Chapter 9 Planning the Audit: Materiality and Audit Risk

Self-review Questions
9.1
State the two main phases in planning an audit and outline the main objective of
each.
1) The overall audit strategy (overall audit plan)
Plans made regarding: how much and what evidence to gather; and how, when
and by whom this should be done.
2) The audit plan (or audit programme)
In effect, operationalizes the overall strategy. Sets out in detail the audit
procedures to be performed in each segment of the audit, indicating those to be
performed during the interim audit and those to be performed during the final
audit. Also frequently includes details of such things as the size of samples to be
tested and how the samples are to be selected.

9.2
Define materiality and explain briefly the distinction between:
i)
Planning materiality (at the financial statement level), and

ii)

The amount of error the auditor is prepared to accept in the financial

statements as a whole while still concluding that they provide a true
and fair view of the state of affairs and profit or loss of the reporting
entity.
The auditor needs to estimate this level of error, or materiality level,
prior to commencing the audit, based on their understanding of the
client, its business and industry, and on their assessment of the
decision needs of users of the auditees financial statements.
Planning materiality and provides basis for planning the nature, timing
and extent of procedures to be performed during the audit.
Lower the level of planning materiality, the greater amount and/or the
more appropriate the evidence that needs to be collected.

Tolerable error (at the account level)

The planning materiality level set also provides a basis for establishing
the maximum amount of error the auditor will accept in an individual
class of transactions, account balance or other disclosure.
Not required to determine a tolerable error for every class of
transactions, account balance or other disclosure.
Most cases audit firms set a tolerable error for significant individual
classes of transactions, account balances and other disclosures.

9.3
Explain briefly what is meant by performance materiality.
ISA 320 definition:
Performance materiality means the amount or amounts set by the auditor at less than
materiality for financial statements as a whole to reduce to an appropriately low level the
probability that the total of uncorrected and undetected misstatements exceeds
materiality for the financial statements as a whole. Also refers to the amount or amounts
set by the auditor at less than materiality level or levels for particular classes of
transactions, account balances or disclosures [i.e. tolerable error].

9.4
Describe briefly the three stages in determining planning materiality.
a) Selecting one or more appropriate benchmark(s);
Selecting appropriate benchmarks: ISA 320 identifies a number of factors that
may affect the selection of an appropriate benchmark:

The elements of the financial statements (e.g. assets, liabilities, equity,

income, expenses);
Whether there are items on which the attention of the users of the
particular entitys financial statements tends to be focused;
The nature of the entity, where the entity is in its life cycle, and the
industry and economic environment in which it operates;
The entitys ownership structure and the way it is financed (e.g. if financed
solely by debt rather than equity, users may put more emphasis on assets,
and claims on them, than on the entitys earnings); and
The relative volatility of the benchmark.
b) Identifying appropriate financial data for the selected benchmark(s);
Identifying financial data: Once appropriate benchmarks have been selected,
financial data for the benchmark needs to be identified.
c) Determining a percentage to be applied to the selected benchmark(s).
ISA 320: Determining a percentage to be applied to a chosen benchmark requires
the exercise of professional judgement. There is a relationship between the
percentage and the chosen benchmark, such that a percentage applied to profit
before tax from continuing operations will normally be higher than a percentage
applied to total revenue. The auditor may consider five percent of profit before
tax from continuing operations to be appropriate for a profit-orientated entity in a
manufacturing industry. Higher or lower percentages, however, may be deemed
appropriate in the circumstances.

9.5
Explain briefly how setting materiality limits at different levels affects planned
audit procedures.
Level at which materiality limits are set affects the planning of audit procedures their
nature, timing and extent.

9.6
Explain briefly what is meant by the auditors desired level of assurance and
how it relates to the auditors desired level of audit risk.
Desired level of assurance the subjectively determined level of confidence that the
auditor wants to have about the fair presentation of the financial statements after the
audit is completed. The higher the level of assurance attained, the more confident the
auditor is that the financial statements [on which a clean report is issued] contain no
material misstatements or omissions.
If auditor wishes to be 95% assured (or confident) that the financial statements on which
(s)he expresses a clean audit opinion are free of material misstatements, this means
(s)he is prepared to accept a 5% risk that the financial statements on which a clean
opinion is expressed contain such errors.
The link (ISA 200): To obtain reasonable assurance, the auditor shall obtain sufficient
appropriate audit evidence to reduce audit risk to an acceptably low level and thereby
enable the audit to draw reasonable conclusions on which to base the auditors opinion.

9.7
Explain briefly the circumstances in which the auditors desired level of audit risk
is likely to be particularly low.
Where there is some doubt about the entitys status as a going concern. If a client is
forced into liquidation shortly after receiving a clean audit report and the financial
statements are subsequently found to contain one or more material errors or omissions,
the auditor may be exposed to litigation. If in such circumstances the auditor reduces
his/her level of audit risk, s(he) will gather more evidence than would otherwise be the
case, and will be particularly concerned to see that the nature of the going concern
problem is adequately disclosed in the notes to the financial statements.

9.8
Explain briefly how the auditors assessment of inherent risk and internal control
risk affects his or her planning of substantive procedures.
Substantive procedures have a direct bearing on detection risk. In general, the
lower the level of inherent risk and internal control risk, the less substantive
procedures which are required to confirm that the financial statements are, in
fact, free of material misstatements.

9.9
Explain briefly the relationship between materiality limits, audit risk and audit
planning.
Audits must be planned so as to ensure that:
Inherent risk is properly assessed [which largely depends on gaining an adequate
knowledge of the clients]
Internal control risk is properly evaluated (which includes planning, performing
and evaluating compliance procedures) and;
Sufficient appropriate substantive procedures are performed so that detection risk
and thus audit risk is reduced to the level desired by the auditor.
Hence in order to reduce audit risk to the desired level the auditor must carefully plan
the nature, timing and extent of audit procedures.
Level of materiality affects the amount and/or appropriateness of the audit evidence the
auditor need to gather.
Linking materiality to audit risk and the extent of audit procedures, we can say the lower,
the more readily misstatements that exist in the pre-audited financial statements will
exceed those limits and thus qualify as material misstatements.
Therefore, all things equal, lower the materiality limits, the higher the auditors
assessment of inherent and control risk and, consequently, the more extensive the audit
procedures that need to be performed in order to reduce audit risk to a low level.
Low materiality limits = high audit risk = more extensive planned audit procedures
High materiality limits = low audit risk = less extensive planned audit procedures

9.10
When

a)
b)

planning an audit, the auditor must consider:

The extent of audit procedures,
The timing of audit procedures,
The nature of audit procedures.
Briefly explain the meaning of each of these terms.
Give on example for each term to illustrate its effect on planning an audit.