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23 views41 pagesChapter 3-2
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Chapter
PHASE I -
RISK ASSESSMENT:
PLANNING THE AUDIT AND
DEVELOPMENT OF OVERALL
AUDIT STRATEGY
Expected Learning Outcomes
After studying this chapter, you should be able to:
Explain the nature, scope and benefits of audit planning.
2. Understand the concept of materiality as applied to financial
audit.
3. Know the levels of planning for the audit such as
* Establishment of overall audit strategy, and
* Development of detailed audit plan
4. Describe the process, benefits and documenting the overall, audit
strategy
5. Explain the significant matters embodied in the detailed audit plan
such as the
* Scope, objectives, timing and required communications
* Direction, supervision and review of audit work done
6. Understand the critical matters in engagement planning including,
but not limited to, the following:
* Application of analytical procedures
«Establishment of audit team
* Consideration of work by other auditors / parties
* Assessment of going concern assumption, related parties.
client's legal obligations
¢ Preparation of initial audit Program, time budget
QU Bs
ad CHAPTER 3
PHASE I - RISK ASESSMENT:
PLANNING THE AUDIT AND
DEVELOPMENT OF OVERALL AUDIT
STRATEGY
PLANNING THE AUDIT
Nature and Scope of Audit Planning
Audit planning involves the establishment of the overall audit strategy for the
engagement and developing an audit plan, in order to reduce audit risk to an
[Link] level. Planning involves the engagement partner and other key
members of the engagement team to benefit from their experience and insight
and to enhance the effectiveness and efficiency of the planning process.
The nature and extent of planning activities will vary according to the size and
complexity of the entity, the auditor’s previous experience with the entity, and
changes in circumstances that occur during the audit engagement.
Planning is a continuous and iterative process that often begins shortly after or in
connection with the completion of the previous audit and continues until the
completion of the current audit engagement. However, in planning an audit, the
auditor considers the timing of certain planning activities and audit procedures
that need to be completed prior to the performance of further audit procedures.
For example, the auditor plans the discussion among engagement team members,
the analytical procedures to be applied as risk assessment procedures, the
obtaining of a general understanding of the legal and ‘Tegulatory framework
applicable to the entity and how the entity is complying with that framework, the
determination of materiality, the involvement of experts and the performance of
other risk assessment procedures prior to identifying and assessing the risks of
material misstatement and. performing further audit procedures at the assertion
level for classes of transactions, account balances, and disclosures that are
responsive to those risks. 40 Chapter 3
Benefits of Audit Planning
Audit planning generally involves the determination of the expected nature
timing and extent of the audit. Among the benefits derived from audit planning
are the following:
(a) It helps ensure that appropriate attention is devoted to important areas of
the audit.
(b) It aids in identifying potential problems and resolving them on a timely
basis.
(c) It helps ensure that the audit is properly organized, managed and performed
in an effective and efficient manner.
(d) It assists in the Proper assignment and review of the work of the
engagement team members.
(e) It-helps coordinate the work to be done by auditors of components and
other parties involved such as experts, specialists, etc.
Concept of Materiality Applied to Audit Planning
Assuring that the audit is conducted in a quality manner is paramount to fulfilling
the users’ expectations about the approach and methodology used by the auditor
And one of the drivers of audit quality is the auditor’s thorough understanding
and effective application of the concept of materiality in conducting the audit
Materiality provides a quantitative threshold or cut-off point, rather than being a
primary qualitative characteristic, which information must have if it is to e useful
The auditor establishes materiality level based on his professional judgment so as
to detect quantitatively material misstatements. Information is material if its
omission or misstatement could influence the economic decisions of users taken
on the basis of the financial statements.
When establishing overall audit strategy, the auditor shall determine materiality
for the. financial statements as a whole. If, in the specific circumstances oft
entity, there is one or more particular classes of transactions, account a
disclosures for which material misstatements of lesser amounts that a
materiality for the financial statements as a whole could be reasonably Pie
to influence the economic decisions of users taken on the basis of the Finan ra
misstatements, the auditor shall also determine the materiality level) © 7
applied to those particular classes of transactions, account balan
disclosures. Phase | - Risk Assessment: Planning the Audit and Development... _41
PSA 320, “Materiality in Planning and Performing an Audit” establishes
standards and deals with the auditor's responsibility to apply the concept of
materiality in planning and performing an audit of financial statements.
To reiterate the importance of the concept of materiality to audit, the definition of
materiality in accordance with the FRSC’s “Framework for the Preparation and
Presentation of Financial Statements” follows:
“Information is material if its omission or misstatement could influence
the economic decisions of users taken on the basis of the financial
statements. Materiality depends on the size of the item or error judged in
the particular circumstances of its omission or misstatement. Thus,
materiality provides a threshold or cut-off point rather than being a
primary qualitative characteristic which information must have if it is to
be useful.”
This definition emphasizes the importance of materiality to reasonable users who
rely on the statements to make decisions. Auditors, therefore, must have
knowledge of the likely uses of their client’s statements and the decisions that are
being made.
In planning the audit, materiality should be considered by the auditor when:
(a) determining the nature,timing and extent of audit procedures;
(b) identifying and assessing the risks of material misstatement; and
(c) determining the nature, timing and extent of further audit.
The auditor’s determination of materiality is a matter of professional judgment
and is affected by the auditor's perception of the financial information needs of
users of the financial statements. In this context, it is reasonable for the auditor to
assume that users:
(a) Have a reasonable knowledge of business and economic activities and
accounting and a willingness to study the information in the financial
statements with renewable diligence;
(6) Understand that financial statements at prepared mud and audited to levels
of materiality;
(c) Recognize the uncertainties inherent in the measurement of amounts based
on the use of estimates, judgment and the consideration of future events;
and
(d) Make reasonable economic decisions on the basis of the information in the
financial statements. Medios of
The auditor a
materiality at two levels:
is the overall materiality (or materiality level for the Financia
statements as a whole)
* Second is the specific materiality (or materiality level for particular lasses
of transactions. account balances or disclosures)
The auditor considers materiality at both the overall financial statement level
and in relation to individual account balances, classes of transactions and
disclosures. Materiality may be influenced by considerations such as legal
and regulatory requirements and considerations relating to individual
financial statement account balances and relationships. This process may
result in different materiality levels depending on the aspect of the financial
statements being considered.
1. Overall materiality
Materiality for the financial statements as a whole (overall materiality)
is based on the auditor's professional judgment as to the highest
amount of misstatement(s) that could be included in the financial
statements without affecting the economic decisions taken by a
financial statement user. If the amount of unconnected misstatements,
either individually or in the aggregate, is higher than the overall
materiality established for the engagement, it would mean that the
financial statements are materially misstated.
Overall materiality is based on the common financial information
needs of the various users as a group. Consequently, the possible effest
of misstatements on specific individual: users, whose needs may vary
widely, is not considered,
N
Specific materiality
In some cases, there may be a need to identify misstatements of lesset
amounts than overall imateriality that would affect the economic
decisions of financial statement users. This could relate to aes
areas such as particular note disclosures (je, managemet
remuneration or industry-specific data), compliance with legislation *
certain terms in a contract, or transactions upon which bonuses
based. It could also relate to the nature of a potential misstatement
PSA 320 likewise requires that performance materiality be set. Phase I ~ Risk Assessment: Planning the Audit and Development ...__43
Performance Materiality
Performance materiality is used by the auditor to reduce the risk to an
appropriate low level that the accumulation of uncorrected and unidentified
misstatements exceeds materiality for the financial statements as a whole
(overall materiality), or materiality levels established for particular classes
of transactions, account balances, or disclosures (specific materiality).
Performance materiality is set at a lower amount (or amounts) than overall
specific materiality. The objective is to perform more audit work than
would be required by the overall or a specific materiality to:
¢ Ensure that misstatements less than overall or specific materiality are
detected, so as to appropriately reduce the probability that the
aggregate of uncorrected errors and undetected misstatements exceed
materiality for the financial statements as a whole; and thus
* Provide a margin or buffer for possible undetected misstatements. This
buffer is between detected but uncorrected misstatements in the
aggregate and the overall or specific materiality.
The margin provides some assurance for the auditor that undetected
misstatements, along with all uncorrected misstatements, will not likely
accumulate to reach an amount that would cause the financial statements to
be materially misstated.
Performance materiality is set in relation to overall materiality or specific
materiality. For example, a specific performance materiality can be set at a
lower amount than overall performance materiality for testing repairs and
maintenance expenses if there is a higher risk of assets not being
capitalized. Specific performance materiality may also be used to perform
additional work in areas that may be sensitive due to the nature of potential
misstatements and their occurrence, rather than their monetary size.
For example, if overall materiality was set at P200,000 and the audit
rocedures were planned to detect all errors in excess of P200,000, it is
quite possible that an error of say P80,000 would go undetected. If three
such errors existed totaling to P240,000, the financial statements would be
materially misstated. If performance materiality was set at P120,000, it
would be much more likely that at least one or all of the P80,000 errors
would be detected. Even if only one of the three errors is identified and
corrected, the remaining P160,000 misstatement would still be less than
200,000 and the financial statements as a whole would not be materially
misstated. 44
Chapter 3
How to Determine Materiality
Auditors make a preliminary assessment of materiality of the financia)
statements as a whole by determining the amount by which they believe the
financial statements could be misstated without affecting users’ decisions.
This-amount is called “preliminary judgment about materiality”
“planning materiality”. This judgment need not be quantified but often is
It is called a preliminary judgment about materiality because it is 4
Professional judgment and may change during the engagement it
circumstances change. The reason for determining “planning materiality"
is to help the auditor plan the appropriate evidence to accumulate. If the
auditor sets a low peso amount, more evidence is required than for a high
amount.
In establishing planning materiality or preliminary judgment about
materiality, an auditor must also consider any potential effect a
misstatement might have which may be greater than the peso amount
involved. A misstatement which may not be material based on quantitative
factors but that does not allow a client to meet a condition in a contractual
Obligation or expectations of a financial statement user may be considered
material. In these instances, amount of planning materiality based on the
Users expectations of income or alter those working on the engagement to
the potential for these types of material misstatement.
Rules of Thumb (For Use as a Starting Point)
Overall |__ Specific
Maleriality is a matter of professional h
judgment rather than a mechanical
existence. As a result, no specific guidance
Is provided in the PSA. However, profit
from continuing profit from continuing
Operations (3% to 7%) is often used in
Practice as having the greatest significance
| provided inthe |
amount (based on | PSAS, Percentages |
professional range from 60% (of |
judgment) forthe | overall or specific |
audit of specific or | materiality), where |
to financial statement users. if this is nota | sensitive financial | there is a higher
useful measure (such as for a not-for-profit | statement areas. | risk of material =|
entity or where profit is not a stable base), misstatement. © |
then consider other bases such as: } B5% where the
4 assessed nsk of
¢ Revenues or expenditures ~ 1% to material
= misstatements
Assets - 1% to 3%
Equity - 3% to 5% erally oF TEN, $88 Ye me
Phase 1 ~ Risk Assessment: Planing the Audit and Development ..._45
Other Considerations
© When accepting new audit engagement, inquire about the overall
materiality used by the previous auditor. If available, this would help
in determining whether further audit procedures may be required on
the opening asset and liability balances.
© Ensure that any experts employed by the entity (to assist the entity in
preparing the financial statements) or used by the audit team are
instructed to use an appropriate materiality level in relation to the
work they perform.
Relationship between Materiality and Audit Risk
When planning the audit, the auditor considers what would make the
financial statements materially misstated. The auditor’s assessment of
materiality, related to specific account balances and classes of transactions,
helps the auditor decide such questions as what items to examine and
whether to use sampling and analytical procedures. This enables the
auditor to select audit procedures that, in combination, can be expected to
reduce audit risk to an acceptably low level.
There is an inverse relationship between materiality and the level of audit
risk, that is, the higher the materiality level, the lower the audit risk and
vice versa. The auditor takes the inverse relationship between materiality
and audit risk into account when determining the nature, timing and extent
of audit procedures For example, if, after planning for specific audit
procedures, the auditor determines that the acceptable materiality level is
lower, audit risk is increased.
The auditor would compensate for this by either:
(a) reducing the assessed level of control risk, where this is possible. and
supporting the reduced level by carrying out extended or additional
tests of control; or
(b) reducing detection risk by modifying the nature, timing and extent of
planned substantive procedures. 46 Chapter 3
Figure 3-1 shows an illustration of a memo on determining, and ayy
materiality,
Figure 3-1 Tlustrative Memo on Deter
4 and Using Materiality
Client: XYZ Comp: ly as
Materlality Assessment
The main users of the financial statements are the bank and the shareholders, The
materiality number used in the last period was P80,000,
Using our professional judgment, we decided to base our materiality on 5% of the profit
before tax. Other bases for ‘materiality, such as revenues, were also considered but it was
felt that profit before tax was the most ‘Meaningful ‘amount in relation to the identified
financial statement users.
For this period, the plan is to use P100,000 as the overall materiality. The concept of
‘materiality and its use in the audit has been discussed in general two terms with the client
Using professional judgment, and the types of misstatements identified in previous audis,
overall performance materiality has been set at 75,000.
A specific materiality for the local sales taxes paid has been set at P10,000 as we are
Tequired to audit and report on this amount to the local goverment.
Prepared by: Date:
Reviewed by: D
SEC Requirements Relative to Materiality (Amended SRC Rule 68)
* On test of materiality, in case of a disc!
information is material
that represents 1
losure deficiency or inconsistency;
if it involves a transaction, amount or account
0% or more of the total of related accounts of
transactions in the financial statements. The test to be used shall be 5%
for companies under groups A & B categories,
In case of a misstatement or error, it shall be material if the amount of
misstatement or error represents 5% or more of the total of related
accounts or transaction in the financial statements. The test to be ¥5*
shall be 2% for companies under groups A & B categories.
me —