1. Audit Planning, Types of Audit Tests and Materiality
Chapter 3
Audit Planning, Types of Audit Tests and Materiality

2. The Phases of an Audit that Relate to Audit Planning
Figure 3–1 The Phases of an Audit that Relate to Audit Planning

3. Prospective Client Acceptance
Obtain and review financial information.
Inquire of third parties regarding client integrity.
Communicate with the predecessor auditor.
Consider unusual business or audit risks.
Determine if the firm is independent.
Determine if the firm has the necessary skills and knowledge.
Determine if acceptance violates any applicable regulatory or ethical requirements.

4. Continuing Client Retention
Evaluate client retention periodically
Near audit completion or after a significant event
Conflicts over accounting and auditing issues
Dispute over fees

5. Preliminary Engagement Activities
Determine the audit engagement team requirements
Assess compliance with ethical and independence requirements
Establish an understanding with the entity

6. Establish Terms of the Engagement
In establishing the terms of the engagement, three topics must be discussed:
The engagement letter.
Using the work of the internal audit function.
The role of those charged with governance.
The terms of the engagement, which are documented in the engagement letter, should include the objectives of the engagement, management’s responsibilities, the auditor’s responsibilities, and the limitations of the engagement.
Who signs the engagement letter?

7. The Engagement Letter
The engagement letter formalizes the arrangement reached between the auditor and the entity.
In addition to the items mentioned in the sample engagement letter in Exhibit 3-1 in the textbook, the engagement letter may include:
Arrangements for use of experts or internal auditors.
Auditor’s responsibilities to communicate audit matters of governance interest.
Additional services to be provided relating to regulatory requirements.
Arrangements regarding other services.

8. Internal Audit Function
Table 3–2 Factors for Evaluating the Reliability of the Internal Audit Function
(continued)

9. Internal Audit Function

10. Those Charged with Governance
Board of Directors
Audit Committee

11. Planning the Audit
The auditor will develop an overall audit strategy for conducting the audit. This will help the auditor to determine what resources are needed to perform the engagement.
An audit plan is more detailed than the audit strategy. Basically, the audit plan should consider how to conduct the engagement in an effective and efficient manner.

12. Planning the Audit
When preparing the audit plan, the auditor should be guided by the results of the client acceptance/continuance process, procedures performed to gain the understanding of the entity, and preliminary engagement activities.
Additional steps:
Assess business risks.
Establish materiality.
Consider multi-locations.
Assess the need for experts.
Consider non-compliances with laws and regulations.
Identify related parties.
Consider additional value-added services.
Document the overall audit strategy and audit plan.

13. To understand the entity’s business and transactions
Assess Business Risks
LO# 7
To understand the entity’s business and transactions
To identify financial statement accounts likely to contain misstatements
By understanding the entity’s business and identifying where misstatements are likely to occur, the auditor can allocate more resources to investigate more risky accounts.
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14. Establish Materiality
Establish overall materiality
(more on this later!)
Establish performance materiality for accounts
Establish performance materiality for disclosures

15. Consider Multi-Locations or Business Units
Consolidated Financial Statements
High Risk
Moderate Risk
Low Risk
The auditor correlates the amount of audit attention devoted to the location or business unit with the level of risk present.

16. Assess the Need for Experts
A major consideration in planning the audit is the need for an auditor’s expert.
The presence of complex information technology may require the use of an IT expert.
What other types of experts might be needed?

17. Consider Non-Compliance with Laws and Regulations
Direct and Material
Material and Indirect
Consider laws and regulations as part of audit
Be aware may have occurred; investigate if brought to attention

18. Consider Non-Compliance with Laws and Regulations
Table 3–3 Information or Circumstances that May Indicate Non-Compliance

19. Some examples from IAS 24 Related Party Disclosure
Related Parties
Some examples from IAS 24 Related Party Disclosure
Parents and subsidiaries.
Significant influence.
Joint control.
Associate entity.
Joint venture.
Management.
Close family of the principal owners & management.
Other parties that can have significant influence.
Sources of Information on Related Parties
Minutes of meetings of those charged with governance.
Conflict-of-interest statements.
Financial and reporting information provided to creditors, investors and regulators
Contracts or other agreements with major customers, vendors and management.
Contracts or other agreements representing significant unusual transactions.

20. Additional Value-Added Services
Tax Planning
Transaction Support
IT-consultancy
Internal Reporting
Processes
Benchmarking
Risk Assessment
Auditors are limited in the types of consulting services that they can offer their audit clients.

21. Document Overall Audit Strategy and Audit Plan
Document overall audit strategy and audit plan, which involves documenting the decisions about
The auditor documents how the entity is managing its risk (via internal control processes) and the effects of the risks and controls on the planned audit procedures.
Nature
Timing
Extent
Auditors ensure they have addressed the risks they identified by documenting the linkage from the entity’s business objectives, strategy, related business and audit risks and internal controls to the audit plan.
The auditor’s preliminary decision concerning control risk determines the level of control testing, which in turn affects the auditor’s substantive tests of the account balances and transactions. A U D I T E S

22. Document Overall Audit Strategy and Audit Plan

23. Supervision of the Audit
Engagement partner should:
Inform engagement team members of their responsibilities
Direct engagement team members to identify and communicate audit issues
Review the work of the engagement team members

24. Risk Assessment Procedures Substantive Procedures
Types of Audit Tests
Risk Assessment Procedures
Used to obtain an understanding of the entity and its environment, including internal control.
Tests of Controls
Performed to obtain audit evidence about the operating effectiveness of controls in preventing, detecting and correcting material misstatements.
Substantive Procedures
Detect material misstatements in a transaction class, account balance, and disclosure element of the financial statements.

25. Tests of Controls Inquiry Inspection Walk- Through Reperformance
Observation

26. Tests of Controls
Table 3–4 Examples of Internal Controls and Tests of Controls

27. Substantive Procedures
Tests of Details
Tests for errors or fraud in individual transactions, account balances and disclosures
Substantive Analytical Procedures
Evaluations of financial information through analysis of plausible relationships among financial and non-financial data

28. Substantive Tests of Transactions
Dual-Purpose Tests
Substantive Tests of Transactions
Tests of Controls
Dual- Purpose Tests

29. Materiality
Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.
Materiality is not an absolute and
it is not a black or white issue!
The determination of materiality
requires professional judgement.

30. Steps in Applying Materiality on an Audit
Determine Overall Materiality
Step 2:
Determine Performance Materiality
Step 3:
Evaluate Audit Findings

31. Step 1: Determine Overall Materiality
The quantitative benchmark for materiality may be a percentage of:
Profit before tax.
Total assets.
Total revenues.
Net assets.
Three year average profit.
The quantitative amounts may be adjusted lower for qualitative factors such as:
Material misstatements in prior years.
High risk of fraud.
Potential loan covenant violations.
Small amounts may cause the entity to miss forecasted earnings.
Volatile business environment.

32. Step 2: Determine Performance Materiality
Performance materiality is the amount or amounts set by the auditor at less than 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.
The purpose of setting performance materiality is to establish a scope for the audit procedures for the individual account balance or disclosure.
In practice auditors commonly set performance materiality for each account at between 50 and 75 per cent of overall materiality. The firms provide guidance in determining the appropriate percentage to use within the range.
There are a number of reasons why total combined performance materiality greater than overall materiality makes sense from an audit planning perspective. 32

33. Step 3: Evaluate Audit Findings
When the audit evidence is gathered, the auditor:
Aggregates misstatements from each account or class of transactions.
Considers the effect of misstatements not adjusted in the prior period.
Examines the cause of the misstatements and determines the impact of the material misstatements on the assessment of fraud and control risk.
The auditor compares the aggregate misstatement to overall materiality.
Performance materiality can be used for determining the fair presentation of the individual accounts.
If the aggregated misstatements are greater than overall materiality, or if misstatements for individual accounts are in excess of performance materiality, the auditor would require the entity to adjust the financial statements or the auditor would have to issue a qualified or adverse opinion. 33