1. Auditing – Study Notes Chapter 9 Planning an Audit
CHAPTER NINE
PLANNING AN AUDIT
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*Explanation of Reference:
First digit in Study Text’s Reference represents chapter number, second and third digits represents
section and sub-section number. Contents in brackets (if any) represent part of the sub-section
which is covered by the learning objective.
Coverage from Question Bank:
After completion of this chapter, you will be able to attempt following questions in ICAP's Question
Bank:
Question # in ICAP’s Question
Bank
Type of Question
Question # in ICAP’s
Question Bank
Type of Question
Q. # 8b (Audit process)
Concept Review
Question
Q. # 62c (Taskeen Co)
Concept Review
Question
Q. # 22 (Acceptance and planning)
Concept Review
Question
Q. # 67b (Analytical
procedures and materiality)
Concept Review
Question
Q. # 31 a (Hurricane)
Concept Review
Question
1 By: Muhammad Asif, ACA
2. Auditing – Study Notes Chapter 9 Planning an Audit
PART A – PLANNING OF AN AUDIT
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Planning Activities:
Planning an audit involves:
establishing the overall audit strategy (that sets scope, timing and direction for
engagement) and
developing audit plan (which includes nature, timing and extent of audit procedures to be
performed by engagement team).
Who is involved in Planning of audit:
The engagement partner and other key members of the engagement team shall be involved in
planning the audit.
Importance/Benefits/Objectives of Planning:
Planning helps to:
1. Identify potential problems (e.g. risks) on timely basis.
2. Pay attention to important areas of audit.
3. Assist in selection of appropriate team and proper assignment of work to them.
4. Perform direction, supervision and review of engagement team.
5. Coordinate with component auditor and experts, if any.
6. Organize and manage engagement so that it is completed efficiently and effectively.
CONCEPT REVIEW QUESTION
Planning an audit involves establishing the overall audit strategy for the engagement and
development of an audit plan. Enumerate the adequate planning benefits during the audit of
financial statements. (05 marks)
(ICMA Pakistan - February 2013)
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Audit Strategy:
Definition:
Audit strategy sets the scope, timing and direction of audit, and guides the development of the audit
plan.
Matters documented in audit strategy:
1. Characteristics of the engagement that determine its scope:
This includes consideration of Applicable Financial Reporting Framework, industry specific
requirements, expected audit coverage, including the number and locations of components
to be covered.
2. Reporting objectives of the engagement
It relates to establishing deadlines for completion of work and key dates for expected
communication.
3. Factors that are significant in directing the engagement team’s efforts:
This includes consideration of materiality threshold, areas of high risks, audit approach to
address risks (e.g. whether to rely on internal controls).
2 By: Muhammad Asif, ACA
3. Auditing – Study Notes Chapter 9 Planning an Audit
4. Nature, timing and extent of resources necessary to perform the engagement:
When resources are needed (e.g. whether resources are to be used at interim audit).
How much resources are to be used and where (e.g. high number and experience of staff
needed on high risk areas)
How to direct, supervise and review resources during audit.
5. Results of preliminary engagement activities and knowledge gained on other
engagements performed for the entity.
Audit Plan:
Definition:
The audit plan is more detailed than the overall audit strategy and includes the nature, timing and
extent of audit procedures to be performed by engagement team members to obtain sufficient
appropriate audit evidence to reduce audit risk to appropriate level.
Matters documented in audit plan:
Nature, timing and extent of planned risk assessment procedures. This includes assessment of
both inherent risk and control risk at financial statement level and at assertion level.
Nature, timing and extent of further audit procedures at assertion level for each material class
of transactions, balance and disclosure of financial statements. This includes:
o Tests of Controls (if auditor wants to rely on controls), and
o Substantive Procedures (depending on risk assessment)
CONCEPT REVIEW QUESTION
(a) Explain the difference between “The Overall Audit Strategy” and the “Audit Plan”. (04 marks)
(b) Identify the matters which are usually discussed / explained in each of the above documents.
(12 marks)
(CA Inter, Autumn 2008)
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Why risk of audit failure is higher in first year of audit:
There is an increased risk of audit failure in the first year of audit client relationship because of:
Limited understanding of entity and its environment.
Possibility of misstatement in opening balances which affect current year’s financial
statements.
Additional considers to reduce risk in initial audit engagement:
To mitigate the audit risk, auditor performs following additional activities prior to starting an initial
audit:
1. Perform procedures regarding accepting of client relationship and specific audit
engagement (specially considering integrity of management).
2. Discuss with management major issues regarding initial selection as auditor (e.g. any
disagreement on accounting treatment or any indication of scope limitation), and
communicate to TCWG these matters and their effect on audit strategy and audit Plan.
3. Communicate with predecessor auditor (if there has been a change in auditor) and make
arrangements e.g. arrangement to review the working papers.
4. Procedures to obtain sufficient appropriate audit evidence regarding opening balance
5. Other procedures in accordance with firm’s quality control system (e.g. assignment of
quality control review for initial audit engagement)
3 By: Muhammad Asif, ACA
4. Auditing – Study Notes Chapter 9 Planning an Audit
CONCEPT REVIEW QUESTION
You are the partner of Alamgir and Company, Chartered Accountants and have received an offer for
appointment as auditor of Guava Limited (GL). The previous year’s audit was carried out by Babur
and Company, Chartered Accountants.
Required:
State the matters that you would consider in establishing the overall audit strategy, including
matters which are to be considered, being the initial audit engagement. (08 marks)
(CA Inter - Spring 2014)
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Interim Audit:
Definition:
Interim audit is that part of the audit which takes place before the year end. Interim audit is not
required by ISAs. Auditor decides to conduct interim considering time pressure, size and
complexity of entity, and effectiveness of controls.
Typical Interim Audit Procedures:
Obtaining understanding of entity and assessing inherent risk.
Obtaining understanding of internal control and assessing control risk.
Documentation and testing of internal controls.
Preliminary analytical procedures
Testing of profit and loss transactions for the year to date.
identification of potential problems which may affect the final audit work
Advantages of Interim audit:
Interim Audit gives following benefits:
a) Earlier identification of significant matters.
b) Flexible planning of human resources.
c) Stakeholders receive audit report quickly.
d) Burden of audit team is spread, therefore, efficiency and effectiveness of audit team is
increased.
Final Audit:
Definition:
Final audit will take place after the year end and concludes with the auditor forming and expressing
an opinion on the financial statements for the whole year.
Typical Procedures performed at Final Audit:
Agreeing financial statements to accounting records
Examining adjustments made during preparation of financial statements
Ensure proper cut-off on sales and purchases.
Substantive Procedures for account balances and transactions.
Study Tip
Interim audit has nothing to do with Internal Audit or Review Engagement.
4 By: Muhammad Asif, ACA
5. Auditing – Study Notes Chapter 9 Planning an Audit
Obtaining Confirmation Letters (e.g. from banks, debtors and creditors)
Obtaining Representation Letter from Management.
Inventory count and follow-up of items noted during inventory count.
Review of subsequent events.
Final analytical procedures.
Going Concern Review
CONCEPT REVIEW QUESTION
Explain the difference between an interim and a final audit. (05 marks)
(ACCA F8 – June 2014)
PART B – AUDIT MATERIALITY
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What is Materiality:
Misstatements, including omissions, are considered material if they, individually or in aggregate,
could reasonably be expected to influence the economic decisions of users taken on the basis of the
financial statements.
Materiality depends on size as well as nature of misstatement.
Use/Purpose of Materiality:
Materiality is determined at the start of the audit but is used at:
Planning stage, to determine nature, timing and extent of audit procedures to be performed.
Performance stage, to ensure that misstatements identified during audit do not exceed
performance materiality.
Reporting stage, to evaluate the effect of uncorrected misstatements on financial
statements, and in forming opinion on financial statements (i.e. whether financial
statements give true and fair view in all material respects).
How is Materiality determined:
On the basis of size, materiality is determined as follows:
Materiality = Chosen Benchmark * Chosen Percentage
Benchmark depends on whether entity is profit oriented or not-for-profit.
Percentage depends on Benchmark and Risk (i.e. risk and materiality have inverse
relationship).
Documentation of Materiality:
The auditor shall document the following aspects of materiality:
(i) Materiality for the financial statements as a whole
(ii) Performance materiality
Exam Tip
Following “rule of thumb” has been established to determine materiality:
1. For profit oriented entity, materiality= Profit before tax * 5%
2. For not-for-profit entity, materiality = Total Revenue or Total Expenses or
Total Assets* 0.5% (or 1%)
5 By: Muhammad Asif, ACA
6. Auditing – Study Notes Chapter 9 Planning an Audit
(iii) Basis of computing materiality
(iv) Any revision of (i) to (ii) as the audit progresses
CONCEPT REVIEW QUESTION
ISA 320 Materiality in Planning and Performing an Audit provides guidance on the concept of
materiality in planning and performing an audit.
Required: Define materiality and determine how the level of materiality is assessed. (05 marks)
(ACCA F8 – June 2010)
Determination of materiality level requires professional judgement on the part of the auditor.
(a) Briefly describe the importance of materiality in the following stages of audit:
(i) Planning stage (01 marks)
(ii) Reporting stage (02 marks)
(b) What aspects of materiality should be documented by an auditor in the working papers?
(04 marks)
(CA CAF- Spring 2016)
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What is Performance Materiality:
Performance Materiality is the amount set by the auditor, less than materiality for the financial
statements as a whole, to reduce the risk that the aggregate of uncorrected and undetected
misstatements exceeds materiality for the financial statements as a whole.
If applicable, performance materiality also refers to the amount or amounts set by the auditor at
less than the materiality level or levels for particular classes of transactions, account balances or
disclosures.
How is Performance Materiality determined:
Determination of performance materiality is not a mathematical calculation. It involves the exercise
of professional judgment and is affected by:
misstatements identified in previous periods; and
expected misstatements in current periods (based on auditor’s risk assessment procedures)
CONCEPT REVIEW QUESTION
You are the training manager in a firm of chartered accountants. Prepare brief presentation for
newly inducted trainees, on Materiality and Performance Materiality. (05 marks)
(CA Inter - Autumn 2014)
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What is Qualitative Materiality:
Qualitative materiality means ignoring the amounts of misstatements and considering its
“qualitative characteristics” to determine whether it is material or not.
6 By: Muhammad Asif, ACA
7. Auditing – Study Notes Chapter 9 Planning an Audit
Examples Areas where Materiality is determined on Qualitative basis:
1. Inadequate or improper description of an accounting policy and related party transactions
2. Non-compliance of legal requirements (e.g illegal payments, money laundering)
3. Fraud
4. A misstatement which is small in size but:
o Converts a loss into profit (and vice-versa).
o Takes financial figures below a certain threshold
o Affects a key ratio (e.g. debt-covenant requirements)
o Directors’ remuneration
o Share capital
CONCEPT REVIEW QUESTION
During the course of an audit, both quantitative as well as qualitative misstatements need to be
considered. Give four examples of qualitative misstatements. (04 marks)
(CA Inter, Spring 2010)
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When is Materiality Revised:
Materiality is revised if auditor obtains new information/evidence which is different from
information/evidence on which original assessment was based e.g.
1. Occurrence of events substantially affecting draft financial statements
2. Revision in risk
3. Change in the auditor’s understanding of the entity and its operations
4. Change in circumstances during audit (e.g. decision to dispose a major part of the business)
Effect of Revision of Materiality on Audit:
If materiality is revised, it may have impact on following aspects of audit:
Performance materiality
Nature, timing and extent of audit procedures
Risk of material misstatement
CONCEPT REVIEW QUESTION
Sajjad is the audit senior on the audit of Hameed Limited (HL). Upon his manager’s instruction
Sajjad had determined the acceptable materiality level to be Rs. 10 million at the initial planning
stage. However, at the time of evaluating the results of audit procedures carried out at the interim
stage, he has reduced the materiality level to Rs. 7.5 million.
Required:
(i) Identify the possible causes which motivated Sajjad to reduce the materiality level. (02 marks)
(ii) Discuss the impact of reduction in the materiality level on audit risk and the audit procedures to
be performed. (05 marks)
(CA Inter - Spring 2010)
7 By: Muhammad Asif, ACA
8. Auditing – Case Studies Chapter 9 Planning an Audit
CHAPTER NINE (CASE STUDIES)
PLANNING AN AUDIT
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Structure of the Case:
You may be given financial information of an audit client and misstatement(s) in the question. You
will be required to calculate materiality from the financial information, and to comment whether
given information is material or not.
Suggested Approach to Solve:
While evaluating whether effect is material or not, consider aggregate effect of misstatement as well
as qualitative aspect of materiality.
Model Case Study:
Case Study 1:
For each of the following scenarios determine:
a) Planning materiality,
b) Performance materiality and
c) Evaluate audit findings.
Scenario 1:
HMK & Co. operates in retail business. The components of its financial statements are:
1. Net Profit 3,200,000
2. Total Revenue 350,000,000
3. Total Assets 240,000,000
Auditor of HMK & Co. allocates 40% of financial statement materiality to inventories. During the audit of
inventories, HMK & Co.’s audit firm detected two misstatements amounting Rs. 60,000 and Rs. 50,000
respectively.
Scenario 2:
Welfare Hospital treats poor patients and runs on donations received from general public. The components of
its financial statements are:
1. Net Profit 15,000
2. Total Revenue 30,000,000
3. Total Assets 22,000,000
Welfare Hospital’s auditor uses 50% of financial statements materiality as performance materiality. During
the course of the audit, audit firm detected one misstatement that resulted in an understatement of expenses
by Rs. 20,000.
1 By Muhammad Asif, ACA
9. Auditing – Case Studies Chapter 9 Planning an Audit
Solution:
Scenario 1:
Planning Materiality:
Auditor shall determine materiality using rule of thumb. As this audit client is a profit oriented entity hence
benchmark will be Profit (total revenue and total assets will be ignored for this purpose). Hence materiality =
Net Profit * 5% i.e. 3,200,000 * 5% = Rs. 160,000
Performance Materiality:
Performance Materiality = Overall Materiality * 40% = 64,000.
Evaluation of Result:
As the amount of misstatement exceeds performance materiality, hence it is material and is required to be
corrected.
(Note: Misstatements in classes of transactions or account balances are compared with performance materiality
and not with overall materiality).
Scenario 2:
Planning Materiality:
Auditor shall determine materiality using rule of thumb. As this audit client is a not-for-profit entity hence
benchmark will be Total Revenue or Total Assets (net profit will be ignored for this purpose). Hence
materiality = Total Revenue * 1% i.e. 30,000,000 * 0.5% = Rs. 150,000 (Note: Alternatively total assets may
also be used to determine materiality)
Performance Materiality:
Performance Materiality = Overall Materiality * 50% = 75,000.
Evaluation of Result:
As the amount of misstatement does not exceed performance materiality, hence it is immaterial on
quantitative basis. However, if corrected, this misstatement will affect key performance indicator i.e. it will
convert its profit into loss, hence it is considered material on the basis of qualitative criteria and is required to
be corrected.
2 By Muhammad Asif, ACA