arens solution manual chapter 8

5/28/2018 arens solution manual Chapter 8

1/482008 Prentice Hall Business Publishing,Auditing 12/e,Arens/Beasley/Elder 8 - 1

Audit Planning and

Analytical Procedures

Chapter 8


2/482008 Prentice Hall Business Publishing,Auditing 12/e,Arens/Beasley/Elder 8 - 2

Learning Objective 1

Discuss why adequate audit

planning is essential.


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2008 Prentice Hall Business Publishing,Auditing 12/e,Arens/Beasley/Elder 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


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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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Make client acceptance decisions

and perform initial audit planning.


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Initial Audit Planning

Client acceptance and continuance

Identify clients reasons for audit

Obtain an understanding with the client

Develop overall audit strategy


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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:

Global operations

Information technology

Human capital


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Understanding of the Clients

Business and Industry

Industry and external environment

Business operations and processes

Management and governance

Objectives and strategies

Measurement and performance

Understand clients business and industry


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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 whichthe 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

Meeting minutes

Code of ethics


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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.

Effectiveness and efficiency of operations

Financial reporting reliability

Compliance with laws and regulations


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Measurement and

Performance

The clients performance measurement system

includes key performance indicators. Examples:

market sharesales 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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Assess client business risk.


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Assess Client Business Risk

Client business r is kis 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

Understand clientsbusiness 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 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 certifyit has informed the auditor and audit

committee of any significant deficiencies

in internal control.


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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.


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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


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 IndustrySelected Ratios


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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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Understand the clients business and industry

Understand clients industry and external

environment

Understand clients operations, strategies,

and performance system


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Assess client business risk

Evaluate management controlsaffecting business risk

Assess risk of material misstatements


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Perform preliminary analytical procedures


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State the purposes of analytical

procedures and the timing

of each purpose.


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1. Required in the planning phase

2. Often done during the testing phase

3. Required during the completion phase

SAS 56 emphasizes the expectations

developed by the auditor.


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Timing and Purposes of

Analytical Procedures(Required)Planning

PhasePurpose

Understand clients

industry and business

Primary

purpose

Assess going concern Secondarypurpose

Indicate possible

misstatements(attention directing)

Primary

purpose

Reduce detailed tests Secondarypurpose

Secondary

purpose

Primarypurpose

Secondarypurpose

Primary

purpose

TestingPhase

(Required)Completion

Phase


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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

Inventory turnover 3.4 3.5 3.9 3.4Gross margin 26.3% 26.4% 27.3% 26.2%

Client Industry

2007 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

2007

(000)Prelim.

% ofNet sales

2006

(000)Prelim.

% ofNet sales


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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 receivable

turnover

Net sales

Average gross receivables=

Days to collectreceivable

365 daysAccounts receivable turnover

=

Inventory

turnover

Cost of goods sold

Average inventory

=

Days to sell

inventory

365 days

Inventory turnover=


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Ability to Meet Long-term Debt

Obligation

Debt to equityTotal liabilities

Total equity=

Times interest

earned

Operating income

Interest expense=


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Profitability Ratios

Earnings

per share

Net income

Average common shares outstanding=

Gross profit

percent

(Net salesCost of goods sold)

Net sales=

Profit margin Operating incomeNet sales

=


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Profitability Ratios

Return oncommon

equity

(Income before taxesPreferred dividends)

Average stockholders equity

=

Return on

assets

Income before taxes

Average total assets=


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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

arens solution manual chapter 8

Documents

solution manual chapter

client business risk

audit anddesigning

audit program

audit approachaccept

overall audit plan

audit approachset materiality

audit costs reasonable3