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7 - 1©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Audit Planning andAnalytical Procedures
Chapter 7
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7 - 2©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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7 - 3©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Planning
The work is to be adequately planned, andassistants, if any, are to be properly supervised.
Acceptable audit risk
Inherent risk
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7 - 4©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Planning an Audit andDesigning an Approach
Accept client andperform initialaudit planning
Understand theclient’s business
and industry
Assess clientbusiness risk
Perform preliminaryanalytical procedures
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7 - 5©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Planning an Audit andDesigning an Approach
Set materiality, andassess acceptable auditrisk and inherent risk
Develop overallaudit plan andaudit program
Understand internalcontrol and assess
control risk
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7 - 6©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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7 - 7©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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7 - 8©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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7 - 9©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Understanding of the Client’s Business and Industry
What are some factors that have increasedthe importance of understanding the
client’s business and industry?
Globaloperations
Informationtechnology
Humancapital
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7 - 10©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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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7 - 11©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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7 - 12©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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7 - 13©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Management and Governance
Management establishes the strategies andprocesses followed by the client’s business.
Governance includes the client’s organizationalstructure, 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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7 - 14©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Client Objectivesand Strategies
Strategies are approaches followed by theentity to achieve organizational objectives.
Auditors should understand client objectives.
Effectivenessand efficiencyof operations
Financialreportingreliability
Compliancewith laws and
regulations
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7 - 15©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Measurement and Performance
The client’s performance measurement systemincludes key performance indicators. Examples:
Performance measurement includes ratio analysisand 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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7 - 16©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 4
Assess client business risk.
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7 - 17©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Assess Client Business Risk
Client business risk is the risk that theclient will fail to achieve its objectives.
What is the auditor’s primary concern?
– material misstatement of the financialstatements due to client business risk
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7 - 18©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
The Client’s Business, Risk, and
Auditor’s Risk AssessmentIndustry and External Environment
Business Operations and Processes
Management and Governance
Objectives and Strategies
Measurement and Performance
Understand Client’sBusiness and Industry
Assess ClientBusiness Risk
Assess Risk ofMaterial Misstatements
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7 - 19©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 5
Perform preliminary
analytical procedures.
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7 - 20©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Preliminary Analytical Procedures
Comparison of client ratios to industryor competitor benchmarks provides an
indication of the company’s performance.
Analytical procedures are also an importantpart of testing throughout the audit.
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7 - 21©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Examples of PlanningAnalytical Procedures
Liquidity Activity RatioInventory turnover 3.46 5.20
Ability to Meet Long-Term ObligationsDebt to equity 1.73 2.51
ProfitabilityReturn on assets 0.09 0.09
Client IndustryShort-Term Debt-Paying AbilityCurrent ratio 3.86 5.20
Selected Ratios
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7 - 22©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Key Parts of Planning
Accept Client and PerformInitial Planning
New clientacceptance and
continuance
Obtain anunderstanding
with client
Identify client’sreasons forthe audit
Staff theengagement
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7 - 23©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Key Parts of Planning
Understand the Client’sBusiness and Industry
Understandclient’s industry
and externalenvironment
Understandclient’s operations,
strategies, andperformance system
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7 - 24©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Key Parts of Planning
Assess ClientBusiness Risk
Evaluate managementbusiness controls
affecting business risk
Assess clientbusiness risk
Assess riskof material
misstatements
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7 - 25©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Key Parts of Planning
Perform PreliminaryAnalytical Procedures
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7 - 26©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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7 - 27©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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7 - 28©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Analytical Procedures
Analytical procedures use comparisons andrelationships to assess whether account
balances or other data appear reasonable.
SAS 56 emphasizes the expectationsdeveloped by the auditor.
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7 - 29©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Timing and Purpose ofAnalytical Procedures
(Required)Planning Phase
Purpose
Understand client’sindustry 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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7 - 30©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Timing and Purpose ofAnalytical Procedures
TestingPhase
Purpose
Understand client’sindustry and business
Assess going concern
Indicate possible misstatements(attention directing)
Secondary purpose
Reduce detailed tests Primary purpose
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7 - 31©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Timing and Purpose ofAnalytical Procedures
(Required)Completion Phase
Purpose
Understand client’sindustry and business
Assess going concern Secondary purpose
Indicate possible misstatements(attention directing)
Primary purpose
Reduce detailed tests
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7 - 32©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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7 - 33©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 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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7 - 34©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Compare Clientand Industry Data
Client Industry2002 2001 2002 2001
Inventory turnover 3.4 3.5 3.9 3.4Gross margin percent 26.3% 26.4% 27.3% 26.2%
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7 - 35©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
Preliminary Net Sales Audited Net SalesNet sales 143 100 131 100Cost of goods sold 103 72 95 72Gross profit 40 28 36 28S & A 32 22 30 23Other 4 3 3 3Net income 4 3 3 2
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7 - 36©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 8
Compute common
financial ratios.
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7 - 37©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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7 - 38©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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7 - 39©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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7 - 40©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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7 - 41©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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7 - 42©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Summary of Analytical Procedures
They involve the computation of ratiosand 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 identifypossible misstatements, reduce detailed tests,
and to assess going-concern issues.
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7 - 43©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
End of Chapter 7