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Audit Planning andAnalytical Procedures
Chapter 8
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Learning Objective 1
Discuss why adequate auditplanning is essential.
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Three Main Reasons for Planning
1. To obtain sufficient competent evidencefor 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 client’s 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 riskand 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 decisionsand perform initial audit planning.
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Initial Audit Planning
Client acceptance and continuance
Identify client’s reasons for audit
Obtain an understanding with the client
Develop overall audit strategy
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Learning Objective 3
Gain an understanding of theclient’s business and industry.
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Understanding of the Client’s Business and Industry
Factors that have increased theimportance of understanding theclient’s business and industry:
Global operations
Information technology
Human capital
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Understanding of the Client’s Business and Industry
Industry and external environment
Business operations and processes
Management and governance
Objectives and strategies
Measurement and performance
Understand client’s business and industry
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Industry and External Environment
Reasons for obtaining an understanding of theclient’s industry and external environment:
1. Risks associated with specific industries2. Inherent risks common to all clients in
certain industries3. Unique accounting requirements
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Business Operationsand 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 OfficesBy viewing the physical facilities, the auditor can asses physical safeguards over assets and interpretaccounting data related to assets.
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Identify Related Parties
A related party is defined as an affiliatedcompany, a principal owner of the clientcompany, or any other party with whichthe client deals, where one of the partiescan influence the management orpolicies of the other.
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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 boardof directors and the audit committee.
Corporate charter and bylaws
Meeting minutes
Code of ethics
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Code of Ethics
In response to the Sarbanes-Oxley Act, the SECnow requires each public company to disclosewhether is has adopted a code of ethics thatapplies to senior management.
The SEC also requires companies to discloseamendments and waivers to the code of ethics.
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Client Objectives and Strategies
Strategies are approaches followed by theentity to achieve organizational objectives.
Auditors should understand client objectives.
Effectiveness and efficiency of operations
Financial reporting reliability
Compliance with laws and regulations
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Measurement and Performance
The client’s performance measurement systemincludes 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 analysisand 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 theclient will fail to achieve its objectives.
What is the auditor’s primary concern?
Material misstatements in the financialstatements due to client business risk
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Client’s Business, Risk, andRisk of Material Misstatement
Understand client’sbusiness and industry
Industry and external environment
Business operations and processes
Management and governance
Objectives and strategies
Measurement and performance
Assess client businessrisk
Assess risk of materialmisstatements
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Sarbanes-Oxley (new title)
The Sarbanes-Oxley Act requires thatmanagement certify it has designeddisclosure controls and procedures toensure that material information aboutbusiness risks is made known to them.
It also requires that management certifyit has informed the auditor and auditcommittee of any significant deficienciesin internal control.
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Enterprise Risk Management
Enterprise risk management (ERM) hasemerged as a new paradigm for managing risk.
ERM integrates and coordinates riskmanagement across the entire enterprise.
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Learning Objective 5
Perform preliminary analyticalprocedures.
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Preliminary Analytical Procedures
Comparison of client ratios to industryor competitor benchmarks provides anindication of the company’s performance.
Preliminary tests can reveal unusualchanges in ratios.
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Examples of Planning Analytical Procedures
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
Short-term debt-paying ability:Current ratio 3.86 5.20
ClientClient IndustryIndustrySelected RatiosSelected Ratios
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Summary of the Partsof Auditing Planning
A major purpose is to gain an understanding of the client’s business and industry.
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Key Parts of Planning
Accept client and perform initial planning
New client acceptance and continuance
Identify client’s reasons for audit
Obtain an understanding with client
Staff the engagement
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Key Parts of Planning
Understand the client’s business and industry
Understand client’s industry and externalenvironment
Understand client’s operations, strategies,and performance system
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Key Parts of Planning
Assess client business risk
Evaluate management controlsaffecting 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 analyticalprocedures and the timingof each purpose.
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Analytical Procedures
1. Required in the planning phase2. Often done during the testing phase3. Required during the completion phase
SAS 56 emphasizes the expectationsdeveloped by the auditor.
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Timing and Purposes of Analytical Procedures
(Required)Planning
PhasePurposeUnderstand client’sindustry and business
Primarypurpose
Assess going concern Secondarypurpose
Indicate possiblemisstatements(attention directing)
Primarypurpose
Reduce detailed tests Secondarypurpose
SecondarypurposePrimarypurpose
SecondarypurposePrimarypurpose
TestingPhase
(Required)Completion
Phase
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Learning Objective 7
Select the most appropriateanalytical procedure fromamong the five major types.
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Five Types of Analytical Procedures
Compare client data with:
1. Industry data2. Similar prior-period data3. Client-determined expected results4. Auditor-determined expected results5. Expected results using nonfinancial data.
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Compare Client and Industry Data
Inventory turnover 3.4 3.5 3.9 3.4Gross margin 26.3% 26.4% 27.3% 26.2%
ClientClient IndustryIndustry2007 2006 2007 2006
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Compare Client Data with Similar Prior Period Data
Net sales $143,086 100.0 $131,226 100.0Cost of goods sold 103,241 72.1 94,876 72.3Gross profit $ 39,845 27.9 $ 36,350 27.7Selling expense 14,810 10.3 12,899 9.8Administrative expense 17,665 12.4 16,757 12.8Other 1,689 1.2 2,035 1.6Earnings before taxes $ 5,681 4.0 $ 4,659 3.5Income taxes 1,747 1.2 1,465 1.1Net income $ 3,934 2.8 $ 3,194 2.4
20072007(000)(000)
Prelim.Prelim.% of% of
Net salesNet sales
20062006(000)(000)
Prelim.Prelim.% of% of
Net salesNet sales
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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
Current ratio Current assetsCurrent liabilities=
Cash ratio (Cash + Marketable securities)Current liabilities=
Quick ratio(Cash + Marketable securities
+ Net accounts receivable)Current liabilities
=
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Liquidity Activity Ratios
Accounts receivableturnover
Net salesAverage gross receivables=
Days to collectreceivable
365 days365 daysAccounts receivable turnover=
Inventoryturnover
Cost of goods soldCost of goods soldAverage inventory=
Days to sellinventory
365 days365 daysInventory turnover=
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Ability to Meet Long-term Debt Obligation
Debt to equity Total liabilitiesTotal equity=
Times interestearned
Operating incomeInterest expense=
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Profitability Ratios
Earningsper share
Net incomeAverage common shares outstanding=
Gross profitpercent
(Net sales – Cost of goods sold)Net sales=
Profit margin Operating incomeNet sales=
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Profitability Ratios
Return oncommonequity
(Income before taxes– Preferred dividends)
Average stockholders’ equityAverage stockholders’ equity=
Return onassets
Income before taxesAverage total assets=
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Summary of Analytical Procedures
They involve the computation of ratiosand other comparisons of recordedamounts to auditor expectations.
They are used in planning to understandthe 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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End of Chapter 8