Chapter 8 Audit Planning and Materiality

Planning an Audit and Designing an Audit Approach

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

There are three main reasons why the auditor should properly plan engagements:

• *Allows the auditor to gather sufficient and appropriate evidence

• Manage cost

• Avoid client misunderstandings

Much of the early planning of audits deals with obtaining information to help auditors assess the following risks:

• Acceptable audit risk

• Audit risk

• Client Business risk

• Risk of material misstatement

Acceptable audit risk:

• How willing the auditor is to accept the F/S may result in a material misstatement (due to error or fraud) after the audit is complete.

  • How much evidence and what evidence to get (sufficient and appropriate evidence)

• How willing are we (auditor) to accept that the F/S) may be materially misstated

Audit risk:

• risk the audit failed to find material fraud/error

• Risk/chance the audited financial statements contain a material misstatement

Client Business risk:

• risk the client will fail to have:

  • Reliable financial reporting

  • Efficient and effective operations

  • Compliance with laws and regulations

• (How risky is the client)

Risk of material misstatment:

• risk the F/S are materially mistated

  • pre audited (unaudited) F/S (one’s management gives to the auditor to audit)

  • What are the odds (risk) unaudited f/s have material error/fraud

Reliable financial reporting:

the more reliable the financial reporting, the less likely it is to have fraud /errors

Client business risk:

• Internal controls over financial reporting

• Journal entries

• Economic transactions

• reliable financial reporting

• Compliance with laws and regulations

• Risk assesment

Risk Assesment

• Inqury

• Analytical Procedures

• Observation

• Inspect

Economic transactions → Journal entries → Internal controls over financial reporting → Unaudited financial statements: Prepared by the client (CEO & CFO)→ Audit of F/S

Audited financial statements:

Free of material misstatement (error/fraud) (Reasonable assurance)

Initial audit planning involves 4 things that should be done early in the audit:

1. Client Acceptance and Continuance

2. Identify Client’s reason for Audit

3. Obtaining an Understanding with the Client

4. Develop Overall Audit Strategy

Client Acceptance and Continuance

• New client Investigation:

  • Investigate the company: Business model, Industry, etc

  • Audit standards require discussion with the previous auditor, and the previous auditor is required to share their work papers (one of the few times there is no client confidentiality)

• Continuing clients:

  • Are there reasons NOT to continue as the auditor

    • Reasons: Staffing, independence, ability, competence(Specialty)

    • →Decline the audit if the auditor cannot get audit risk to an acceptable level

Identify Client’s reason for Audit

• Auditor’s acceptable audit risk affected

  • Ex: Private company looking for a bank loan vs. regulatory compliance audit

Obtaining an Understanding with the Client

Auditing standards require an engagement letter

• Lay out fees/timing/scope

• *Will NOT disclose: Audit strategy or Materiality

Develop Overall Audit Strategy

• Develop (and document) Preliminary audit strategy (scope, timing, direction of audit)

  • Guides audit plan

  • Will change as you learn new information

Required to perform Risk Assesment procedures:

Obtain audit evidence to identify and assess the risk of material misstatement and for design further audit procedures

Risk assessment procedures include (4types of evidence)

• Inquiries of management or others within the entity

• Analytical Procedures, and

• Observation and Inspection of client operations (Efficent, Internal controls), policies (what are their accounting policies(Documants showing the accounting treatment)), and other documents and records

Obtain an understanding of: GOOGLE

• Industry and external environment

  • Ex: Industry: Tech,

  • External: things outside of the client's control: Regulation, competitors, macroeconomic trends

  • Google operating enviornment

• Business operations and processes

  • Ex: Revenue model, payment and collection, public or private

  • Point of sale, contract revenue, larger A/R balance

• Management and governance

  • Ex: How is it run, who’s the CEO, Board/Audit committee, Tone at the top

  • Who are they, what’s their experience

• Client objectives and strategies

  • Ex: Growth/growth strategy, where is management taking the company

  • Sales growth, inovation

• Measurement and performance

  • Ex: How are things like revenue, reward points, warranties measured? Look at trends

  • Analytical Procedures (industry comparisons, year to year), Read accounting policies

Strategic Understanding of the Client’s Business and Industry

1. Industry and external enviornment

2. Business operations and processes

3. Managment and governance

4. Objectives and stratigies

5. Measeurment and performance

Auditors are Required to perform preliminary analytical procedures as part of

risk assessment procedures (Planning analytical procedures)

• Better understand client’s business and industry

  • and assess client business risk

Preliminary analytical tests can:

• Reveal Unusual changes in ratios compared to prior years or industry averages

• Identify areas with Increased risk of misstatement

  • Allows the auditor to perform additional procedures

    • Ex: Dutch bros→ 2 years revenue doubled

      • Not proof of anything, but this would indicate a potential risk → plan additional procedures

• Auditing standards define materiality as:

  • 
    

• The Magnitude of misstatements, including omissions, that individually, or when aggregated with other misstatements, are substantially likely to influence the judgment made by a reasonable user of the financial statements

  • Individual: 1 misstatement of $10 mil

  • Aggregate: 10 misstatements of $1 mil ($10 mil aggregate)

    • Both are material

Auditors follow five related steps in applying materiality:

1. Set the materiality for the financial statements as a whole

2. Determain Performance Materiality

3. Estimate total mistatment in segment

4. Estimate the combined misstatment

5. Compare combined estimet with preliminary or revised judgment about materiality

Factors affecting Preliminary materiality judgment include:

• Materiality is a relative rather than an absolute concept

  • Makes benchmarks (#) necessary (But not absolute)

  • Qualitative & Quantitative factors affect materiality

  • Usually set materiality (overall materiality) with a rule of thumb

    • % of sales, net income, assets

      • Ex: 1% of sales

Performance materiality is defined as:

• The amount(s) set by the auditor at less than materiality for the financial statements as a whole (Overall materiality) 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

• Break up overall materiality to a lower level or amount for the various segments or cycles of the audit

  • In other words: take overall materiality, make a smaller amount for the cycles to ensure that when they're added together, misstatements are not more than overall materiality

Note: performance materiality is

Inversely related to the amount of evidence an auditor will accumulate

• HIGHTER MATERIALITY=LESS EVEDENCE

• The process of determining performance materiality is referred to as

• the allocation of the preliminary judgment about materiality (Overall materiality) to segments

  • Allocating materiality

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: tolerable misstatement = performance materiality

  • *AICPA: Tolerable mistament→ application of performance materiality to a specific sample or procedure

    • We will use this definition in class

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

• Certain accounts have more misstatements

• Overstatements and understatements must be considered

• Relative audit costs affect the allocation

When auditors perform audit procedures for each segment of the audit, they document two types of misstatements:

• Known misstatements

• Likely misstatements

Known misstatements

• Determine the exact amount of the misstatement

  • *→ invoice 50% sale should be $10500; J/E posted for $100500 →issue is $90000→KNOW

Likely misstatement

• Differences between management and auditor estimates

  • Warrant expense: Pixel Google says .5% Warranty, 10000000*.005= 50000

  • Auditor days 1.0%, 10000000*.01=100000

    • 2x difference

• Projections of misstatements based on audit samples (Excel example)