AC19 AUDITING THEORY

MODULE 5 AUDIT PLANNING

BY: DANIEL CALAOR

PSA 300 (REDRAFTED) PLANNING AN AUDIT OF FINANCIAL STATEMENTS states that

the auditor should plan the audit so that the engagement will be performed in an effective
manner.
a. It involves establishing the overall strategy for the engagement and developing an
audit plan and a detailed approach for the expected nature, timing and extent of the
audit.
b. It involves the engagement partner and other key members of the engagement team
to benefit from their experience and insight and to enhance the effectiveness and
efficiency of the planning process.

BENEFITS OF AUDIT PLANNING

Adequate planning of the audit work accomplished among others the following:
a. Ensures that appropriate attention is devoted to important areas of the audit.
b. Enables the auditor to identify potential problems and resolve them on a timely basis.
c. Helps to ensure that the engagement is properly organized and managed in order to
be performed in an effective and efficient manner.
d. Assists in the proper assignments of the engagement team members.
e. Facilitates the direction and supervision of engagement team members and review of
their work.
f. Assists in coordination of work done by auditors of components and experts.

EXTENT OF AUDIT
The extent of planning will vary according to:
a. Size of the entity (SME, Multinational Company, Conglomerate, etc.)
b. Complexity of the audit
c. Auditor’s experience with the entity and knowledge of the business
d. Changes in circumstances that occur during the audit engagement.

PLANNING is not a discrete phase of an audit, but rather a continual and iterative
process that often begins shortly after (or in coordination with) the completion of the
previous audit and continues until the completion of the current audit engagement.

In planning an audit, the auditor considers the following:

a. Discussion among engagement team members
b. Analytical procedures to be applied as risk assessment procedures
c. Obtaining of a general understanding of the legal and regulatory framework
applicable to the entity and how the entity is complying with that framework
d. Determination of materiality
e. Involvement of experts
f. Determination of assessment procedures prior to identifying and assessing the risks
of material misstatement and performing further audit procedures at the assertion
level of classes of transactions, account balances, and disclosures that are
responsible to those risks.

PLANNING ACTIVITIES
The auditor should establish the overall audit strategy for the audit.
Overall audit strategy sets the scope, timing and direction of the audit and guides the
development of the more detailed audit plan.
The establishment of OVERALL AUDIT STRATEGY involves:
a. Determining the characteristics of the engagement that define its scope, such as
financial reporting framework used industry-specific reporting requirements and the
locations of the components of the entity.
b. Ascertaining the reporting objectives of the engagement to plan the timing of the
audit and the nature of the communications required, such as the deadlines for
interim and final reporting, and key dates for the expected communications with
management and TCWG.
c. Considering the important factors that will determine the focus of the engagement
team’s efforts.

AUDIT PLAN is an overview of the expected scope and conduct of the audit. This is the
overall audit plan sets out in BROAD TERMS the NTE of the audit procedures to be
performed. The auditor should develop an AUDIT PLAN for the audit in order to reduce the
audit risk to an acceptably low level.

AUDIT PLAN includes the following:

a. Description of the NTE of planned risk assessment procedures sufficient to assess
the risks of material misstatement.
b. Description of the NTE of planned further audit procedures at the assertion level for
each material class of transactions, account balances and disclosures.
c. Such other procedures required to be carried out for the engagements to comply with
PSAs.

AUDIT PROGRAM executes the audit strategy, sets out in DETAIL the audit procedures to
be performed in each segment of the audit which includes:
• Detailed list of procedures
• Audit objectives per assertion
• Working papers needed

It is a set of audit procedures SPECIFICALLY designed for each audit. The program which
includes both substantive test and tests of controls will enable the auditor to express an
opinion on the financial statements taken as whole. The auditor should develop and
document an audit program setting out the NTE of planned audit procedures required to
implement the overall audit plan. The audit program serves as a set of instructions to
assistants involves in the audit and as a means to control and record the proper execution of
the work. The audit program may also contain the audit objectives in which hours are
budgeted for the various audit areas or procedures.

On initial engagements, the audit program typically will develop in three stages:
1. The broad phases of the program can be outlined at the time of the engagement.
2. Other details of the program can be identified after the review of internal control
structure and accounting procedures has begun.
3. Procedures on specific phases of the audit can be further challenged and revised as
the work progresses.

On recurring engagements, the program for the preceding audit should be studied before
preparing the program for the current audit. The program of the current audit should reflect
modifications or are required by the experience gained in the business, internal control or
accounting methods of the client.
“The overall audit plan and the audit program should be revised as necessary during the
course of the audit. Planning is continuous throughout the engagement because of changes
in conditions or unexpected results of audit procedures. The reasons for significant changes
would be recorded.”

An audit program that is properly prepared used provides:

1. Evidence of proper planning of the work and allows a review of the proposed scope
of the audit. The program gives the partner, manager and other members of the audit
team an opportunity to review the proposed scope of the audit BEFORE the work
performed, when there is still time to modify the proposed audit procedures.
2. Guidance to less experienced staff members
3. Evidence of work performed.
4. Means of controlling the time spent on an audit
5. Evidence of the consideration of control risk in designing the proposed audit
procedures.

TIME BUDGET is an estimate of the total hours an audit is expected to take. It is based on
the information obtained in the first major step in the audit, obtaining an understanding of the
client.

STEPS IN THE AUDIT PLANNING

I. OBTAINING AN UNDERTANDING OF THE ENTITY AND ITS ENVIRONMENT
According to PSA 315 (REDRAFTED) IDENTIFYING AND ASSESSING THE
RISKS OF MATERIAL MISSTATEMENT THROUGH UNDERSTANDING THE
ENTITY AND ITS ENVIRONMENT, in performing an audit of financial
statements, the auditor should have or obtain a knowledge of the business
sufficient to enable the auditor to identify and understand the events, transactions
and practice that, in the auditor’s judgment, may have a significant effect on the
financial statements or on the examination or audit report.

The auditor’s level of knowledge for an engagement would include a general

knowledge of the economy and the industry within the entity operates, and a
more peculiar knowledge of how the entity operates. The level of knowledge
required by the auditor would, however, ordinarily be less than that possessed by
management.

PSA 315 Redrafted outlines the KEY STEPS in understanding the entity and its
environment: (IINOM)
a. Industry, regulatory and other external factors, including applicable financial
reporting framework
1. Industry conditions
Understanding industry conditions include understanding the market for a
client’s products, the competition, the entities and competitor’s capacity
relative to market conditions and price competition.

2. Regulatory environment
The regulatory environment can have direct economic consequences and
effect accounting and disclosure requirements. PSA 250 “Consideration of
Laws and Regulations in an Audit of a Financial Report” states that the
auditor must obtain a general knowledge of the legal and regulatory
framework applicable to the entity and the industry and the entity’s level of
compliance.
 3. Economy-wide factors
The general economy and its effect on the entity’s business should also
be considered by the auditor. This includes the general level of economy
activity, interest rates and the availability of financing, and the level of
inflation.

NOTE: For new client, understanding industry is best obtained AT THE

CLIENT’S PREMISES.

b. Internal Control
Please refer to the discussion below.

c. Nature of the entity, including its selection and application of accounting

policies
1. Business operations
Knowledge of the entity’s business operations includes understanding
such matters as the entities
a. Method of obtaining revenues
b. Products or services and markets
c. Conduct of operations
d. Location of production facilities, warehouse and offices
e. Employment
f. Transaction with related parties

Knowledge of the entity’s business may influence the selection and

application of accounting policies. Auditors use the knowledge of the
entity’s operations to identify significant inherent risks. Another important
aspect of understanding the business operations involves OBTAINING
KNOWLEDGE OF RELATED PARTY TRANSACTIONS. Related party
transactions are transaction between a company and its management,
principal owners, their immediate family members, and/or affiliated
companies. These transactions represent high inherent risks because
they may not have the economic substance of an arm’s-length transaction
between two independent parties. PSA 550 RELATED PARTIES describe
the important procedures that should be performed in planning an audit.

2. Investments
Knowledge of the entity’s investing activities includes understanding the
entity’s
a. Capital investment activities, including investments in plant and
equipment and technology and any recent or planned changes.
b. Acquisitions, mergers or disposals of plant activities
c. Investments and dispositions of securities and loans
d. Investments in non-consolidated entities, including partnerships, joint
ventures and special-purpose entities.

3. Financing
Knowledge of the entity’s financing activities includes understanding the
entity’s
a. Debt structure, including covenants, restrictions, guarantees and off-
balance sheet financing arrangements
b. Group structure – major subsidiaries and associated entities, including
consolidated and non-consolidated structures.
c. Leasing of property, plant and equipment for use in the business
d. Beneficial owners
 e. Use of derivative financial instruments

4. Financial Reporting
Knowledge of the entity’s financial reporting activities includes
understanding such matters the entity’s
a. Accounting principles and industry-specific practices
b. Revenue recognition practices
c. Accounting for fair value
d. Inventories
e. Industry specific significant accounts and transactions classes
f. Accounting for unusual or complex transactions, including those in
controversial or emerging areas, such as accounting for share-based
transactions
g. Financial statement presentation and disclosures

d. Objectives and strategies and the related business risks that may result in a
material misstatement of the financial statements.
According to PSA 315 Redrafted, the auditor shall obtain an understanding of
the entity’s objectives and strategies and the related business risks that may
result in material misstatement of the financial report. These terms are
defined as follows:

Entity’s objectives – are the OVERALL PLANS for the entity as defined by
TCWG and management.
Entity’s strategies – are the OPERATIONAL APPROACHES by which
management intends to achieve the objectives.
Business risks – result from significant conditions, events, circumstances,
actions or inactions that could adversely affect the entity’s ability to achieve its
objectives and execute its strategies, or through the setting of inappropriate
objectives and strategies.

Matters that auditor may consider include:

a. Industry developments
b. New products or services
c. Expansion of the business
d. Current and prospective financing requirements

A BUSINESS RISK APPROACH allows the auditor to identify the threats that
the organization faces in attempting to achieve its goals and the extent to
which these give risk to audit risks. It also recognizes that most business risks
will eventually have financial consequences and therefore, have an effect on
the financial statements. Sometimes referred to TOP-DOWN APPROACH,
everything is considered at the highest level when reviewing business risks
and then worked down to the lowest level where a material risk might be
possible.

Business risks can be categorized as follows:

1. Financial risks – theses are risks arising from the company’s financial
activities or the financial consequences of operations.
2. Operational risks – these are risks arising from the operations of the
business.
3. Compliance risk – these are risks arising from noncompliance with laws,
regulations, policies, procedures and contracts.
 e. Measurement and review of the entity’s financial performance
Matters that auditor may consider include:
a. Key ratios and operating statistics
b. Key performance indicators
c. Employee performance measures and incentive compensation plans
d. Industry trends
e. The use of forecasts, budgets and variance analysis
f. Analyst reports and credit rating reports.

II. PERFORMING ANALYTICAL PROCEDURES

PSA 520 (REDRAFTED) ANALYTICAL PROCEDURES requires that auditor
apply analytical procedures in the planning stage of the audit to obtain a more
detailed understanding and to identify area if potential risk. Such procedures are
performed during the planning phase to:
1. Enhance the understanding of the entity’s business and
2. Identify unexpected fluctuations and unusual relationships

Analytical procedures involve the analysis of significant ratios and trends where
plausible relationship among financial and non-financial data may reasonably be
expected to exist and continue in the absence of known condition to the contrary.

STEPS IN APPLYING ANALYTICAL PROCEDURES

1. Develop expectations regarding financial statement using: (FAINT)
a. Financial statements of prior years
b. Anticipated results
c. Industry averages
d. Non-financial information
e. Typical relationships among financial statements account balances

2. Compare expectations with the financial statements under audit

3. Investigate significant unexpected differences
NOTE: If several accounts have unexpected relationships – ADDITIONAL
TEST OF DETAILS ARE REQUIRED.

Analytical procedures also include the study of relationships

a. Among elements within the financial statements, such as a study of gross
margin percentages.
b. Between financial information and relevant non-financial information, such as
the study of payroll costs for a number of employees.

IMPORTANT CHARACTERISTICS OF ANALYTICAL PROCEDURES

STAGE OF THE AUDIT REQUIRED PURPOSE
Planning Yes To assist in planning the NTE of
other audit procedures.

To identify specific/significant risks

NOTE: NATURE is the most
important consideration in
responding to the assessed risk.
Test of Control Not Not Applicable
Applicable
Substantive Testing No To obtain evidential matter about
particular assertions related to
 account balances or classes of
transactions.
Overall Review Yes To assist in assessing the
conclusions reached and in the
evaluation of overall financial
statement presentation.

ANALYTICAL PROCEDURES AS A SUBSTANTIVE TEST (based in SAS)

• May provide appropriate assurance for some assertions
• Determine the suitability of particular substantive analytical procedures for
given assertions, taking into account the assessed risks of material
misstatements and test of details, if any for these assertions
• Evaluate the reliability of data from which the auditor’s expectations of
recorded amounts or ratios is developed, taking into account the source,
comparability and nature and relevance of information available and
controls over preparation.
• Develop an expectation of recorded amounts or ratios and evaluate
whether the expectations are sufficiently precise to identify a
misstatement that individually or when aggregated with other
misstatements, may cause the financial statements to be materially
misstated and
• Determine the amount of any difference of recorded amounts from
expected values that is acceptable without further investigation.

III. CONSIDERATION OF FRAUD IN AUDIT PLANNING

The auditor is required the ROMM in the financial statements due to fraud.
According to PSA 240 (REDRAFTED) THE AUDITOR’S RESPONSBILITIES
RELATING TO FRAUD IN AN AUDIT OF FINANCIAL STATEMENTS, it requires
that when obtaining an understanding of the entity and its environment, including
internal control, the auditor shall consider whether the information obtained
indicates that one or more fraud risk factors are present.

In making the assessment whether fraud risk factors are present, the auditor
should understand the three conditions that are generally present when fraud
occurs. These are known as the FRAUD TRIANGLE (PAO).

RISK ASSESSMENT PROCEDURES are procedures used to obtain an

understanding of the entity and its environment sufficient to assess the risks and
consider these risks in designing the audit plan.
These include the following: (IIAO)
1. Inquiries with the following:
a. TCWG – environment in which FS are prepared.
b. Internal Audit personnel – effectiveness of entity’s internal control.
c. Employees – evaluating appropriateness of the selection and
application of certain accounting policies.
d. In-house legal counsel – litigation, compliance with laws and
regulation.
e. Marketing/Sales personnel – changes in entity’s strategy, trends and
arrangements.
Example: Variance analysis, Ratio analysis, Trend analysis,
Regression (most common example)

2. Analytical Procedures (please see discussion above)

3. Observation and Inspection (VWORD)
 a. Visits to the entity’s premises and plant facilities
b. Walk-throughs of systems (procedure used to confirm an auditor’s
understanding of a client’s internal control)
c. Operations
d. Reports
e. Documents

OTHER INFORMATION SOURCES

1. External legal counsel
2. Externally available data sources including analysts’, industry journals,
government statistics, surveys, texts and financial newspapers

RISK ASSESSMENT TASKS

1. Identify risks by developing an understanding of the entity and its
environment, including relevant controls that relate to the risks. Analyse the
strategic risks and the significant classes of transactions.
2. Relate the defined risks to what could go wrong in management’s assertions
about rights, obligations, presentation and disclosure.
3. Determine whether the risks are of magnitude that could result in a material
misstatement of the financial statements.
4. Consider the likelihood that the risks will result in a material misstatement of
the financial statements and their impact on classes of transactions, account
balances and disclosures.

IV. IDENTIFYING AND ASSESSING ROMM THROUGH UNDERSTANDING THE

ENTITY AND ITS ENVIRONMENT
The ROMM may be separated into 2 components – Inherent risk and control
risks. Both are function of the CLIENT and ITS ENVIRONMENT.

INHERENT RISKS – is the possibility of material misstatement of an assertion

before considering the client’s internal control. Factors that affect inherent risk
relate to either the nature of the client and its environment or the nature of the
particular financial statement element.

In assessing the inherent risk, it is often to segregate transactions into three

types – ROUTINE, NON-ROUTINE and ESTIMATION.

ROUTING transactions involve recurring financial statement activities recorded in

the accounting records in the normal course of business. This type of
transactions restricts inherent risk, although controls certainly must be
implemented to assure proper recording.
EXAMPLES
1. Sales
2. Purchases
3. Cash disbursements
4. Cash records
5. Payroll transactions

NON-ROUTINE transactions involve activities that occur only periodically.

Inherent risk may be HIGH in this type of transactions because they are not part
of the normal flow of transactions and specialized skills may be needed to
perform the activity.
EXAMPLES
1. Taking of physical inventories
2. Calculating depreciation expense
 3. Adjusting financial statements for foreign currency gains and
losses

ESTIMATION transactions are those activities that create accounting estimates.

These activities have HIGH inherent risk because they involve management
judgments or assumptions.
EXAMPLES
1. Estimating the allowance for uncollectible accounts
2. Estimating warranty reserves
3. Assessing assets for impairment

Factors affecting INHERENT RISK at FS LEVEL (PSA 315)

• Management Integrity
NOTE: In assessing management integrity the auditor should
RESEARCH the BACKGROUND and HISTORIES of OFFICERS.
• Management Characteristics (i.e., aggressive financial reporting)
• Operating Characteristics (i.e., profitability)
• Industry Characteristics (i.e., industry turmoil)

Factors affecting INHERENT RISK at ACCOUNT BALANCE LEVEL

• Susceptibility of the account to theft
• Complexity of calculations related to account
• Complexity underlying transactions and other events
• Degree of judgment involved in determining account balances

CONTROL RISK – risk that a material misstatement could occur in a relevant

assertion and not be PREVENTED or DETECTED on a timely basis by the
client’s internal control. It is a function of the effectiveness of both the design and
operation of internal control in achieving the client’s objectives relevant to the
preparation of financial statements.

Both INHERENT RISK and CONTROL RISK exist independently of the audit of
financial statements. That is, the risk of misstatement exists regardless of
whether an audit is performed. The auditor may make separate assessments of
the two risks or an overall assessment of the risk of material misstatement for the
relevant assertions.

DETECTION RISK – risk that the auditor will FAIL TO DETECT a material
misstatement that exists in relevant assertion. It is a function of the effectiveness
of audit procedures and their application by the auditors. Unlike inherent and
control risk, IT DOES NOT EXIST WHEN NO AUDIT IS PERFORMED. Rather
than assessing detection risk, auditors seek to restrict it through performance of
substantive procedures.

MEASURING AUDIT RISK

AR = IR x CR x DR

AUDIT RISK – is the risk that the auditor gives an inappropriate audit opinion
when the financial statements are materially misstated.

In setting the desired audit risk, auditor seek an appropriate balance between the
costs of an incorrect audit opinion and the costs of performing the additional
procedures necessary to reduce audit risk.
The first step involves obtaining an understanding of the entity and assessing the
level of business risks. Auditors than consider the effect these factors could have
on the ROMM at the financial statement level.

STEPS IN USING THE AUDIT RISK MODEL

1. Set the desired level of Audit Risk
2. Assess the level of Inherent risk
3. Assess the level of Control risk
4. Determine the acceptable level of Detection risk
5. Design the Substantive procedures

RELATIONSHIP AMONG RISK COMPONENTS

Given that an auditor’s objective is to achieve an acceptably low level of audit risk
as is practicable, and recognizing the cost of performing audit procedures, there
is an inverse relationship between the assessed levels of inherent and control
risks and the level of detection risk that the auditor can accept. Thus, if inherent
and control risks are assessed as being low, the auditor can tolerate a higher
level of detection risk, enabling a reduction in the extent of substantive
procedures that must be undertaken. However, it is important to note that an
auditor may tolerate different levels of risks in different audits depending on the
auditor’s professional judgment of the perceived consequences of the risks being
taken.

The audit risk model provides a framework for auditors to follow in responding to
these assessed risks through their choice of audit procedures. PSAs are not
specific on what is acceptable level of audit risk, and use of the audit risk model
required a significant degree of judgment by the auditor. In relating the
components of audit risk, the auditor generally expresses each component in
non-quantitative terms (LOW, MEDIUM and HIGH).

ACCEPTABLE DETECTION RISK MATRIX

CONTROL RISK
HIGH MEDIUM LOW
INHERENT HIGH Lowest Lower Medium
RISK MEDIUM Lower Medium Higher
LOW Medium Higher Highest

NOTE:
All events and conditions
(NO REQUIRED DOCUMENTATION)

Events and conditions relevant to the entity

Our objective is to identify those that are
Relevant to the entity

RISK FACTORS – those events and conditions that affects susceptibility

of an assertion of misstatement BEFORE consideration of controls.

ROMM Likelihood of OCCURENCE and potential MAGNITUDE of material

misstatements to determine when a risk factor gives rise to a ROMM. (WE
ARE REQUIRED TO DOCUMENT ROMM)
PSA 320 MATERIALITY IN PLANNING AND PERFORMING AN AUDIT
MATERIALITY
Materiality underlies the application of accounting and auditing standards and
thus has a pervasive effect in a financial statement audit. An auditor is able to
give an unqualified audit opinion if the financial statements are free from material
misstatements. Materiality is particularly important for the auditor at two of the
key phases of the audit process: PLANNING (determining the NTE of audit
procedures) and at the EVALUATION of extent of material misstatements as a
basis of audit opinion.

“Materiality means that an information which is omitted, misstated or not

discloses has the potential to adversity effect decisions about the allocation of
scarce resources made by users of the financial report or discharge of
accountability by management or the governing body of the entity”

There is an INVERSE RELATIONSHIP between MATERIALITY and AUDIT RISK

and the auditor should take the relationship into consideration when determining
the NTE of audit procedures. Where the auditor considers that there is a higher
risk of material misstatement, materiality will be aet at a lower level.

PRELIMINARY JUDGMENTS ABOUT MATERIALITY

The auditor must assess the risks associated with each client and each audit
engagement. As stated in PSA 315 REDRAFTED, the auditor shall identify and
assess the ROMM at the FINANCIAL STATEMENT LEVEL and at the
ASSERTION LEVEL for classes of transactions, account balances and
disclosures.

LEVELS OF MATERIALITY
1. PLANNING MATERIALITY
This assessment is referred to as PLANNING MATERIALITY and may differ from
the materiality levels used at the conclusion of the audit in the evaluation of audit
findings because surrounding circumstances may change, and additional
information about the entity will have been obtained during the course of the
audit.

The PREIMINARY JUDGMENT or ESTIMATE ABOUT MATERIALITY represents

the maximum amount by which a set of financial statement could be misstated
and still cause the auditor to believe that the decisions of reasonable users would
be affected. One of the common criteria in setting preliminary judgement about
materiality is the size of the client company.

TOLERABLE MISSTATEMENT – amount of planning materiality that is allocated

to an account balance or class of transactions. The process allocation may be
done judgmentally using formal quantitative approaches.

MATERIALITY AT THE FS LEVEL

Quantitative guideline
In assessing quantitative importance of a misstatement, the auditor needs to
relate the peso amount of the error to the financial statement under examination.
AASSB provides some quantitative threshold guidance to help determine
materiality.
a. An amount that is equal or greater than 10% of the appropriate base
amount is presumed to be material.
b. An amount that is equal to or less than 5% of the appropriate base
amount is presumed not to be material.
 c. Whether an amount between 5% and 10% is immaterial is a matter of
professional judgment.

The resulting materiality amount in pesos is known as PLANNING

MATERIALITY.

Qualitative considerations
These relate to the causes of misstatements or to misstatements that do not have
quantifiable effect. A misstatement that is quantitatively immaterial may be
qualitatively material.
a. The significance of the misstatement to the particular entity.
b. The pervasiveness of the misstatement
c. The effect of misstatement on the financial statement as a whole.

2. PERFORMANCE MATERIALITY
PERFORMANCE MATERIALITY- is set to reduce to an appropriately low-level
probability that the aggregate of uncorrected and undetected misstatements in
the financial statements exceeds for financial statements as a whole.

3. ASSERTION LEVEL/SPECIFIC MATERIALITY

ASSERTION LEVEL is set for a particular class of transaction or account
balance, and considers the following: (U FLIP)
• Understanding the view of TCWG
• Financial Reporting Framework
• Law and Regulation
• Industry Disclosures
• Particular Aspects in the business

MATERIALITY AT THE ACCOUNT BALANCE

Account balance misstatement is the MINIMUM misstatement that can exist in an
account balance or it to be considered materially misstated. Misstatement up to
that level is known as “PERFORMANCE MATERIALITY/TOLERABLE ERROR”.
This is the amount of planning materiality that is allocated to an account balance
or class of transactions. The recorded balance of an account generally
represents the upper limit on the amount by which an account can be overstated.
Thus, accounts with balances smaller than materiality are sometimes said to be
immaterial in terms of risk of overstatements.

RELATIONSHIP BETWEEN MATERIALITY AND AUDIT EVIDENCE

Materiality, like risk, is a key factor that affects the auditor’s judgment about the
sufficiency of audit evidence. It is generally correct to say, that the LOWER the
MATERIALITY, the GREATER the amount of EVIDENCE that is needed
(INVERSE RELATIONSHIP).
USING MATERIALITY TO EVALUATE AUDIT EVIDENCE
If there are misstatements in the accounts, then the auditor may perform
additional audit procedures to ask that management correct the errors. If the
uncorrected errors exceed the materiality and management refuses to make
adjustments, then the auditor may consider issuing a QUALIFIED or ADVERSE
audit opinion. The uncorrected aggregated misstatements (also knows as
LIKELY MISSTATEMENTS) that the auditor needs to examine when considering
whether they misstate the financial statements include:
a. Specific misstatements identified by the auditor
b. The auditor’s best estimates of the other misstatements that cannot be
specifically identified (PROJECTED ERRORS).

STEPS IN APPLYING MATERIALITY

DURING PLANNING
1. Establishing a PRELIMINARY JUDGMENT about MATERIALITY
2. Determine TOLERABLE MISSTATEMENT

AT AUDIT COMPLETION
3. Estimate likely misstatements and compare the totals to the preliminary
judgment about materiality.

ESTIMATE LIKELY MISSTATEMENTS AND PRELIMINARY JUDGMENT

ABOUNT MATERIALITY
In evaluating whether the financial statements are prepared, in all material
respects, in accordance with an applicable financial reporting framework, the
auditor should assess whether the aggregate of uncorrected misstatements that
have been identified during the audit is material.

The aggregate of uncorrected misstatements which is known as ESTIMATE

LIKELY MISSTATEMENTS comprises:
1. Specific misstatements identified by the auditor including the net effect of
UNCORRECTED MISSTATEMENTS identified during the audit or previous
periods.
2. The auditor’s best estimate of other misstatements which cannot be
specifically identified.

If the aggregate of the uncorrected misstatements that the auditor has identified
approaches the performance materiality level, the auditor would consider whether
it is likely that undetected misstatements, when taken with aggregate uncorrected
misstatements could exceed materiality level. In such case, the auditor would
consider reducing audit risk by performing additional or extended procedures or
by requesting management to adjust financial statements for identified
misstatements.

NOTE: Materiality during the audit is flexible. There is a need to revise materiality
when facts come to the attention of the auditor that necessitates a revision.

The auditor is required to include in the audit documentation the amounts and the
factors considered in the determination of the materiality levels including the
basis for any revisions to those materiality levels. Audit documentation should
demonstrate the judgment and rationale used by the auditor in determining
materiality levels.
OTHER AUDIT CONSIDERATION
AUDIT STRATEGIES – the audit strategy significantly affects detailed work performed in the
audit. The interrelationship among audit evidence, materiality and the components of audit
risk affects the auditor’s decision on the type of audit strategy chosen – PREDOMINANTLY
SUBSTANTIVE APPROACH and LOWER ASSESSED LEVEL OF CONTROL RISK
APPROACH.

NOTE: If the auditor assesses the appropriate controls do not exist or are likely to be
ineffective, then no reliance can be placed on internal controls – control risk is assessed at
relatively high level and therefore PREDOMINANTLY SUBSTANTIVE APPROACH will be
adopted. More substantive procedures will be performed. An audit strategy that relies on
internal controls to support the use of a reduced level of substantive procedures is
sometimes referred to as LOWER ASSESSED LEVEL OF CONTROL RISK APPROACH
also known as COMBINED APPROACH. This is not a single strategy, but range of
strategies determined by the relative effectiveness of applicable control procedures
(combined assessments of inherent risk and materiality).