Auditing and Assurance Services

Seventeenth Edition, Global Edition

Chapter 7
Audit Planning and Materiality

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

7.1 Discuss why adequate audit planning
is essential

7.2 Make client acceptance decisions and

perform initial audit planning

7.3 Gain an understanding of the client’s

business and industry

7.4 Perform preliminary analytical

procedures

7.5 Apply the concept of materiality to the

audit

7.6 Make a preliminary judgment about

what amounts to consider material

7.7 Determine performance materiality

during audit planning

7.8 Use materiality to evaluate audit

findings

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

7.1 Discuss why adequate audit planning
is essential
7.2 Make client acceptance decisions and
perform initial audit planning
7.3 Gain an understanding of the client’s
business and industry
7.4 Perform preliminary analytical
procedures
7.5 Apply the concept of materiality to the
audit
7.6 Make a preliminary judgment about
what amounts to consider material
7.7 Determine performance materiality
during audit planning
7.8 Use materiality to evaluate audit
findings
Planning
• There are three main reasons why the auditor should
properly plan engagements:
– Enable the auditor to obtain sufficient appropriate
evidence for the circumstances
– Help keep audit costs reasonable
– Avoid misunderstandings with the client
• Much of the early planning of audits deals with obtaining
information to help auditors assess the following risks:
– Acceptable audit risk
– Client business risk
– Risk of material misstatement
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
 Figure 7.1
Planning an Audit and Designing an Audit Approach

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

 Accept Client and Perform Initial Audit Planning
Initial audit planning involves four things that should be done early in the audit:
7.1 Discuss why adequate audit a) Decides whether to accept a new client or continue serving an existing one
planning is essential b) Identifies why the client wants or needs an audit
7.2 Make client acceptance decisions c) Obtains an understanding with the client about the terms of the engagement
and perform initial audit d) Develops the overall strategy for the audit
planning

7.3 Gain an understanding of the

a) Client Acceptance and Continuance
client’s business and industry – New client investigation:
▪ Investigate the company to determine its acceptability
7.4 Perform preliminary analytical
procedures ▪ New (successor) auditor is required by auditing standards to
communicate with the predecessor auditor
7.5 Apply the concept of materiality to
the audit
– Continuing clients:
▪ Evaluate existing clients annually to determine whether there are
7.6 Make a preliminary judgment about b) Identify Client’s
reasons for notfor
Reasons continuing
Audit to do the audit
what amounts to consider
material – Auditor’s acceptable audit risk may be affected by the client’s reasons for
audit
7.7 Determine performance materiality
during audit planning c) Obtaining and Understanding with the Client
– Auditing standards require that auditors obtain an understanding with the
7.8 Use materiality to evaluate audit
client in an engagement letter
findings
d) Develop Overall Audit Strategy
– Develop and document a preliminary audit strategy that sets the scope,
timing, and direction of the audit and that guides the development of the
audit plan
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

7.1 Discuss why adequate audit
planning is essential
7.2 Make client acceptance decisions
and perform initial audit planning
7.3 Gain an understanding of the client’s
business and industry
7.4 Perform preliminary analytical
procedures
7.5 Apply the concept of materiality to
the audit
7.6 Make a preliminary judgment about
what amounts to consider
material
7.7 Determine performance materiality
during audit planning
7.8 Use materiality to evaluate audit
findings
Understand the Client’s Business and Industry
• Auditing standards require the auditor to perform risk
assessment procedures to:
– Obtain an understanding of the client’s business and its
environment
– Assess the risk of material misstatements in the financial
statements, including inquiries of management and
analytical procedures
Obtaining a good understanding of the following components
allow auditors to develop a strategic approach to understand
the client’s business and industry:
– Industry and external environment
– Business operations and processes
– Management and governance
– Client objectives and strategies
– Measurement and performance
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
7.1 Discuss why adequate audit planning
is essential
7.2 Make client acceptance decisions and
perform initial audit planning
7.3 Gain an understanding of the client’s
business and industry
7.4 Perform preliminary analytical
procedures
7.5 Apply the concept of materiality to the
audit
7.6 Make a preliminary judgment about
what amounts to consider material
7.7 Determine performance materiality
during audit planning
7.8 Use materiality to evaluate audit
findings
Perform Preliminary Analytical Procedures
• Auditing standards require the auditor to perform risk assessment
procedures to:
– Obtain an understanding of the client’s business and its environment
– Assess the risk of material misstatements in the financial
statements, including inquiries of management and analytical
procedures
• Auditors are required to perform preliminary analytical procedures as part
of risk assessment procedures to better understand the client’s business
and industry, and to assess client business risk
• Preliminary analytical tests can:
– Reveal unusual changes in ratios compared to prior years, or to
industry averages
– Help the auditor identify areas with increased risk of misstatements
that require further attention during the audit
• In the audit of the Worldwide Wholesale Company, you did extensive ratio
and trend analysis as part of preliminary audit planning. Your analytical
procedures identified the following:
– The rate of inventory turnover has steadily decreased for 3
years.
• Evaluate the potential significance of this change on the fair presentation
of financial statements.
• State the follow-up procedures you would perform for this fluctuation to
determine whether a material
Copyright misstatement
© 2020 Pearson exists.
Education Ltd. All Rights Reserved.
7.1 Discuss why adequate audit
planning is essential
7.2 Make client acceptance
decisions and perform initial
audit planning
7.3 Gain an understanding of the
client’s business and
industry
7.4 Perform preliminary analytical
procedures
7.5 Apply the concept of materiality
to the audit
7.6 Make a preliminary judgment
about what amounts to
consider material
7.7 Determine performance
materiality during audit
planning
7.8 Use materiality to evaluate audit
findings
Materiality
Auditing standards define materiality as:
– The magnitude of misstatements that individually, or when
aggregated with other misstatements, could reasonably be
expected to influence the economic decisions of users made
on the basis of the financial statements
Auditors follow five related steps
in applying materiality:
– Determines materiality for the
financial statements as a whole
– Determines performance
materiality
– Estimate the amount of
misstatements in each segment
– Estimate the combined
misstatement
– Compare combined estimate
with preliminary or revised
judgement about materiality
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
7.1 Discuss why adequate audit planning
is essential Materiality for Financial Statements as a Whole
7.2 Make client acceptance decisions and
perform initial audit planning
• Factors affecting preliminary materiality judgment include:
– Materiality is a relative rather than an absolute concept
7.3 Gain an understanding of the client’s
business and industry – Because materiality is relative, it is necessary to have
benchmarks for establishing whether misstatements are
7.4 Perform preliminary analytical
procedures material
– Qualitative factors affect materiality
7.5 Apply the concept of materiality to the
audit

7.6 Make a preliminary judgment about

what amounts to consider material

7.7 Determine performance materiality

during audit planning

7.8 Use materiality to evaluate audit

findings

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

7.1 Discuss why adequate audit planning
is essential
Determine Performance Materiality
• Performance materiality is defined as:
7.2 Make client acceptance decisions and
perform initial audit planning – The amount(s) set by the auditor at less than materiality for
the financial statements as a whole to reduce to an
7.3 Gain an understanding of the client’s
appropriately low level the probability that the aggregate of
business and industry
uncorrected and undetected misstatements exceeds
7.4 Perform preliminary analytical materiality for the financial statements as a whole
procedures
• Performance materiality is inversely related to the amount of
7.5 Apply the concept of materiality to the evidence an auditor will accumulate
audit
• The process of determining performance materiality is referred to
7.6 Make a preliminary judgment about
what amounts to consider material as the allocation of the preliminary judgment about materiality to
segments
7.7 Determine performance materiality
during audit planning • The determination of performance materiality is based on
professional judgment and reflects the amount of misstatement an
7.8 Use materiality to evaluate audit
findings
auditor is willing to accept in a particular segment
– PCAOB refers to this amount as tolerable misstatement

• Auditors face three major difficulties in allocating materiality

to balance sheet accounts:
– Auditors expect certain accounts to have more
misstatements than others
– Both overstatements and understatements must be
considered
– Relative audit costs affect the allocation
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
7.1 Discuss why adequate audit
planning is essential
Estimate Misstatement and Compare with Preliminary Judgment
7.2 Make client acceptance decisions
and perform initial audit planning
• When auditors perform audit procedures for each segment
7.3 Gain an understanding of the client’s
business and industry of the audit, they document two types of misstatements:
– Known misstatements
7.4 Perform preliminary analytical
procedures ▪ Those where the auditor can determine the amount of
7.5 Apply the concept of materiality to
the misstatement in the account
the audit – Likely misstatements
7.6 Make a preliminary judgment about ▪ Differences between management’s and the auditor’s
what amounts to consider judgment about estimates of account balances
material
▪ Projections of misstatements based on the auditor’s
7.7 Determine performance materiality tests of a sample from a population
during audit planning

7.8 Use materiality to evaluate audit

findings

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.