Audit Principles and Practices – DFA 3103

UNIT 4 AUDIT PLANNING

Unit Structure

4.0 Overview
4.1 Learning Outcomes
4.2 Audit Planning
4.3 Planning Procedures
4.4 Knowledge of the Business
4.5 Understanding the Accounting and Internal Control Systems
4.6 Audit Risk
4.7 Materiality
4.8 Audit Programme
4.8.1 Timing of Audit Work
4.9 Working Papers
4.9.1 Importance of Working Papers
4.9.2 Contents of Working Papers
4.9.3 Filing of Audit Working Papers
4.9.3.1 Permanent Audit File
4.9.3.2 Current Audit File
4.10 Summary
4.11 Activity

4.0 OVERVIEW

It essential that auditors perform preliminary planning at the start of the audit to
understand the client’s business and its accounting and internal control system, assess the
audit risk, determine the materiality level, prepare the audit programmes and co-ordinate,
supervise and review the audit. Audit planning is important to both internal and external

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auditors. This unit will consider the auditing standards that are relevant in planning an
audit and the other related matters like audit risk, materiality and audit programme.

4.1 LEARNING OUTCOMES

By the end of this Unit, you should be able to do the following:

1. Explain the objectives of audit planning.

2. Describe the sources and nature of information gathered at the audit planning
stage.
3. Explain the procedures to be adopted for an efficient audit planning.
4. Describe the various sources of evidence that are available to auditors in obtaining
the essential knowledge of business.
5. Explain the link between audit planning and audit risk.
6. Explain the meaning of the concept of materiality and its relevance at the
planning stage.
7. Explain the purposes of audit programme.
8. Explain the meaning of working papers and its significance in auditing.

4.2 AUDIT PLANNING

According to ISA 200 Objective and General Principles Governing an Audit of Financial
Statements, the auditor should carry out an audit in accordance with ISAs and ethical
principles to provide reasonable assurance that the financial statements are free from
material misstatement. In other words, auditors should not simply assume that financial
statements are correct but they should look for supporting evidence also. Therefore, the
auditor should bear in mind that circumstances may exist which cause the financial
statements to be materially misstated.

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Audit planning is a crucial stage of an audit assignment. It is necessary to plan activities

before they are performed. ISA 300 Planning an Audit of Financial Statements states that
‘the auditor should plan the audit so that the engagement will be performed in an
effective manner’. This implies that adequate planning of the audit is essential to ensure
that attention is focused on key areas of the audit, potential problems are identified and
the audit work is completed expeditiously.

The extent of the planning will depend on the size of the client firm, the complexity of
the audit assignment and the auditor’s experience and knowledge of the client’s business.
According to ISA 315 Understanding the Entity and its Environment and Assessing the
Risks of Material Misstatement, the auditors are required to obtain knowledge of the
business, sufficient to enable them to identify and understand those issues that may have
a significant impact on the financial statements. Knowledge of the client’s business is
vital as it assists the auditor to identify events, transactions and practices which may have
a material effect on the financial statements.

4.3 PLANNING PROCEDURES

Auditors would normally follow the planning procedures given below:

 Understand the background of the client’s business and attempt to identify any
problems inherent to that business industry which may affect the audit work.
 Consider the extent to which the auditor may wish to rely upon internal controls
and the extent to which work can be allocated to interim or final audit stages.
 Review audit files to be aware of matters raised in the audit of the previous year
and determine its relevance to the current audit.
 Assess the impact of any changes in legislation or accounting practice on the
financial statements of the client.
 Review any management accounts prepared by the client to identify issues that
may be relevant to the current audit.

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 Discuss with management of the client to identify problem areas, for example, no
stock count procedures or the debtors’ list is not up to date.
 Consider the timing of important stages in the preparation of the financial
statements, for example, dates of physical stocktaking, balancing of receivables
and payables ledgers, posting of general ledgers, preparation of trial balance and
draft accounts.
 Consider the extent to which the auditors may rely on the financial data prepared
by the client’s staff.
 Consider the extent to which the auditor may rely on the work done by the
internal auditor.
 Consider the need for expert assistance in the audit team.
 Determine the number and grade of audit staff to be allocated to each stage of the
audit.
 Discuss with members of the audit team on any foreseeable problems.
 Prepare a budget to allocate the time of each member of the audit team. The
budget should also be used to control the time spent on that audit and major
variations should be investigated.
 Inform the client of the expected date of attendance by the auditors and obtain the
client’s agreement.

The above planning procedures will enable the auditor’s firm to develop an overall audit
plan as stated by ISA 300. The key contents of the overall audit plan include the
following:

 The auditor’s knowledge of the business;

 Understanding the accounting and internal control systems;
 Risk and materiality level appropriate to the client;
 The nature, timing and extent of procedures;
 Coordination, direction, supervision and review.

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4.4 KNOWLEDGE OF THE BUSINESS

As mentioned earlier, ISA 315 requires auditors to obtain knowledge of the business,
sufficient to enable them to identify and understand those issues that may have a
significant impact on the financial statements. Knowledge is important both before and
after the acceptance of the audit engagement because the business environment is not
static, it changes with time.

Essentially, the auditors should consider the following issues in relation to knowledge of
the business:

 General economic factors, for example, government policies, inflation, level of

economic activity, interest rates and so on.

 The conditions of the industry affecting the client’s business, for example,
technological changes, business risk, regulatory framework, rising, stable or
declining demand

 The entity’s itself, for example, corporate structure, capital structure,

management objectives, board of directors, internal audit function and so on.

 The entity’s business which includes the nature of business ( manufacturing,

wholesaler, financial services etc), products or services and markets, key
suppliers, research and development, legislations and regulations, debt structure
and so on.

 The entity’s financial performance and conditions, for example, key ratios,
operating statistics and trends.

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 The entity’s reporting environment, for example, regulatory requirements,

legislation, accounting requirements, audit reporting requirements and users of
the financial statements.

Various sources of evidence are available to the auditor in obtaining the essential
knowledge of client’s entity. The most common sources are listed below:

 Discussion with the client’s management and senior staff personnel.

 Meetings with previous auditors but should obtain consent of the client.
 Discussion with internal audit staff and review of internal audit reports.
 Discussion with people outside the client’s entity, for example, the industry
regulators.
 Review of prior year working papers.
 Review publications related to the industry, like government statistics, surveys,
texts, trade journals, financial newspapers, banks reports.
 Legislation and regulations that are relevant to the client’s business.
 Documents produced by the client, for example, the financial statements.

4.5 UNDERSTANDING THE ACOUNTING AND INTERNAL

CONTROL SYSTEMS

Auditors should obtain understanding of the accounting process and internal control
systems sufficient to enable them to identify specific risks and to develop appropriate
audit plan. Auditors should understand the records and procedures used to record,
process, summarise and report material classes of transactions and to maintain
accountability for assets. The issues of accounting and internal control systems will be
discussed in greater details in the later units.

In this unit, more emphasis will be laid on audit risk, planning materiality and audit
programmes.

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4.6 AUDIT RISK

Audit Risk (AR) is the risk that the auditor gives an inappropriate opinion on the
Financial Statements. There is a link between audit risk and audit planning. The audit
firm should normally strive to minimise audit risk or be prepared to accept that a certain
level of risk is inevitable. Overall planning procedures need to be set in consideration of
the level of audit risk.

Total audit risk which is the risk of giving an inappropriate opinion when financial
statements are materially misstated, has three components:

1. Inherent risk

There is a certain degree of susceptibility of an account balance or class of transaction to

material misstatement while assuming no related internal controls. Some types of
business, especially cash based, are inherently more risky than others. Clearly the
assessment of inherent risk is an important part of overall audit planning and particularly
relevant in deciding whether or not to accept a new audit or deciding the initial audit
approval to a new audit following acceptance.

2. Control risk

There is a risk that material misstatement could occur in an account balance or

transaction (individual or aggregate) without being highlighted by internal control
systems. The particular problem faced by the auditor at the outset of the audit of a new
client is that an assessment of control risk can only be made when a detailed examination
of systems and controls has been undertaken. Having done the audit in previous years, the
auditor will be better prepared. The assessment of control risk helps the auditors to
determine the forms of audit testing (tests of control or substantive tests) to achieve the
desired level of overall audit assurance.

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3. Detection risk

Detection risk refers to the risk that the auditor’s substantive procedures will not detect
material misstatement in account balances or classes of transactions. The auditor will be
better placed to respond to detection risk since it is largely under the control of the audit
firm in setting adequate procedures or staff control systems.

4.7 MATERIALITY

The International Accounting Standard Committee (IASC), now replaced by the

International Accounting Standard Board (IASB), has defined materiality in the
following terms

‘Information is material if its omission or misstatement could influence the economic

decisions of users taken on the basis of the financial statements’.

In planning the audit, materiality plays a vital role in determining the nature, timing and
extent of audit procedures and evaluating the effects of misstatements. Auditors therefore
need to establish materiality levels to ensure that material misstatements or omissions in
the accounting records are detected. The most important figure in a set of accounts is
profit before tax and this is the essential criteria for measuring materiality. It is generally
agreed that:

 Errors over 10 % - material

 Errors between 5 % and 10 % - may be material
 Errors under 5 % - not material

The term ‘error’ includes fraud, irregularities and uncertainties. Normally, the
uncertainties will be taken as the product of the financial effect of the uncertainty and the

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probability of it happening. The ‘error’ will be the total of the errors detected during the
audit. If the total of the errors is material, then

 Either the financial statements will have to be adjusted.

 Or if the directors refuse to amend the financial statements, the auditor will have
to consider the appropriate modifications to the audit report.

Other factors to be considered regarding materiality include:

 Repetitive small errors. For example, a relatively small error in a month end
procedure can cumulatively have a material effect, if repeated.
 Qualitative aspects, for example, inadequate description of accounting policies.
 Relativity of errors. For example, the omission of Rs 10,000 in the accounts of a
large company may not be material whereas in a small business the contrary
would probably be true.

There is an inverse relationship between materiality and the level of audit risk. The
higher the materiality level, the lower the audit risk, and vice versa. Where the materiality
is low, audit risk is increased and the auditor can compensate for this by carrying out
additional tests of control or increasing substantive procedures.

4.8 AUDIT PROGRAMME

Once the auditors have gained sufficient knowledge of the entity’s business, assessed
associated audit risk and determined the materiality level, they should develop and
document an audit programme covering the nature, timing and extent of planned audit
procedures to implement the overall audit plan.

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The audit programme is a document that records the detailed procedures to be followed
during the audit. The detailed procedures should take into account the following factors:

 The assessment of inherent and control risk

 The level of confidence which the audit procedures are planned to provide
 The assistance to be provided by the client and the client’s staff
 The need for expert third party assistance
 The timing of audit test

The programme typically comprises instructions to staff in order to control and record the
work. The objectives for each audit area and a time budget for various areas and
procedures are also included in the programme.

4.8.1 Timing of Audit Work

Based on the nature of the business being audited, the auditors will establish the most
appropriate timing of audit work. Auditing may be done at or after the year end. The
audit work is divided into interim and final audits. During interim audit, the auditors
focus mainly on planning and test of controls whereas at final audit, substantive tests are
carried out. It is also possible that the auditors are present throughout the year, especially
where the client is so large. This is known as continuous audit.

4.9 WORKING PAPERS

ISA 230 Documentation states that auditors should prepare working papers which are
sufficiently complete and detailed to provide an overall understanding of the audit.
Working papers should record planning information, the work done and when it was done
and results and conclusions. Usually, the form and content of working papers are affected
by the following:

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 The nature of the engagement

 The form of the auditors’ report
 The nature and complexity of the entity’s business
 The nature and condition of the entity’s accounting and internal control systems
 The specific methodology and technology use by the auditors

4.9.1 Importance of Working Papers

1. They are useful for future reference, especially to auditors who had no previous
experience with the audit with an understanding of the work performed.

2. They support the audit report, particularly, the reasoning on all significant matters
that require the exercise of judgement.

3. They assist not only in the control of current audit but also in the planning and
control of future audits.

4. The preparation of working papers encourages auditors to adopt a systematic

approach to their audit work, which in turn is likely to improve quality of the
work.

4.9.2 Contents of Working Papers

Working papers should include the following:

 Information likely to be of continuing importance on recurring audits, for

example, the legal and organisational structure of the client’s entity.
 Auditing planning information, for example, audit planning memoranda and time
budgets.

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 Evidence of the auditor’s understanding of the accounting and internal control

systems including the evaluation and assessment of risk.
 Analysis of transactions and balances.
 A record of the audit programme.
 Copies of correspondence with the client.
 Evidence of review of audit work.
 Supporting schedules to financial statements including analysis of significant
ratios and tends.
 Letter of engagement and letter of representation.
 Copies of financial statements and auditors’ reports.
 Reports to management accounting and internal control systems.

4.9.3 Filing of Audit Working Papers

Working papers are generally filed in two main files, namely,

 Permanent Audit File ( PAF)

 Current Audit File (CAF)

4.9.3.1 Permanent Audit File

The main purposes of the PAF are to document information of continuing importance to
the audit and to provide audit staff new to the audit information regarding the client’s
affairs and the nature of audit.

PAF usually contains the following documents:

 Engagement letters and letters of authority

 New client questionnaire
 Memorandum and articles

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 Partnership agreement or trust deed

 Nature and history of the business
 Registered office
 Ownership and management structure
 Board minutes of continuing relevance
 Professional advisors such as bankers, lawyers, stockbrokers and so on
 Copies of management letters
 Other legal documents such as prospectuses
 Previous years’ signed accounts and analytical review
 Accounting and internal control systems notes

4.9.3.2 Current Audit File

The key purposes of the CAF are to document information of relevance to the current
year’s audit and to provide evidence that adequate examination of the client’s affairs
has been made.

CAF usually contains the following documents:

 Copy of final signed financial statements

 Copy of draft financial statements
 Accounts checklist
 Management accounts details
 A summary of unadjusted errors and final journal entries
 Planning programme
 Budget and fee estimate
 Management letter and letter of representation
 Time and cost summary
 Notes of board minutes
 Audit programme

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 Lead schedules
 Third party confirmations and certificates

4.10 SUMMARY

It is important to remember the following:

1. According to ISA 200, the auditor should carry out an audit in accordance with
ISAs and ethical principles to provide reasonable assurance that the financial
statements are free from material misstatement.

2. ISA 300 Planning an Audit of Financial Statements states that ‘the auditor should
plan the audit so that the engagement will be performed in an effective manner.

3. Planning procedures are important as they will enable the auditor to develop an
overall audit plan.

4. ISA 315 requires auditors to obtain knowledge of the business, sufficient to

enable them to identify and understand those issues that may have a significant
impact on the financial statements. Knowledge is important both before and after
the acceptance of the audit engagement.

5. Auditors should obtain understanding of the accounting process and internal

control systems sufficient to enable them to identify specific risks and to develop
appropriate audit plan.

6. There is a link between audit risk and audit planning. The audit firm should
normally strive to minimise audit risk or be prepared to accept that a certain level
of risk is inevitable.

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7. According to IASC, information is material if its omission or misstatement could

influence the economic decisions of users taken on the basis of the financial
statements.

8. In planning the audit, materiality plays a vital role in determining the nature,
timing and extent of audit procedures and evaluating the effects of misstatements.

9. The audit programme is a document that records the detailed procedures to be

followed during the audit. Audit programme covers the nature, timing and extent
of planned audit procedures.

10. ISA 230 Documentation states that auditors should prepare working papers which
are sufficiently complete and detailed to provide an overall understanding of the
audit. Working papers should record planning information, the work done and
when it was done and results and conclusions.

4.11 ACTIVITY

Question 1

Describe the sources and nature of information gathered in planning audit and review
assignments.

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Question 2

Describe the importance of the materiality concept at the audit planning stage.

Question 3

Distinguish between audit plan and audit program.

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