Audit planning involves three main reasons: 1) to obtain sufficient evidence, 2) to help keep costs reasonable, and 3) to avoid misunderstandings with the client. The key parts of planning include accepting the client, understanding the client's business and industry, assessing business risks, and performing preliminary analytical procedures. Analytical procedures are used in the planning, testing, and completion phases of the audit to understand the client, identify possible misstatements, and reduce detailed tests. Common financial ratios used in analytical procedures include liquidity, activity, debt obligation, and profitability ratios.

1. Audit Planning and Analytical Procedures Chapter 8

3. Three Main Reasons for Planning 1. To obtain sufficient competent evidence for the circumstances 2. To help keep audit costs reasonable 3. To avoid misunderstanding with the client

5. 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.

6. 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.

11. 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

12. Industry and External Environment 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

14. 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.

15. 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.

17. 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.

22. Client’s Business, Risk, and Risk of Material Misstatement Understand client’s business and industry Industry and external environment Business operations and processes Management and governance Objectives and strategies Measurement and performance Assess client business risk Assess risk of material misstatements

23. Sarbanes-Oxley (new title) 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.

24. 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.

26. Preliminary Analytical Procedures Comparison of client ratios to industry or competitor benchmarks provides an indication of the company’s performance. Preliminary tests can reveal unusual changes in ratios.

27. 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 Client Industry Selected Ratios

28. Summary of the Parts of Auditing Planning A major purpose is to gain an understanding of the client’s business and industry.

32. Key Parts of Planning Perform preliminary analytical procedures

35. Timing and Purposes of Analytical Procedures (Required) Planning Phase Purpose Understand client’s industry and business Primary purpose Assess going concern Secondary purpose Indicate possible misstatements (attention directing) Primary purpose Reduce detailed tests Secondary purpose Secondary purpose Primary purpose Secondary purpose Primary purpose Testing Phase (Required) Completion Phase

37. 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.

38. Compare Client and Industry Data Inventory turnover 3.4 3.5 3.9 3.4 Gross margin 26.3% 26.4% 27.3% 26.2% Client Industry 2007 2006 2007 2006

39. Compare Client Data with Similar Prior Period Data 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 2007 (000) Prelim. % of Net sales 2006 (000) Prelim. % of Net sales

42. Short-term Debt-paying Ability Current ratio Current assets Current liabilities = Cash ratio = Quick ratio = (Cash + Marketable securities) Current liabilities (Cash + Marketable securities + Net accounts receivable) Current liabilities

43. Liquidity Activity Ratios Accounts receivable turnover Net sales Average gross receivables = Days to collect receivable 365 days Accounts receivable turnover = Inventory turnover Cost of goods sold Average inventory = Days to sell inventory 365 days Inventory turnover =

44. Ability to Meet Long-term Debt Obligation Debt to equity Total liabilities Total equity = Times interest earned Operating income Interest expense =

45. 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 =

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

47. 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.

48. End of Chapter 8