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Chapter 3 Audit Planning,

Types of AuditTests, and

Materiality

McGraw-Hill/Irwin Copyright © !" #y The McGraw-Hill Co$panies, Inc% All

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The Phases of an Audit That Relate to AuditPlanning

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Do we want the client?

3

CLIENT ACCEPTANCE?

or

CLIENT CONTINUANCE?

The decision is linked closely to - Auditor Business Risk &

Audit Risk (AR, R, !R, DR"

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Do we want the client?AICPA Statement on Quality Control Std. No. 7

Policies and procedures should be established for deciding whether toaccept or continue a client relationship and whether to perform aspeci c engagement for that client. Such policies and procedures shouldprovide the rm with reasonable assurance that the likelihood ofassociation with a client whose management lacks integrity isminimi ed.

Such policies and procedures should also provide reasonable assurancethat the rm!appropriately considers the risks associated withproviding professional services in the particular circumstances.

"o minimi e the risk of misunderstandings regarding the nature# scope# andlimitations of the services to be performed# policies and proceduresshould provide for obtaining an understanding with the client regardingthose services. Professional standards may provide guidance in decidingwhether the understanding should be oral or written.

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Prospective Client$cceptance

1. Obtain and review financia infor!ation.2. In" ire of t$ird %artie& re'ardin' c ient

inte'rit(.

3. Con&ider n & a b &ine&& or a dit ri&)&.

*. +eter!ine if t$e fir! i& inde%endent.

,. +eter!ine if t$e fir! $a& t$e nece&&ar(&)i & and )now ed'e.

. +eter!ine if acce%tance vio ate& an(

a%% icab e re' ator( a'enc(re" ire!ent& or t$e Code of Profe&&ionaCond ct.

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Continuing Client %etention

Eva ate c ientretention %eriodica (

Near a dit co!% etionor after a &i'nificant

event

Conf ict& overacco ntin' anda ditin' i&& e&

+i&% te over fee&

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Preliminary &ngagement$ctivities

+eter!ine t$e A ditEn'a'e!ent Tea!

e" ire!ent&

A&&e&& Co!% iance wit$Et$ica e" ire!ent&/Inc din' Inde%endence

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&stablish "erms of the&ngagement

T$e ter!& of t$e en'a'e!ent/ w$ic$ are doc !ented int$e engagement letter / &$o d inc de t$e ob ective& of

t$e en'a'e!ent/ !ana'e!ent & re&%on&ibi itie&/ t$ea ditor & re&%on&ibi itie&/ and t$e i!itation& of t$e

en'a'e!ent.

$o &i'n& t$e en'a'e!ent etter?

In e&tab i&$in' t$e ter!& of t$e en'a'e!ent/t$ree to%ic& ! &t be di&c &&ed4

1.T$e en'a'e!ent etter5

2.U&in' t$e wor) of t$e interna a ditor&5

and3.T$e ro e of t$e a dit co!!ittee.

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"he &ngagement 'etterT$e en'a'e!ent etter for!a i7e& t$e arran'e!ent reac$edbetween t$e a ditor and t$e c ient.

In addition to t$e ite!& !entioned in t$e&a!% e en'a'e!ent etter in E8$ibit 3-1 int$e te8tboo)/ t$e en'a'e!ent etter !a(

inc de4

# Arran'e!ent& for &e of &%ecia i&t& orinterna a ditor&.

# An( i!itation& of iabi it( of t$e a ditoror c ient.

# Additiona &ervice& to be %rovided.#Arran'e!ent& re'ardin' ot$er &ervice&.

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(nternal $uditorsLO# ,

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"he $udit Committee

; bco!!itteeof t$e board of

director&

No &%ecificre" ire!ent&for %rivate (

$e d co!%anie&

;ection 3:1 of ;arbane&-O8 e( Act re" ire& t$efo owin' for a dit co!!ittee !e!ber& of% b ic ( $e d co!%anie&4

#

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Planning the $udit# T$e a ditor wi deve o% an overa a dit &trate'( for

cond ctin' t$e a dit. T$i& wi $e % t$e a ditor todeter!ine w$at re&o rce& are needed to %erfor!t$e en'a'e!ent.

# An a dit % an i& !ore detai ed t$an t$e a dit&trate'(.

# =a&ica (/ t$e a dit % an &$o d con&ider $ow tocond ct t$e en'a'e!ent in an effective and

efficient !anner.

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Planning the $udit$en %re%arin' t$e a dit % an/ t$e a ditor &$o d be ' idedb( t$e re& t& of t$e c ient acce%tance>contin ance %roce&&/

%roced re& %erfor!ed to 'ain an nder&tandin' of t$e entit(/and %re i!inar( en'a'e!ent activitie&.

Additiona &te%&4#A&&e&& b &ine&& ri&)&.#E&tab i&$ !ateria it(#Con&ider ! ti ocation&.#A&&e&& t$e need for &%ecia i&t&.#Con&ider vio ation& of aw& and re' ation&#Identif( re ated %artie&.#Con&ider additiona va e-added &ervice&#+oc !ent t$e overa a dit &trate'(/ a dit

% an/ and %re%are a dit %ro'ra!& .

Let & oo) at eac$of t$e&e &te%&.

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$ssess )usiness %isks

To nder&tand t$ec ient & b &ine&&and tran&action&

To identif(financia &tate!entacco nt& i)e ( to

contain error&

By understanding the client$s %usiness and identifyingwhere errors are likely to occur, the auditor can allocate

ore resources to in'estigate necessary accounts

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E&tab i&$ overa!ateria it(!ore on t$i& ater@

E&tab i&$ to erab e!i&&tate!ent foracco nt&

E&tab i&$ to erab e!i&&tate!ent fordi&c o& re&

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&stablish *ateriality

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Con&o idatedBinancia

;tate!ent&

i'$ i&)

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+se of Specialists

A !a or con&ideration in % annin' t$e a dit i& t$e need fora &%ecia i&t.

T$e &e of an IT &%ecia i&ti& a &i'nificant a&%ect of!o&t a dit en'a'e!ent&.

T$e %re&ence of co!% e8infor!ation tec$no o'(

!a( re" ire t$e &e of anIT &%ecia i&t.

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$at ot$er t(%e& of&%ecia i&t& !i'$t be

needed?

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Consider ,iolations of 'awsand %egulations

llegal Acts

Direct and*aterial

!onsider lawsand regulationsas )art of audit

*aterial andndirect

Be aware ay ha'eoccurred+

in'estigate if%rought to attention

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(llegal $ctsLO# 0

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%elated Parties

;o!e e8a!% e& fro! BA;= A;C To%ic6,:/ D e ated Part( +i&c o& re&

#Affi iate& of t$e enter%ri&e.#Entitie& &in' e" it( !et$od to

acco nt for inve&t!ent&.

#Tr &t& for benefit of e!% o(ee&.#Princi%a owner& of enter%ri&e.

#

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$dditional ,alue-$ddedServices

Ta8 P annin';(&te!

+e&i'n andInte'ration

Internae%ortin'

i&)A&&e&&!ent =enc$!ar)in'

E ectronicCo!!erce

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A ditor& w$o a dit % b ic co!%anie& are i!ited int$e t(%e& of con& tin' &ervice& t$at t$e( can offer

t$eir a dit c ient&.3-21

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Document $uditStrategy and Plan

Nat re

Ti!in'

E8tent

A ditor& en& re t$e( $ave addre&&ed t$e ri&)& t$e(identified b( doc !entin' t$e in)a'e fro! t$e

c ient & b &ine&&/ ob ective&/ and &trate'( to t$ea dit % an.

T$e a ditor & %re i!inar( deci&ion concernin'contro ri&) deter!ine& t$e eve of contro te&tin'/w$ic$ in t rn affect& t$e a ditor & & b&tantive te&t&

of t$e acco nt ba ance& and tran&action&.

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+oc !ent overa a dit &trate'( anda dit % an/ w$ic$ invo ve& doc !entin'

t$e deci&ion& abo t

T$e a ditor doc !ent& $ow t$ec ient i& !ana'in' it& ri&) via

interna contro %roce&&e& andt$e effect& of t$e ri&)& and

contro & on t$e % anned a dit%roced re&.

A

U+

I

T

T

E

;

T

; 3-22

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Document $udit StrategyLO# 0

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Supervision of the $udit# En'a'e!ent %artner and ot$er & %ervi&or(

!e!ber& of t$e tea!4

# Infor! en'a'e!ent tea! !e!ber& of t$eirre&%on&ibi itie&

# +irect en'a'e!ent tea! !e!ber& to identif(and co!! nicate a dit i&& e&

# eview t$e wor) of t$e en'a'e!ent tea!!e!ber&

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"ypes of $udit "ests

i&) A&&e&&!entProced re&

U&ed to obtain an nder&tandin' oft$e entit( and it& environ!ent/inc din' it& interna contro .

Te&t& of Contro &+irected toward t$e eva ation of t$e

effectivene&& of t$e de&i'n ando%eration of interna contro &.

; b&tantiveProced re&

+etect !ateria !i&&tate!ent& in atran&action c a&&/ acco nt ba ance/

and di&c o& re co!%onent of t$efinancia &tate!ent&.

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"ests of Controls

In" ir( In&%ection

a )t$ro '$ e%erfor!ance

Ob&ervation

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"ests of ControlsLO# 9

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Substantive Procedures

Ana (ticaProced re&

Te&t& of+etai &

Te&t& for error& or

fra d in individ atran&action&/acco nt ba ance&/

and di&c o& re&

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Eva ation& of financia

infor!ation t$ro '$ ana (&i&of % a &ib e re ation&$i%&a!on' financia and non-

financia data

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Dual-Purpose "ests

; b&tantiveTe&t& of

Tran&action&

Te&t& ofContro &

+ a -

P r%o&eTe&t&

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*ateriality "he +nited States Supreme Courtinterpretation of materiality is that a factis material if there is a substantial

likelihood that the!fact would have been

viewed by the reasonable investor ashaving signi cantly altered the /total mi01of information made available.2

*ateriality is not an a%solute andit is not a %lack or white issue

The deter ination of aterialityre uires )rofessional .udg ent

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Steps in $pplying *aterialityon an $udit

/te) 01Deter ine a ateriality le'el for the o'erall financial state ents

()lanning ateriality"

/te) 21Deter ine tolera%le isstate ent

(allocation of ateriality at indi'idual account class of transactions le'el"

/te) 314'aluate auditing findings(near the end of the audit"

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Step 4 Determine 5verall*ateriality

The uantitati'e %ase for ateriality is a )ercentage of1

# nco e %efore ta5es

# nco e fro continuing o)erations

#Three year a'erage inco e

#Total assets#Total re'enues

# 6ross )rofit

The uantitati'e a ountsay %e ad.usted lower for ualitati'e factors such as1

# *aterial isstate ents in)rior years

# Potential for fraud orillegal acts

# Potential loan co'enant'iolations

# 7igh arket )ressures

# 7igh fraud risk

# 7igher than nor al risk

of %ankru)tcy

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*ateriality &0amples

33

Other 1. 'reater of a&&et& or rev& 2>3

Sliding scale 2-,F of GP if between H:-2:)

1-2F if between H2:/:::-1<1>2-1F if between H12F if over H1::<

Blends avera'e& diff. !et$od&

Constant % ,F of %reta8 inco!e 1>2F of tota a&&et& 1F of tota e" it( 1>2F of tota reven e&

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Step 6 4Determine "olerable*isstatement

"olerable misstatement is the amount ofplanning materiality allocated to an account orclass of transactions. Combined tolerable

misstatement is generally greater than planningmateriality because78ot all accounts will be misstated by their full tolerablemisstatement allocation.$udits of individual accounts are conducted simultaneously.*ateriality is often a small fraction of the account beingaudited and planned procedures will be su9ciently preciseto identify signi cant misstatements.:hen errors are identi ed# additional testing is typicallyperformed in that account and related accounts.5verall materiality serves as a safety net.2

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Step 3 4 &valuate $udit;indings

:hen the audit evidence is gathered# theauditor7

$ggregates misstatements from each account or

class of transactions ect of misstatements not ad ustedin the prior period.

Compares the aggregate misstatement to planningmateriality.(f the aggregate misstatement is less thanplanning materiality# the auditor can conclude that

the nancial statements are fairly presented# ifnot# an ad ustment should be made.

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&nd of Chapter 3