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Chapter 8
Audit Planning and Materiality
Concept Checks
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1. The eight major steps in planning audits are:
1. Accept client and perform initial planning
2. Understand the client’s business and industry
3. Perform preliminary analytical procedures
and the possibility of fraud. The auditor should be especially concerned with
the possibility of fraudulent financial reporting since it is difficult to uncover.
3. The five elements of a strategic understanding of the client’s business are:
requirements unique to the client’s industry.
2. Business Operations and Processes – Considers factors such as
manufacturing operations.
3. Management and Governance – Encompasses the organizational
committee.
4. Client Objectives and Strategies – Understand the client’s strategic
5. Measurement and Performance – Understand key performance
objectives.
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1. The preliminary judgment about materiality is the maximum amount by
1. Materiality is a relative, rather than an absolute, concept.
2. Benchmarks are needed for evaluating materiality.
3. Qualitative factors affect materiality decisions.
2. A preliminary judgment about materiality is set for the financial statements as
a whole. Performance materiality is the maximum amount of misstatement
that would be considered material for an individual segment of the audit, or
account balance. The amount of performance materiality for any given
segment or account is dependent upon the preliminary judgment about
3. Known misstatements are those where the auditor can determine the actual
amount of the misstatement. Likely misstatements are from differences in
management’s and the auditor’s judgment about an estimate, or from the
Review Questions
8–1 There are three primary benefits from planning audits: it helps the auditor
with the predecessor auditor. This enables the successor to obtain information
about the client so that he or she may evaluate whether to accept the engagement.
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8–2 (continued)
The predecessor is required to respond to the successor’s request for
8–3 Auditing standards require auditors to document their understanding of the
terms of the engagement with the client in an engagement letter. The engagement
letter should include the engagement’s objectives, the responsibilities of the
letter informs the client that the auditor cannot guarantee that all acts of fraud
will be discovered.
8-4 Because the Sarbanes–Oxley Act of 2002 explicitly shifts responsibility for
8-5 One of the principles underlying auditing standards notes that the auditor
obtains an understanding of the entity and its environment to provide a basis for
identifying and assessing the risks of material misstatements in the financial
statements. Auditors need an understanding of the client’s business and industry
of the five areas, are as follows:
1. Industry and External Environment – Read industry trade publications,
AICPA Industry Audit Guides, and regulatory requirements.
2. Business Operations and Processes – Tour the plant and offices,
identify related parties, and inquire of management.
meetings, and inquire of management.
4. Client Objectives and Strategies – Inquire of management regarding
their objectives for the reliability of financial reporting, effectiveness and
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8–5 (continued)
5. Measurement and Performance – Read financial statements, perform
objectives.
8–6 During the course of the plant tour, the CPA will obtain a perspective of the
client’s business, which will contribute to the auditor’s understanding of the entity
and its environment. Remember that an important aspect of the audit will be an
The nature of the company’s products and the manufacturing facilities and
processes will reveal the features of the cost system that will require close audit
attention. For example, the audit of a company engaged in the custom–manufacture
of costly products such as yachts would require attention to the correct charging
and solved by other CPAs in similar audits.
The auditor’s observation of the manufacturing processes will reveal
whether there is idle plant or machinery that may require disclosure in the
financial statements. Should the machinery appear to be old or poorly maintained,
and he or she may make preliminary estimates of audit staff requirements. In this
regard, the auditor will notice the various storage areas and how the materials
are stored. The auditor may also keep in mind for further investigation any
apparently obsolete inventory.
methods of production scheduling, timekeeping procedures, and whether work
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8–6 (continued)
evaluation of internal control. The auditor’s overall impression of the client’s plant
will suggest the accuracy and adequacy of the accounting records that will be
audited.
8–8 A related party is defined by auditing standards as an affiliated company,
principal owner of the client company, or any other party with which the client deals
where one of the parties can influence the management or operating policies of
the other.
8–9 Because of the lack of independence between the parties involved, the
Sarbanes–Oxley Act prohibits related party transactions that involve personal
loans to executives. It is now unlawful for any public company to provide
8–10 Fairly recent economic events and the continued instability in global
financial markets led to the collapse of several large financial firms, which
triggered a broader economic decline affecting all industries. These declines are
likely to have a significant impact on financial reporting.
evaluate management’s judgments and estimates.
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8–10 (continued)
substantial doubt about the entity’s ability to continue as a going concern.
8–11 The information in a mortgage that is likely to be relevant to the auditor
includes the following:
1. The parties to the agreement
2. The effective date of the agreement
3. The amounts included in the agreement
4. The repayment schedule required by the agreement
5. The definition and terms of default
6. Prepayment options and penalties specified in the agreement
8–12 Information in the client’s minutes that is likely to be relevant to the auditor
includes the following:
1. Declaration of dividends
2. Authorized compensation of officers
3. Acceptance of contracts and agreements
4. Authorization for the acquisition of property
It is important to read the minutes early in the engagement to identify items
that need to be followed up on as a part of conducting the audit. For instance, if
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8–13 The three categories of client objectives are (1) reliability of financial
reporting, (2) effectiveness and efficiency of operations, and (3) compliance with
1. Reliability of financial reporting – The financial reporting framework
selected by management may affect the reliability of financial
reporting. For example, management’s selection of the cash basis
of accounting may affect the risks of material misstatement differently
than the risk of material misstatement that might be present if
accumulation for material accounts. In contrast, if
management has little regard for the reliability of
auditor’s assessment of risk for the planned evidence accumulation
for inventory.
3. Compliance with laws and regulations – It is important for the auditor
to understand the laws and regulations that affect an audit client,
evidence for pension–related accounts would increase.
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8–14 The purpose of a client’s performance measurement system is to measure
the client’s progress toward specific objectives. Performance measurement includes
ratio analysis and benchmarking against key competitors.
Performance measurements for a chain of retail clothing stores could
include gross profit by product line, sales returns as a percentage of clothing
sales, and inventory turnover by product line. An Internet portal’s performance
measurements might include number of Web site hits or search engine speed. A
hotel chain’s performance measures include occupancy percentages and
average room rate.
1. Making internal comparisons to ratios of previous years or to budget
forecasts.
2. In cases where the client has more than one branch in different
proper cutoff and possible understatement.
8–17 Materiality is defined as the magnitude of misstatements that individually,
or when aggregated with other misstatements, could reasonably be expected to
statements.
“Obtain reasonable assurance,” as used in the audit report, means that
the auditor does not guarantee or insure the fair presentation of the
regarding the application of materiality. The auditor must, therefore, exercise
considerable professional judgment in the application of materiality.
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8–19 Because materiality is relative rather than absolute, it is necessary to
have benchmarks for establishing whether misstatements are material. For
example, in the audit of a manufacturing company, the auditor might use as
benchmarks: net income before taxes, total assets, current assets, and
working capital. For a governmental unit, such as a school district, there is no
net income before taxes, and therefore that would not be an available
benchmark. Instead, the primary benchmarks would likely be fund balances, total
assets, and perhaps total revenue.
8–20 The following qualitative factors are likely to be considered in evaluating
materiality:
they affect a trend in earnings.
8–21 If an audit is being performed on a medium–sized company that is part of
a conglomerate, the auditor must make a materiality judgment based upon the
conglomerate. Materiality may be larger for a company that is part of a
8–22 There are several possible answers to the question. One example is:
Cash $ 500 Overstatement
Fixed assets $3,000 Overstatement
Long–term loans $1,500 Understatement
The least amount of performance materiality was allocated to cash and
long–term loans because they are relatively easy to audit. The majority of the
total allocation was to fixed assets because there is a greater likelihood of
misstatement of fixed assets in a typical audit.
might influence an investor (e.g., disclosure of a related party transaction).
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8–24 If performance materiality for accounts receivable is $40,000 and the
performed using sampling techniques, the auditor would also project total
known misstatements to the population and may perform additional tests
depending on the outcome.
Multiple Choice Questions From CPA Examinations
8–25 a. (4) b. (1) c. (4)
8–28 a. (3) b. (3) c. (3)