Audit_I_Chapter_3,_Pt_I,_Audit_Planning_&_Materiality.pptx

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1. Chapter 3 Audit Planning Ch 3 Part I - Audit Planning and Materiality

2. Learning Objectives 3.1.1 Discuss why adequate audit planning is essential 3.1.2 Make client acceptance decisions and perform initial audit planning 3.1.3 Gain an understanding of the client’s business and industry 3.1.4 Perform preliminary analytical procedures 3.1.5 Apply the concept of materiality to the audit 3.1.6 Make a preliminary judgment about what amounts to consider material 3.1.7 Determine performance materiality during audit planning 3.1.8 Use materiality to evaluate audit findings Audit I YA AAUSC 2022

3. Audit Planning (ISA 300) Auditing is a task which involves risk, thus proper planning is essential. Knowledge of client’s business is very important part of planning; it helps to reduce risk associated with the client. There are three main reasons why the auditor should properly plan engagements: ( B enefits of planning engagements): 1.To obtain sufficient appropriate evidence 2. To keep audit costs reasonable 3. To avoid misunderstandings with the client Proper planning helps to avoid two extremes: under audit (which increases auditors risk of legal liability) and over audit (which results in high cost of audit/in- efficency ). Audit I YA AAUSC 2022

4. ..Audit Planning Much of the early planning of audits deals with obtaining information to help auditors assess the following risks which significantly influence the conduct and cost of audits. : Acceptable audit risk Client business risk Risk of material misstatement What is audit risk? What are the components of audit risk? What is acceptable audit risk? Audit I YA AAUSC 2022

5. ..Audit Planning Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. It is a function of the risk of material misstatement ( inherent risk and control risk ) and the risk that the auditor will not detect such misstatement (detection risk that arise from sampling & non sampling risk ). Audit Risk=Risk of Material Misstatement X Detection Risk Audit risk can make the auditor to provide unmodified (clean report) when FSs are materially misstated; in such cases the auditor can be sued by users of FS , disciplinary actions can be taken by professional body and the firm could damage its reputation. To avoid such damaging effects, the auditor will plan & perform the audit to reduce audit risk to an acceptably low level. Audit I YA AAUSC 2022

6. ..Audit Planning The auditing profession has no official standards for an acceptable level of overall audit risk, except that it should be “acceptably low ” Acceptable audit risk is 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. Zero risk is certainty , A 100 percent risk is complete uncertainty . Planning the audit helps to keep the risk with in acceptable/normal limit When auditors prefer lower acceptable audit risk , it means that they want to be more certain that the financial statements are not materially misstated and vise versa. Eg accepting 10% risk requires 90% accuracy accepting only 5% risk requires 95% accuracy (more accuracy) Audit I YA AAUSC 2022

7. ..Audit Planning An efficient and effective audit can only be undertaken if adequate planning has taken place. Audit planning involves: establishing the overall audit strategy and developing the actual audit plan. The objective of ISA 300 is to establish the overall audit strategy and to develop an audit plan to reduce audit risk to an acceptably low level. Who shall involve in planning an audit? the engagement partner and other key members of the audit team who shall all be involved in both the audit planning and discussions amongst the engagement team [ISA300.5 ) Audit I YA AAUSC 2022

8. ..Audit Planning Client business risk is the risk that the entity fails to achieve its objectives or execute its strategies . Business risk can arise from factors such as significant changes in industry conditions or events such as regulatory changes, or from the setting of inappropriate objectives or strategies. For example, the auditor may identify declines in economic conditions that adversely affect sales and the collectibility of accounts receivable . Audit I YA AAUSC 2022 1000155015668CBEKiros Habtu Ferede

9. ..Audit Planning The risk of material misstatement is the risk that the financial statements contain a material misstatement due to fraud or error prior to the audit. The risk of material misstatement is a function of the susceptibility of the financial statements (as a whole or in individual accounts) to misstatement, and the effectiveness of the client’s controls in preventing or detecting and correcting the misstatements. Continuing with the previous example, declining economic conditions may increase the likelihood that the company may take inappropriate actions to meet sales targets or understate the allowance for doubtful accounts, especially if the client does not have adequate controls over sales and collection of accounts receivable Audit I YA AAUSC 2022

10. ..Audit Planning Risk of material misstatement is the risk that the FSs are materially misstated prior to audit.(ISA 200,13n). What is misstatement? Misstatement is the difference b/n the reported amount, classification, presentation, or disclosure of a FS item and the amount, classification, presentation, or disclosure that is required for the item to be in accordance with applicable FR framework. Misstatements can arise from error or fraud . Audit I YA AAUSC 2022

11. ..Audit Planning Categories of Misstatement Factual Misstatements It is a misstatement about which there is no doubt Judgmental Misstatements It is the difference in an accounting estimate that the auditor considers unreasonable , or the selection or application of accounting policies that the auditor considers inappropriate. Projected Misstatements It is the auditor’s best estimate of the total misstatement in a population through the projection of misstatements identified in a sample. (ISA 450,A6) Audit I YA AAUSC 2022

12. ..Audit Planning Risk of material misstatement comprises inherent risk & control risk Inherent Risk: It is the risk arising naturally in the business and specific accounts/transactions. Examples of inherent risk : Complex accounting treatment -where accounting standards require a specific accounting treatment, the client may not understand its application, this will result in misstatement Nature of industry, entity or the nature of the balance itself - eg . Inventory is inherently risky if it quickly becomes obsolete as it may not be valued appropriately at the LCNRV as required by IAS 2. Inherent risk is affected by the nature of the entity; for example, the industry it is in and the regulations it falls under, and also the nature of the strategies it adopts Audit I YA AAUSC 2022

13. .. ..Audit Planning ..Inherent Risk: Inherent risk factors may be qualitative/quantitative : Qualitative factors include: Complexity, subjectivity, change, uncertainty, susceptibility to misstatement due to management bias. (ISA 315, A7) Audit I YA AAUSC 2022

14. ..Risk of Material Misstatement … Inherent Risk: Example of inherent risk PPE will be Overstated if expenditures on repairs is treated as capital expenditure Overstated if assets lives have been extended for depreciation purpose without any justification for the increase Overstated if assets ordered but not delivered are included in the FSs Understated if capital expenditure has been incorrectly expensed. Audit I YA AAUSC 2022

15. .. ..Audit Planning Control Risk It is the risk that the accounting control system will fail to detect and prevent errors. The client should have controls such as authorization, segregation of duties, reconciliations, physical controls etc. If these controls are effective, they will: prevent the misstatements from occurring or detect misstatements that have occurred, so that the client can take action to correct them If these controls are nor effective, : Control risk will increase and there will be a greater risk of misstatements occurring in the FSs. Audit I YA AAUSC 2022

16. .. ..Audit Planning Detection Risk: it is the risk that the auditors will not detect material misstatements Detection risk comprises Sampling risk and on-sampling risk . Sampling risk -the risk that the auditor’s conclusion based on a sample is different from the conclusion that would be reached if the whole population was tested ( i.e the sample was not representative of the population from which it was chosen. (ISA 530 Audit sampling) Non-sampling risk -the risk that the auditor’s conclusion is inappropriate for any other reason, eg . The application of inappropriate procedures or the failure to recognize a misstatement (ISA 530 Audit sampling) To summarize: Audit risk= Inherent risk X Control risk X Detection risk Or = Risk of Material Misstatement x Detection risk *Remember, audit planning is needed to reduce audit risk to an acceptable level. Audit I YA AAUSC 2022

17. Figure 8.1 Planning an Audit and Designing an Audit Approach (The Planning process) (Planning process 1-4) will be discussed in 3.1 (This part) (Planning process 5-8) will be discussed in 3.2 (next part) Audit I YA AAUSC 2022

18. Accept Client and Perform Initial Audit Planning (Pre-planning) This pre-planning process is also known as ‘Preliminary engagement activity) Initial audit planning (Pre-planning) involves four things that should be done early in the audit: 1. Performing procedures to accept a new client or continue serving an existing one 2. Identifies why the client wants or needs an audit 3. Obtains an understanding with the client about the terms of the engagement 4. Develops the overall strategy for the audit ( engagement staffing and any required audit specialists) Audit I YA AAUSC 2022

19. …Accept Client and Perform Initial Audit Planning 1. Client Acceptance and Continuance is a decision that is made before incurring any significant costs that cannot be recovered. The audit firm should only accept new clients after performing client screening Factors to be considered before accepting new client: Professional clearance Auditing standards require, with the consent of the client, the new auditor to communicate the predecessor auditor (outgoing auditor) and obtain relevant information such as (disagreement with management, over fees, application of audit procedures, integrity of management (existence of breaches of laws and regulations) If the client doesn’t permit the communication, refuse to accept the audit engagement Audit I YA AAUSC 2022

20. …Accept Client and Perform Initial Audit Planning …1. Client Acceptance and Continuance …. Factors to be considered before accepting new client: Independence and objectivity (if threats to independence and objectivity cannot be managed to an acceptable level, the engagement should not be accepted) Lack of management integrity- (if they involves in criminal activities such as money laundering, if they override controls, reach laws and regulations, if they intimidate auditors, if they provide false documents…) Availability of Resources – The firm should consider availability of resources to complete the audit on time. Professional competence- The firm should accept the engagement if it has necessary skill and experience to perform. Acceptability of fee- The firm should consider if fee is sufficent Audit I YA AAUSC 2022

21. …Accept Client and Perform Initial Audit Planning …1. Client Acceptance and Continuance Preconditions for an audit: As per ISA 210, before accepting/continuing with an engagement, it is essential for the auditor to ensure preconditions are present: Preparation of FSs as per the applicable Financial Reporting framework Application of internal control system that makes FSs to show true and fair view Providing the auditor with access to all relevant and information and explanation Audit I YA AAUSC 2022

22. …Accept Client and Perform Initial Audit Planning …1. Client Acceptance and Continuance Continuing with existing clients: Evaluate existing clients annually to determine whether there are reasons for not continuing to do the audit The auditor may decide not to continue with the existing client if there is: Disagreement with management ( eg on the type of opinion to issue, unpaid fees, or other matters) Doubts over management integrity Presence of excessive risks Audit I YA AAUSC 2022

23. …Accept Client and Perform Initial Audit Planning (Pre-planning) 2. Identify Client’s Reasons for Audit Auditor’s acceptable audit risk may be affected by the client’s reasons for audit Knowledge of statement users and their intended uses of the statements affect the decision on acceptable audit risk. The auditor is likely to accumulate more evidence, Eg .- When the statements are to be used extensively in the case of publicly held companies , - those with extensive indebtedness , and - companies that are to be sold in the near future . Audit I YA AAUSC 2022

24. …Accept Client and Perform Initial Audit Planning 3. Obtains an understanding with the client about the terms of the engagement A clear understanding of the terms of the engagement should exist between the client and the CPA firm . Auditing standards require that auditors document their understanding with the client in an engagement letter , including: the engagement’s objectives, the responsibilities of the auditor and management, about assistants to be assigned for the auditor (data providers), fees, impositions like deadline for the work, and the engagement’s limitations (to inform what auditors are not responsible for eg guaranteeing for complete discovery of fraud). Audit I YA AAUSC 2022

25. …Accept Client and Perform Initial Audit Planning …3. Obtains an understanding with the client about the terms of the engagement Purpose of Engagement letter Engagement letter specifies the nature of the contract b/n the audit firm and the client. It helps to: Minimize misunderstanding b/n the auditor and the client Confirm acceptance of the engagement Set out terms and conditions of the engagement Engagement letter should be reviewed every year, and be revised if there is any change (change in senior mgt, change is scope of work..) Link Ch 3\Link 1 Example of engagement letter.docx Audit I YA AAUSC 2022

26. …Accept Client and Perform Initial Audit Planning 4 . Develop Overall Audit Strategy The audit strategy that sets the scope, timing, and direction of the audit and that guides the development of the audit plan As per ISA 300, the audit strategy helps the auditor to determine: Resources to deploy for specific audit areas ( eg experience level, external experts) The amount of resources to allocate ( ie . No. of team members) When this resources are to be deployed How the resources are managed, directed and supervised, including the time of meeting, debriefings and reviews. (ISA 300,A8) Audit I YA AAUSC 2022

27. ..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 A through understanding of the client’s business and industry is essential to conduct an adequate audit. Reasons for Understanding Clients Business & Industry: Many industries have unique accounting requirement that the auditor must understand to evaluate whether the client’s F/Ss are in accordance with GAAPs. There are inherent risks that are typically common to all clients in certain industries. Audit I YA AAUSC 2022

28. ..Understand the Client’s Business and Industry Obtaining a good understanding of the following components allow auditors to develop a strategic approach to understand the client’s business and industry : Industry and external environment ( to identify risks associated with specific industries ) Business operations and processes (to have better understanding of the operations, identify related parties, assess inherent and control risks) Management and governance ( to understand management’s philosophy and operating style, its ability to identify and respond to risk, since this influence the risk of material misstatements in the financial statements) Client objectives and strategies (helps the auditor to assess client business risk and inherent risk in the financial statements). Measurement and performance (unreasonable performance measurement system may increase inherent risk by encouraging aggressive accounting). Eg . Objective -Market share; Reward- based on sales volume Audit I YA AAUSC 2022

29. ..Understand the Client’s Business and Industry The importance of understanding the entity and its environment It helps the auditor to assess the identified risks of material misstatement (inherent and control risk) at the financial statement level and assertion levels to design further audit procedures in response to these risks) (ISA 315,13) Sources of information to obtain an understanding of entity and its environment: Auditor’s past experience Audit firm partner/manager/prior year team/prior year files, industry experts Analytical procedures (ratios, trends,) Client (Discussion, observation, website, brochures) External (Industry data, trade press) Audit I YA AAUSC 2022

30. ..Understand the Client’s Business and Industry Why? To identify and assess the risks of material misstatement To enable the auditor to design and perform further audit procedures To provide a frame of reference for exercising audit judgment What? Industry, regulatory and other external factors , Nature of the entity, including operations, ownership and governance Entity's selection and application of accounting policies Objectives and strategies and related business risks– Measurement and review of the entity's financial performance Internal control (which we shall look at in detail) How? Enquiries of management, appropriate individuals Analytical procedures Observation and inspection Prior period knowledge Audit I YA AAUSC 2022

31. Perform Preliminary Analytical Procedures ISA 520 Auditors are required to perform preliminary analytical procedures as part of risk assessment procedures: to better understand the client’s business and industry, and to assess client business risk They serve as attention directing tools Eg . Comparison of client’s ratios to industry or competitor benchmarks to provide an indication of the company’s performance. Computing ratios indicating short-term debt paying ability (liquidity) ability to meet long-term obligations and preferred dividends , activity and profitability ratios etc.   Such preliminary tests: can reveal unusual changes in ratios compared to prior years , or to industry averages, and help the auditor identify areas with increased risk of misstatements that require further attention during the audit. Audit I YA AAUSC 2022

32. Set Preliminary Judgment of Materiality & Performance Materiality Materiality Misstatements, including omissions, are considered to be material if they, individually, or when aggregated with other misstatements, could reasonably be expected to influence the economic decisions of users made on the basis of the financial statements (ISA 320) As per ISA 320, Misstatements are considered to be material if they, individually or in aggregate, could reasonably be expected to influence the economic decisions of users. Judgments about materiality are made in the light of surrounding circumstances of the entity, and are affected by the size and nature of a misstatement or a combination of both . Judgments about matters that are material to users of financial statements are based on a consideration of the common financial information needs of users as a group . Audit I YA AAUSC 2022

33. …Set Preliminary Judgment of Materiality & Performance Materiality What does Materiality implies? Why it is considered? If FSs contain material misstatement, they can not be considered to show true and fair view. The focus of an audit is identifying the significant risks of material misstatement in the FSs and then designing procedures aimed at identifying and quantifying tem. The auditor must be concerned with identifying 'material' errors, omissions and misstatements. Both the amount (quantity) and nature (quality) of misstatements need to be considered, eg lack of disclosure regarding ongoing litigation is likely to be considered material . Audit I YA AAUSC 2022

34. …Set Preliminary Judgment of Materiality & Performance Materiality ….What does Materiality implies? Why it is considered? At all stages of the audit, including during risk assessment, the auditor must bear in mind what the overall objectives are. As per ISA 200 Overall objectives of the independent auditor are: 'To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement , whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects , in accordance with an applicable financial reporting framework ; and to report on the financial statements, and communicate as required by the ISAs, in accordance with the auditor's findings . So, the auditor is required to obtain assurance about whether the financial statements are free from material misstatement. Audit I YA AAUSC 2022

35. …Set Preliminary Judgment of Materiality & Performance Materiality How Materiality is determined? The determination of material misstatement is a matter of professional judgment, and judgments concerning materiality are made in relation to the specific circumstances surrounding the entity. In addition, judgments are also made considering the size, complexity and objectives of the entity. Materiality is set at the planning stage of the audit and auditors are aware that certain transactions or events may be material both in nature as well as in value Audit I YA AAUSC 2022

36. …Set Preliminary Judgment of Materiality & Performance Materiality Material by size ISA 320 recognizes the need to establish a financial threshold to guide audit planning and procedures. The following are used as a staring point: ½ to 1% revenue 5-10% profit before tax 1-2% total assets These are common benchmarks, but different audit firms may use different benchmarks or different thresholds for each client. Audit I YA AAUSC 2022

37. …Set Preliminary Judgment of Materiality & Performance Materiality Material by nature Materiality is not only looked at from a financial perspective, some items may be material by nature. Examples include: Misstatements that affect compliance with regulatory requirements Misstatements that affect compliance with debt covenants (Contractual obligations) Misstatements that when adjusted, would turn a reported profit in to a loss for the year Link Ch 3\1. Illustration on Materiality.docx Misstatements that when adjusted, would turn a reported net- asset position in to net-liability position Transactions with directors, eg . Salary and benefits, personal use of assets, etc Disclosures in the FSs relating to possible future legal claims or going concern issues. Audit I YA AAUSC 2022

38. …Set Preliminary Judgment of Materiality & Performance Materiality Concept check Define the meaning of the term materiality as it is used in accounting and auditing. What is the relationship between materiality and the phrase obtain reasonable assurance used in the auditor’s report? Explain why materiality is important but difficult to apply in practice. Audit I YA AAUSC 2022

39. …Set Preliminary Judgment of Materiality & Performance Materiality Auditors follow five related steps in applying materiality: Step 1: Determines materiality for the financial statements as a whole Step 2: Determines performance materiality Step 3: Estimate the amount of misstatements in each segment Step 4: Estimate the combined misstatement Step 5: Compare combined estimate with preliminary or revised judgment about materiality Audit I YA AAUSC 2022

40. Figure 8.5 Steps in Applying Materiality Audit I YA AAUSC 2022

41. …Set Preliminary Judgment of Materiality & Performance Materiality .. Steps in applying materiality Step 1: Set Materiality for Financial Statements as a Whole (Set Preliminary judgment about Materiality) It is the maximum amount by which the auditor believes the statements could be misstated and still not affect the decisions of reasonable users. This judgment is one of the most important decisions the auditor makes, and it requires considerable professional wisdom . It is set by using a top-down approach that involves setting an overall material amount for the financial statements and this will be allocated to particular accounts . It is called a preliminary judgment about materiality because, it may change during the engagement. This judgment must be documented in the audit files . Audit I YA AAUSC 2022

42. …Set Preliminary Judgment of Materiality & Performance Materiality .. Steps in applying materiality …Step 1: Set Materiality for Financial Statements as a Whole (Set Preliminary judgment about Materiality) Auditors set a preliminary judgment about materiality to help plan the appropriate evidence to accumulate. The lower the dollar amount of the preliminary judgment, the more evidence required. (low level implies higher accuracy level, and requires more evidence and vice versa) Factors affecting preliminary materiality judgment include: Materiality is a relative rather than an absolute concept (what is material to one Co. may not be material to other) Because materiality is relative, it is necessary to have benchmarks for establishing whether misstatements are material ( eg . Based on profit before tax, based on total asset…) Qualitative factors affect materiality ( eg . Amounts involving fraud are usually considered more important than unintentional errors of equal dollar amounts since it shows honesty) Audit I YA AAUSC 2022

43. …Set Preliminary Judgment of Materiality & Performance Materiality Step 2: Determine Performance Materiality ( Allocate preliminary judgment about materiality to segment) Performance materiality refers to a value set lower than overall materiality, and this lower threshold is used by the auditor when designing and performing audit procedures. It 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. (ISA 320) The process of determining performance materiality is referred to as the allocation of the preliminary judgment about materiality to segments Determining performance materiality (allocation) is necessary because evidence is accumulated by segments rather than for the financial statements as a whole. Most practitioners allocate materiality to balance sheet rather than income statement accounts. Audit I YA AAUSC 2022

44. …Set Preliminary Judgment of Materiality & Performance Materiality …..Step 2: Determine Performance Materiality The determination of performance materiality is based on professional judgment and reflects the amount of misstatement an auditor is willing to accept in a particular segment PCAOB refers to this amount as tolerable misstatement Setting performance materiality reduces the risk that the auditor will fail to identify misstatements that are material when added together. Determining performance materiality is very much dependent on the auditor's professional judgment. In summary, it is affected by: The nature and extent of misstatements identified in prior audits The auditor's understanding of the entity Result of risk assessment procedures Performance materiality is inversely related to the amount of evidence an auditor will accumulate (low level implies higher accuracy level, more evidence and vice versa) Audit I YA AAUSC 2022

45. …Set Preliminary Judgment of Materiality & Performance Materiality …..Step 2: Determine Performance Materiality Auditors face three major difficulties in allocating materiality to balance sheet accounts: Auditors expect certain accounts to have more misstatements than others Both overstatements and understatements must be considered Relative audit costs affect the allocation (If performance materiality were set lower, more costly audit procedures such as inspection and confirmation would be necessary . ) Regardless of how the allocation is done, when the audit is completed, the auditor must be confident that the combined misstatements in all accounts are less than or equal to the preliminary (or revised) judgment about materiality Audit I YA AAUSC 2022

46. …Set Preliminary Judgment of Materiality & Performance Materiality Step 3: Estimate the amount of misstatements in each segment When auditors perform audit procedures for each segment of the audit, they document two types of misstatements: Known misstatements: For these type, the auditor can determine the amount of the misstatement in the account For example, when auditing property, plant, and equipment, the auditor may identify capitalized leased equipment that should be expensed because it is an operating leas e. Likely misstatements- These are two types: Type 1: Differences between management’s and the auditor’s judgment about estimates of account balances ( eg . differences in the estimate for the allowance for uncollectible accounts or for warranty liabilities.) Type 2: Projections of misstatements based on the auditor’s tests of a sample from a population. (table 8-2) illustrates steps3,4 & 5 as follows using 3 accounts: Audit I YA AAUSC 2022

47. …Set Preliminary Judgment of Materiality & Performance Materiality ..Step 3: Estimate the amount of misstatements in each segment Audit I YA AAUSC 2022

48. …Set Preliminary Judgment of Materiality & Performance Materiality …Step 3: Estimate the amount of misstatements in each segment ( …Analysis based on Table 8-2: ) Cash: Tolerable misstatement for cash is $4,000, 100% is checked,; the auditor has found unrecorded bank charge of $2,000. no allowance for sampling risk as 100% is checked. (Total misstatement is $2,000). *Remember it is below the misstatement amount assigned to cash, of $4000. assume the estimated allowance for sampling risk is 50 percent of the direct projection of the misstatement amounts for the accounts where sampling was used (accounts receivable and inventory) A/R: Tolerable misstatement for A/R is $20,000, 100% is not checked,(Sampling is used); The auditor calculates likely misstatement for accounts receivable using known misstatements detected in those samples. The auditor has found a misstatement of $12,000; Allowance for sampling risk of $6,000 (50% of 12,000) is needed as 100% is not checked. (Total misstatement is $18,000). *Remember it is below the misstatement amount assigned to A/R, of $20,000 . Audit I YA AAUSC 2022

49. …Set Preliminary Judgment of Materiality & Performance Materiality …Step 3: Estimate the amount of misstatements in each segment ( …Analysis based on Table 8-2: ) Inventory: Tolerable misstatement for Inventory is $36,000, 100% is not checked,(Sampling is used); The auditor calculates likely misstatement for inventory using known misstatements detected in those samples. The auditor has found a misstatement of $31,500; Allowance for sampling risk of $15,750 (50% of 31,500) is needed as 100% is not checked. (Total misstatement is $47,250). *Now it is above the misstatement amount assigned to Inventory, of $36,000. Audit I YA AAUSC 2022

50. …Set Preliminary Judgment of Materiality & Performance Materiality Step 3: Estimate the amount of misstatements in each segment …Likely misstatements- These are two types: Type 2: Projections of misstatements based on the auditor’s tests of a sample from a population Direct projection of estimate of misstatement = Net misstatement in the sample x Total Total sampled recorded population value Eg : Assume that in auditing inventory, the auditor found Br 3,500 of net overstatement amount in a sample of Br 50,000 of the total populations of Br450,000. The $3,500 identified misstatement is known misstatement The estimate of the likely misstatement is calculated as: Estimated misstatement (projection) = 3,500 x 450,000 50,000 31,500 Audit I YA AAUSC 2022

51. … Set Preliminary Judgment of Materiality & Performance Materiality Step 4: Estimate the combined misstatement ( …Analysis based on Table 8-2: ) In combining the misstatements in Table 8-2, we can observe that the known misstatements and direct projection of likely misstatements for the three accounts adds to $45,500. However, the total allowance for sampling risk ($16,800) is less than the sum of the individual sampling risk amounts ($0+$6,000+$15,750=21750). This is because the allowance for sampling risk represents the maximum misstatement in account details not audited. It is unlikely that this maximum misstatement amount exists in all accounts subjected to sampling. Audit I YA AAUSC 2022

52. …Set Preliminary Judgment of Materiality & Performance Materiality Step 5: Compare combined estimate with preliminary or revised judgment about materiality ( …Analysis based on Table 8-2) Table 8-2 shows that total estimated likely misstatement of $62,300 exceeds the preliminary judgment about materiality of $50,000. The major area of difficulty is inventory, where estimated misstatement including allowance for sampling risk of $47,250 is significantly greater than performance materiality of $36,000. Because the estimated combined misstatement exceeds the preliminary judgment, the financial statements are not acceptable. The auditor can either ensure/determine whether the estimated likely misstatement actually exceeds $50,000 by performing additional audit procedures or require the client to make an adjustment for estimated misstatements. If the auditor decides to perform additional audit procedures, they will be concentrated in the inventory area. Audit I YA AAUSC 2022

53. …Set Preliminary Judgment of Materiality & Performance Materiality ..Step 5: Compare combined estimate with preliminary or revised judgment about materiality ( …Analysis based on Table 8-2) If the estimated net overstatement amount for inventory had been $28,000 ($10,000 plus $18,000 allowance for sampling risk), the auditor probably would not have needed to expand audit tests because it would have met both the tests of” performance materiality ($36,000, as $28,000 < $36,000) and the preliminary judgment about materiality ($2,000 + $18,000 + $28,000 = $48,000 < $50,000). Summary: Remember, a major purpose of audit planning is to gain an understanding of the client’s business and industry, which is used to assess: acceptable audit risk, client business risk, and the risk of material misstatements in the financial statements Audit I YA AAUSC 2022

54. Figure 8.1 Planning an Audit and Designing an Audit Approach (The Planning process) (Planning process 1-4) focusing on Materiality is discussed in 3.1 (This part) (Planning process 5-8, focusing on risk assessment ) will be discussed in 3.2 (next part) Audit I YA AAUSC 2022

55. …Set Preliminary Judgment of Materiality & Performance Materiality Concept check 1. What is meant by setting a preliminary judgment about materiality? Identify the most important factors affecting the preliminary judgment. 2. Distinguish between the terms performance materiality and preliminary judgment about materiality. How are they related to each other? 3. Explain the difference between known and likely misstatements. Assume the auditor tests a sample of $100,000 of inventory and finds misstatements totaling $5,000. What is the likely misstatement if the account balance is $500,000? Audit I YA AAUSC 2022

56. End of Chapter 3: Part I Questions Audit I YA AAUSC 2022