Audit Planning and

Analytical Procedures

Chapter 8

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Learning Objective 1
Discuss why adequate audit
planning is essential.

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Three Main Reasons for
Planning
1. To obtain sufficient appropriate evidence
for the circumstances

2. To help keep audit costs reasonable

3. 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.

Understand the clients business and industry.

Assess client business risk.

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.

Understand internal control and assess control risk.

Gather information to assess fraud risks.

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

1. Client acceptance and continuance

2. Identify clients reasons for audit

3. Obtain an understanding with the client

4. Develop overall audit strategy

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Learning Objective 3
Gain an understanding of the
clients business and industry.

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Understanding of the Clients
Business and Industry
Factors that have increased the
importance of understanding the
clients business and industry:

Information technology
Global operations

Human capital

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Understanding of the Clients
Business and Industry
Understand clients 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
Reasons for obtaining an understanding of the
clients 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

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Tour the Plant and Offices
By viewing the physical facilities,
the auditor can asses physical
safeguards over assets and interpret
accounting data related to assets.

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Identify Related Parties
A related party is defined as an affiliated
company, a principal owner of the client
company, or any other party with which
the client deals, where one of the parties
can influence the management or
policies of the other.

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Management and Governance
Management establishes the strategies and
processes followed by the clients business.

Governance includes the clients 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 clients performance measurement system

includes key performance indicators. Examples:

market share Web site visitors

sales per employee same-store sales
unit sales growth 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 auditors primary concern?

Material misstatements in the financial
statements due to client business risk

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Clients Business, Risk, and
Risk of Material Misstatement
Industry and external environment
Understand clients
business and industry
Business operations and processes

Management and governance

Assess client business
risk
Objectives and strategies

Assess risk of material Measurement and performance

misstatements

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Sarbanes-Oxley Act
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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Learning Objective 5
Perform preliminary analytical
procedures.

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Preliminary Analytical
Procedures
Comparison of client ratios to industry
or competitor benchmarks provides an
indication of the companys performance.

Preliminary tests can reveal unusual

changes in ratios.

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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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Summary of the Parts
of Auditing Planning
A major purpose is to gain an understanding
of the clients business and industry.

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Key Parts of Planning

Accept client and perform initial planning

New client acceptance and continuance

Identify clients reasons for audit

Obtain an understanding with client

Staff the engagement

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Key Parts of Planning

Understand the clients business and industry

Understand clients industry and external

environment

Understand clients operations, strategies,

and performance system

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Key Parts of Planning

Assess client business risk

Evaluate management controls

affecting business risk

Assess risk of material misstatements

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Key Parts of Planning

Perform preliminary analytical procedures

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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

AU 329 emphasizes the expectations

developed by the auditor.

1. Required in the planning phase

2. Often done during the testing phase
3. Required during the completion phase

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Timing and Purposes of
Analytical Procedures
(Required) (Required)
Planning Testing Completion
Purpose Phase Phase Phase
Understand clients Primary
industry and business purpose
Assess going concern Secondary Secondary
purpose purpose
Indicate possible Primary Secondary Primary
misstatements
(attention directing) purpose purpose purpose
Reduce detailed tests Secondary Primary
purpose 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 Types of Analytical
Procedures
Compare client data with:

1. Industry data
2. Similar prior-period data
3. Client-determined expected results
4. Auditor-determined expected results
5. Expected results using nonfinancial data.

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Compare Client and Industry
Data
Client Industry
2009 2008 2009 2008
Inventory turnover 3.4 3.5 3.9 3.4
Gross margin 26.3% 26.4% 27.3% 26.2%

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Compare Client Data with
Similar Prior Period Data
2009 2008
(000) % of (000) % of
Prelim. Net sales Prelim. Net sales

Net sales $143,086 100.0 $131,226 100.0

Cost of goods sold 103,241 72.1 94,876 72.3
Gross profit $ 39,845 27.9 $ 36,350 27.7
Selling expense 14,810 10.3 12,899 9.8
Administrative expense 17,665 12.4 16,757 12.8
Other 1,689 1.2 2,035 1.6
Earnings before taxes $ 5,681 4.0 $ 4,659 3.5
Income taxes 1,747 1.2 1,465 1.1
Net income $ 3,934 2.8 $ 3,194 2.4

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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

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Short-term Debt-paying Ability

(Cash + Marketable securities)

Cash ratio =
Current liabilities

(Cash + Marketable securities

Quick ratio = + Net accounts receivable)
Current liabilities

Current assets
Current ratio =
Current liabilities

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Liquidity Activity Ratios

Accounts receivable Net sales

=
turnover Average gross receivables
Days to collect 365 days
=
receivable Accounts receivable turnover
Inventory Cost of goods sold
=
turnover Average inventory
Days to sell 365 days
=
inventory Inventory turnover
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Ability to Meet Long-term Debt
Obligation
Total liabilities
Debt to equity =
Total equity

Times interest Operating income

=
earned Interest expense

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Profitability Ratios

Earnings Net income

=
per share Average common shares outstanding

Gross profit (Net sales Cost of goods sold)

=
percent Net sales

Operating income
Profit margin =
Net sales

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Profitability Ratios

Return on Income before taxes

=
assets Average total assets

Return on (Income before taxes

common = Preferred dividends)
equity 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 clients 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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