Chapter 7: Audit Planning and Materiality
Planning (1 of 2)
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
Figure 7.1 Planning an Audit and Designing an Audit
Approach
Accept Client and Perform Initial Audit Planning
Initial audit planning involves four things that should
be done early in the audit:
- Decides whether to accept a new client or
continue serving an existing one
- Identifies why the client wants or needs an
audit
- Obtains an understanding with the client about
the terms of the engagement
- Develops the overall strategy for the audit
Client Acceptance and Continuance
New client investigation:
- Investigate the company to determine its
acceptability
- New (successor) auditor is required by auditing
standards to communicate with the
predecessor auditor
Continuing clients:
- Evaluate existing clients annually to determine
whether there are reasons for not continuing to
do the audit
Identify Client’s Reasons for Audit
- Auditor’s acceptable audit risk may be affected
by the client’s reasons for audit
Obtaining and Understanding with the Client
- Auditing standards require that auditors obtain
an understanding with the client in an
engagement letter
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
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
Figure 7.3 Strategic Understanding of the Client’s
Business and Industry
Let’s Discuss (1 of 7)
Identify the eight major steps in planning audits.
1. Accept client and perform initial audit planning
2. Understand the client's business and industry
3. Perform preliminary analytical procedures
4. Set professional judgment of materiality and
performance materiality
5. identify the significant risks due to fraud or error
6. Assess client business risk
7. Understand internal control and assess control risk
8. Finalize overall audit strategy and audit plan
What factors should an auditor consider prior to
accepting an engagement?
Prior to accepting a client, the auditor should
investigate the client. The primary purpose is to
evaluate the integrity of the client and the possibility of
management fraud. The auditor should be especially
concerned with the possibility of management fraud
since it is difficult to uncover. The auditor does not want
to needlessly expose him- or herself to the possibility of
a lawsuit for failure to detect such fraud.
Explain the five elements that are part of a strategic
understanding of the client’s business.
- Industry and external environment
Understand risks and accounting requirements
- Business operations and processes
Considers factors such as key customers and
suppliers, sources of financing, and
manufacturing operations.
- Management and governance
Encompasses the organizational structure and
the activities of the board of directors and audit
committee.
- Client objectives and strategies
Understand the client's strategic plan and
objectives related to financial reporting,
effectiveness and efficiency of operations, and
compliance with laws and regulations.
- Measurement and performance
Understand key performance indicators used by
management to assess progress toward its
objectives.
Let’s Discuss (2 of 7)
What are the benefits derived from planning audits?
three primary benefits from planning audits: it helps the
auditor obtain sufficient appropriate evidence for the
circumstances, helps keep audit costs reasonable helps
avoid misunderstandings with the client
What is the purpose of an engagement letter? What
subjects should be covered in such a letter?
An engagement letter is an agreement between the
public accounting firm and the client concerning the
conduct of the audit and related services. It should state
what services will be provided, whether any restrictions
will be imposed on the auditor’s work, deadlines for
completing the audit, and assistance to be provided by
client personnel. The engagement letter also informs
the client that the auditor is not responsible for the
discovery of fraud.
Explain why auditors need an understanding of the
client’s industry. What information sources are
commonly used by auditors to learn about the client’s
industry?
Auditors need an understanding of the client's business
and industry because the nature of the business and
industry affect business risk and the risk of material
misstatements in the financial statements.
1. Industry and External Environment - Read industry
trade publications
2. Business Operations and Processes - Tour the plant
and offices
3. Management and Governance - Read the corporate
charter and bylaws
4. Client Objectives and Strategies - Inquire of
management
5. Measurement and Performance - Read financial
statements, perform ratio analysis
Perform Preliminary Analytical Procedures (1 of 2)
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
Let’s Discuss (3 of 7)
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.
Unsalable or outdated inventory may be in existence
and might need a price cut to whichever lower of its
cost or its market value.
State the follow-up procedures you would perform for
this fluctuation to determine whether a material
misstatement exists.
A sample of larger inventory item must be selected and
the client must be asked to program the successive
transactions which upset these items. The company's
ability to sell these items and selling prices of the client
must be noted. Any item which the client is selling
below the cost, add a judicious markup for casing the
selling price or for the items which the client is not able
to sell suggest that client should markdown the
inventory to its market value.
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
Figure 7.5 Steps in Applying Materiality
Materiality for Financial Statements as a Whole
Factors affecting preliminary materiality judgment
include:
- Materiality is a relative rather than an absolute
concept
- Because materiality is relative, it is necessary to
have benchmarks for establishing whether
misstatements are material
- Qualitative factors affect materiality
Let’s Discuss (4 of 7)
Define the meaning of the term materiality as it is used
in accounting and auditing. What is the relationship
between materiality and the phrase obtain reasonable
assurance used in the auditor’s report?
Materiality is defined as: the magnitude of an omission
or misstatement of accounting information that,
considering the surrounding circumstances, makes it
probable that the judgment of a reasonable person
relying on the information would have been changed or
influenced by the omission or misstatement. "Obtain
reasonable assurance," as used in the audit report,
means that the auditor does not guarantee or insure
the fair presentation of the financial statements. There
is some risk that the financial statements contain a
material misstatement.
Explain why materiality is important but difficult to
apply in practice.
Materiality is important because if financial statements
are materially misstated, users' decisions may be
affected, and thereby cause financial loss to them. It is
difficult to apply because there are often many different
users of the financial statements. The auditor must
therefore make an assessment of the likely users and
the decisions they will make.
Determine Performance Materiality (1 of 3)
Performance materiality is defined as:
- The amount(s) set by the auditor at less than
materiality for the financial statements as a
whole to reduce to an appropriately low level
the probability that the aggregate of
uncorrected and undetected misstatements
exceeds materiality for the financial statements
as a whole
Performance materiality is inversely related to the
amount of evidence an auditor will accumulate
The process of determining performance materiality is
referred to as the allocation of the preliminary
judgment about materiality to segments
The determination of performance materiality is based
on professional judgment and reflects the amount of
misstatement an 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
Estimate Misstatement and Compare with Preliminary
Judgment
When auditors perform audit procedures for each
segment of the audit, they document two types of
misstatements:
- Known misstatements
Those where the auditor can determine the amount of
the misstatement in the account
- Likely misstatements
Differences between management’s and the auditor’s
judgment about estimates of account balances
Projections of misstatements based on the auditor’s
tests of a sample from a population
Let’s Discuss (5 of 7)
What is meant by setting a preliminary judgment
about materiality? Identify the most important factors
affecting the preliminary judgment.
The preliminary judgment about materiality is the
maximum amount by which the auditor believes the
financial statements could be misstated and still not
affect the decisions of reasonable users. Several factors
affect the preliminary judgment about materiality and
are as follows:
1. Materiality is a relative rather than an absolute
concept.
2. Benchmarks are needed for evaluating materiality.
3. Qualitative factors affect materiality decisions.
4. Expected distribution of the financial statements will
affect the preliminary judgment of materiality. If the
financial statements are widely distributed to users, the
preliminary judgment of materiality will probably be set
lower than if the financial statements are not expected
to be widely distributed.
5. The level of acceptable audit risk will also affect the
preliminary judgment of materiality.
Distinguish between the terms performance
materiality and preliminary judgment about
materiality. How are they related to each other?
Performance materiality is the maximum amount of
misstatement that would be considered material for an
individual segment of the audit, or account balance. The
amount of performance materiality for any given
segment or account is dependent upon the preliminary
judgment about materiality. Ordinarily, performance
materiality for any given segment or account would
have to be lower than the preliminary judgment about
materiality.
Let’s Discuss (6 of 7)
Explain the difference between known and likely
misstatements. Assume the auditor tests a sample of
$100,000 of inventory and finds misstatements
totaling $5,000. What is the likely misstatement if the
account balance is $500,000?
Known misstatements are those where the auditor can
determine the actual amount of the misstatement.
Likely misstatements are from differences in
management's and the auditor's judgment about an
estimate, or from the projection of sample
misstatements to the population being tested. If the
auditor tests a sample of $100,000 of inventory and
finds misstatements totaling $5,000, the likely
misstatement if the account balance is $500,000 is
$25,000 ($5,000/100,000 x $500,000).
Let’s Discuss (7 of 7)
Provide two examples of when an auditor might set a
lower level of performance materiality for a particular
class of transactions, account balance, or disclosure.
When allocating the preliminary judgment about
materiality for the financial statements as a whole to
individual segments, the auditor considers both
efficiency and effectiveness of the audit. An auditor
might set a lower level of performance materiality for a
particular account balance if it is easy to audit and no
misstatements are expected (e.g., notes payable), or if
the auditor expects that a misstatement of a lower
amount in a particular account or transaction might
influence an investor (e.g., disclosure of a related party
transaction).
Assume materiality for the financial statements as a
whole is $100,000 and performance materiality for
accounts receivable is set at $40,000. If the auditor
finds one receivable that is overstated by $55,000,
what should the auditor do?
If performance materiality for accounts receivable is
$40,000 and the auditor finds a $55,000 overstatement
of a receivable balance, the auditor would document
the misstatement and evaluate results of the remaining
audit procedures in accounts receivable. The $55,000
overstatement is an example of a known misstatement.
The auditor could request the client make an
adjustment to correct the overstatement or make a
note of the overstatement for follow-up at a later point
in the audit. If accounts receivable testing was
performed using sampling techniques, the auditor
would also project total known misstatements to the
population and may perform additional tests depending
on the outcome
Chapter 8: Assessing the Risk of Material
Misstatement
Audit Risk (1 of 2)
Auditors accept some level of or uncertainty in
performing the audit function
The assessment of risks is a matter of professional
judgment, rather than a precise measurement
- Responding to these risks properly is critical to
achieving a high-quality audit
The risk of material misstatement is the risk that the
financial statements contain a material misstatement
due to fraud or error prior to the audit.
The risk of material misstatement exists at two levels:
- Overall financial statement level
- Assertion level
Let’s Discuss (1 of 6)
Why is it important for the auditor to consider the risk
of material misstatement at the overall financial
statement level?
It is important for the auditor to consider risks at the
overall financial statement level given those risks may
increase the likelihood of risks of material misstatement
across a number of accounts and assertions for those
accounts
Provide two examples of factors that might increase
the risk of material misstatement at the overall
financial statement level.
For example, deficiencies in management's integrity or
competence can increase the likelihood that material
misstatements may be present in several assertions
affecting several classes of transactions, account
balances, or financial statement disclosures. Similarly,
declining economic conditions or significant changes in
the industry may increase the risk of material
misstatement at the overall financial statement level.
Risk Assessment Procedures
Risk assessment procedures include the following:
- Inquiries of management and others within the
entity
- Analytical procedures
- Observation and inspection
- Discussion among engagement team members
- Other risk assessment procedures
The performance of risk assessment procedures is
designed to help the auditor obtain an understanding
of the entity for purposes of assessing the risk of
material misstatement when planning the audit
- They are used to assess the risk of material
misstatement and the required extent of
further audit procedures
Figure 8.1 Role of Risk Assessment Procedures
Considering Fraud Risk (1 of 2)
• The risk of not detecting a material
misstatement due to fraud is higher than the
risk of not detecting a misstatement due to
error
• Identifying material misstatements due to fraud
is difficult
• Auditing standards outline procedures the
auditor should perform to obtain information
from management about their consideration of
fraud
• The auditor’s consideration of the risk of
material misstatement due to fraud is made at
both
- The financial statement level and at the
assertion level
• The auditor’s risk assessment should be ongoing
throughout the audit
• Auditing standards require the auditor to
presume that risk of fraud exists in revenue
recognition
Identification of Significant Risks
• A significant risk represents an identified and
assessed risk of material misstatement that, in
the auditor’s professional judgment, requires
special audit consideration.
• Significant risks are likely to be included in
public company audit reports as critical audit
matters
• Significant risks often relate to:
- Nonroutine transactions
- Matters that require significant judgment
- Fraud risk
Let’s Discuss (2 of 6)
At what two levels does the auditor assess the risk of
material misstatement?
Describe the types of procedures that constitute risk
assessment procedures.
Let’s Discuss (3 of 6)
Why is it important to distinguish the auditor’s
assessment of the risk of material misstatement due to
fraud from the assessment of the risk of material
misstatement due to error?
Describe examples of characteristics of transactions
and balances that might cause an auditor to determine
that a risk of material misstatement is a significant
risk.
Audit Risk Model (1 of 2)
• The audit risk model helps auditors decide how
much and what types of evidence to
accumulate for each relevant audit objective
• The audit risk model assessments may be
quantitative or non-quantitative
Most firms prefer non-quantitative assessments of risk
(such as low, moderate, and high) due to the difficulty
in precisely quantifying measures of risk
Figure 8.2 Audit Risk Model and Understanding the
Client’s Business and Industry
The four risks in the audit risk model:
- Planned detection risk
- Inherent risk
- Control risk
- Acceptable audit risk
Table 8.1 Illustration of Differing Evidence Among
Cycles
Assessing Acceptable Audit Risk (1 of 2)
Auditors must decide the appropriate acceptable audit
risk for an audit
- Auditors first decide on engagement risk and
then use engagement risk to modify acceptable
audit risk
- Engagement risk is
The risk that the auditor or audit firm will suffer harm
after the audit is finished, even though the audit report
was correct
Research points to several factors affecting
engagement risk and, therefore, acceptable audit risk:
- The degree to which external users rely on the
statements
- The likelihood that a client will have financial
difficulties after the audit report is issued
- The auditor’s evaluation of management’s
integrity
Table 8.2 Methods Practitioners Use to Access
Acceptable Audit Risk
Let’s Discuss (4 of 6)
Define the audit risk model and explain each term in
the model.
Explain the causes of an increased or decreased
planned detection risk.
Assessing Inherent Risk
• The assessment of inherent risk represents
auditors’ attempt to predict where
misstatements are most and least likely in the
financial statement segments
 • This assessment affects the amount of evidence
that the auditor needs to accumulate, the
assignment of staff, and the review of audit
documentation
• Auditors begin their assessments of inherent
risk during the planning phase and update the
assessments throughout the audit
The auditor should consider several major factors
when assessing inherent risk (1 of 2):
- Nature of the client’s business
- Results of previous audits
- Initial versus repeat engagement
- Related parties
- Complex or nonroutine transactions
- Judgment required to correctly record account
balances and transactions
- Makeup of the population
- Factors related to fraudulent financial reporting
- Factors related to misappropriation of assets
Let’s Discuss (5 of 6)
Explain what is meant by the term acceptable audit
risk.
What is its relevance to evidence accumulation?
Explain the effect of extensive misstatements found in
the prior year’s audit on inherent risk, planned
detection risk, and planned audit evidence.
Figure 8.3 Factors Influencing Risks and Relationship of
Risks to Planned Evidence
Relationship of Risks to Evidence and Factors
Influencing Risks
Auditors respond to risk primarily by changing the
extent of testing and types of audit procedures,
including:
- Incorporating unpredictability in the audit
procedures used
- Modifying audit evidence
- Requiring more experienced staff
- Reviewing the engagement more carefully than
usual
Other factors to consider:
- Audit risk for segments
- Relating performance materiality and risks to
balance-related audit objectives
- Measurement limitations
- Tests of details of balances evidence-planning
worksheet
- Revising risks and evidence
Table 8.3 Relationships of Risk to Evidence
Relationship of Risk and Materiality to Audit Evidence
The concepts of materiality and risk in auditing are
closely related and inseparable:
- Risk is a measure of uncertainty
- Materiality is a measure of magnitude or size
- Performance materiality is not a part of the
audit risk model, but
The combination of performance materiality and the
audit risk model factors determines planned audit
evidence
Figure 8.5 Relationship of Performance Materiality and
Risks to Planned Evidence
Let’s Discuss (6 of 6)
Auditors have not been successful in measuring the
components of the audit risk model.
How is it possible to use the model in a meaningful way
without a precise way of measuring the risk?
Explain how audit risk and materiality are related and
why they need to be considered together in planning
an audit.