Chapter 3

Audit Planning,
Types of Audit
Tests and
Materiality
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 The Phases of an Audit
that Relate to Audit Planning
Figure 3–1 The Phases of an Audit that Relate
to Audit Planning

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 Prospective Client
Acceptance
1. Obtain and review financial information.
2. Inquire of third parties regarding client integrity.
3. Communicate with the predecessor auditor.
4. Consider unusual business or audit risks.
5. Determine if the firm is independent.
6. Determine if the firm has the necessary skills and
knowledge.
7. Determine if acceptance violates any applicable
regulatory or ethical requirements.

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Continuing Client Retention

Evaluate client retention

periodically

Near audit completion or

after a significant event

Conflicts over
accounting and auditing Dispute over fees
issues

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Preliminary Engagement
Activities

Determine the audit engagement

team requirements

Assess compliance with ethical

and independence requirements

Establish an understanding with

the entity
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 Establish Terms of the
Engagement
In establishing the terms of the engagement, three
topics must be discussed:
1.The engagement letter.
2.Using the work of the internal audit function.
3.The role of those charged with governance.

The terms of the engagement, which are

documented in the engagement letter, should
include the objectives of the engagement,
management’s responsibilities, the auditor’s
responsibilities, and the limitations of the
engagement.
Who signs the engagement letter?
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The Engagement Letter
The engagement letter formalizes the arrangement
reached between the auditor and the entity.

In addition to the items mentioned in the sample

engagement letter in Exhibit 3-1 in the textbook,
the engagement letter may include:
•Arrangements for use of experts or
internal auditors.
•Auditor’s responsibilities to communicate
audit matters of governance interest.
• Additional services to be provided relating to
regulatory requirements.
•Arrangements regarding other services.
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 Internal Audit Function
Table 3–2 Factors for Evaluating the Reliability of the Internal Audit Function

(continued)
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Internal Audit Function

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Those Charged with
Governance

Board of Directors

Audit Committee

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 Planning the Audit

• The auditor will develop an overall audit

strategy for conducting the audit. This will
help the auditor to determine what
resources are needed to perform the
engagement.
• An audit plan is more detailed than the
audit strategy. Basically, the audit plan
should consider how to conduct the
engagement in an effective and efficient
manner.

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 Planning the Audit
When preparing the audit plan, the auditor should be guided
by the results of the client acceptance/continuance process,
procedures performed to gain the understanding of the
entity, and preliminary engagement activities.
Additional steps:
•Assess business risks.
•Establish materiality.
•Consider multi-locations.
•Assess the need for experts.
•Consider non-compliances with laws and regulations.
•Identify related parties.
•Consider additional value-added services.
•Document the overall audit strategy and audit plan.
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 LO# 7

Assess Business Risks

To understand To identify financial

the entity’s statement accounts
business and likely to contain
transactions misstatements

By understanding the entity’s business and identifying where

misstatements are likely to occur, the auditor can allocate
more resources to investigate more risky accounts.

3-13
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Establish Materiality

Establish overall
materiality
(more on this later!)

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 Consider Multi-Locations or
Business Units
Consolidated
Financial
Statements

Low
Risk

The auditor correlates the amount of audit attention devoted to the location or
business unit with the level of risk present.
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Assess the Need for Experts

A major consideration in planning the audit is the

need for an auditor’s expert.

The presence of complex

information technology
may require the use of an
IT expert.

What other types of

experts might be
needed?

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Consider Non-Compliance
with Laws and Regulations
Non-Compliance

Direct and Material and

Material Indirect

Be aware may
Consider laws have occurred;
and regulations investigate if
as part of audit brought to
attention
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Consider Non-Compliance
with Laws and Regulations
Table 3–3 Information or Circumstances that May
Indicate Non-Compliance

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 Related Parties
Some examples from IAS 24
Related Party Disclosure
•Parents and subsidiaries.
•Significant influence.
•Joint control.
•Associate entity.
•Joint venture.
•Management.
•Close family of the
principal owners & management.
•Other parties that can have
significant influence.
Sources of Information on
Related Parties
•Minutes of meetings of those charged
with governance.
•Conflict-of-interest statements.
•Financial and reporting information
provided to creditors, investors and
regulators
•Contracts or other agreements with
major customers, vendors and
management.
•Contracts or other agreements
representing significant unusual
transactions.
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Additional Value-Added
Services

Tax Transaction IT-

Planning Support consultancy

Internal
Risk
Reporting Benchmarking
Assessment
Processes

Auditors are limited in the types of

consulting services that they can offer
their audit clients.
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 Document Overall Audit
Strategy and Audit Plan
Document overall audit The auditor documents how the
strategy and audit plan, entity is managing its risk (via
which involves internal control processes) and the
documenting the decisions effects of the risks and controls on
about the planned audit procedures.

A
U Nature
D
I
T
Timing
T
E
S
T
Extent
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Document Overall Audit
Strategy and Audit Plan

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Supervision of the Audit

• Engagement partner should:

• Inform engagement team members of their
responsibilities
• Direct engagement team members to
identify and communicate audit issues
• Review the work of the engagement team
members

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Types of Audit Tests

Risk Used to obtain an understanding of

Assessment the entity and its environment,
Procedures including internal control.

Performed to obtain audit evidence

about the operating effectiveness
Tests of
of controls in preventing, detecting
Controls and correcting material
misstatements.
Detect material misstatements in a
Substantive transaction class, account balance,
Procedures and disclosure element of the
financial statements.

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 Tests of Controls

Inquiry Inspection

Observation

Walk-
Reperformance
Through

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 Tests of Controls
Table 3–4 Examples of Internal Controls and Tests
of Controls

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Substantive Procedures

Substantive
Tests of
Analytical
Details
Procedures

Evaluations of
Tests for errors or financial information
fraud in individual through analysis of
transactions, account plausible
balances and relationships among
disclosures financial and non-
financial data

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Dual-Purpose Tests

Substantive
Tests of
Tests of
Controls
Transactions

Dual-
Purpose
Tests

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 Materiality

Misstatements,
Misstatements, including
including omissions,
omissions, areare considered
considered to to
be
be material
material ifif they,
they, individually
individually or
or in
in the
the aggregate,
aggregate,
could
could reasonably
reasonably be be expected
expected toto influence
influence the
the
economic
economic decisions
decisions of of users
users taken
taken on
on thethe basis
basis of
of the
the
financial
financial statements.
statements.

Materiality is not an absolute and

it is not a black or white issue!
The determination of materiality
requires professional judgement.

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Steps in Applying Materiality
on an Audit
Step
Step 1:
1:
Determine
Determine Overall
Overall Materiality
Materiality

Step
Step 2:
2:
Determine
Determine Performance
Performance Materiality
Materiality

Step
Step 3:
3:
Evaluate
Evaluate Audit
Audit Findings
Findings

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Step 1: Determine Overall
Materiality
The quantitative amounts
The may be adjusted lower for
The quantitative
quantitative benchmark
benchmark qualitative factors such as:
for
for materiality
materiality may
may be
be aa
percentage
percentage of:of: •Material misstatements in prior
•• Profit years.
Profit before
before tax.
tax.
•• Total •High risk of fraud.
Total assets.
assets.
•• Total •Potential loan covenant
Total revenues.
revenues. violations.
•• Net
Net assets.
assets. •Small amounts may cause the
•• Three
Three year
year average
average profit.
profit. entity to miss forecasted
earnings.
•Volatile business environment.

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 Step 2: Determine
Performance Materiality
Performance
Performance materiality
materiality isis the
the amount
amount or or amounts
amounts set
set by
by the
the auditor
auditor
at
at less
less than
than overall
overall materiality
materiality to
to reduce
reduce toto an
an appropriately
appropriately lowlow level
level
the
the probability
probability that
that the
the aggregate
aggregate of of uncorrected
uncorrected andand undetected
undetected
misstatements
misstatements exceeds
exceeds materiality
materiality for
for the
the financial
financial statements
statements as as aa
whole.
whole.
••The purpose of setting performance materiality is to establish a scope
The purpose of setting performance materiality is to establish a scope
for
for the
the audit
audit procedures
procedures forfor the
the individual
individual account
account balance
balance oror
disclosure.
disclosure.
••In practice auditors commonly set performance materiality for each
In practice auditors commonly set performance materiality for each
account
account at at between
between 50 50 and
and 7575 per
per cent
cent of
of overall
overall materiality.
materiality. The
The firms
firms
provide
provide guidance
guidance inin determining
determining the the appropriate
appropriate percentage
percentage to to use
use
within
within the
the range.
range.
••There are a number of reasons why total combined performance
There are a number of reasons why total combined performance
materiality
materiality greater
greater than
than overall
overall materiality
materiality makes
makes sense
sense from
from anan audit
audit
planning
planning perspective.
perspective.
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 Step 3: Evaluate Audit
Findings
When
When the
the audit
audit evidence
evidence is is gathered,
gathered, the
the auditor:
auditor:
Aggregates
Aggregates misstatements
misstatements fromfrom each
each account
account oror class
class of of
transactions.
transactions.
Considers
Considers the
the effect
effect of
of misstatements
misstatements not
not adjusted
adjusted inin the
the prior
prior period.
period.

Examines
Examines thethe cause
cause of
of the
the misstatements
misstatements and
and determines
determines the the impact
impact
of
of the
the material
material misstatements
misstatements on on the
the assessment
assessment of of fraud
fraud and and control
control
risk.
risk.auditor compares the aggregate misstatement to overall
The
materiality.
Performance materiality can be used for determining the fair
presentation of the individual accounts.
If the aggregated misstatements are greater than overall materiality,
or if misstatements for individual accounts are in excess of
performance materiality, the auditor would require the entity to adjust
the financial statements or the auditor would have to issue a qualified
or adverse opinion. © 2017 McGraw-Hill Education (Malaysia) Sdn Bhd