Chapter 8.2 Audit Planning and Materiality

Audit Planning: 8 steps

1. Accept client and perform initial audit planning

2. understand the client’s business and industry

3. perform preliminary analytical procedures

4. set preliminary judgment of materiality and performance materiality

5. identify significant risks due to fraud or error

6. assess inherent risk

7. understand internal control and assess control risk

8. finalize overall audit strategy and audit plan

Understanding the Client’s Business and Industry; AICPA Principle states

the auditor identifies and assesses risks of material misstatement, whether due to error or fraud, based on an understanding of the entity and its environment, the applicable financial reporting framework, and the entity’s internal control

Auditing Standards require the auditor to

• perform risk assessment procedures to obtain audit evidence that provides an appropriate basis for identifying and assessing risks of material misstatement, whether due to error or fraud, and designing further audit procedures

Risk Assessment procedures consist of

• inquires

• inspections and observations

• analytical procedures

Understanding the Client’s Business and Industry

• industry and external environment

• business operations and processes

• management and governance

• objectives and strategies

• measurement and performance

Industry and External Environment

1. Risks associated with specific industries: affect the auditor’s assessment of client business risk and acceptable audit risk

• financial services

• health insurance

2. Inherent risks common to all clients in certain industries:

• fashion clothing industry (inventory)

• consumer loan industry (accounts receivable)

3. Unique accounting requirements

• audit of a city government, auditor must understand governmental accounting and auditing requirements

• construction companies, railroads, not for profit organizations, financial institutions

External: wide volatility in economic conditions, technological developments, cyclical or seasonal activity, extent of competition, and regulatory requirements

Business Operations and Processes

The auditor should understand

• major source of revenue

• key customers and suppliers

• sources of financing

• information about related parties

Ex: if dependent on a few major customers could result in bad debt or obsolete inventory, dependent on few products could be obsolete in tech fields

Business Operations and Processes

Tour the Plant and Offices

by viewing the physical facilities, the auditor can assess physical safeguards over assets, interpret accounting data related to assets (inventory in process and factory equipment), or observe activities that may impact the need for disclosures triggered by activities affecting the environment

Business Operations and Processes

Identify Related Parties

• Entity that has the ability to significantly influence management or operating policies of the reporting entity

  • Management & members of immediate family

  • Principal owners & members of immediate family

  • Affiliates

  • Entities for which investments are accounted for by the equity method

  • Trusts for the benefit of employees that are managed by management

The Auditor disclosure requirement includes

• determine that related party transactions are properly disclosed in the auditor’s permanent files

  • nature of the relationship

    • description of transaction

    • dollar amounts of transactions

    • amounts due to and due from related parties

Auditing standards require the auditor to ask management to

• Determine the existence of related parties

• identify transactions with related parties

• type and purpose of transaction

• examine related party transactions: obtain an understanding of controls that management has established to identify, authorize, and approve related party transactions, including reasons for exceptions to the entity’s policies and procedures if any have been granted

Auditors must also make inquiries of

• concerns they may have about the entity’s relationships and transactions with related parties reported to those charged with governance

• learn about related parties by reviewing SEC filings and examining stockholders’ listings to identify principal stockholders.

Sarbanes-Oxley Act of 2002

prohibits related party transactions that involve personal loans to officers or directors

exception; banks are permitted to make loans to directors and officers using market rates

Management and Governance

Management establishes the strategies and processes followed by the client’s business

An auditor should assess management’s philosophy and operating style and its ability to identify and respond to risk, as these significantly influence the risk of material misstatements in the financial statements

Governance includes the client’s organizational structure, as well as the activities of the board of directors and the audit committee

• corporate charter and bylaws

• code of ethics

• meeting minutes

Code of Ethics

In response to the Sarbanes-Oxley Act, the SEC now requires each public company to disclosure whether it has adopted a code of ethics that applies to senior management

• The SEC also requires companies to disclose amendments and waivers to the code of ethics

company that has not adopted such a code must disclose this fact and explain why it has not done so.

Growing stakeholder interest in environmental, social, and governance (ESG) matters

Social component: entity’s values, business relationships, human capital, product quality and safety, and diversity and inclusion policies and efforts

Governance: system of rules, practices, and processes for overseeing those kinds of issues

Minutes of Meetings

• official record of the meetings of the board of directors and stockholders.

• include key authorizations and summaries of the most important topics discussed at these meetings and the decisions made by the directors and stockholders

• Example

  • compensation of officers

  • new contracts and agreements

  • acquisitions of property, loans, and dividend payments

  • discussions about litigation

  • a pending issuance of stock

  • potential merger

• SHOULD BE INCLUDED IN AUDIT FILES

Client Objectives and Strategies

strategies are approaches followed by the entity to achieve organizational objectives

Auditor should understand client objectives

• reliability of financial reporting

• efficiency and effectiveness of operations

• compliance with laws and regulations

As part of understanding the client’s objectives related to compliance with laws and regulations, the auditor should become familiar with the terms of client contracts and other legal obligations.

long-term notes and bonds payable, stock options, pension plans, contracts with vendors for future delivery of supplies, government contracts for completion and delivery of manufactured products, royalty agreements, union contracts, and leases

Measurement and Performance

The client’s performance measurement system includes key performance indicators like

• market share

• sales per employee

• unit sales growth

• web site visitors

• same store sales

• sales/square foot

Inherent risk of financial statement misstatements may be increased if the client has set unreasonable objectives or if the performance measurement system encourages aggressive accounting

Performance measurement includes ratio analysis and benchmarking against key competitors

Preliminary Analytical Procedures

• Auditors perform preliminary analytical procedures to better understand the client’s business and to assess business risk.

• For example, a comparison of client ratios to industry or competitor benchmarks provides an indication of the company’s performance.

• Such tests can identify unusual changes and help the auditor identify areas with increased risk of misstatements.

Examples of Planning analytical procedures

Short-term debt-paying ability: current ratio

Liquidity activity ratio: inventory turnover

Ability to meet long-term obligations: Debt to equity

Profitability ratio: Profit Margin

Materiality

The magnitude of an omission or misstatement of accounting information that 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.

To apply materiality in practice, auditors need to know the users of the client’s financial statements and the decisions that are being made

Performance Materiality

The amount 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.

(Arens uses the term “preliminary judgment of materiality” for performance materiality at the financial statement level.)

Performance Materiality

refers to the amount or amounts set by the auditor at less than the materiality level or levels for particular classes of transactions, account balances, or disclosures.

(Arens uses the term “performance materiality” for classes of transaction, account balances, and disclosures.

Steps in Applying Materiality

1. Set preliminary judgment about materality

2. determine performance materality

Planning extent of tests

3. Estimate total misstatement in segment

4. Estimate the combined misstatement

5. Compare combined estimate with judgment about materiality

evaluating results

Set preliminary judgment

The preliminary judgment about materiality is the maximum amount by which the auditor believes the statements could be misstated and still not affect the decisions of reasonable users.

Preliminary judgment = Materiality - $1

Factors Affecting Judgment

1. Materiality is a relative rather than an absolute concept: what is material depends on the size of company

2. bases are needed for materiality: benchmarks (Net income, net sales, gp, net assets)

3. qualitative factors affect materiality: fraud more important than unintentional errors, misstatements with possible consequences from contractual obligation eg a loan, affect a trend in earnings

Relative v Absolute Concept

Given: $10 Million misstatement

Conclusion: Misstatement is material for Hillsburg Hardware

Total Assets = $61 Million

 Income before Taxes = $6 Million

Given: $10 million misstatement

Conclusion: Misstatement is immaterial for IBM

Total Assets = $ 117 Billion

Income before Taxes = $ 12 Billion

bases are needed for materiality

Primary base- Net income before taxes

Other primary bases

• Net sales

• Gross profit

• Total assets or Net assets

Secondary bases

• Current assets

• Current liabilities

• Stockholders' equity

• Total assets

Qualitative Factors- Fraud

Fraud

Misstatements involving fraud are more important than unintentional errors of equal dollar amounts.

Example:

An intentional misstatement of inventory is more important than a clerical error in inventory of the same dollar amount.

Qualitative Factors- Contractual obligations

Contractual obligations

Misstatements that are minor may be material if there are possible consequences arising from contractual agreements.

Example:

An immaterial misstatement that overstates working capital so that it meets the required minimum in a loan agreement may be material.

Qualitative Factors- Trend in Earnings

Trend in earnings

• An immaterial misstatement may be material if it affects a trend in earnings.

Examples

• An immaterial misstatement that allows a company to achieve a continued 3% growth in annual earnings may be material.

• An immaterial misstatement that causes a loss to be reported as a profit may be material.

Illustrative Materiality Guidelines

Professional judgment is to be used at all times in setting and applying materiality guidelines. As a general guideline, the following policies are to be applied:

1. The combined total of misstatements in the financial statements exceeding 6 percent is normally considered material. A combined total of less than 3 percent is presumed to be immaterial in the absence of qualitative factors. Combined misstatements between 3 percent and 6 percent require the greatest amount of professional judgment to determine their materiality.

2. The 3 percent to 6 percent must be measured in relation to the appropriate benchmark. Many times there is more than one benchmark to which misstatements should be compared. The following guides are recommended in selecting the appropriate benchmark:

   1. Income statement. Combined misstatements in the income statement should ordinarily be measured at 3 percent to 6 percent of operating income before taxes. A guideline of 3 percent to 6 percent may be inappropriate in a year in which income is unusually large or small. When operating income in a given year is not considered representative, it is desirable to substitute as a benchmark a more representative income measure. For example, average operating income for a 3-year period may be used as the benchmark.

   2. Balance sheet. Combined misstatements in the balance sheet should originally be evaluated for current assets, current liabilities, and total assets. For current assets and current liabilities, the guidelines should be between 3 percent and 6 percent, applied in the same way as for the income statement. For total assets, the guidelines should be between 1 percent and 3 percent, applied in the same way as for the income statement.

3. Qualitative factors should be carefully evaluated on all audits. In many instances, they are more important than the guidelines applied to the income statement and balance sheet. The intended uses of the financial statements and the nature of the information in the statements, including footnotes, must be carefully evaluated.

Allocate Preliminary Judgment about Materiality to Segments

This step is necessary because evidence is accumulated by segments rather that for the financial statements as a whole.

Most practitioners allocate materiality to balance sheet accounts.

Most income statement misstatements have  an equal effect on the balance sheet.

There are fewer balance sheet accounts than income statement accounts in most audits.

Allocate Preliminary Judgment about Materiality to Segments

AICPA vs PCAOB

Performance Materiality (AICPA)

Tolerable Misstatement (PCAOB)

Materiality allocated to any given account balance

reflects the amount of misstatement an auditor is willing to accept in a particular segment

Auditors face three major difficulties in allocating materiality to balance sheet accounts

Auditors expect certain accounts to have more misstatements than other accounts.

Both overstatements and understatements must be considered.

Relative audit costs affect the allocation.

Types of misstatements

Known misstatements- those where the auditor can determine the amount of the misstatement in the account. For example, when confirming accounts receivable, the auditor may identify a sales transaction incorrectly recorded in the wrong fiscal period due to a cutoff error

Likely misstatements

Differences between management’s judgment and the auditor’s judgment about estimates of account balances: differences in the estimate for the allowance for uncollectible accounts or for warranty liabilities

Projections of misstatements based on the auditor’s tests of a sample from a population

Estimated Total Misstatement

Net misstatement of the sample / total sampled x Total recorded population value = Direct projection estimate of misstatement

n8-23

8-24

8-25 (CPA Exam Multiple Choice)

n8-26 (Becker CPA Exam Multiple Choice)

n8-27 (Audit planning)

n8-32 (Preliminary Analytical Procedures)

n8-34 (Evaluating audit results for assets in the audit of Roberts Manufacturing.)

??

Analytical Procedures used in planning an audit should focus on identifying

1. material weaknesses in the system of internal control.

2. the predictability of financial data from individual transactions.

3. the various assertions that are embodied in the financial statements.

4. areas that may represent specific risks relevant to the audit.

4

• Which of the following will most likely indicate the existence of related parties?

  1. (1)Writing down obsolete inventory prior to year end

  2. (2)Failing to correct deficiencies in the client’s system of internal control

  3. (3)An unexplained increase in gross margin

  4. (4)Borrowing money at a rate significantly below the market rate

4

• Which of the following is least likely to be included in the auditor’s engagement letter?

  1. (1)Details about the preliminary audit strategy

  2. (2)Overview of the objectives of the engagement

  3. (3)Statement that management is responsible for the financial statements

  4. (4)Description of the level of assurance obtained when conducting the audit

1

• In which of the following circumstances would an auditor of an issuer be least likely to reevaluate established materiality levels?

  (1)The materiality level was established based on preliminary financial statement amounts that differ significantly from actual amounts.

  • (2)The client disposed of a major portion of the client’s business.

  • (3)The client released third-quarter results before the SEC-prescribed deadline.

  • (4)Significant new contractual arrangements draw attention to a particular aspect of a client’s business that is separately disclosed in the financial statements.

3

• Which of the following procedures would a CPA least likely perform during the planning stage of the audit?

• (1)Determine the timing of testing

  • (2)Take a tour of the client’s facilities

  • (3)Perform inquiries of outside legal counsel regarding pending litigation

  • (4)Determine the effect of information technology on the audit

3

A successor auditor’s inquiries of the predecessor auditor should include questions regarding

(1)the number of engagement personnel the predecessor assigned to the engagement.

(2)the assessment of the objectivity of the client’s internal audit function.

(3)communications to management and those charged with governance regarding significant deficiencies in the system of internal control.

(4)the response rate for confirmations of accounts receivable.

3

• Review accounting principles unique to the client’s industry

2- Understand the client’s business and industry

• 2.Determine the likely users of the financial statements

1- Accept client and perform initial audit planning

• 3.Evaluate the appropriate financial statement measures for determining amounts likely to be considered material by users of the financial statements

4- Set preliminary judgment of materiality and performance materiality

• 4.Identify whether any specialists are required for the engagement

1- Accept client and perform initial audit planning

• 5.Send an engagement letter to the client

1- Accept client and perform initial audit planning

• 6.Tour the client’s plant and offices

2-  Understand the client’s business and industry

• 7.Specify materiality levels to be used in testing of accounts receivable

4- Set preliminary judgment of materiality and performance materiality

• 8.Compare key ratios for the company to those for industry competitors

3- Perform preliminary analytical procedures

• 9.Review management’s risk management controls and procedures

2- Understand the client’s business and industry

• 10.Identify potential related parties that may require disclosure

2- Understand the client’s business and industry

• When approached to perform an audit for the first time, the CPA should make inquiries of the predecessor auditor. This is a necessary procedure because the predecessor may be able to provide the successor with information that will assist the successor in determining whether

• 1. (1)the predecessor’s work should be used.

  2. (2)the company follows the policy of rotating its auditors.

  3. (3)in the predecessor’s opinion, the system of internal control of the company has been satisfactory.

  4. (4)the engagement should be accepted.

4

• A successor would most likely make specific inquiries of the predecessor auditor regarding

• 1. (1)specialized accounting principles of the client’s industry.

  2. (2)the competency of the client’s internal audit staff.

  3. (3)the uncertainty inherent in applying sampling procedures.

  4. (4)disagreements with management as to auditing procedures

4

• Which of the following circumstances would most likely pose the greatest risk in accepting a new audit engagement?

• 1. (1)Staff will need to be rescheduled to cover this new client.

  2. (2)There will be a client-imposed scope limitation.

  3. (3)The firm will have to hire a specialist in one audit area.

  4. (4)The client’s financial reporting system has been in place for 10 years.

2

• Which one of the following statements is correct concerning the concept of materiality?

• 1. (1)Materiality is determined by reference to guidelines established by the AICPA.

  2. (2)Materiality depends only on the dollar amount of an item relative to other items in the financial statements.

  3. (3)Materiality depends on the nature of an item rather than the dollar amount.

  4. (4)Materiality is a matter of professional judgment.

4

• In considering materiality for planning purposes, an auditor believes that misstatements aggregating $10,000 will have a material effect on an entity’s income statement, but that misstatements will have to aggregate $20,000 to materially affect the balance sheet. Ordinarily, it is appropriate to design audit procedures that are expected to detect misstatements that aggregate

• 1. (1)$20,000.

  2. (2)$15,000.

  3. (3)$10,000.

  4. (4)$30,000.

3

• A client decides not to record an auditor’s proposed adjustments that collectively are not material and wants the auditor to issue the report based on the unadjusted numbers. Which of the following statements is correct regarding the financial statement presentation?

• 1. (1)The financial statements are free from material misstatement, and no disclosure is required in the notes to the financial statements.

  2. (2)The financial statements do not conform with generally accepted accounting principles (GAAP).

  3. (3)The financial statements contain unadjusted misstatements that should result in a qualified opinion.

  4. (4)The financial statements are free from material misstatement, but disclosure of the proposed adjustment is required in the notes to the financial statements.

1