6-1. What is the objective of audit planning?

International Standards on Auditing (ISA) 300, ‘Planning an Audit of Financial Statements’, states, the
objective of the auditor is to plan the audit so that it will be performed in an effective manner... The auditor
shall establish an overall audit strategy that sets the scope, timing and direction of the audit, and that
guides the development of the audit plan. The objective of planning is to determine the amount and type
of evidence and review required to give the auditor assurance that there is no material misstatement of
the financial statements. This is Phase II in the Audit Process Model (see Illustration 6.1).

6-2. List the planning procedures.

(1) Perform audit procedures to understand the entity and its environment, including the entity’s internal
control; (2) Assess the risks of material misstatements of the financial statements; (3) Determine
materiality; and (4) Prepare the planning memorandum and audit programme, containing the auditor’s
response to the identified risks.

6.3 Understanding the Entity and its Environment

6-3. ISA 315 provides an overview of the procedures that the auditor should follow in order to obtain an
understanding, sufficient to assess the risks and consider these risks in designing the audit plans
describe the procedures.

The risk assessment procedures should, at a minimum, be a combination of the following:

 Inquiries of management and others within the entity: It is important to have discussions with the
client’s management about their objectives and expectations, and plans for achieving these
goals. The discussions may encompass short-term management objectives such as increasing
profit, reducing investment in working capital, introducing new product lines, reducing taxes or
reducing selling and distribution expenses. Expectations should be explored concerning the
company’s external agents such as customers, suppliers, shareholders, financial institutions,
government, etc. However, although management will typically be the most effective and efficient
information source, it might be worthwhile to obtain information from others, in order to reduce the
potential for bias.
 Analytical procedures: These may help the auditor in identifying unusual transactions or positions.
Analytical procedures usually involve a comparison of company results to that of the industry.
There are publications of major industry ratios and trends that might be helpful to the auditor
doing analytical procedures (see Chapter 7 Internal Control and Control Risk).
 Observation and inspection: These procedures may cover a broad area, ranging from the
observation of an entity’s core activities, the reading of management reports or internal control
manuals to the inspection of documents. A visit to, and tour of, the company premises will help
the auditor develop a better understanding of the client’s business and

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operations. Viewing the facilities helps to identify some internal control safeguards. Seeing the production
process will help in assessing the inventory movement and the use of fixed assets. Observations of the
orderliness, cleanliness and physical layout of facilities and of the employees’ routine functions and work
habits can often tell the auditor more about the client than can be learned from studying the accounting
records. Knowledge of the physical facilities and plant layout may point to the right questions to ask
during the planning phase, or getting the right answers to questions later in the audit. Knowing the layout
will assist in planning how many audit staff members will be needed to participate in observing the
physical inventory. On the site visit one may see signs of potential problems. Rust on equipment may
indicate that plant assets have been idle. Excessive dust on raw materials or finished goods may indicate
a problem of obsolescence. The auditors can see the physical extent of segregation of duties within the
client organisation by observing the number of office employees.

6-4. How can understanding a certain industry help an auditor?

It is important to understand the client’s industry because many industries have unique accounting
requirements that the auditor must understand to evaluate the client’s financial statements. An auditor
may be able to identify industry risks that will affect the assessment of planning risk. Understanding
inherent risks common to all companies in a certain industry helps the auditor identify the inherent risks of
the individual company.

6.4 Audit Risk Model

6-5. What are the definitions of the three audit risk components?

The following are ISA 200’s definitions of the three audit risk components:

 Inherent risk – the susceptibility of an assertion about a class of transaction, account balance or
disclosure to a misstatement that could be material, either individually or when aggregated with
other misstatements, before consideration of any related controls.
 Control risk – the risk that a misstatement that could occur in an assertion about a class of
transaction, account balance or disclosure and that could be material, either individually or when
aggregated with other misstatements, will not be prevented, or detected and corrected, on a
timely basis by the entity’ internal control.
 Detection risk – the risk that the procedures performed by the auditor to reduce audit risk to an
acceptably low level will not detect a misstatement that exists and that could be material, either
individually or when aggregated with other misstatements.

6-8. How is materiality defined in the ISAs (specifically ISA 320)?

Materiality is not specifically defined in the ISAs. ISA 320, instead, defines materiality in the context of an
audit and as performance materiality. Although financial reporting frameworks may discuss materiality in
different terms, in the context of an audit, they generally explain that:

i. Misstatements, including omissions, are considered to be material if they, individually or in the

aggregate, could reasonably be expected to influence the economic decisions of users taken on
the basis of the financial statements.
ii. Judgements about materiality are made in light of surrounding circumstances, and are affected by
the size or nature of a misstatement, or a combination of both.
iii. Judgements about matters that are material to users of the financial statements are based on a
consideration of the common financial information needs of users as a group. The possible effect
of misstatements on specific individual users, whose needs may vary widely, is not considered.

6-9. What four factors are generally considered in determining materiality? Briefly discuss them.

What is material is often difficult to determine in practice. A variety of factors may be considered: size of
item, nature of item, the circumstances and the cost-benefit of auditing materiality.
  Size of the item: The most common application of materiality has to do with the size of the item
considered. A large dollar amount item omitted from the financial statements is generally material.
 Nature of the item: The nature of an item is its qualitative characteristics. An auditor cannot
quantify the materiality decision in all cases; certain items may have significance even though the
dollar amount may not be quite as large as the auditor would typically assume. The nature of an
item makes it material even though quantitatively it may be classified as immaterial. For example,
a political bribe by a client, even though immaterial in size, may nevertheless be of such a
sensitive nature and have such an effect on the company that financial statement users would
need to be told.
 Circumstances: The materiality of an error depends upon the circumstances of its occurrence.
There are two types of relevant circumstances: the context of the accounting information in which
an item or error occurs and the economic decision making process employed by the users of the
accounting information.
 Cost benefit: Accounting materiality differs from auditing materiality. Accounting materiality is ex
post, or after the fact. That is, given a particular item, should it be disclosed? In that case, cost-
benefit decisions are not relevant because the item has already been discovered and no
additional cost is required. Auditing materiality, on the other hand, is ex ante, before the fact.
Materiality is a planning concept which is used to design the audit to detect material items; no
material items have been found yet. There are additional costs for an

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auditor to discover a material error. Therefore, auditing materiality always requires professional
judgement to make cost-benefit decisions. The decision must be made during the early, planning stages
of the audit when the extent of misstatement of the financial statement cannot be known.

1. 6-11. Define fraud and give the ISA standard on fraud.

The audit standards define fraud as ‘an intentional act by one or more individuals among
management, those charged with governance, employees or third parties, involving the use of
deception to obtain an unjust or illegal advantage’. The Audit Standard on fraud, ISA 240, ‘The
Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements’, deals with the
auditor’s responsibilities relating to fraud. Specifically, it expands on how risk assessment and
response are to be applied in relation to risks of material misstatement due to fraud.

6-12. Describe the difference between financial statement fraud and misappropriation of assets.

Fraudulent financial reporting can be caused by management’s effort to manage earnings in

order to deceive financial statement users as to the company’s performance and profitability.
Such earnings management may start with small actions such as inappropriate adjustment of
assumptions or changes in judgements by management. Pressures to meet market expectations
and the desire to maximise executive compensation may cause these actions to increase until
they result in fraudulent financial reporting. On the other hand, management of some other
entities may be motivated to reduce earnings by a material amount to minimise tax or to inflate
earnings to secure bank financing.

Misappropriation of assets involves the theft of an entity’s assets and is often perpetrated by
employees in relatively small and immaterial amounts. However, it can also involve management
who are usually more able to disguise or conceal misappropriations in ways that are difficult to
detect. Misappropriation of assets is often accompanied by false or misleading records or
documents in order to conceal the fact that the assets are missing or have been pledged without
proper authorisation.
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6.7 Using the Work of Others (including ISA 610, ISA 620) and Considering

Auditee Use of Service Organisations ISA 402)

6-13. Define auditor’s expert. What must the auditor consider when evaluating the work of an
auditor’s expert?

An auditor’s expert is an individual or organisation possessing expertise in a field other than

accounting or auditing, whose work in that field is used by the auditor to assist the auditor in
obtaining sufficient appropriate audit evidence. An auditor’s expert may be either an auditor’s
internal expert (who is a partner or staff, including temporary staff, of the auditor’s firm or a
network firm), or an auditor’s external expert. The auditor must evaluate whether the auditor’s
expert has the necessary competence, capabilities and objectivity. Furthermore, the auditor must
obtain a sufficient understanding of the expert’s field of expertise to evaluate the adequacy their
work. Evaluating the work of the auditor’s expert means reviewing the relevance and
reasonableness of their findings and its consistency with other audit evidence. If that expert’s
work involves use of significant assumptions and methods, the auditor must evaluate the
relevance and reasonableness of that approach. If that expert’s work involves the use of source
data that is significant to that expert’s work, the auditor considers the relevance, completeness
and accuracy of that source data.

6-15. Planning procedures. Constantijn & Nianias, Soma Orkaton Logistons (SOLs), have been hired to
audit Eidola Company, a biochemical company listed on the Athens Stock Exchange. Constantijn &
Nianias is auditing the client for the first time in the current year as a result of a dispute between Eidola
and the previous auditor over the proper booking of sales and accounts receivable for sales of inventory
that has not been delivered but has for practical purposes been completed and sold.

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Eidola has been grown from a small start up to a highly successful company in the industry in the past
seven years, primarily as a result of many successful mergers negotiated by George Panis, the president
and chairman of the board. Although other biotech firms have had difficulty in recent years, Eidola
continues to prosper, as shown by its constantly increasing earnings and growth. Bayer, the large
German chemical company, has a special discount contract with them and represents 15 per cent of their
sales. In the last year, however, the company’s profits turned downward.

His board of directors that include many of his old university classmates generally supports Panis. The
board, which meets twice annually, recently issued a policy on corporate ethics conduct. Panis says he
owes much of his success to the hiring of aggressive young executives paid relatively low salaries
combined with an unusually generous profit-sharing plan. The corporate structure is very informal, as
Panis does not believe than any employee should have a title or a specific job description as it ‘gives
people airs’. Panis’s only corporate objective is ‘to make large profits so our stock price will increase and
our shareholders will be happy’.

The management information system at Eidola is very limited and they lack sophisticated accounting
records for a company that size. The information system will be updated this year. The personnel in the
accounting department are competent but somewhat overworked and underpaid relative to the other
employees, and therefore turnover is high. The most comprehensive records are for production and
marketing because Panis believes these areas are more essential to operations than accounting. There
are only four internal auditors and they spend the majority of their time taking inventories, which is time
consuming because inventories are located at 11 facilities in four countries.

The financial statements for the current year include a profit 20 per cent less than the last year, but the
auditors feel it should be a larger decrease because of the reduced volume and the disposal of a segment
of the business, Kata-Karpos. The disposal of this segment was considered necessary because it had
become increasingly unprofitable over the past three years. When it was acquired from Christopher
Panis, George Panis’s brother, it was considered profitable even though its largest customer was Kata-
Klino, also owned by Christopher Panis.

Eidolon is considered under-financed by market analysts. There is excessive current debt and
management is reluctant to sell equity on the capital markets because increasing the number of shares
will decrease share price. George Panis is now talking to several large companies in hopes of a merger.

Required:

1. Briefly discuss which matters Constantijn & Nianias, SOLs should consider for each of the first
three planning procedures.
2. What techniques should the auditors use to gather the needed information?

Major concerns Reasons for concern b. Investigation approach

1. Eidola Company is a publicly Low acceptable audit risk is associated with public stockholders
N/A
traded company. and governmental regulating agencies.

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Thorough research into the previous history

of the company, review of the working
Unfamiliarity with the company, its papers prepared on previous engagements
2. First-year audit. operations and its previous by the predecessor auditors, discussion with
history. the members of the previous audit team and
thorough documentation and analysis of the
company’s internal control structure.
3. Relationship with Attempt by management to record Thorough discussion with previous auditors
previous auditors was transactions improperly (i.e. as and client personnel as to the nature of
severed over accounting they had done in the previous these disputes, the handling of these items
disputes. year). and the effect on the current year.
Normally companies follow the
4. The company has trends of their industry. The
Constantijn & Nianias should be more
prospered even though company’s prosperity could
sceptical than usual and they should be
its industry as a whole indicate misrepresented financial
especially alert to signs of a downturn in
has suffered dramatic statements or a downturn several
business.
setbacks in recent years. years after the industry’s
experience.
5. Most of Eidola growth Mergers must be considered Constantijn & Nianias should review all
has come from mergers. because they involve complicated merger documents for this and the prior
transactions affecting several year.
 parties.
The board of directors might be Constantijn & Nianias should review board
6. Board of directors
overly influenced by Panis and do of directors meetings to see if the board is
include old friends and
not meet often enough to acting as a ‘rubber stamp’ for Panis’s
meet only twice per year.
adequately govern. policies.
7. Executives receive
Constantijn & Nianias should be especially
relatively low salaries Executives have an unusually
alert for the possibility of income generating
with a high proportion of high motivation to create large
transactions which are improper. They
income resulting from an profits for the company; in fact,
should develop audit procedures to test
unusually generous their existence depends on it.
revenue transactions in detail.
profit-sharing plan.
There are no job titles to reflect
8. No specific job experience, status or authority Constantijn & Nianias should examine all
description for any which may lead to insecurity of key asset controls were employees may
employee. personnel and a free for all have access for possible overrides.
attitude.
9. Panis’s corporate
A single-minded attitude to Constantijn & Nianias should review sales
objective ‘to make large
increase profits and stock price and expense cutoff, existence of accounts
profits so our stock price
may lead to abuses. receivable and accounting policies.
will increase’.

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The audit trail and the Constantijn & Nianias should be

10.The accounting records for
the company are not highly
sophisticated.
11.The personnel in the
accounting department are
being over-worked and unpaid transactions or to assure that transactions. Lack of support for
relative to other employees.
12.Only four internal auditors
whose primary work is inventory
counts.
13.The first six months’ profit
decreased by only 20% from the
previous year even though the
volume was reduced
significantly and a segment of
the business was disposed of.
14.Kata-Karpos, which was
purchased from George Panis’s prior to the purchase may
brother as an attractive
acquisition several years ago, of its sales were to a related reasonableness of the transactions
has been an unprofitable
segment. Most of the sales of
support for transactions may deliberate in their examination of detailed
be non- existent or difficult to transactions. Lack of support for
achieve. transactions should not be tolerated.
These employees may not be
motivated to achieve Constantijn & Nianias should be
accurate recording of deliberate in their examination of detailed
the proper internal controls transactions should not be tolerated.
are enforced.
Internal audit department
may not be relied upon to
There is a possibility that internal controls
assure compliance with laws
may not be relied upon (because of small
and accounting standards or
number of auditors).
effective operation of internal
controls.
The reduction in volume and
Constantijn & Nianias perform a review
disposal of the segment
have to be alert and professionally
normally would have
sceptical in their audit, in particular with
produced a more dramatic
regard to where judgement is involved.
drop in profits.
The profits of Kata-Karpos Constantijn & Nianias should investigate
the original purchase of Kata-Karpos. If
have been inflated since most possible, they should verify the
company. The sale of Kata- between Kata- Karpos and Kata-Klino
Karpos during the year could prior to the purchase of the company by
 Eidola Company. In addition, they should
Kata-Karpos were to another have been another non- investigate the sale of Kata- Karpos
company which George Panis’s arm’s-length transaction with during the current year to determine if the
brother also owns, Kata Klino. the potential for error. sales agreement is reasonable under the
circumstances.
The auditor should consider sources of
Such under financing could financing available to the company and
15.Financial analysts believe
lead to financial difficulties determine whether or not disclosure
that Eidola is severely under
and possible bankruptcy for should be made of the difficulties
financed.
the company. associated with the company’s financing
problems.

16.Panis is talking to several companies for a possible merger.

The possibility of a merger means that acceptable audit risk must be set low.

The auditors must substantially increase their substantive tests.

6-19.