AUDIT

PLANNING
AND
MATERIALITY
CHAPTER 8

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 CHAPTER 8 LEARNING OBJECTIVES

8-1 Discuss why adequate audit planning is essential.

8-2 Make client acceptance decisions and perform initial audit
planning.
8-3 Gain an understanding of the clients business and industry.
8-4 Perform preliminary analytical procedures.
8-5 Apply the concept of materiality to the audit.
8-6 Make a preliminary judgment about what amounts to
consider material.
8-7 Determine performance materiality during audit planning.
8-8 Use materiality to evaluate audit findings.

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 OBJECTIVE 8-1
Discuss why adequate
audit planning is
essential.

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 PLANNING
AICPA auditing standards state:

Three main reasons that the auditor should properly

plan the audit engagement:
Enable the auditor to obtain sufficient appropriate
evidence for the circumstances.
Help keep audit costs reasonable.
Avoid misunderstandings with the client.
The eight major steps in audit planning are detailed in
Figure 8-1.

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 PLANNING

Three risk terms relevant to audit planning:

Acceptable audit risk: A measure of how willing the auditor
is to accept that the financial statements may be materially
misstated after the audit is completed and an unmodified
opinion has been issued.
Client business risk: The risk that the entity fails to achieve
its objectives or execute its strategies.
Risk of material misstatement: The risk that the financial
statements contain a material misstatement due to fraud or
error prior to the audit.

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 OBJECTIVE 8-2
Make client acceptance
decisions and perform initial
audit planning.

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 ACCEPT CLIENT AND PERFORM INITIAL
AUDIT PLANNING
Initial audit planning involves four things:
1. The auditor decides whether to accept a new client or continue
serving an existing client.
2. The auditor identifies why the client wants or needs an audit.
3. To avoid misunderstandings, the auditor obtains an
understanding with the client about the terms of the
engagement.
4. The auditor develops the overall strategy for the audit,
including engagement staffing and any required audit
specialists.

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 ACCEPT CLIENT AND PERFORM INITIAL
AUDIT PLANNING (CONT.)

Client Acceptance and Continuance

New Client Investigation: CPA firms must take care in
accepting new clients. The new (successor) auditor is
required by auditing standards to communicate with the
predecessor auditor.

Due to confidentiality requirements, the client must

consent to this communication.
The purpose is to determine if the client lacks integrity or
if there were disputes about accounting principles.

Continuing Clients: CPA firms evaluate existing clients to

determine whether a continuing client presents risks due to
lackCopyright
of integrity.
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 ACCEPT CLIENT AND PERFORM INITIAL
AUDIT PLANNING (CONT.)

Identify Clients Reasons for Audit

Risk factors associated with the clients reasons for an audit
include the likely statement users and the intended uses of
the statements.

Obtain an Understanding with the Client

A clear understanding of the terms of the engagement
should exist between the auditor and the client. Auditing
standards require that there be an engagement letter which
includes the engagements objectives. An example of an
engagement letter is presented in Figure 8-2 on page 225.

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 ACCEPT CLIENT AND PERFORM INITIAL
AUDIT PLANNING (CONT.)

Develop Overall Audit Strategy

After understanding the clients reason for an audit, the
auditor should develop and document a preliminary audit
strategy.

Select Staff for Engagement and Evaluate Need for

Outside Specialists

The CPA firm must select staff for the engagement who are
knowledgeable about the clients business. If the CPA firm
lacks expertise, they may need to hire outside specialists.
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 OBJECTIVE 8-3
Gain an understanding of the
clients business and
industry.

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UNDERSTAND THE CLIENTS BUSINESS AND INDUSTRY

Auditing standards require the auditor to perform risk

assessment procedures to obtain an understanding of
the clients business and its environment to assess risk
of material misstatements.

An overview of the strategic approach to understanding

the clients business and industry is illustrated in Figure
8-3.

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 UNDERSTAND THE CLIENTS BUSINESS
AND INDUSTRY (CONT.)

Industry and External EnvironmentThere are three

primary reasons for obtaining a good understanding of the
clients industry and external environment:
1. Risks associated with specific industries may affect the
auditors assessment of client business risk.
2. Many risks are common to all clients in certain industries.
3. Many industries have unique accounting requirements that
the auditor must understand to evaluate whether the
financial statements are in accordance with accounting
standards.
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 UNDERSTAND THE CLIENTS BUSINESS
AND INDUSTRY (CONT.)

Business Operations and ProcessesThe auditor should

understand factors such as major sources of revenue, key
customers and suppliers, sources of financing, and
information about related parties that may increase client
business risk.
Tour Client Facilities and OperationsTouring facilities is
helpful in obtaining an understanding of the clients
operations.

Identify Related PartiesBecause related party transactions

may not be at arms length, auditing standards require that
related parties and related party transactions be disclosed in
the financial statements.
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 UNDERSTAND THE CLIENTS BUSINESS
AND INDUSTRY (CONT.)

Management and GovernanceThe auditor needs to assess

managements philosophy and operating style and its ability
to identify and respond to risk. Governance includes the
organizational structure as well as operations of the board of
directors and the audit committee.
Code of EthicsPublic companies must disclose whether they
have adopted a code of ethics that applies to senior
management. Auditors should have an understanding of the
code of conduct and investigate any changes.
Minutes of MeetingsCorporate minutes are the official
record of the meetings of the board of directors. They
include key authorizations and summaries of important
topics discussed. The auditor should read the minutes to
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 UNDERSTAND THE CLIENTS BUSINESS
AND INDUSTRY (CONT.)

Client Objectives and StrategiesThe auditor should

understand the client objectives related to:
1. Reliability of financial reporting
2. Effectiveness and efficiency of operations
3. Compliance with laws and regulations
Business risks can arise that threaten managements
objectives. Knowledge of managements objectives and
strategies help the auditor to assess client business risk and
the risk of misstatements.

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 UNDERSTAND THE CLIENTS BUSINESS
AND INDUSTRY (CONT.)

Measurement and PerformanceA clients performance

measurement system includes key performance indicators
(KPIs) that management uses to evaluate progress toward its
objectives. Examples include:
market share Web site visitors
sales per employee same-store sales
unit sales growth sales/square foot

If the client has set unreasonable objectives, especially when

employees are incentivized to meet performance goals, there
may be an incentive for aggressive accounting, which
increases the risk of financial statement misstatement.
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 OBJECTIVE 8-4
Perform preliminary
analytical procedures.

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 PERFORM PRELIMINARY ANALYTICAL
PROCEDURES
As noted in Chapter 7, auditors are required to
perform preliminary analytical procedures as part
of risk assessment.

Key financial ratios, along with industry standards,

are presented in Table 8-1.
Common-size financial statements are also often
used for one or more years for comparison as a
preliminary analytical procedure. This is illustrated
in Figure 8-4 on page 233.

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 OBJECTIVE 8-5
Apply the concept of
materiality
to the audit.

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 MATERIALITY
The fourth step in audit planning is to make a
preliminary judgment about materiality for the audit.
Auditing standards define materiality as the magnitude
of misstatements that individually, or when aggregated
with other misstatements, could reasonably be expected
to influence the economic decision of users.

There are five steps to applying materiality as noted in

Figure 8-5. The first two are part of the planning
process.

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 OBJECTIVE 8-6
Make a preliminary judgment
about what amounts to
consider material.

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 MATERIALITY FOR FINANCIAL STATEMENTS
AS A WHOLE

Step 1 in Figure 8-5 is to set materiality for the

financial statements as a whole as part of the
planning process.
Factors Affecting Preliminary Materiality Judgment:
Materiality is a relative rather than an absolute concept.
Benchmarks are needed for evaluating materiality.
Qualitative factors also affect materiality.

Illustrative guidelines are shown in Figure 8-6 in the form

of policy guidelines of a CPA firm.

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 OBJECTIVE 8-7
Determine performance
materiality during audit
planning.

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 DETERMINE PERFORMANCE MATERIALITY
Step 2 in Figure 8-5 is to determine performance materiality,
which can also be referred to as the allocation of the preliminary
judgment about materiality to segments.
PCAOB standards refer to performance materiality as tolerable
misstatement.
Performance materiality for an account is often set at 5075 percent
of overall materiality.
Auditors have three major difficulties when allocating materiality to
balance sheet accounts:
1. Auditors expect certain accounts to have more misstatements than
others.
2. Both overstatements and understatements must be considered.
3. Relative audit costs affect the allocation.
Figure 8-7 illustrates the allocation process.

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 OBJECTIVE 8-8
Use materiality to evaluate
audit findings.

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 ESTIMATE MISSTATEMENT AND COMPARE WITH
PRELIMINARY JUDGMENT

Auditors document all misstatements found for each audit segment.

These may be known misstatements or likely misstatements.
Known misstatements are those that the auditor can determine the
amount of misstatement in the account.
There are two types of likely misstatements:
1. Differences between managements and the auditors judgment
about estimates of account balances
2. Projections of misstatements based on the auditors tests of a
sample
The last three steps in applying materiality are illustrated in Table
8-2.

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