Audit Planning, Misstatements, and Materiality

AUDIT PLANNING
• After client acceptance and continuance decisions, the auditor is expected to design and
conduct an audit that provides reasonable assurance that material misstatements will
be detected.

Objective after client acceptance: design and provide reasonable assurance that material
misstatements will be detected

• Misstatement: reported vs. required to be reported (amount, classification,

presentation or disclosure)
• Types:
• Error: unintentional misstatements (honest mistake)
• Fraud: intentional act of deception that results in misstatement

*higher possibility of detecting errors (cause in fraud - there are efforts to hide)

Types of Fraud
• Fraudulent financial report (Management Fraud)
• Intentional misstatements in FS to deceive FS users
• Accomplished through:
i. Manipulation, falsification or alteration (ex. Recording AR of fictitious
customers to increase assets) - creating evidence that would justify your
fraud
ii. Misrepresentation or intentional omission of events, transactions or
other significant information (ex. Omitting, advancing, or delaying
recognition of sales to meet projections)
iii. Intentional misapplication of accounting principles (ex. Inappropriately
adjusting method in estimating depreciation expense to reduce profit
subject to tax)
• Misappropriation of assets (Employee Fraud)
• Theft of entity's assets
• Examples
i. Embezzle cash received
ii. Steal physical assets and IP
iii. Cause the entity to pay for goods not received
iv. Use entity's assets for personal use
• Responsibility of fraud detection still rests in the management
• Auditor: reasonable assurance that FS are free from material misstatements

MATERIALITY (accounting word rather than audit word)

• A concept that relates to the significance or importance of an item
• Material: any information in the F/S that, when omitted, misstated, or obscured, could
reasonably be expected to influence decisions that F/S users make (IAS 1)
• PSA 320 requires auditor to make a preliminary estimate of materiality for use during
the examination
• Determination of what is considered material is a matter of professional judgment and
necessarily involves:
• Quantity (Magnitude). Most audit firms have definitive, quantitative materiality
guidelines that aid in the initial determination of a materiality amount

• Percentage of revenue/gross profit/gross assets/equity

• Blended methods of combining the above (percentage) and finding an average
• Sliding scale method/graduated table (i.e. corresponding rate for every range)
In determining the appropriate base/benchmark to use, auditors usually consider
information that is important for the external users. Considerations include: component
of the F/S, laws and regulations, and nature of the industry.
• Examples:
• Asset management company or hedge fund: net assets
• Manufacturing industry: profit before tax (why pre-tax? Since there are diff tax
rates for every country)
• High technology start-up: revenue
• Regional operating headquarters/NGOs: Expenses
• Banks: Net cash
• Construction Industry: PPE/Buildings
• Quality (Nature). Qualitative factors such as the potential effects of the information to
the decisions.
• The auditor should use the quantitative guideline as a starting point and then
adjust as necessary for qualitative characteristics of the particular audit client.
• Materiality levels used in audit:
• Overall materiality
• The smallest aggregate level of misstatements that could be
material to any one of the F/S. Also called “planning
materiality”, “materiality at the F/S level” or “materiality level
for the F/S as a whole”
• Performance materiality. (population-wide audit)
• The amounts set by the auditor at less than the overall
materiality to make sure that the aggregate of uncorrected and
undetected immaterial misstatements does not exceed overall
materiality. Auditors commonly set performance materiality for
each account as a percentage of overall materiality.
• Also refers to the materiality amount or amounts set for
particular classes of transactions, account balances, or
disclosures.
•

IF SET IS TOO HIGH IF SET IS TOO LOW

Auditor might NOT perform Auditor might perform

sufficient procedures to detect more procedures than
material misstatements necessary
• Tolerable misstatement:
 • the maximum amount of misstatement in an account
balance that the auditor could tolerate and still not
judge the underlying account balance to be materially
misstated (applied in audit sampling/samples)
• Determining materiality levels is an important aspect in
planning the audit as it helps in ensuring that the audit
is cost-efficient (money, time, etc.)
• Limit work done based on materiality levels
• The auditor’s assessment of materiality, related to specific
accounts, helps the auditor select audit procedures that can be
expected to reduce audit risk to an acceptable low level. The
higher the materiality, the lower the audit risk.