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 client’s 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 lack of integrity.
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 ACCEPT CLIENT AND PERFORM INITIAL
AUDIT PLANNING (CONT.)
Identify Client’s Reasons for Audit
Risk factors associated with the client’s 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 engagement’s 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 client’s 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 client’s 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 client’s
business and industry.

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 UNDERSTAND THE CLIENT’S BUSINESS AND INDUSTRY

Auditing standards require the auditor to perform risk assessment

procedures to obtain an understanding of the client’s business and
its environment to assess risk of material misstatements.

An overview of the strategic approach to understanding the client’s

business and industry is illustrated in Figure 8-3.

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 UNDERSTAND THE CLIENT’S BUSINESS
AND INDUSTRY (CONT.)

Industry and External Environment—There are three primary

reasons for obtaining a good understanding of the client’s industry and
external environment:
1. Risks associated with specific industries may affect the auditor’s
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 CLIENT’S BUSINESS
AND INDUSTRY (CONT.)
Business Operations and Processes—The 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 Operations—Touring facilities is helpful in
obtaining an understanding of the client’s operations.

Identify Related Parties—Because related party transactions may not be at

arm’s length, auditing standards require that related parties and related
party transactions be disclosed in the financial statements.

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 UNDERSTAND THE CLIENT’S BUSINESS
AND INDUSTRY (CONT.)
Management and Governance—The auditor needs to assess management’s
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 Ethics—Public 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 Meetings—Corporate 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 identify matters relevant to the audit.

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 UNDERSTAND THE CLIENT’S BUSINESS
AND INDUSTRY (CONT.)
Client Objectives and Strategies—The 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 management’s objectives. Knowledge
of management’s objectives and strategies help the auditor to assess client
business risk and the risk of misstatements.

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 UNDERSTAND THE CLIENT’S BUSINESS
AND INDUSTRY (CONT.)

Measurement and Performance—A client’s 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.

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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 50–75 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.

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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.

(Note: At the end of the audit, the auditor must evaluate the amount of misstatements, both known and
likely, and make a determination regarding the original preliminary materiality judgment. )

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 management’s and the auditor’s judgment about
estimates of account balances
2. Projections of misstatements based on the auditor’s tests of a sample

The last three steps in applying materiality are illustrated in Table 8-2.

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