Income before taxes ÷ Average total assets
Return on common equity:
(Income before taxes – Preferred dividends)
÷ Average stockholders’ equity
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.