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Audit Planning and Analytical Procedures

Chapter 8

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

8-1

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

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

8-3

Planning an Audit and Designing an Audit Approach steps 1-Accept client and perform initial audit planning.

2- Understand the clients business and industry.


3- Assess client business risk. 4-Perform preliminary analytical procedures.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

8-4

Planning an Audit and Designing an Audit Approach


5- Set materiality and assess acceptable audit risk and inherent risk. 6- Understand internal control and assess control risk.

7-Gather information to assess fraud risks.


8-Develop overall audit plan and audit program.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

8-5

Step 1- Initial Audit Planning


a. Client acceptance and continuance

b. Identify clients reasons for audit


c. Obtain an understanding with the client d. Develop overall audit strategy

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

8-6

Step 2- Understanding of the Clients Business and Industry


a-Industry and external environment b-Business operations and processes
c-Management and governance d-Objectives and strategies e-Measurement and performance
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a- 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

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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B- Business Operations and Processes


Factors the auditor should understand:
Major sources of revenue

Key customers and suppliers


Sources of financing Information about related parties

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

8-9

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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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C- 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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D- 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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E- Measurement and Performance


The clients 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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Step 3 -Assess Client Business Risk


Client business risk is the risk that the
client will fail to achieve its objectives. Material misstatements in the financial statements due to client business risk

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Step 4- 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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Common Financial Ratios


Short-term debt-paying ability liquidity activity ratios

Ability to meet long-term debt obligations


Profitability ratios

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Short-term Debt-paying Ability


Cash ratio (Cash + Marketable securities) = Current liabilities (Cash + Marketable securities = + Net accounts receivable) Current liabilities

Quick ratio

Current assets Current ratio = Current liabilities

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Activity Ratios
Accounts receivable Net sales = turnover Average gross receivables

Days to collect receivable


Inventory turnover Days to sell inventory

365 days = Accounts receivable turnover


Cost of goods sold = Average inventory 365 days = Inventory turnover
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2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

Ability to Meet Long-term Debt Obligation


Debt to equity = Times interest = earned Total liabilities Total equity 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


Operating income Net sales

Profit margin =

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Profitability Ratios
Return on = assets Return on common = equity Income before taxes Average total assets (Income before taxes Preferred dividends) Average stockholders equity

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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