Lecture 6

Audit planning and materiality

Chapter 8
Lecturer: Yen Pham

Adapted from 2014 Pearson Education

Learning Objectives

u Reasons for planning

u Initial audit planning
u Understand the client’s business and industry
u Perform preliminary analytical procedures
u Materiality
u Preliminary judgment about materiality
u Performance materiality
u Misstatements

2
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

8-3
 overall audit plan and audit program. The first four parts of the planning phase of an
audit are studied in this chapter. The last four are studied separately in later chapters.

Three Main FIGURE 8-1 Planning an Audit and Designing an Audit Approach

Reasons for Accept client and perform

initial audit planning

Planning Understand the client’s

business and industry

Perform preliminary
analytical procedures

Set preliminary judgment

of materiality and
performance materiality

Identify significant risks

due to fraud or error

Assess inherent risk

Understand internal control

and assess control risk

Finalize overall audit

strategy and audit plan

Chapter 8 / AUDIT PLANNING AND MA

8-4
 u Clientacceptance and
continuance

1. u Identify client’s reasons for audit

Initial Audit
u Obtain an understanding with the
Planning client

u Develop overall audit strategy

8-5
Client Acceptance and Continuance

Ø New client investigations

• If previously audited, the new auditor is required to
communicate with the predecessor auditor
• Client permission required

Ø Continuing clients
• Annual evaluations whether to continue based on
issues, fees, and client integrity

8-6
Identify Reasons for the Audit

Ø Two major factors affecting acceptable risk

• Likely statement users
• Intended uses of the statements
Ø Likely to accumulate more evidence for companies
that are
• Publicly held
• Have extreme indebtedness
• Likely to be sold

8-7
Obtaining an Understanding
with the Client

Ø Engagement terms should be understood between CPA

and client.
Ø Standards require an engagement letter describing:
• objectives
• responsibilities of auditor and management
• schedules and fees
Ø Informs client that auditor cannot guarantee all acts of
fraud will be discovered

8-8
Develop Overall Audit Strategy

Ø Preliminary audit strategy should consider

• client’s business and industry
• material misstatement risk areas
• number of client locations
• past effectiveness of controls
Ø Preliminary strategy helps auditor determine resource
requirements and staffing
• staff continuity
• need for specialists

8-9
Client business risk is the risk that
the client will fail to meet its
objectives. 2.
Ø Declines in economic Understanding
conditions
Ø Information technology
of the Client’s
Ø Global operations
Business and
Ø Human capital Industry

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Understanding of the Client’s
Business and Industry
8-11
Reasons for obtaining an
understanding of the client’s industry
and external environment:
Ø Risks associated with specific Industry and
industries
External
Ø Inherent risks common to all
clients in certain industries Environment
Ø Unique accounting requirements

8-12
Factors the auditor should understand:

Business
Ø Major sources of revenue
Ø Key customers and suppliers
Operations
Ø Sources of financing and Processes
Ø Information about related parties

8-13
 Tour the Plant
and Offices

Touring the physical facilities

enables the auditor to assess
Ø asset safeguards and
interpret
Ø accounting data related to
assets.

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Ø Affiliated companies
Ø Principal owners of the client Identify
Ø Any other party with which the
client deals
Related
Ø A party who can influence Parties
management or client policies

8-15
Management and Governance

Governance insights:
Governance includes:
• Corporate charter and
• Organizational structure
bylaws
• Board activities
• Code of ethics
• Audit committee activities.
• Meeting minutes

Management establishes the strategies and

processes followed by the client’s business.
8-16
Client objective 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

8-17
Measurement and Performance

The client’s performance measurement system

includes key performance indicators. Examples:

Ø market share Ø Web site visitors

Ø sales per employee Ø same-store sales
Ø unit sales growth Ø sales/square foot

Performance measurement includes ratio analysis

and benchmarking against key competitors.

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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.

8-19
Recall: Lecture 5

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21
Materiality

Ø Auditor’s responsibility is to determine whether

financial statements are materially misstated.

Ø Auditor will bring material misstatements to the

client’s attention so corrections can be made.

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the more evidence required. Examine the financial statements of Hillsburg Hardware

Set preliminary judgment

FIGURE 8-5 Steps in Applying Materiality of materiality and
performance materiality

Set materiality
Step for the Identify significant risks
1 financial statements due to fraud or error
as a whole
Planning
extent of tests Assess inherent risk
Determine
Step
performance Understand internal control
2
materiality and assess control risk

Finalize overall audit

Estimate total
Step strategy and audit plan
misstatement
3
in segment

Estimate the
Step
combined
4
misstatement Evaluating
results

Compare combined
Step estimate with
5 preliminary or
revised judgment
about materiality

Chapter 8 / AUDIT PLANNING AND MATERIALITY 235

Steps in Applying Materiality

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 Preliminary Judgment About
Materiality

The maximum amount by which the auditor believes

the statements could be misstated and still not affect
the decisions of reasonable users

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Preliminary Judgment About Materiality

Materiality is a relative
Rather than an absolute concept.

Benchmarks are needed for

evaluating materiality.

Qualitative factors also affect materiality.

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Performance Materiality

an amount less than the level of overall materiality

to reduce level the probability that the aggregate
of uncorrected and undetected misstatements
exceeds materiality for the financial statements as a whole

performance materiality is commonly set as

a standard percentage of the preliminary judgment
about materiality for the financial statements

9-26
Known and likely Misstatements

Auditor can determine the misstated amount in an account

(“Known”)

Two types of “Likely” misstatements:

Ø Judgmental differences
Ø Projections of misstatements from audit samples

9-27
 inventory using known misstatements detected in those samples. To illustrate the
for sampling risk for cash because the total amount of misstatement is known, not
calculation, assume that in auditing inventory the auditor found $3,500 of net over-
estimated.
statement amounts in a sample the
In combining of misstatements
$50,000 of the total8-2,
in Table population of $450,000.
we can observe Themis-
that the known
$3,500 identifiedstatements
misstatement is aprojection
and direct known misstatement. To calculate
of likely misstatements the estimate
for the three accounts adds
of the likely misstatements for the total
to $45,500. However, population
the total allowance forof sampling
$450,000, the
risk auditor
is less makes
than the a the
sum of
direct projection individual
of the knownsampling risk amounts.from
misstatement This the
is because
samplethetoallowance for sampling
the population and risk
adds an estimatedrepresents
allowance the maximum misstatement in account details not audited. It is unlikely
for sampling risk. The calculation of the direct projection
that this maximum misstatement amount exists in all accounts subjected to sampling.
estimate of misstatement is: shows that total estimated likely misstatement of $62,300 exceeds the
Table 8-2
preliminary judgment about materiality of $50,000. The major area of difficulty is
inventory, where estimated misstatement Directfor
including allowance projection
sampling risk of
Net misstatements in the sample ($3,500) Total recorded
$47,250 is significantly greater×than performance materialityestimate of Because the
of $36,000.
population value =
Total sampled combined misstatement exceeds the preliminarymisstatement
estimated($50,000) judgment, the financial
($450,000)
statements are not acceptable. The auditor can either determine whether the esti-
($31,500)
mated likely misstatement actually exceeds $50,000 by performing additional audit
(Note that the direct projection of likely misstatement for accounts receivable of
Illustration of Comparison of Estimated Total Misstatement to
TABLE$12,000
8-2 is not illustrated.)
Preliminary Judgment About Materiality
The allowance for sampling risk results because the auditor has sampled only
a portion of the population and there isKnown
Performance a risk that the sampleAllowance
Misstatement does not for accurately
Account Materiality and Direct Projection Sampling Risk Total
represent the population. (We’ll discuss this in more detail in Chapters 15 and 17.)
Cash
In this simplified example,$ 4,000 we’ll assume the $estimated
2,000
allowance$ forNAsampling risk$ 2,000

is 50 percent of the direct projection

Accounts receivable 20,000 of the misstatement
12,000 amounts 6,000
for the accounts 18,000
Inventory where sampling was used (accounts 36,000 receivable 31,500
and inventory). There is no allowance
15,750 47,250
for misstatement
Total estimated samplingamountrisk for cash because the total amount $45,500 of misstatement$16,800is known, $62,300
not
Preliminaryestimated.
judgment about materiality $50,000
In
NA = Not applicable.
combining the misstatements in Table 8-2, we can observe that the known mis-
statements
Cash audited 100 percent. and direct projection of likely misstatements for the three accounts adds
to $45,500. However, the total allowance for sampling risk is less9-28 than the sum of the
242 individual
Part 2 / THEsampling
AUDIT PROCESSrisk amounts. This is because the allowance for sampling risk
represents the maximum misstatement in account details not audited. It is unlikely
audit are studied in this chapter. The last four are studied separately in later chapters.

FIGURE 8-1 Planning an Audit and Designing an Audit Approach

Accept client and perform

initial audit planning

Understand the client’s

business and industry

Perform preliminary
analytical procedures

Set preliminary judgment

of materiality and
performance materiality

Identify significant risks

due to fraud or error

Assess inherent risk

Understand internal control

and assess control risk

Finalize overall audit

strategy and audit plan

8-29
Chapter 8 / AUDIT PLANNING AND MATERIALITY