Chapter 3

Audit Planning,
Types of Audit
Tests, and
Materiality

McGraw-Hill/Irwin

Copyright © 2012 by The McGraw-Hill Companies, Inc. All

The Phases of an Audit That Relate to Audit
Planning

LO# 1

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Do we want the client?
CLIENT ACCEPTANCE?
or
CLIENT CONTINUANCE?
The decision is linked closely to Auditor Business Risk &
Audit Risk (AR, IR, CR, DR)
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Do we want the client?
AICPA Statement on Quality Control Std. No. 7
Policies and procedures should be established for deciding whether to
accept or continue a client relationship and whether to perform a
specific engagement for that client. Such policies and procedures should
provide the firm with reasonable assurance that the likelihood of
association with a client whose management lacks integrity is
minimized.
Such policies and procedures should also provide reasonable assurance
that the firm…appropriately considers the risks associated with
providing professional services in the particular circumstances.
To minimize the risk of misunderstandings regarding the nature, scope, and
limitations of the services to be performed, policies and procedures
should provide for obtaining an understanding with the client regarding
those services. Professional standards may provide guidance in deciding
whether the understanding should be oral or written.

Prospective Client
Acceptance
1. Obtain and review financial information.

LO# 1

2. Inquire of third parties regarding client
integrity.
3. Consider unusual business or audit risks.
4. Determine if the firm is independent.
5. Determine if the firm has the necessary
skills and knowledge.
6. Determine if acceptance violates any
applicable regulatory agency
requirements or the Code of Professional
Conduct.

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LO# 1

Continuing Client Retention
Evaluate client
retention periodically

Near audit completion
or after a significant
event

Conflicts over
accounting and
auditing issues

Dispute over fees

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Preliminary Engagement
Activities

LO# 2

Determine the Audit
Engagement Team
Requirements

Assess Compliance with
Ethical Requirements,
Including Independence
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Establish Terms of the
Engagement

LO# 3

In establishing the terms of the engagement,
three topics must be discussed:
1.The engagement letter;
2.Using the work of the internal auditors;
and
3.The role of the audit committee.

The terms of the engagement, which are documented in
the engagement letter, should include the objectives of
the engagement, management’s responsibilities, the
auditor’s responsibilities, and the limitations of the
engagement.
Who signs the engagement letter?
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LO# 4

The Engagement Letter
The engagement letter formalizes the arrangement reached
between the auditor and the client.
In addition to the items mentioned in the
sample engagement letter in Exhibit 3-1 in
the textbook, the engagement letter may
include:

• Arrangements for use of specialists or
internal auditors.

• Any limitations of liability of the auditor
or client.

• Additional services to be provided.
•Arrangements regarding other services.

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LO# 5

Internal Auditors

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LO# 6

The Audit Committee
Subcommittee
of the board of
directors
No specific
requirements
for privately
held companies

Section 301 of Sarbanes-Oxley Act requires the
following for audit committee members of
publicly held companies:

•Member of board of directors and independent.
•Directly responsible for overseeing work of any

registered public accounting firm employed by the
company.

•Must preapprove all audit and nonaudit services
provided by its auditors.

•Must establish procedures to follow for complaints.
•Must have authority to engage independent counsel.
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LO# 7

Planning the Audit
• The auditor will develop an overall audit strategy for
conducting the audit. This will help the auditor to
determine what resources are needed to perform
the engagement.
• An audit plan is more detailed than the audit
strategy.
• Basically, the audit plan should consider how to
conduct the engagement in an effective and
efficient manner.

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LO# 7

Planning the Audit
When preparing the audit plan, the auditor should be guided
by the results of the client acceptance/continuance process,
procedures performed to gain an understanding of the entity,
and preliminary engagement activities.
Additional steps:
•Assess business risks.
•Establish materiality
•Consider multilocations.
•Assess the need for specialists.
•Consider violations of laws and regulations
•Identify related parties.
•Consider additional value-added services
•Document the overall audit strategy, audit

Let’s look at each
of these steps.

plan, and prepare audit programs.

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LO# 7

Assess Business Risks
To understand the
client’s business
and transactions

To identify
financial statement
accounts likely to
contain errors

By understanding the client’s business and identifying
where errors are likely to occur, the auditor can allocate
more resources to investigate necessary accounts.
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LO# 7

Establish Materiality
Establish overall
materiality
(more on this later!)

Establish tolerable
misstatement for
accounts

Establish tolerable
misstatement for
disclosures

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LO# 7

Consider Multilocations or
Business Units
Consolidated
Financial
Statements

High Risk

Moderate
Risk

Low
Risk

The auditor correlates the amount of audit attention devoted to the location or
business unit with the level of risk present.
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LO# 7

Use of Specialists
A major consideration in planning the audit is the need for
a specialist.
The use of an IT specialist
is a significant aspect of
most audit engagements.
The presence of complex
information technology
may require the use of an
IT specialist.

What other types of
specialists might be
needed?
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Consider Violations of Laws
and Regulations

LO# 7

Illegal
Acts
Direct and
Material

Material and
Indirect

Consider laws
and regulations
as part of audit

Be aware may have
occurred;
investigate if
brought to attention
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LO# 7

Illegal Acts

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LO# 7

Related Parties
Some examples from FASB ASC Topic
850, “Related Party Disclosures”

•Affiliates of the enterprise.
•Entities using equity method to
account for investments.

How to Identify
Related Parties

•Review board minutes.
•Review conflict-of-interest
statements.

•Trusts for benefit of employees.
• Financial and reporting
information provided to creditors,
•Principal owners of enterprise.
investors, and regulators.
•Management.
•Contracts or other agreements
•Immediate families of the principal with major customers, vendors,
owners and management.

and management.

•Other parties that can have

•Review significant unusual

significant influence.

transactions.

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LO# 7

Additional Value-Added
Services
Tax Planning

System
Design and
Integration

Internal
Reporting

Risk
Assessment

Benchmarking

Electronic
Commerce

Auditors who audit public companies are limited in
the types of consulting services that they can offer
their audit clients.
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LO# 7

Document Audit
Strategy and Plan
Document overall audit strategy and
audit plan, which involves documenting
the decisions about

Nature

The auditor documents how the
client is managing its risk (via
internal control processes) and
the effects of the risks and
controls on the planned audit
procedures.

Timing

Auditors ensure they have addressed the risks they
identified by documenting the linkage from the
client’s business, objectives, and strategy to the
audit plan.

Extent

The auditor’s preliminary decision concerning
control risk determines the level of control testing,
which in turn affects the auditor’s substantive tests
of the account balances and transactions.

A
U
D
I
T
T
E
S
T
S

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LO# 7

Document Audit Strategy

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LO# 8

Supervision of the Audit
• Engagement partner and other supervisory
members of the team:
• Inform engagement team members of their
responsibilities
• Direct engagement team members to identify
and communicate audit issues
• Review the work of the engagement team
members

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LO# 9

Types of Audit Tests
Risk Assessment
Procedures

Used to obtain an understanding of
the entity and its environment,
including its internal control.

Tests of Controls

Directed toward the evaluation of the
effectiveness of the design and
operation of internal controls.

Substantive
Procedures

Detect material misstatements in a
transaction class, account balance,
and disclosure component of the
financial statements.
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LO# 9

Tests of Controls
Inquiry

Inspection
Observation

Walkthrough

Reperformance

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LO# 9

Tests of Controls

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LO# 9

Substantive Procedures
Tests of
Details

Analytical
Procedures

Tests for errors or
fraud in individual
transactions,
account balances,
and disclosures

Evaluations of financial
information through analysis
of plausible relationships
among financial and nonfinancial data

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LO# 9

Dual-Purpose Tests
Substantive
Tests of
Transactions

Tests of
Controls

DualPurpose
Tests

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LO# 10

Materiality
The United States Supreme Court
interpretation of materiality is that a fact
is material if there is “a substantial
likelihood that the…fact would have been
viewed by the reasonable investor as
having significantly altered the ‘total mix’
of information made available.”
Materiality is not an absolute and
it is not a black or white issue!
The determination of materiality
requires professional judgment.
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Steps in Applying Materiality
on an Audit

LO# 11

Step 1:
Determine a materiality level for the overall financial statements
(planning materiality)

Step 2:
Determine tolerable misstatement
(allocation of materiality at individual account/class of transactions level)

Step 3:
Evaluate auditing findings
(near the end of the audit)
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LO# 11

Step 1 – Determine Overall
Materiality
The quantitative base for
materiality is a percentage of:

The quantitative amounts
may be adjusted lower for
qualitative factors such as:

• Income before taxes.

• Material misstatements in
prior years.

•Income from continuing
operations.

• Potential for fraud or
illegal acts.

•Three year average income.

• Potential loan covenant
violations.

•Total assets.
•Total revenues.
• Gross profit.

• High market pressures.
• High fraud risk.
• Higher than normal risk
of bankruptcy.
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Materiality Examples
Constant %
5% of pretax income
1/2% of total assets
1% of total equity
1/2% of total revenues

Sliding scale
2-5% of GP if between $0-20k
1-2% if between $20,000-1M
1/2-1% if between $1M-100M
1/2% if over $100M

Blends
averages diff. methods
Other
1.6(greater of assets or revs)2/3
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LO# 11

Step 2 –Determine Tolerable
Misstatement
Tolerable misstatement is the amount of
planning materiality allocated to an account or
class of transactions. Combined tolerable
misstatement is generally greater than planning
materiality because:


Not all accounts will be misstated by their full tolerable
misstatement allocation.
Audits of individual accounts are conducted simultaneously.
Materiality is often a small fraction of the account being
audited and planned procedures will be sufficiently precise
to identify significant misstatements.
When errors are identified, additional testing is typically
performed in that account and related accounts.
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Overall materiality serves as a “safety net.”

Step 3 – Evaluate Audit
Findings

LO# 11

When the audit evidence is gathered, the
auditor:

Aggregates misstatements from each account or
class of transactions (including known and likely
misstatements).
Considers the effect of misstatements not adjusted
in the prior period.
Compares the aggregate misstatement to planning
materiality.
If the aggregate misstatement is less than
planning materiality, the auditor can conclude that
the financial statements are fairly presented, if
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not, an adjustment should be made.

End of Chapter 3

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