Chapter 9 – Planning the Audit: Materiality and Audit Risk
Self-review Questions
9.1
State the two main phases in planning an audit and outline the main objective of each.
1) The overall audit strategy (overall audit plan)
Plans made regarding: how much and what evidence to gather; and how, when and by whom this should be done.
2) The audit plan (or audit programme)
In effect, operationalizes the overall strategy. Sets out in detail the audit procedures to be performed in each segment of the audit, indicating those to be performed during the interim audit and those to be performed during the final audit. Also frequently includes details of such things as the size of samples to be tested and how the samples are to be selected.
9.2
Define ‘materiality’ and explain briefly the distinction between:
i) Planning materiality (at the financial statement level), and
· The amount of error the auditor is prepared to accept in the financial statements as a whole while still concluding that they provide a true and fair view of the state of affairs and profit or loss of the reporting entity.
· The auditor needs to estimate this level of error, or materiality level, prior to commencing the audit, based on their understanding of the client, its business and industry, and on their assessment of the decision needs of users of the auditee’s financial statements.
· ‘Planning materiality’ and provides basis for planning the nature, timing and extent of procedures to be performed during the audit.
· Lower the level of planning materiality, the greater amount and/or the more appropriate the evidence that needs to be collected.
ii) Tolerable error (at the account level)
· The planning materiality level set also provides a basis for establishing the maximum amount of error the auditor will accept in an individual class of transactions, account balance or other disclosure.
· Not required to determine a tolerable error for every class of transactions, account balance or other disclosure.
· Most cases – audit firms set a tolerable error for significant individual classes of transactions, account balances and other disclosures.
9.3
Explain briefly what is meant by ‘performance materiality’.
ISA 320 definition:
Performance materiality means the amount or amounts set by the auditor at less than materiality for financial statements as a whole to reduce to an appropriately low level the probability that the total of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole. Also refers to the amount or amounts set by the auditor at less than materiality level or levels for particular classes of transactions, account balances or disclosures [i.e. tolerable error].
9.4
Describe briefly the three stages in determining planning materiality.
a) Selecting one or more appropriate benchmark(s);
Selecting appropriate benchmarks: ISA 320 identifies a number of factors that may affect the selection of an appropriate benchmark:
· The elements of the financial statements (e.g. assets, liabilities, equity, income, expenses);
· Whether there are items on which the attention of the users of the particular entity’s financial statements tends to be focused;
· The nature of the entity, where the entity is in its life cycle, and the industry and economic environment in which it operates;
· The entity’s ownership structure and the way it is financed (e.g. if financed solely by debt rather than equity, users may put more emphasis on assets, and claims on them, than on the entity’s earnings); and
· The relative volatility of the benchmark.
b) Identifying appropriate financial data for the selected benchmark(s);
Identifying financial data: Once appropriate benchmarks have been selected, financial data for the benchmark needs to be identified.
c) Determining a percentage to be applied to the selected benchmark(s).
ISA 320: Determining a percentage to be applied to a chosen benchmark requires the exercise of professional judgement. There is a relationship between the percentage and the chosen benchmark, such that a percentage applied to profit before tax from continuing operations will normally be higher than a percentage applied to total revenue. The auditor may consider five percent of profit before tax from continuing operations to be appropriate for a profit-orientated entity in a manufacturing industry. Higher or lower percentages, however, may be deemed appropriate in the circumstances.
9.5
Explain briefly how setting materiality limits at different levels affects planned audit procedures.
Level at which materiality limits are set affects the planning of audit procedures – their nature, timing and extent.
9.6
Explain briefly what is meant by ‘the auditor’s desired level of assurance’ and how it relates to the auditor’s ‘desired level of audit risk’.
Desired level of assurance – the subjectively determined level of confidence that the auditor wants to have about the fair presentation of the financial statements after the audit is completed. The higher the level of assurance attained, the more confident the auditor is that the financial statements [on which a clean report is issued] contain no material misstatements or omissions.
If auditor wishes to be 95% assured (or confident) that the financial statements on which (s)he expresses a ‘clean’ audit opinion are free of material misstatements, this means (s)he is prepared to accept a 5% risk that the financial statements on which a ‘clean’ opinion is expressed contain such errors.
The link (ISA 200): To obtain reasonable assurance, the auditor shall obtain sufficient appropriate audit evidence to reduce audit risk to an acceptably low level and thereby enable the audit to draw reasonable conclusions on which to base the auditor’s opinion.
9.7
Explain briefly the circumstances in which the auditor’s desired level of audit risk is likely to be particularly low.
Where there is some doubt about the entity’s status as a going concern. If a client is forced into liquidation shortly after receiving a ‘clean’ audit report and the financial statements are subsequently found to contain one or more material errors or omissions, the auditor may be exposed to litigation. If in such circumstances the auditor reduces his/her level of audit risk, s(he) will gather more evidence than would otherwise be the case, and will be particularly concerned to see that the nature of the going concern problem is adequately disclosed in the notes to the financial statements.
9.8
Explain briefly how the auditor’s assessment of inherent risk and internal control risk affects his or her planning of substantive procedures.
Substantive procedures have a direct bearing on detection risk. In general, the lower the level of inherent risk and internal control risk, the less substantive procedures which are required to confirm that the financial statements are, in fact, free of material misstatements.
9.9
Explain briefly the relationship between materiality limits, audit risk and audit planning.
Audits must be planned so as to ensure that:
· Inherent risk is properly assessed [which largely depends on gaining an adequate knowledge of the clients]
· Internal control risk is properly evaluated (which includes planning, performing and evaluating compliance procedures) and;
· Sufficient appropriate substantive procedures are performed so that detection risk – and thus audit risk – is reduced to the level desired by the auditor.
Hence in order to reduce audit risk to the desired level the auditor must carefully plan the nature, timing and extent of audit procedures.
Level of materiality affects the amount and/or appropriateness of the audit evidence the auditor need to gather.
Linking materiality to audit risk and the extent of audit procedures, we can say the lower, the more readily misstatements that exist in the pre-audited financial statements will exceed those limits and thus qualify as material misstatements.
Therefore, all things equal, lower the materiality limits, the higher the auditor’s assessment of inherent and control risk and, consequently, the more extensive the audit procedures that need to be performed in order to reduce audit risk to a low level.
Low materiality limits = high audit risk = more extensive planned audit procedures
High materiality limits = low audit risk = less extensive planned audit procedures
9.10
When planning an audit, the auditor must consider:
· The extent of audit procedures,
· The timing of audit procedures,
· The nature of audit procedures.
a) Briefly explain the meaning of each of these terms.
b) Give on example for each term to illustrate its effect on planning an audit.