chp 8 - audit planning & materiality

what is phase 1 of audits?

plan and design an audit approach based on risk assessment procedures

what’s the first step of phase 1

accept client and perform initial audit planning

• are we going to accept the client?

new vs. continuing clients

continuing client:

• annual reassessment of if firm wants to serve client

new client:

• a lot of background research

• the biggest thing: can we serve this client?

  • are we independent

  • do we have enough expertise for their industry

  • do we have enough resources

what must we obtain to show that we have an understanding with the client?

an engagement letter

• signed by both the auditor and management

• defines our role as auditors

  • what are we providing vs. what are we not

  • fees

when performing our initial audit planning we must…

determine overall audit strategy

• what firm resources do we need for this client?

  • staffing, expertise level, etc

what are the 3 basic preliminary planning procedures?

1. understand the client’s business and industry

2. assess client’s business risk

3. perform preliminary analytical procedures

what are the two things you must understand to know your client’s business and industry?

1. industry & regulatory environment

2. client business operations

industry & regulatory environment

• industry-specific accounting standards: revenue recognition, inventory costing

• regulatory requirements (SEC, FDA, banking) affecting financial reporting

• competitive dynamics explaining margin trends and pricing pressures

client business operations (this also kind of plays into client’s business risk)

• business model: how does company actually make money?

• key customer/supplier relationships — concentration risk?

• significant contracts, commitments, and off-balance-sheet arrangements

• related-party transactions — heightened scrutiny required

client’s business risk

• threats to client’s objectives that may cause misstatement

• examples: market disruption, litigation, financing risk, obsolete inventory

what is the purpose of performing preliminary analytical procedures?

identify areas where misstatements are likely — guides audit effort

3 potential comparison approaches for analytical procedures

1. evaluate interim financial statements

   1. compare YTD CY v. PY same period — what changed and why?

   2. flag unusual fluctuations in revenue, expenses, margins, or specific accounts

2. ratio analysis over time (trend analysis)

   1. track current ratio, AR turnover, inventory turnover, gross margin over time

   2. unexplained improvement is as concerning as deterioration

3. comparison with competitors & industry benchmarks

   1. if inventory turnover is 2x the industry average — why?

   2. industry data: risk management association (RMA), Bloomberg, S&P

definition of materiality

FASB: magnitude of omission or misstatement of accounting info that makes it probable that the judgement of a reasonable person relying on the info would have been changed or influenced

SCOTUS: “substantial likelihood that the fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.”

breaking down materiality

• magnitude: a threshold concept — not every error matters

• surrounding circumstances: context matters enormously

• reasonable person: a sophisticated user - not an expert, but financially literate

• would have been changed or influenced: materiality is about decision relevance

key implication: materiality is a JUDGEMENT CALL — no single correct answer exists

materiality is measured in 2 ways

1. quantitative

2. qualitative

can the same dollar amount be material for one company and not another?

yes! materiality must always be assessed relative to entity size and context — NEVER in isolation

materiality benchmarks

because materiality is judgmental, there are benchmarks as starting points

warning: starting point, not the final answer

common benchmarks:

• net income before taxes (~5%)(most common for profitable companies)

• net revenues/total revenues (1-2%)

• total assets (1-3%)

• current assets (3-6%)

• current liabilities (3-6%)

which benchmark depends on what users focus on

• creditors focus on: assets, cash flow, liabilities

• investors focus on: net income, EPS, revenue growth

• loss or breakeven companies: use revenues or total assets (not net income)

using materiality: three-step application

** materiality is not set once and forgotten - it is used throughout the audit

step 1: determine preliminary materiality judgment

step 2: set performance materiality by account

step 3: evaluate audit findings at conclusion

step 1: determine preliminary materiality judgment

• select appropriate audit benchmark; apply percentage range

• adjust for qualitative factors (nature of item, regulatory implications)

• made during planning, but may be updated throughout the audit

more on step 1:

• considers the financial statements as a whole

• represents the maximum amount by which the auditor believes the F/S could be misstated and still not affect decisions of reasonable users

• used to help plan the appropriate evidence to accumulate

  • the lower the dollar amount, the more evidence required

step 2: set performance materiality by account

• Allocate lower thresholds to high-risk, high-balance accounts

• Performance materiality determines sample sizes and extent of testing

step 3: evaluate audit findings at conclusion

• Aggregate all uncorrected misstatements found during the audit

• If total misstatements < overall materiality: financial statements are fairly presented

• If total misstatements > overall materiality: material misstatement — require adjustment or qualify opinion

Performance Materiality (Tolerable Misstatement) (step 2)

Problem: Overall materiality = $1M. You find $950K of errors. Is that OK?

• Not necessarily — because you have NOT audited 100% of transactions.

So the solution is to use a performance materiality (Tolerable Misstatement):

• Materiality applied at the ACCOUNT or ASSERTION level

• Set LOWER than overall materiality — buffer for undetected errors in untested areas

• Aggregate errors across all accounts should stay below overall materiality

Key characteristics:

• Can differ by account — higher-risk accounts get LOWER performance materiality

• Drives sample sizes: lower performance materiality = larger sample required

• Typically set at 50%-75% of overall materiality (varies by firm)

Example: Overall materiality $1M; performance materiality for inventory = $500K