FAR EASTERN UNIVERSITY

ACT1202 – Auditing and Assurance Principles

AT.05 Rian Ceasar P. Soliman, CPA, MBA
Audit Planning and Materiality

Topic Outline
1. Accept client and perform initial planning
a) Planning the Audit of Financial Statements activities.
b) Accept Client and Perform Initial Planning Activities 2. Understand the client business and industry.
c) Understand the Client’s Business and Industry 3. Perform preliminary analytical procedures.
d) Perform Preliminary Analytical Procedures 4. Set preliminary judgment of materiality and
e) Materiality performance materiality.
f) Materiality for the Financial Statements as a Whole 5. Identify significant risks due to fraud or error.
g) Determine Performance Materiality 6. Assess inherent risk.
h) Estimate Misstatement and Compare with Preliminary 7. Understand internal control and assess control
Judgment risk.
8. Finalize overall audit strategy and audit plan.

Planning the Audit of Financial Statements ● The nature and extent of the above planning activities
will vary according to:
● the size and complexity of the entity.
● The auditor should plan the audit so that it will be
performed in an effective manner, i.e., to obtain
● the key engagement team members’ previous
experience with the entity; and
reasonable assurance that the financial statements
are free from material misstatement.
● the changes in circumstances that occur during
the audit engagement.
● In addition, adequate planning also helps keep the
Changes to Planning Decisions during the Course of
cost of an audit at a reasonable level and to avoid
the Audit
misunderstandings with the client.
● The auditor shall update and change the overall audit
● Audit planning involves:
strategy and the audit plan as necessary during the
a. establishing the overall audit strategy (which sets
course of the audit.
the scope, timing, and direction of the audit); and
b. developing an audit plan (a detailed approach for ● The establishment of the overall audit strategy and
the expected nature, timing, and extent of the the detailed audit plan are not necessarily discrete or
audit). sequential processes but are closely interrelated since
changes in one may result in consequential changes
Benefits of Audit Planning to the other.
● Appropriate attention to important areas of the audit. Acceptable Audit Risk, Client Business Risk, and the
● Identify and resolve potential problems timely. Risk of Material Misstatement
● Organize and manage the audit engagement so that
it is performed in an effective and efficient manner. ● Much of the early planning activities deal with
● Assist in the proper selection of engagement team obtaining information to help auditors assess these
members and the assignment of work to them. risks (acceptable audit risk, client business risk, and
● Facilitate the direction and supervision of engagement the risk of material misstatement).
team members and the review of their work.
● Assist, where applicable, in coordination of work done ● Acceptable audit risk is a measure of how willing
by auditors of components and experts. the auditor is to accept that the financial statements
may be materially misstated after the audit is
Overview of Audit Planning and Risk Assessment completed and an unmodified opinion has been
Activities issued. The lower the acceptable audit risk, the more
certain the auditor wants to be about the fairness of
● Planning is not a discrete phase of an audit, but rather the client’s financial statements. Usually, riskier
a continual and iterative process. Planning, however, clients such as listed entities and entities in complex
includes consideration of the timing of certain industries are assigned with lower acceptable audit
activities and audit procedures that need to be risk because auditors want to become more certain
completed prior to the performance of further audit about the accuracy of the audit. For entities that are
procedures, i.e., tests of controls and substantive considered as lower risk clients, like privately held
audit procedures. companies with minimal investors and creditors, the
auditor can assign higher acceptable audit risk since
● The following are the major activities and procedures fewer stakeholders are expected to scrutinize the
performed in audit planning and risks assessment: financial statements.
Rian Ceasar P. Soliman, CPA © 2024. This content is protected and may not be shared, uploaded, or distributed.
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b. False, True d. False, False

● 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 Accept Client and Perform Initial Planning
changes in industry conditions or events such as Activities
regulatory changes, or from the setting of
inappropriate objectives or strategies. For example, ● Initial audit planning involves the following activities,
the auditor may identify declines in economic all of which should be done early in the audit:
conditions that adversely affect sales and the a. The auditor decides whether to accept a new client
collectability of accounts receivable. or continue serving an existing one. This
determination is typically made by an experienced
● The risk of material misstatement is the risk that auditor who is in a position to make important
the financial statements contain a material decisions. The auditor wants to make this decision
misstatement due to fraud or error prior to the early, before incurring any significant costs that
conduct of the audit. The risk of material cannot be recovered.
misstatement is a function of the susceptibility of the b. The auditor identifies why the client wants or
financial statements (as a whole or in individual needs an audit. This information is likely to affect
accounts) to misstatement, and the effectiveness of the remaining parts of the planning process.
the client's controls in preventing or detecting and c. To avoid misunderstandings, the auditor obtains
correcting the misstatements. an understanding with the client about the terms
of the engagement.
● Assessing acceptable audit risk, client business risk d. The auditor develops the overall strategy for the
and the risk of material misstatement is crucial in audit, including engagement staffing and any
audit planning. It influences the nature of audit required audit specialists.
procedures, the volume of evidence required, and the
selection of staff based on experience. ● The auditor shall only undertake or continue audit
engagement where the auditor:
✎ Concept check: Answer questions no. 1 to 4. ● is competent to perform the engagement and has
the capabilities, time and resources to do so;
1. The audit plan sets the scope, timing and direction of ● complies with relevant ethical requirements; and
the audit, and guides the development of the more ● considers the integrity of the client.
detailed audit strategy.
New Client Investigation
The audit strategy is more detailed than the audit plan
and includes the nature, timing and extent of audit ● CPA firms investigate new clients for acceptability,
procedures to be performed by engagement team examining their business reputation, financial
members in order to obtain sufficient appropriate stability, and relations with previous CPA firms. An
audit evidence to reduce audit risk to an acceptably auditor does not want to associate itself with a client
low level. whose management lacks integrity. At the same time,
a. True, True c. False, False the auditor should only accept engagements that they
b. True, False d. False, True are competent to perform. Finally, ethical
requirements, especially regarding independence,
2. Which of the following is not one of the three main must be considered and met before accepting a client.
reasons why the auditor should properly plan
engagements? ● When taking over from another CPA firm, the new
a. To enable the auditor to obtain sufficient (successor) auditor must communicate with the
appropriate evidence. predecessor auditor. This helps in deciding whether to
b. To avoid misunderstandings with the client. accept the engagement by uncovering issues like
c. To help keep audit costs reasonable. client integrity or disputes over accounting principles.
d. To enable proper on-the-job training of The successor auditor normally inquires the following
employees. from the predecessor auditor about the prospective
client:
3. The auditor uses knowledge gained from the ● Integrity of management
understanding of the client's business and industry to ● Disagreements with management about audit
assess procedures or accounting principles
a. client business risk. c. inherent risk ● Communication with Audit Committee about
b. control risk. d. audit risk fraud, illegal acts, or internal control
● Understanding as to the Reasons for change in
4. As acceptable audit risk is decreased, the likely cost auditor
of conducting an audit increases.
● If a client will not permit the communication or the
The risk of material misstatement is the risk that the predecessor will not provide a comprehensive
financial statements contain a material misstatement response, the successor should consider that fact in
due to fraud or error prior to the audit. ultimately deciding whether to accept or reject the
a. True, False c. True, True client engagement.

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the expected audit report form and content, and any

● The responsibility to initiate communication lies with limitations of the engagement.
the successor auditor, but the predecessor must
respond, respecting client confidentiality and ● It is in the interest of both the client and the auditor
obtaining client permission before sharing that the auditor sends the engagement letter,
information. If a client refuses communication or the preferably before the commencement of the audit to
predecessor's response is limited, the successor help avoid misunderstandings with respect to the
auditor should reconsider the engagement, unless engagement.
further extensive investigation justifies it.
● For listed companies, the audit committee selects and
● Successor auditors may also conduct investigations hires the external auditor and hence signs the
through local attorneys, other CPAs, banks, and even engagement letter. In private companies, the
professional investigators to understand the client's engagement letter is typically signed by the
background and management reputation. management.

● Auditors must ensure that the financial reporting ● The engagement letter also details any restrictions on
framework used by the client for preparing financial the auditor's work, deadlines for audit completion,
statements is appropriate, considering the entity's assistance from client personnel, schedules for the
nature, the financial statements' purpose, and any auditor, and fee agreements. It also informs the client
relevant laws or regulations. Common financial that the auditor cannot guarantee the detection of all
reporting frameworks in the Philippines include instances of fraud.
Philippine Financial Reporting Standards (PFRS) and
PFRS for SMEs. ● The information in the engagement letter is crucial for
audit planning, influencing the timing of tests and the
Continuing Client total time required for the audit and other services.
The CPA firm must adapt to unexpected
● CPA firms evaluate existing clients annually to decide circumstances or lack of client assistance, potentially
if they should continue providing audit services. extending the engagement duration. Client-imposed
Reasons to discontinue may include previous conflicts restrictions can impact the audit procedures and
over audit scope, type of opinion, unpaid fees, or potentially the type of audit opinion issued.
other issues. A critical reason for discontinuing a client
is if the auditor determines the client lacks integrity. Limitation on Scope Prior to Audit Engagement
Even without previous issues, a CPA firm might decide Acceptance
to stop auditing a client due to excessive risk, such as
potential regulatory conflicts that could lead to the ● The auditor shall not accept an audit engagement, if
client's financial failure and subsequent lawsuits management or those charged with governance
against the firm. imposes a limitation on the scope of work that will
result to disclaimer of opinion unless required by law
Identify Client’s Reasons for Audit or regulation to do so.

● The main factors influencing acceptable audit risk are Engagement Letter
the potential users of the financial statements and the
purposes for which they will use these statements. An engagement letter documents and confirms
More evidence is typically gathered by the auditor for a. The auditor’s appointment;
financial statements that will be extensively used, b. Objective and scope of an audit;
such as those of publicly held companies, companies c. Responsibilities of the management and the auditor;
with significant debt, and businesses planning to sell and
in the near future. d. Forms of any reports to be issued.

● Understanding the most likely uses of the statements Principle contents of an engagement letter include:
can be achieved through prior experience with the • Scope of the audit
client and discussions with its management. As the • The form of any communication to be issued
audit progresses, the auditor may gain additional • Limitations of the engagement
insights into the reasons for the audit and how the • Arrangements regarding planning and performance of
financial statements will be utilized, which can impact the audit
the assessment of acceptable audit risk. • Management to issue written representation
• Timely submission of requirements by client
Obtain an Understanding with the Client management
• Facts that may affect financial statements
● A clear understanding of the engagement terms • Arrangements as to fees and billings
between the client and the CPA firm is essential, and • Acknowledgement of receipt of engagement letter and
auditing standards mandate this understanding be agreement to its terms
formalized in an engagement letter. The
engagement letter outlines the objectives of the When relevant, engagement letter may also include
engagement, responsibilities of both the auditor and
management, the financial reporting framework used,

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• Arrangements regarding other auditors and experts, including international locations. Specialists in areas
internal auditor, or other client personnel, previous like business valuation and IT risk assessment might
auditor in case of initial audits. also be involved. Smaller audits might need only a few
• Restriction as to the auditor’s responsibilities. number of staff members.
• Reference to any further agreements.
• Any obligation to provide audit working papers to third Consider the Need for Experts or Specialist
parties.
● If specialized knowledge is required for the audit,
Changes in the Terms of Engagement consulting with a specialist may be necessary.
Auditing standards govern the selection and review of
An auditor who, before completion of the engagement, is specialists, who may be employed by the auditing firm
requested to change the engagement to one which or external expert engaged by the firm. Examples
provides a lower level of assurance, should consider the include diamond experts for valuing diamonds or
appropriateness of doing so. actuaries for insurance loss reserves.

Possible reasons for changing the terms of the ● The auditor must understand the client's business to
engagement include change in the circumstances or determine if a specialist is needed, assess their
requirements of the client, misunderstanding as to the qualifications, and understand the objectives and
nature of the engagement, or restriction on the scope of scope of their work. The auditor should also evaluate
the engagement. the specialist's relationship with the client to ensure
objectivity.
Accepting the Change
● Using a specialist does not change the auditor's
If the change is reasonably justified, the auditor prepares responsibility for the audit, and the audit report
a new engagement letter, and the final report should be should not refer to the specialist unless it affects the
based on the revised terms without any reference to the audit opinion.
original engagement except if the new engagement is an
agreed-upon procedures engagement where reference to ✎ Concept check: Answer questions no. 5 to 11.
procedures already performed as part of the audit are
normally included as part of the report. 5. Initial audit planning involves four matters. Which of
the following is not one of these?
Rejecting the Change a. Develop an overall audit strategy.
b. Request that bank balances be confirmed.
If the change in engagement is not reasonably justified, c. Schedule engagement staff and audit specialists.
the auditor shall reject the change and continue with the d. Identify the client's reason for the audit.
original engagement.
6. Which of the following will an auditor least likely
If the auditor is not permitted to continue the original discuss with the former auditors of a potential client
engagement, the auditor shall withdraw from the prior to acceptance?
engagement and consider whether there is any obligation a. Integrity of management.
to report to relevant parties such as those charged with b. Reasons for changing audit firms.
governance or shareholders. c. Disagreements with management regarding
accounting principles.
Develop Overall Audit Strategy d. Methods to be used in selecting items for testing.
7. If permission from client to discuss its affairs with the
● After understanding the client's audit reasons, the proposed auditor is denied by the client, the
auditor should develop a preliminary audit predecessor auditor should:
strategy, documenting the scope, timing, and a. Keep silent of the denial.
direction of the audit, which then guides the b. Disclose the fact that the permission to disclose
development of an audit plan. This strategy takes into is denied by the client.
account the nature of the client’s business, industry, c. Disclose adequately to proposed auditor all
and areas of higher risk for significant misstatements. noncompliance made by the client.
The auditor also considers other factors like the d. Seek legal advice before responding to the
number of client locations and the past effectiveness proposed auditor
of client controls in shaping the audit approach. This
helps in determining the required resources, including 8. It is in the interest of both client and auditor that the
staffing for the engagement. auditor sends an audit engagement letter, preferably
before
Selecting Staff for Engagement a. The performance of substantive testing.
b. The commencement of the engagement.
● Staff selection is crucial for compliance with auditing c. The completion of audit.
standards and audit efficiency. Staff must have d. Before the issuance of audit report.
appropriate competence and knowledge about the
client's industry. Large audits may require multiple 9. Which is usually included in an engagement letter?
partners and staff with varied experience levels, The objectives of the Identification of the
possibly involving individuals from different offices, engagement financial reporting

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framework used by ● Auditors obtain understanding of the client’s industry

management to be able to assess industry-specific risks, Common
a. Yes Yes industry risks and unique reporting requirements.
b. No No o Industry-specific risks. Auditors assess risks
c. Yes No unique to industries like financial services and
d. No Yes technology, which can affect client business risk
and influence the decision to accept
10. When a change in the type of engagement from higher engagements.
to lower level of assurance is reasonably justified, the o Common industry risks. Familiarity with
report based on the revised engagement industry-wide risks, such as inventory
a. Should not contain a separate paragraph that obsolescence in retail computer or gadget
refers to the original engagement. products or collection risks in consumer loans,
b. Should not refer to any procedures that may have helps auditors assess client-specific risks and
been performed in the original engagement. material misstatements.
c. Omits reference to the original engagement. o Specific reporting requirements. Auditors need
d. All of the above to understand industry-specific accounting
requirements, like those for financial institutions
11. If a change in the type of engagement from higher to and other specialized industries, to ensure
lower level of assurance is not justified, the auditor clients' compliance with these standards.
should
a. Continue with the revised engagement, but make ● Knowledge of the client's external factors, including
explicit reference about the original engagement. economic volatility, competition, and regulatory
b. Continue with the revised engagement, and not requirements, is vital for comprehensive risk
make explicit reference about the original assessment and effective audit planning.
engagement.
c. Refuse to agree to management’s request on the Business Operations and Processes
change of engagement and continue with the
original engagement. ● Auditors need to understand factors like primary
d. Withdraw from the engagement. revenue sources, key customers and suppliers,
financing sources, and related party information, as
these can highlight areas of increased client business
Understand the Client’s Business and Industry risk.

● A comprehensive understanding of the client's Tour Client Facilities and Operations

business, industry, and operations is critical for the
auditor to effectively conduct an audit. One of the key ● Conducting a tour of the client's facilities offers
principles in auditing standards emphasizes the valuable insights into their business operations. This
importance of this understanding for risk assessment: firsthand observation allows the auditor to observe
operational processes directly and meet and interact
"The auditor identifies and assesses risks of material with key personnel outside of the accounting
misstatement, whether due to fraud or error, based on an department.
understanding of the entity and its environment, including
the entity's internal control." ● Viewing the physical facilities enables the auditor to
evaluate physical safeguards over assets, understand
● Auditing standards require that auditors perform risk the context of accounting data related to assets like
assessment procedures to understand client's in-process inventory and factory equipment. This
business and industry. This understanding should be firsthand knowledge equips the auditor to better
sufficient and appropriate to identify and assess the identify risks, such as unused equipment that might
risk of material misstatements in the financial indicate operational inefficiencies, inventory that may
statements and includes both management inquiries be unsalable, posing financial risks. Interacting with
and analytical procedures. non-accounting employees during the tour and the
audit process further aids the auditor in gaining a
deeper understanding of the client's business and
enhancing the assessment of various business risks.

Identify Related Parties

● Related party transactions are important for auditors

because accounting standards mandate their
disclosure in financial statements if they are material.
A related party is defined as an affiliated company, a
principal owner of the client, or any party that can
Industry and External Environment influence the client's management or operating
policies. Related party transactions are transactions
among related parties whether a price is charged or
not. Common examples include transactions between

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a parent and subsidiary, equipment exchanges Understanding the client's objectives and strategies is
between companies owned by the same person, and crucial for assessing client business risk and the risk
loans to officers. A less common example is significant of misstatements in financial statements.
management influence by a key customer.
● Auditors should familiarize themselves with the
● These transactions are not arm's-length, posing a risk client's contracts and legal obligations, including long-
of being valued differently than transactions with term notes and bonds payable, stock options, pension
independent third parties. Due to disclosure plans, supply and government contracts, royalty
requirements, lack of independence, and potential for agreements, union contracts, and leases. Most
fraudulent reporting, auditors often assess high risks contracts are examined during specific phases of the
for related party transactions. audit. For example, pension plan provisions are
emphasized during the audit of unfunded pension
● Auditors need to identify all related parties early in the liabilities. Reviewing and obtaining these documents
engagement and include them in permanent audit early in the engagement helps the auditor gain a
files. Disclosures should detail the nature of the better perspective of the organization and assess risks
relationship, transaction descriptions, amounts, and more effectively. Later, these documents are
balances with related parties. Auditing standards examined in detail during the tests of individual audit
require auditors to ask management to identify areas.
related parties and transactions, and understand the
controls for identifying, authorizing, and approving Measurement and Performance
these transactions.
● A client's performance measurement system often
● Auditors should inquire with governance bodies, like includes key performance indicators (KPIs) that
the board of directors, about concerns regarding extend beyond basic financial statement figures.
related party relationships and transactions. These KPIs are tailored to the client's specific
Reviewing SEC filings and examining shareholders' objectives and can encompass metrics like market
listings can reveal principal stockholders and potential share, sales per employee, unit sales growth, website
related parties. unique visitors, same-store sales, country-specific
sales, and sales per square foot for retailers.
Management and Governance
● The inherent risk of financial statement
● An auditor needs to assess management's philosophy misstatements may increase if the client sets
and operating style, including its approach to unrealistic objectives or if the performance
identifying and responding to risks. These aspects measurement system promotes aggressive
significantly impact the risk of material misstatements accounting practices.
in financial statements.
● Performance measurement also involves ratio
● A company's governance structure, encompassing its analysis and benchmarking against key competitors.
organizational setup and activities of the board of It's important for auditors to either conduct ratio
directors and audit committee, plays a crucial role in analysis or review the client's key performance ratios
managing risks. An effective board of directors is key as part of understanding the business. Performing
in ensuring the company takes appropriate risks, preliminary analytical procedures, which include
avoiding unnecessary or excessive risks. The audit evaluating these ratios, is a crucial step in the audit
committee contributes to risk management by planning process. This approach helps auditors in
overseeing financial reporting, helping to mitigate the identifying potential areas of risk and planning their
chances of aggressive accounting practices. audit procedures accordingly.

● To understand the client's governance system, ✎ Concept check: Answer questions no. 12 to 18.
auditors should understand how the board and audit
committee operate. This includes reviewing the
12. In order to obtain an understanding of the client's
company's code of ethics and corporate minutes
business, the audit firm will consider
for insights into their oversight and decision-making
a. inherent and control risk of the client.
processes.
b. audit risk to the CPA firm.
c. the client's business risk and the risk of material
Client Objectives and Strategies
misstatements in the financial statements.
d. the CPA firm's potential ongoing revenue from the
● Auditors should understand the client's strategies to
audit client.
achieve organizational objectives, particularly in areas
such as:
1. Reliability of financial reporting.
2. Effectiveness and efficiency of operations.
3. Compliance with laws and regulations.

● Despite management efforts, business risks can

threaten the achievement of these objectives.

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13. Many risks are common to all clients in certain and industry, and to assess client business risk.
industries. During planning, auditors often analyze aggregated
data to observe trends, patterns, and inconsistencies.
Management's philosophy and operating style This analysis can include comparisons of current data
influence the risk of material misstatements in the with historical data, budgets, or industry standards to
financial statements. identify significant or unexpected variances.
a. True, False c. True, True Aggregated data helps in identifying areas that may
b. False, True d. False, False require more detailed audit attention.

14. Most auditors assess the risk of material misstatement ● Analytical procedures help in directing the auditor's
as high for related parties and related-party focus to areas of higher risk or potential concern. For
transactions because instance, significant fluctuations in revenue or
a. of the unique classification of related-party expenses compared to previous periods can prompt a
transactions required on the balance sheet. more detailed examination.
b. of the lack of independence between the parties.
c. of the unique classification of related-party ● Common-size financial statements convert absolute
transactions required on the income statement. financial data into percentages of a common base
d. it is required by generally accepted accounting figure, like total assets or sales. This standardization
principles. allows for easier comparison across time periods or
with industry peers. These statements help in
15. Which of the following would most likely not be identifying trends and relationships that may not be
classified as a related-party transaction? apparent in the raw financial data.
a. an advance of one week's salary to an employee
b. sales of merchandise between affiliated ● Ratios like liquidity ratios including activity ratios,
companies solvency ratios, and profitability ratios provide
c. loans or credit sales to the principal owner of the insights into the financial health and operational
client company efficiency of the client. Auditors use these ratios to
d. exchanges of equipment between two companies compare with industry averages, historical data, or
owned by the same person the client’s own budgeted figures to spot anomalies.
Comparing the client's financial metrics with industry
16. Which of the following best describes the corporate or sector benchmarks helps in assessing the client’s
minutes of an entity? performance relative to its peers. This comparison can
a. official record of the meetings of the board of reveal deviations from industry norms, which might
directors and the stockholders signal areas of risk or misstatement.
b. unofficial record of the meeting of the board of
directors ● Analytical procedures assist auditors in the risk
c. official record of management meeting with assessment process by highlighting areas where the
investors and creditors of the company risk of material misstatement might be higher. They
d. unofficial record of the board of directors' enable auditors to plan the audit more effectively by
meetings focusing resources on areas that pose greater risks.

17. Auditors should understand client objectives related to ✎ Concept check: Answer questions no. 19 to 23.
a. reliability of financial reporting.
b. effectiveness and efficiency of operations.
19. The auditors use analytical procedures during the
c. compliance with laws and regulations.
course of an audit. The most important phase of
d. all of the above.
performing these procedures is the:
a. Vouching of all data supporting various ratios.
18. When analyzing a client's performance measurement
b. Investigation of significant variations and unusual
system,
relationships.
a. only income statement numbers are used.
c. Comparison of client-computed statistics with
b. inherent risk of financial statement misstatements
industry data on a quarterly and full-year basis.
may be decreased if the performance
d. Recalculation of industry date.
measurement system encourages aggressive
accounting.
20. Analytical procedures used in planning an audit should
c. the auditor is likely to decrease the extent of
focus on
testing if the client has set unreasonable
a. Reducing the scope of tests of controls and
objectives.
substantive tests.
d. ratio analysis and benchmarking against key b. Providing assurance that potential material
competitors are utilized.
misstatements will be identified.
c. Enhancing the auditor’s understanding of the
Perform Preliminary Analytical Procedures client’ s business required to identify areas of
heightened risk.
● Auditors are required to perform preliminary d. Assessing the adequacy of the available evidence.
analytical procedures as part of risk assessment
procedures to better understand the client's business

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21. Which of the following nonfinancial information would of transactions, account balances, and
an auditor most likely consider in performing disclosures.
analytical procedures during the planning phase of an 3. Estimate Total Misstatement in Segment:
audit? Throughout the engagement, estimate the
a. Turnover of personnel in the accounting misstatement amount in each segment.
department. 4. Estimate the Combined Misstatement: Near the
b. Objectivity of audit committee members. end of the audit, calculate the total estimated
c. Square footage of selling space. misstatement from all segments.
d. Management's plans to repurchase stock. 5. Compare Combined Estimate with Preliminary or
Revised Judgment about Materiality: Evaluate if
22. When performing planning analytical procedures for a the total estimated misstatement exceeds the
client the auditor detected that the gross profit predetermined materiality level, which may
percentage had declined by 50% from the previous necessitate adjustments or revisions in the audit
year to the year currently under audit. The auditor approach.
should
a. investigate the possibility the client may have
✎ Concept check: Answer questions no. 24 to 25.
made an error in their cost of goods sold
computation.
b. assist management in developing greater cost 24. Which of the following is part of planning?
efficiencies in their product line. a. Set materiality for the financial statements as a
c. prepare a going concern opinion for the client. whole.
d. advise the client to have extensive disclosure to b. Estimate total misstatement in the segment.
alleviate investor concerns. c. Estimate the combined misstatement.
d. Compare the combined estimated with
23. Auditors try to identify predictable relationships when preliminary judgment.
using analytical procedures. Which of the following
accounts would most likely yield the highest level of 25. When dealing with materiality,
evidence regarding relationships that involve a. if the client refuses to correct a material
transactions? misstatement, the auditor is required to adjust the
a. Accounts payable c. Payroll expense financial statements.
b. Accounts receivable d. Advertising expense b. management is responsible for determining
whether financial statements are materially
misstated.
Materiality c. materiality must be determined as a percentage
of sales.
d. the auditor must bring any material
● After preliminary analytical procedures, the next step
misstatements to the client's attention.
in audit planning is making a preliminary judgment
about materiality for the audit of financial statements.
Materiality influences the type of audit report issued
Materiality for the Financial Statements as a
and relates to the concept that misstatements,
individually or collectively, could impact the economic Whole
decisions of users based on the financial statements.
● Auditors are required to establish an initial judgment
● Auditors must identify material misstatements and of materiality early in the audit while developing the
inform the client for correction. If the client refuses to overall audit strategy. This is known as the
correct material misstatements, the auditor may need preliminary judgment about materiality. It is
to issue a qualified or adverse opinion, depending on termed "preliminary" because it may change during
the misstatement's materiality and pervasiveness. the audit process based on new information or
insights gained. This judgment must be documented
● Materiality judgments depend on understanding the in the audit files, as it forms a crucial part of the audit
financial statement users and their decision-making planning process.
processes. Materiality levels may vary based on the
nature of the decisions, such as those in a merger and ● The preliminary judgment about materiality for the
acquisition agreement. However, in practice, auditors financial statements as a whole is the maximum
may not fully know all users or their decisions, making amount by which the auditor believes the statements
materiality a complex professional judgment. could be misstated and still not affect the decisions of
reasonable users. This judgment is one of the most
● The general steps in establishing materiality judgment important decisions the auditor makes, and it requires
are as follows: considerable professional judgment.

1. Set Materiality for Financial Statements as a ● The amount set for preliminary materiality directly
Whole: Determine the overall materiality level for influences the amount of evidence the auditor needs
the financial statements. to gather. A lower materiality threshold means more
2. Determine Performance Materiality: Assess evidence is required while a higher materiality
materiality for segments of the audit, like classes threshold means less evidence may be obtained.

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● Auditors may adjust the preliminary judgment about Misstatements that alter a consistent trend in
materiality during the audit, termed as the revised earnings might be considered material. A notable
judgment of materiality. This revision usually occurs instance is if a company that has been showing a
due to changes in factors that influenced the initial steady income increase suddenly reports a decrease,
judgment or new developments, such as the or if a misstatement changes a reported loss into a
availability of current financial statements or profit.
significant qualitative events like debt issuance. The
auditor's initial judgment about materiality is shaped ✎ Concept check: Answer questions no. 26 to 31.
by several factors, including the financial statement
context, the nature of the client’s business, and the
26. Why do auditors establish a preliminary judgment
economic environment.
about materiality?
a. to determine the appropriate level of staff to
Factors Affecting Preliminary Materiality Judgment
assign to the audit
b. so the client can know what records to make
Several factors affect the auditor's preliminary judgment
available to the auditor
about materiality for a given set of financial statements.
c. to help plan the appropriate evidence to
accumulate
Materiality is a relative Rather Than an Absolute Concept
d. to finalize the control risk assessment
● A misstatement of a given magnitude might be
27. In determining a materiality level for the financial
material for a small company, whereas the same peso
statements as a whole, a percentage is often applied
mis statement could be immaterial for a large one.
to a chosen benchmark as a starting point in that
This makes it impossible to establish peso value
determination. Which of the following factors may
guidelines for a preliminary judgment about
affect the identification of an appropriate benchmark?
materiality that are applicable to all audit clients. a. The elements of the financial statements (e.g.,
There is no
assets, liabilities, equity, income, expenses).
b. Whether there are items on which the attention of
Benchmarks are Needed for Evaluating Materiality
the users of the particular entity’s financial
statements tends to be focused (e.g., for the
● Materiality is not absolute but relative, depending on
purpose of evaluating financial performance users
the context of the financial information. This
may tend to focus on profit, revenue or net
necessitates benchmarks to determine the materiality
assets).
of misstatements. For businesses focused on profit,
c. The nature of the entity, where the entity is at in
profit income before taxes is often the primary
its life cycle, and the industry and economic
benchmark for materiality. It is seen as a crucial piece
environment in which the entity operates.
of information for users.
d. All of the above.
● In cases where profit is highly variable or does not
28. The auditor establishes a materiality level for the
provide a stable basis, other benchmarks may be
financial statements as a whole when developing the
more appropriate. Not-for-profit organizations often
overall audit strategy. But identified misstatements
use different benchmarks due to their distinct financial
below this level are not necessarily immaterial due to
structures. Other common benchmarks include net
qualitative considerations, such as
sales, gross profit, total assets, or net assets. Auditors
a. b. c. d.
must consider whether misstatements materially
Possible bias of Yes Yes Yes Yes
affect the reasonableness of other financial
management
benchmarks, such as current assets, total assets,
The cumulative effect in Yes Yes Yes No
current liabilities, and owners' equity.
the future
Regulatory or contractual
● Auditing standards require that auditors document
requirements Yes Yes Yes Yes
their preliminary judgment about materiality and the
Occurrence of fraud or Yes No No Yes
rationale behind the chosen benchmark in the audit
illegal acts
files.
Whether the misstatement
conceals a negative Yes Yes No No
Qualitative Factors Also Affect Materiality
trend in profitability
● The significance of misstatements to users can vary,
29. Which of the following is the primary basis used to
even for amounts of equal peso value, depending on
decide materiality for a profit-oriented entity?
the nature of the misstatement. a. net sales
b. net assets
● For example, misstatements resulting from fraud are
c. profit before tax
generally viewed as more serious than unintentional
d. all of the above
errors of the same amount. This is because fraud
directly questions the honesty and reliability of
management or personnel. Also, even minor
misstatements can become material if they have
implications for contractual obligations. Finally,

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30. When determining materiality, consider accounts receivable fairly stated if it is

a. the preliminary judgment about materiality can be misstated by P5 million or less. In other engagement
increased, but not decreased during the audit. standards (such as the PCAOB auditing standards in
b. auditing standards provide specific materiality the US) refer to this amount as tolerable
guidelines to practitioners. misstatement, whereas Philippine Standards on
c. only one benchmark can be used. Auditing (PSA) define tolerable misstatement as the
d. the application of guidelines requires considerable application of performance materiality to a particular
professional judgment. sampling procedure. For consistency, we will use the
term performance materiality rather than tolerable
31. CPA firms can establish policy guidelines to help their misstatement to be consistent with the PSAs.
auditors determine materiality.
✎ Concept check: Answer questions no. 32 to 36.
Profit before taxes is the normal base used to
determine materiality for a not-for-profit organization.
32. Having set the level of materiality for the financial
a. True, False c. True, True
statements as a whole, the auditor now turns his
b. False, True d. False, False
attention to determining performance materiality.
Which of the following statements about performance
materiality is NOT true?
Determine Performance Materiality a. Performance materiality is used to reduce the risk
that the aggregate of uncorrected and undetected
● Performance materiality is defined as the amount(s) misstatements exceeds materiality for the
set by the auditor at less than materiality for the financial statements as a whole to an acceptable
financial statements as a whole to reduce to an level.
appropriately low level the probability that the b. Performance materiality refers to the amounts set
aggregate of uncorrected and undetected by the auditor at higher than the materiality level
misstatements exceeds materiality for the financial for particular classes of transactions, account
statements as a whole. balances or disclosures where the materiality level
might otherwise mean that such items are not
● Since auditors gather evidence in segments (like tested.
account balances or transactions) rather than for the c. Once the materiality for the financial statements
entire financial statements, performance materiality as whole has been set, a lower level of
assists in determining the necessary level of audit performance materiality is determined by the
evidence. It is inversely related to the amount of auditor using his or her professional judgement.
evidence required; lower performance materiality d. The performance materiality level is affected by
means more evidence is needed. the auditor's understanding of the entity and the
nature and extent of misstatements identified in
Setting Performance Materiality: prior audits.

● Often set at 50-75% of the overall materiality for the 33. Which of the following terms refers to the application
financial statements. It can vary for different of performance materiality when performing variables
transaction classes, account balances, or disclosures, audit sampling procedure (i.e., test of details)?
especially in areas needing more focus. Factors like a. Tolerable deviation rate.
overall audit assurance and audit evidence cost also b. Tolerable misstatement.
influence performance materiality levels. c. Expected deviation rate.
d. Expected misstatement.
● Materiality is then allocated to various segments of
audit in a process called the allocation of the 34. Auditors commonly allocate materiality to balance
preliminary judgment about materiality to segments. sheet accounts rather than income statement
Auditors do not use a standard percentage and accounts because most income statement
consider audit assurance and the cost of audit misstatements have a(n) _____ effect on the balance
evidence in determining performance materiality. sheet.
Most practitioners allocate materiality to statement of a. Reduced c. Equal
financial position accounts rather than comprehensive b. Undetermined d. Increased
income statement accounts, because most
comprehensive income statement misstatements 35. Which of the following is an incorrect statement
have an equal effect on the statement of financial regarding the allocation of the preliminary judgment
position due to the nature of double-entry accounting. about materiality to balance sheet accounts?
a. Auditors expect certain accounts to have more
● The determination of performance materiality is based misstatements than others.
on professional judgment and reflects the amount of b. The allocation has virtually no effect on audit costs
misstatement an auditor is willing to accept in a because the auditor must collect sufficient
particular segment. For example, if an auditor decides appropriate audit evidence.
to allocate P5 million of a total preliminary judgment c. Auditors expect to identify overstatements as well
about materiality of P10 million to accounts as understatements in the accounts.
receivable, this means the auditor is willing to d. Relative audit costs affect the allocation.

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36. The materiality level for the financial statements as a ✎ Concept check: Answer questions no. 37 to 40.
whole (or the materiality level for a particular class of
transactions, account balance or disclosure, if
37. ________ misstatements are those where the auditor
applicable) may need to be revised (adjusted either
can determine the amount of the misstatement in the
downward or upward) as a result of the following
account.
a. a change in circumstances that occurred during
a. Potential
the audit
b. Likely
b. new information
c. Known
c. a change in the auditor’s understanding of the
d. Projected
entity and its operations as a result of performing
further audit procedures. 38. Likely misstatements can result from
d. all of the above
Computation of Differences Projections of
the sampling between misstatements
Estimate Misstatement and Compare with error for the cash management's based on an
Preliminary Judgment account and an auditor's auditor's tests of
judgment about a sample from a
● The initial two (2) steps involve setting materiality for account balances population
the financial statements as a whole and determining a. No Yes Yes
performance materiality for audit segments. These b. Yes Yes No
are crucial in the planning phase of the audit. The last c. No No Yes
three (3) steps are the result of executing audit tests d. Yes No No
and are detailed in subsequent topics. They involve
estimating and combining misstatements and 39. When evaluating the audit findings, the auditor should
comparing them with materiality. be satisfied that the
a. amount of known misstatement is documented in
● During audit procedures for each segment, auditors the management representation letter.
document identified misstatements. These are b. estimate of the total known and likely
classified into two types: known misstatements and misstatements is less than a material amount.
likely misstatements. Known misstatements also c. estimate of the total likely misstatement includes
called as “factual misstatements” are misstatements sample error.
with quantifiable amounts, such as an incorrectly d. amount of known misstatement is acknowledged
recorded sales transaction identified during accounts and recorded by the client.
receivable confirmation.
40. The preliminary judgment on materiality is compared
● There are two types of likely misstatements: to the total estimated misstatement amount to
● Differences in Judgment or “judgmental determine if an account balance is materially
misstatements”: These occur from differing misstated.
opinions between management and auditors on
estimates of account balances, like allowances for Total estimated misstatements include known
uncollectible accounts or warranty liabilities. misstatements and projected misstatements plus a
● Projections from Samples or “projected sampling error.
misstatements”: When auditors test a sample and a. True, False c. True, True
find misstatements, they project these findings to b. False, True d. False, False
estimate the total misstatements in the entire
population, like estimating inventory ***End***
misstatements from a sampled test.

● The projected misstatement amounts for each

account are aggregated. This combined likely
misstatement is then compared with the set
materiality level (step 5 of the process) to evaluate
their significance relative to the overall financial
statements.

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