Chapter 8 Audit Planning and Materiality

Figure 8.1 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

Planning

  • 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: how willing the auditor is to accept the F/S may have a Material (due to error or fraud) after the audit is complete.

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

    • Audit risk: risk the audit failed to find material fraud/error

    • Client Business risk: risk the client will fail to have: (How risky is the client)

      • Reliable financial reporting

      • Efficient and effective operations

      • Compliance with laws and regulations

    • 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)

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)
Risk of material misstatement: 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, Jouranl entries, Economic transactions, reliable financial reporting, Compliance with aws and regulations,Risk assesment

Risk Assesment: Inqury, Analytical Procedures, Observation, Inspect
Acceptable audit risk: How willing are we (auditor) to accept (F/S) may be materially misstated
Audit risk: RIsk/chance the audited financial statements contain a material misstatement

Accept Client and Perform Initial Audit Planning (1 of 2)

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

    1. 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

    2. Identify Client’s reason for Audit

      • Auditor’s acceptable audit risk affected

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

    3. Obtaining an Understanding with the Client

      • Auditing standards require an engagement letter

        • Lay out fees/timing/scope

        • *Will NOT disclose: Audit strategy or Materiality

    4. 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

Understand the Client’s Business and Industry (1 of 2)

  • Required to perform Risk Assesment procedures:

    • Obtain audit evidence to identify and assess risk of material misstatmentand 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

Figure 8.2 Strategic Understanding of the Client’s Business and Industry

  1. Industry and external environment

  2. Business operations and processes

  3. Management and governance

  4. Objectives and strategies

  5. Measurement and performance

Let’s Discuss (1 of 7)

  • Identify the eight major steps in planning audits.

  • What factors should an auditor consider prior to accepting an engagement?

  • Explain the five elements that are part of a strategic understanding of the client’s business.

Let’s Discuss (2 of 7)

  • What are the benefits derived from planning audits?

  • What is the purpose of an engagement letter?

    • What subjects should be covered in such a letter?

  • Explain why auditors need an understanding of the client’s industry.

    • What information sources are commonly used by auditors to learn about the client’s industry?

Perform Preliminary Analytical Procedures

  • 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

Let’s Discuss (3 of 7)

  • In the audit of the Worldwide Wholesale Company, you did extensive ratio and trend analysis as part of preliminary audit planning. Your analytical procedures identified the following:

    • The rate of inventory turnover has steadily decreased for 3 years.

  • Evaluate the potential significance of this change on the fair presentation of financial statements.

  • State the follow-up procedures you would perform for this fluctuation to determine whether a material misstatement exists.

Materiality (1 of 2)

  • 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:

    • Set the materiality for the financial statements as a whole

    • Determain Performance Materiality

    • Estimate total mistatment in segment

    • Estimate the combined misstatment

    • Compare combined estimet with preliminary or revised judgment about materiality

Materiality for Financial Statements as a Whole (overall materiallity/Preliminary materiality→ How wrong can the financial statements overall be?)

  • 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

Let’s Discuss (4 of 7)

  • Define the meaning of the term materiality as it is used in accounting and auditing.

    • What is the relationship between materiality and the phrase obtain reasonable assurance used in the auditor’s report?

  • Explain why materiality is important but difficult to apply in practice.

Determine Performance Materiality (1 of 3)
*Not the same as overall materiallity

  • 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 inversly 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

Estimate Misstatement and Compare with Preliminary Judgment

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

      • 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)

Let’s Discuss (5 of 7)

  • What is meant by setting a preliminary judgment about materiality?

    • Identify the most important factors affecting the preliminary judgment.

  • Distinguish between the terms performance materiality and preliminary judgment about materiality.

    • How are they related to each other?

Let’s Discuss (6 of 7)

  • Explain the difference between known and likely misstatements. Assume the auditor tests a sample of $100,000 of inventory and finds misstatements totaling
    $5,000.

    • What is the likely misstatement if the account balance
      is $500,000?

Let’s Discuss (7 of 7)

  • Provide two examples of when an auditor might set a lower level of performance materiality for a particular class of transactions, account balance, or disclosure.

  • Assume materiality for the financial statements as a whole is $100,000 and performance materiality for accounts receivable is set at $40,000.

    • If the auditor finds one receivable that is overstated by $55,000, what should the auditor do?