ch 3 audit: Audit Planning, Types of Audit Tests and Materiality
Chapter 3: Audit Planning, Types of Audit Tests and Materiality
Prospective Clients
A new auditor must request permission from the prospective client to contact the prior (old) auditor.
Inquiries to the Predecessor Auditor
Information regarding the integrity of management.
Disagreements with management concerning:
Accounting policies.
Auditing procedures.
Other significant matters.
The reason for the auditor change.
Any need for discussion regarding:
Fraud.
Noncompliance with laws and regulations.
Significant deficiencies or material weakness in internal controls.
Request prior year audit workpapers to:
Help understand the client's business.
Verify the end-of-year balances.
Other Procedures to Evaluate a Prospective Client
Obtain financial information.
Ask third parties (e.g., the client's bankers and lawyers) for information on the client and the integrity of management.
Conduct background checks on management.
Assess whether there are any issues that would demand special attention or involve extra risk, such as:
Industry-specific risks.
Going concern issues. A "going concern" exists when there is substantial doubt about the company's ability to continue for the next 1 year.
Determine if the accounting firm is independent of the client.
Assess if the firm possesses the necessary technical skills and industry knowledge.
Auditor Independence
Independent in fact: The auditor's mental attitude of being unbiased and impartial when performing the audit.
Independent in appearance: Auditors should avoid circumstances that might cause others to perceive their independence may be compromised.
Opinion shopping: When a client consults with multiple auditors to find one who will agree with the client's preferred accounting treatment.
Evaluate Continuing Clients
Reasons an auditor might not want to continue the auditor-client relationship:
Disputes over accounting or auditing issues.
Dispute over audit fees.
Changes in senior management, legal requirements, or reporting requirements.
Significant change in the nature of the client's business.
Significant change in the size of the client's business.
Pre-Engagement Activities
Engagement letter: Functions like a contract.
Addressed to the audit committee (if a public company).
States the objectives of the engagement (e.g., to audit the financial statements as of 12/31/2024).
Outlines the responsibilities of both the auditor and management.
May discuss the use of internal auditors or specialists.
The external auditor must assess the competence (education, quality of work) and objectivity of internal audit (e.g., can the internal audit report directly to the audit committee?).
Specifies any other services to be provided (e.g., tax).
Details the fees.
Auditor's Responsibilities
Conduct the audit in accordance with GAAS (Generally Accepted Auditing Standards) and standards established by the PCAOB (Public Company Accounting Oversight Board).
Design the audit to obtain reasonable assurance of detecting error or fraud that would have a material effect on the financial statements.
Management's Responsibilities
Make all financial records available to the auditor.
Establish and maintain effective internal controls over financial reporting.
The financial statements are the responsibility of management (specifically, the CEO and CFO).
Audit Committees (Public Companies)
Responsible for financial reporting oversight.
Must be independent of the company (i.e., not an employee or other consultant/service provider).
Responsible for the appointment, compensation, and oversight of the auditor.
Must pre-approve non-audit services.
Must be able to hire independent counsel/advisors if necessary.
Establish procedures for handling complaints/information regarding accounting, internal control, or auditing matters.
Planning the Audit
The auditor will develop an overall strategy for conducting the audit.
This strategy helps the auditor determine:
What resources are needed to perform the engagement.
Reporting objectives.
Deadlines.
Required communications (e.g., to the Audit Committee).
SEC Requirements for 10-K Filing
Large accelerated filers: 60 days after year-end.
Accelerated filers: 75 days after year-end.
Non-accelerated filers: 90 days after year-end.
Example: Orange Company is an accelerated filer with a June 30th year-end. They filed their 2022 10-K with the SEC on August 25, 2024. Did they comply? Yes. (June 30 + 75 days is Sept 13th. August 25 is 56 days, well within the deadline).
Audit Plan
A comprehensive list of the specific audit procedures that the audit team needs to perform to gather sufficient (quantity) and appropriate (quality) evidence on which to base their opinion on the financial statements.
Describes the nature, timing, and extent of the planned audit procedures:
Nature: What (the purpose or type of test).
Timing: When (before year-end, interim, or after year-end).
Extent: How much (e.g., sample size).
Planning Activities (Continued)
Assess business risks and establish materiality.
Consider multi-locations.
Assess the need for a specialist.
Assess the possibility of illegal acts.
Identify related parties.
Conduct preliminary analytical procedures.
Consider additional value-added services.
Document audit strategy and audit plan, and prepare the audit programs.
Related Parties
Some examples from FASB ASC Topic 850, “Related Party Disclosures”:
Affiliates of the enterprise.
Entities using the equity method to account for investments.
Trusts for the benefit of employees.
Principal owners of the enterprise.
Management.
Immediate families of the principal owners and management.
Other parties that can have significant influence.
How to Identify Related Parties:
Review board minutes.
Review conflict-of-interest statements.
Review transactions with major customers, suppliers, borrowers, and lenders.
Review large, unusual, or nonrecurring transactions, especially at year-end.
Review loan agreements for guarantees.
Example: 3M Proxy Statement Related Person Transaction Policy and Procedures
The Board of Directors has a written policy administered by the Nominating and Governance Committee.
Applies to any transaction where the company/subsidiary is a participant, the amount involved exceeds 120,000, and a Related Person has a direct or indirect material interest.
Such transactions are referred to the Committee for approval, ratification, or other action.
The Committee approves only transactions in the company's best interests, considering:
The nature of the Related Person's interest.
Material terms (e.g., no less favorable than arms-length transactions).
Significance to the Related Person and the Company.
Whether the transaction impairs director/executive officer judgment.
Other relevant matters.
Any Committee member who is a Related Person for a transaction under review cannot participate in deliberations or vote, but may be counted for quorum purposes.
Example: Texas Roadhouse – 10K Footnote 17 - Related Party Transactions
Lease for a Longview, Texas restaurant from an entity controlled by a former Chief Operating Officer. Initial 15-year lease, renewed to October 31, 2019, with options for three additional 5-year terms. Rent approx. 20,500 per month, totaling approx. 0.2 million annually.
14 franchise restaurants (as of 2014) owned partly or wholly by officers, directors, and stockholders of the company.
Preliminary Analytical Procedures
Purpose: To assist the auditor in better understanding the client’s business and to plan the nature, timing, and extent of audit procedures.
Requirement: Required to be performed during the planning stages of an audit.
Methods:
Review ratios (e.g., current ratio, inventory turnover) and trends.
Assess if account balances and relationships appear reasonable.
Compare current data to prior periods, expected results, or other trends.
Why perform them?
To understand the client’s business and transactions.
To identify financial statement accounts likely to contain errors.
To assist in identifying material fraud.
To assess risks. (Referencing McDonald's financial data as an example for such analysis).
Types of Audit Tests
Risk Assessment Procedures: Used to obtain an understanding of the entity and its environment, including its internal control.
Test of Controls: Evaluate the effectiveness of the design and operations of internal controls.
Substantive Procedures: Tests designed to detect material misstatements in individual transactions, account balances, or disclosures in the financial statements.
Dual Purpose Tests and Walkthrough
Dual Purpose Tests: Tests that concurrently evaluate the effectiveness of controls and test for monetary misstatements.
Example: Agree sales invoices to shipping documents and customer orders – review product type, price, and quantity and recalculate information on the invoice.
Walkthrough: Tracing a transaction from its inception all the way to the general ledger and then into the financial statements.
Substantive Procedures (Two Types)
Analytical Procedures: Evaluating financial information through analysis of plausible relationships.
Tests of Details: Tests for errors or fraud in individual transactions, account balances, and disclosures.
Example: Partial Audit Program for Substantive Procedures Testing of Accounts Receivable
1. Obtain the aged accounts receivable trial balance:
Foot the trial balance and agree the total to the accounts receivable control account.
Randomly select thirty accounts; agree information to original sales invoice and determine appropriate aging category.
2. Confirm a sample of accounts receivable:
For all responses with exceptions, follow up on the cause of the error.
For all nonresponses, examine subsequent cash receipts and/or supporting documents.
Summarize sampling and confirmation results.
3. Test sales cutoff by identifying the last shipping advice for the year and examining five large sales for three days before and after year-end.
4. Test the reasonableness of the allowance for doubtful accounts:
Test reasonableness using past percentages on bad debts.
For any large account in the aged trial balance greater than 90 days old, test for subsequent cash receipts.
5. Prepare a memo summarizing the tests, results, and conclusions.
Purposes of Analytical Procedures
Preliminary Analytical Procedures: Used to assist the auditor to better understand the business and to plan the nature, timing, and extent of audit procedures.
Substantive Analytical Procedures: Used to obtain evidential matter about particular assertions related to account balances or classes of transactions.
Final Analytical Procedures: Used as an overall review of the financial information in the final review stage of the audit.
Materiality
Steps in Applying Materiality on an Audit
Determine Overall Materiality.
Determine Tolerable Misstatement (Allocation of materiality at an account or transaction level).
Evaluate audit findings.
What is Materiality?
A dollar amount that, if omitted or misstated in the accounting information, would probably influence the decision of a reasonable person relying on the information.
Determine Overall Materiality
Quantitative factors (Rules of Thumb):
Public companies: 5\%\ of pretax income.
Non-public companies: 5\%-\text{10%}\ of pretax income.
Companies operating at a loss or near break-even: 0.5\%\ to 1\%\ of total assets or total revenue.
Not-for-Profit organizations: 0.5\%\ of net assets.
Mutual Funds: 0.5\%\ of total assets.
Companies with volatile earnings: Average of prior 3\ years pretax income.
Consider Qualitative factors (How do changes in an account affect…):
Debt covenants.
Meeting earnings numbers (e.g., going from a profit to a loss, or barely meeting requirements for a bonus).
Bankruptcy risk.
High fraud risk.
Trivial Misstatements
Approximately 3\%-5\%\ of overall materiality.
Generally not posted to the summary of unadjusted misstatements.
Unless: They involve fraud, misappropriation of assets, or management override of controls. These are considered significant and require follow-up, even if small in dollar amount.
Possibility of Undetected Misstatements
Auditors must consider the possibility of undetected misstatements when evaluating whether unrecorded (not posted) misstatements are material, especially as the level of uncorrected misstatements approaches materiality.
Example: Require that uncorrected adjustments do not exceed 60\%\ of overall materiality or do not exceed tolerable misstatement.
The threshold can vary based on risk factors.
Determine Tolerable Misstatement
Definition: The amount of planning materiality that is allocated to an account or class of transactions.
Typical Range: 50\%-75\%\ of materiality.
An estimate of the maximum amount of misstatement the auditor can accept in the account.
Helps establish a scope for the audit procedures.
This should provide reasonable assurance that material misstatements will be identified and that any unidentified misstatements would not add up to a material amount.
Example: If Materiality = \$10\ million and Tolerable Misstatement = 50\%\ of materiality = \$5\ million.
The auditor's goal is to identify with reasonable assurance all misstatements of at least \$10\ million, and also ensure that any unidentified misstatements would not aggregate to \$10\ million.
Therefore, the auditor can only “tolerate” a misstatement of \$5\ million in an account balance; this is the threshold for designing audit procedures.
Impact of Tolerable Misstatement Levels
If materiality is too high, then tolerable misstatement is also high, and the auditor may not obtain sufficient appropriate audit evidence to support the opinion.
If materiality is too low, then tolerable misstatement is also low, and the auditor may overaudit or be inefficient.
The lower the tolerable misstatement, the more testing the auditor has to do.
Factors that might cause the auditor to choose a lower tolerable misstatement:
High fraud risk.
Numerous misstatements in prior years.
Weak internal controls.
Changes in important accounting personnel.
Evaluate Aggregated Misstatements: Cases
Case 1: Unrecorded Misstatements Less Than Planning Materiality
Planning Materiality > Unrecorded Misstatements.
Example: \$2\ million > \$1.5\ million.
Financial statements are fairly presented. An unqualified opinion can generally be issued, but it may also depend on requirements related to undetected misstatements.
Case 2: Unrecorded Misstatements More Than Planning Materiality
Planning Materiality < Unrecorded Misstatements.
Example: \$2\ million < \$3\ million.
Financial statements are not fairly presented.
The client needs to book more journal entries before an unqualified opinion can be issued.
Evaluating Misstatements (Continued)
The auditor will discuss with the client the need to book any misstatements in an account or class of transactions that are greater than tolerable misstatement.
Misstatements must be considered separately and in total.
Example: If the sales account is material to the financial statements and has a material overstatement, this misstatement should be corrected even if there is an offsetting overstatement of an operating or administrative expense.
Illustration of Offsetting Errors:
| Current Condition | True Condition |
| :---------------------- | :---------------------- |
| Sales: \$6,000,000\ | \$5,000,000\ |
| Expenses: \$(2,000,000)\ | \$(1,000,000)\ |
| Net Income: \$4,000,000\ | \$4,000,000\ |
Though net income is the same, individual accounts are materially misstated.