CHAPTER 3:

PROCESS OF ASSURANCE:
PLANNING THE ASSIGNMENT

Instructor: Dr. Tạ Thu Trang

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 Obtaining and accepting an
engagement
Obtaining an
After acceptance
engagement
Agreeing terms of an
Obtaining and engagement
planning
Understanding the entity
assurance and analytical procedures
engagements
Analytical procedures

Planning Materiality

Audit Risk

Audit strategy and plan

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 CHAPTER 3 LEARNING OBJECTIVES

3-1 Planning
3-2 Analytical Procedures
3-3 Materiality
3-4 Audit Risk
3-5 Fraud

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 OBJECTIVE 3-1
Planning

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 PLANNING
To recap, the overall objectives of the auditor (as set out in ISA (UK)
200) are:
• To obtain reasonable assurance about whether the financial
statements as a whole are free from material misstatement, in all
material respects.
• To report on the financial statements, and communicate as
required in accordance with the auditor's findings (ISA (UK) 200,
para.11)
The planning process is an important stage in the assurance process
as this is where risks and expectations are considered. This is outlined
in general terms by ISA (UK) 300 Planning an Audit of Financial
Statements. ISA (UK) 300 whereby 'The objective of the auditor is to
plan the audit so that it will be performed in an effective manner' (ISA
(UK) 300, para.4).

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 PLANNING
Plan the audit

Understand the entity and its environement

Assess risk of material misstatement

Select audit procedures to respond to risk of material misstatement

Risk assessment includes Risk assessment does not

expectation that controls include expectation that
operate effectively controls operate effectively

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 PLANNING
Risk assessment includes Risk assessment does not
expectation that controls include expectation that
operate effectively controls operate effectively

Tests of controls
Unsatisfactory Report
to management
Satisfactory

Restricted substantive tests Full substantive tests

Report to management
Overall review of
financial statements Full substantive tests

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 OBJECTIVE 3-2
Understanding the entity and its
environment

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 PLANNING
3.1. UNDERSTANDING THE ENTITY

ISA (UK) 315 Identifying and Assessing the Risks of Material

Misstatement through Understanding the Entity and Its Environment
states that 'the objective of the auditor is to identify and assess the
risks of material misstatement, whether due to fraud or error, at the
financial statement and assertion levels, through understanding the
entity and its environment, including the entity's internal control,
thereby providing a basis for designing and implementing responses to
the assessed risks of material misstatement'.
It is the duty of the auditor to have an understanding of the entity and
its environment.

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 PLANNING
3.2. UNDERSTANDING THE ENTITY

Why?
• To identify and assess the risks of material misstatement in the financial
statements
• To enable the auditor to design and perform further audit procedures
• To provide a frame of reference for exercising audit judgement

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 PLANNING
3.2. UNDERSTANDING THE ENTITY
What ?
Matters to consider when obtaining an understanding of the entity (page 55)
- Market and competition
- Product technology
Industry, regulatory and
- Accounting principles
other external factors
- Tax/legislation
- Interest rates/inflation,…

Nature of the entity including -Financial reporting

selection and application of
accounting policies - Business operations

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 PLANNING
UNDERSTANDING THE ENTITY
Matters to consider when obtaining an understanding of the entity

- New products/services
Objectives and strategies
- Expansion
and related business risks
- Use of IT,…

Measurement and review - Trends

of the entity's financial - Ratios, KPIs
performance - Budgets and forecasts,...

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 PLANNING
UNDERSTANDING THE ENTITY
Matters to consider when obtaining an understanding of the entity

5 components of internal
Internal control
control

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 PLANNING
3.2.UNDERSTANDING THE ENTITY
How?
The methods to obtain the understanding the entity
• Inquiries of management and others within the entity
• Analytical procedures
• Observation and inspection
• Prior period knowledge
• Discussion of the susceptibility of the financial statements to material
misstatement among the engagement team

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 CONTEXT EXAMPLE: INQUIRIES OF MANAGEMENT AND
OTHERS

Read page 54 – Assurance

ICAEW Workbook

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 CONTEXT EXAMPLE: INQUIRIES OF MANAGEMENT AND
OTHERS

Read page 56– Assurance

ICAEW Workbook

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 Interactive question 2: Understanding the entity

In order to obtain an understanding of the entity, auditors must use a combination of which four
of the following procedures?

A. Inspection
B. Observation
C. Inquiry
D. Analytical procedures
E. Computation

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 OBJECTIVE 3-3
Analytical procedures

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 PLANNING
3.3. ANALYTICAL PROCEDURES
Analytical procedures (AP) means evaluation of financial information
through the study of plausible relationships among both financial and
non-financial data.
AP encompass Investigation of unusual/significant changes
Analytical procedures include:
- The consideration of comparisons with:
• Prior periods
• Anticipated results of the entity such as Budgets or forecasts
or expectation of the auditor
• Industry information
- The consideration of relationship between:
• elements of financial information, ie ratio analysis
• financial and non-financial information, ie payroll costs to the
number of employees.
=> Simple comparisons or complex analysis
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 PLANNING
3.3. ANALYTICAL PROCEDURES
Analytical procedures are used at all stages of the audit:
- ISA (UK) 315, Identifying and Assessing the Risks of Material Misstatement also
requires the auditor to use analytical procedures (preliminary analytical
procedures) => Risk assessment procedures
- ISA (UK) 520, Analytical Procedures requires auditors to apply analytical
procedures as substantive procedures (substantive analytical procedures)
- ISA (UK) 520, Analytical Procedures requires auditors to apply analytical
procedures in the overall review at the end of the audit (review analytical
procedures)

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 PLANNING
3.3. ANALYTICAL PROCEDURES
Analytical procedures in planning the audit
- Used at the risk assessment stage
- Possible sources of information about client include:
• Interim financial information
• Budgets
• Non-financial information
• Boards minutes
• Discussion or correspondence with client at the year end.

- Determine the nature, timing and extent of other audit procedures

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 PLANNING
3.3. ANALYTICAL PROCEDURES
Analytical procedures in planning the audit – key ratios
Heading/ratio Formula
Performance Profit before interest and tax
Return on capital employed Equity + net debt
Net profit for the period
Return on shareholders' funds Share capital+reserves
Gross profit × 100
Gross profit margin
Revenue
Cost of sales × 100
Cost of sales percentage
Revenue
Operating costs / overheads × 100
Operating cost percentage
Revenue
Profit before interest and tax × 100
Net margin/operating margin
Revenue

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 PLANNING
3.3. ANALYTICAL PROCEDURES
Analytical procedures in planning the audit – key ratios

Heading/ratio Formula
Short-term liquidity Current assets :
Current ratio Current liabilities
Receivables + current investments +
Quick ratio cash :
Current liabilities
Long-term solvency Net debt
Gearing ratio Equity
Profit before interest payable
Interest cover
Interest payable

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 PLANNING
3.3. ANALYTICAL PROCEDURES
Analytical procedures in planning the audit – key ratios

Heading/ratio Formula
Efficiency Revenue
Net asset turnover Capital employed
Cost of sales
Inventory turnover
Inventories
Inventory × 365
Inventory days
Cost of sales
Trade receivables × 365
Trade receivables collection period
Revenue
Trade payables × 365
Trade payables payment period
Credit purchases

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 CONTEXT EXAMPLE: ANALYTICAL PROCEDURES

Read page 58& 59 – Assurance

ICAEW Workbook

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 Interactive question 3: Analytical procedures

Read page 59 – Assurance

ICAEW Workbook

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 OBJECTIVE 3-4
Materiality

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 PLANNING
3.4. MATERIALITY

Materiality: a matter may be deemed to be material (by its size or nature) if

its omission or misstatement could influence the economic decisions of
users taken on the basis of the financial statements.
An expression of the relative significant or importance of particular matter in
the context of financial statement as a whole.

ISA (UK) 320 Materiality in Planning and Performing an Audit states that
'materiality and audit risk are considered by the auditor when:
• Identifying and assessing the risks of material misstatement;
• Determining the nature, timing and extent of audit procedures; and
• Evaluating the effect of uncorrected misstatements, if any, on the financial
statements and in forming the opinion in the auditor's report.’
(ISA (UK) 320, para.A1)

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 PLANNING
3.4. MATERIALITY

ISA (UK) 320, Materiality in Planning and Performing an Audit paragraph A1 states
that ‘materiality and audit risk are considered throughout the audit, in particular,
when:
• identifying and assessing the risks of material misstatement;
• determining the nature, timing and extent of further audit procedures; and
• evaluating the effect of uncorrected misstatements, if any, on the financial
statements and in forming the opinion in the auditor’s report’.

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 PLANNING
MATERIALITY
Materiality guidelines
The auditor must use their professional judgement when assessing
and setting the level of materiality for an engagement.
To set the materiality level they need to decide the level of error
(quantitative) which would distort the view given by the financial
statements. Because many users of financial statements are primarily
interested in the profitability of the company, the level is often
expressed as a proportion of profit; however, the auditors will often
calculate a range of values, such as those shown below, and then take
a weighted average of all the figures.

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 PLANNING
MATERIALITY
- Materiality considerations during audit planning
- Materiality assessment will help the auditors to decide:
• how many and what items to examine
• whether to use sampling techniques
• what level of misstatement is likely to lead to an auditor to say the financial
statements do not give a true and fair view
- To set the materiality level the auditors need to decide the level of misstatement
that would distort the view given by the accounts. Because many users of accounts
are primarily interested in the profitability of the company, the level is often
expressed as a proportion of its profits.

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 PLANNING
MATERIALITY
Materiality guidelines
Value %
Profit before tax 5 - 10
Revenue ½–1
Total assets 1–2

Materiality can also have qualitative characteristics, in that the

transaction or balance may be material in nature, regardless of the
monetary value of the item. Therefore, it is imperative to look at both the
nature of the transaction as well as the size of it when considering
whether it is material to the financial statements.

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 PLANNING
MATERIALITY
Performance materiality: The amount or amounts set by the auditor at less than
materiality for the financial statements as a whole to reduce to an appropriately low
level the probability that the aggregate of uncorrected and undetected
misstatements exceeds materiality for the financial statements as a whole.

Tolerable misstatement is the maximum misstatement that an auditor is prepared

to accept in a class of transactions or balances in the financial statements

Refer to Figure 3.2. Audit materiality

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 PLANNING
MATERIALITY

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 PLANNING
MATERIALITY
• The concept of performance materiality focuses on the difference between the
level of tolerable misstatement and the level of actual misstatements detected

• The higher the assessed risk, the lower the performance materiality must be set.
This means that the auditor will perform more audit work than if the concept of
performance materiality did not exist.

• Setting performance materiality involves the use of professional judgement

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 CONTEXT EXAMPLE: PERFORMANCE MATERIALITY

Read page 62& 63 – Assurance

ICAEW Study guide

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 PLANNING
MATERIALITY
Review of materiality

The level of materiality must be reviewed

constantly as the audit progresses, and
changes may be required because:
• Draft financial statements are altered
(due to material error and so on) and
therefore overall materiality changes
• External factors may cause changes
in risk estimates
Such changes may be caused by errors
or misstatements found during testing.

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 OBJECTIVE 3-5
Audit Risk

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 PLANNING
AUDIT RISK

Audit risk: The risk that the auditor expresses an inappropriate audit
opinion when the financial statements are materially misstated.
(FRC Ethical Standard, Glossary of terms)

• Auditors follow a risk-based approach to auditing. In the risk-based

approach, auditors analyse the risks associated with the client’s
business, transactions and systems which could lead to
misstatements in the financial statements, and direct their testing to
risky areas.
• Under ISA (UK) 200 Overall Objectives of the Independent Auditor
and the Conduct of an Audit in Accordance with International
Standards on Auditing (UK), the auditor should plan and perform
the audit to reduce audit risk to an acceptably low level.

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 AUDIT RISK MODEL

Risk of Material Risk that the Auditors

Audit Risk = Misstatement * Fail to Detect
the Misstatement

= Inherent Control Detection

Risk * Risk * Risk

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 PLANNING
AUDIT RISK
Risk of material misstatement in the financial statements

Inherent risk: The susceptibility of an assertion about a class of

transaction, account balance or disclosure to a misstatement that
could be material, either individually or when aggregated with other
misstatements, before consideration of any related controls.

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 PLANNING
AUDIT RISK
Risk of material misstatement in the financial statements
The risk of such misstatement is greater for some assertions and
related classes of transactions, account balances and disclosures than
for others. For example:
• Complex financial accounting requirement or choice of treatment.
• Transactions consisting of amounts derived from accounting
estimates pose greater risks than transactions consisting of relatively
routine, factual data.
• The business, or the industry, may be under pressure to produce
results in a tough economic climate, for example, where the
business is seeking new funding or directors' bonuses are reliant on
company results.
• Balance is important in the account

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 PLANNING
AUDIT RISK
Risk of material misstatement in the financial statements
Inherent risk:
• The auditors must use their professional judgement and all available knowledge
to assess inherent risk.
• ISA (UK) 315 requires auditors to determine where on the spectrum of inherent
risk an item lies. The ‘spectrum of inherent risk’ refers to a range of possible
risks, organised in terms of their significance.
• Inherent risk is affected by the nature of the entity.

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 PLANNING
AUDIT RISK

Risk of material misstatement in the financial statements

Control risk: The risk of a misstatement that could occur in an assertion

about a class of transactions, account balance or disclosure, and that
could be material, either individually or when aggregated with other
misstatements, and not being prevented, or detected and corrected, on a
timely basis by the entity's internal control

We shall look at controls in more detail in Chapter 5 Internal Control

Systems. In this topic you will learn about the types of controls you might
expect to see in a company, and therefore be able to identify weaknesses
or deficiencies, which indicate control risk.

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 PLANNING
AUDIT RISK
Risk at the the financial statement level and at assertion level
ISA (UK) 315 distinguishes between risks at the financial statement level and at the
assertion level. Risks at the financial statement level are pervasive in their effect
(ISA (UK) 315: para. A195) and thus require an overall response. The ISA also
points out that risks at the financial statement level may also affect individual
assertions, an example of which might be a risk of fraud which could affect the
assertions relating to the recognition of revenue, which are prone to risk as a result
of fraud.
Context example: Financial statement level risk (page 65)

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 PLANNING
AUDIT RISK
Risk that the auditor will not detect a material misstatement in
the financial statements

Detection risk: The risk that the procedures performed by the auditor to
reduce audit risk to an acceptably low level will not detect a misstatement
that exists and that this error could be material, either individually or when
combined with other factors.

The auditor manages overall audit risk by manipulating detection risk, the
only element of audit risk the auditor has control over. This because the
more work the auditors carry out, the lower detection risk becomes,
although it can never be entirely eliminated due to the inherent limitations
of an audit.

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 PLANNING
AUDIT RISK

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 AUDIT RISK MODEL

Risk of Material Risk that the Auditors

Audit Risk = Misstatement * Fail to Detect
the Misstatement

= Inherent Control Detection

Risk * Risk * Risk

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 PLANNING
AUDIT RISK

 Context Example: Audit risk 1 & 2 (Read page 66)

 Interactive question 4: Audit risk (page 66-67)

Assurance - ICAEW Workbook

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PLANNING
AUDIT RISK
Identifying and assessing the risks
Identify risks throughout the process of obtaining an
understanding of the entity and its environment

Assess the identified risks and link them to what can

go wrong at the assertion level

Consider whether the risks are of a magnitude that could result in

a material misstatement

Consider the likelihood of the risks

causing a material misstatement
Chap 2: Obtaining and planning assurance engagements 8
9
 PLANNING
AUDIT RISK

 Context Example: Understanding the entity and identify risks

(Read page 67& 68)

 Interactive question 5: Identify risks (page 68)

Assurance - ICAEW Study guide

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 PLANNING
AUDIT RISK
Significant Risk

Significant risk: An identified risk of material misstatement […] for which

the assessment of inherent risk is close to the upper end of the spectrum
of inherent risk due to the degree to which inherent risk factors affect the
combination of the likelihood of a misstatement occurring and the
magnitude of the potential misstatement should that misstatement occur
[…] (ISA (UK) 315: para. 12l).

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 PLANNING
AUDIT RISK
Significant risks
Some risks may be significant risks, which require special audit
consideration. ISA (UK) 315 sets out the following factors which
indicate that a risk might be a significant risk:
• Risk of fraud
• Related to recent significant economic, accounting or other
development
• The complexity of the transaction
• It is a significant transaction with a related party
• The degree of subjectivity in the financial information
• It is an unusual transaction
When the auditor identifies a significant risk, if they haven't done so
already, they must evaluate the design and implementation of the
entity's internal controls in that area.

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PLANNING
AUDIT RISK
The ISA notes that although it is less likely that the entity will have
controls for non-routine risks, there may still be some. After all, management will
still need to respond to these risks in some way. The auditor should understand
whether there are controls such as:
• review of assumptions by senior management or experts
• documented processes for estimations
• approval by those charged with governance
 PLANNING
AUDIT RISK
Related party transactions
Definition: a related party is someone (or a company) who is related to the entity, its
owners or its management (ISA (UK) 550, Related Parties)
• Transactions with related parties might take place for reasons other than the
entity’s normal business.
• Related party transactions are inherently risky.
• Most financial reporting frameworks, including IFRS, therefore require
companies to disclose related party transactions, and this is usually done in the
notes to the financial statements.
• In addition, ISA 550 notes that auditors need to understand related party
relationships and transactions in order to ensure that the economic reality of a
transaction is reflected in the financial statements.

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 PLANNING
FRAUD

Fraud: An intentional act by one or more individuals among

management, those charged with governance, employees, or third
parties, involving the use of deception to obtain an unjust or illegal
advantage.

Error: An unintentional misstatement in financial statements, including the

omission of an amount or a disclosure.

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 PLANNING
FRAUD

Characteristics of fraud
Two types of fraud causing material misstatement in financial statements:
• Fraudulent financial reporting: involves intentional misstatements, including
omissions of amounts or disclosures in financial statements, to deceive financial
statement users
• Misappropriation of assets: involves the theft of an entity’s assets and is often
perpetrated by employees in relatively small and immaterial amounts. However,
it can also involve management who are usually more capable of disguising or
concealing misappropriations in ways that are difficult to detect

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 PLANNING
FRAUD
Responsibilities in relation to fraud
• The company’s management is responsible for preventing and detecting both fraud and
error. They do this by putting in place a system of internal control over the company’s
transactions and exercising oversight over this system, and by creating a culture of
honesty and ethical behaviour.
• The auditor is responsible for obtaining reasonable assurance that the financial
statements are free from material misstatement, whether caused by fraud or error.
Material misstatements from fraud are at greater risk of not being detected than material
misstatements from error
• The auditor is responsible for maintaining professional scepticism throughout the audit,
considering the possibility of management override of controls, and recognising that audit
procedures effective for detecting errors may not be effective for detecting fraud
• The auditor may also have a responsibility to report a fraud to an external, relevant
authority
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 PLANNING
FRAUD
Auditor’s objectives:
The auditor’s objectives in relation to fraud are:
• To identify and assess the risks of material misstatement due to fraud
• To obtain evidence regarding these risks by designing and implementing
appropriate responses
• To respond appropriately to any actual or suspected fraud identified during the
audit
• ISA (UK) 315 requires there to be a discussion among the engagement team
about where fraud might take place at the entity, which is usually done during
the planning phase.

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 PLANNING
AUDIT STRATEGY AND PLAN
Exam focus point:

Audit strategy: The formulation of the

general strategy for the audit, which
sets the scope, timing and direction of
the audit and guides the development
of the audit plan.
Audit plan: An audit plan is more
detailed than the strategy and sets out
the nature, timing and extent of audit
procedures.

ISA (UK) 300, Planning an audit of

financial statements

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 PLANNING
AUDIT STRATEGY AND PLAN
The audit strategy
• Broad scope of the audit
• Consider the impact of any preliminary analysis or impact of
existing knowledge of the industry
• Review and consideration of the key audit factors (as determined
using the professional judgement of the auditor)
• Nature, timing and extent of the resources necessary (size of the
audit team, requirement to use specialists)
• Management, direction and supervision of the audit team (decisions
on the timing of briefing meetings, partner reviews, manager visits
etc)

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 PLANNING
AUDIT STRATEGY AND PLAN

The audit plan

• More detailed than the audit strategy
• Nature, timing and extent of the specific audit procedures required
for each material class of transactions, account balance or
disclosure
• Planning these procedures takes place over the course of the audit
to ensure that the audit complies with ISAs (UK)

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 PLANNING
AUDIT STRATEGY AND PLAN
The key objectives of planning an audit are:
• Ensure appropriate attention is devoted to important areas of the
audit, as determined by the auditor’s professional judgment.
• Identify potential problems and resolve them on a timely basis
• Ensure that the work is properly organised and managed
• Assign work to engagement team members properly, according to
ability, experience or technical knowledge
• Facilitate direction and supervision of engagement team members,
ensuring timely review and clear reporting

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 PLANNING
AUDIT STRATEGY AND PLAN

Key contents of an overall audit plan

• General economic conditions
• Current trends and developments in the industry
Understanding
• Understanding principal business strategies and the financial
the entity’s
performance (for example, obtaining management accounts for
environment
the year to date)
• Extent of the experience and competence of management
Understanding • Any reporting developments which may affect the client, such
the as revenue recognition changes
accounting and • Any new accounting or auditing legislative changes
internal control • Referring to prior year files, considering any emphasis from
systems earlier audits and types of tests used in the past

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 PLANNING
AUDIT STRATEGY AND PLAN

Key contents of an overall audit plan

• Setting of materiality for audit planning purposes (use
management accounts and/or prior year results)
Risk and • Possibility of material misstatements, using past experience
materiality where applicable
• Identification of complex accounting areas, such as long term
contracts or inventory valuation
• If there is inventory, consider attending inventory physical count
(if possible)
Nature, timing
• If there are large plant and machinery or properties, consider
and extent of
whether physical verification is required
procedures
• What information technology is available, can testing be
completed on the system or more substantive work required?

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 PLANNING
AUDIT STRATEGY AND PLAN

Key contents of an overall audit plan

• Staffing availability and level of experience
Supervision • Consider attending year-end procedures if areas of high risk
and review and/or value
• The number of locations, do they all require a visit?
• The risk that there are new or special issues that require
additional attention this audit year (such as new accounting
standards)
Other
• Any changes to the scope or statutory responsibilities?
matters
• Additional pressures or financial liens which may increase risk of
misstatement (such as bank loans, investment opportunities,
management bonuses)

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 PLANNING
SUMMARY

Planning ISA (UK) 200

Understanding Materiality ISA Analytical Audit

the entry Audit (UK) 320 procedures Audit risk strategy and
risk ISA (UK) plan
315 Quantitative Ratio analysis
Qualitative Review of financial
Identify and assess
risks of material
statement Inherent risk
misstatement

Professional Control risk

judgment

Professional Detection risk

scepticism

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