Unit 5: Materiality, Audit Strategy and Plan

Material misstatement occurs when misstatement or omission of info in the fin statements is
significant enough to change or influence investing / purchasing decision (this can happen due to
error or fraud)

ISA 450: Evaluation of Misstatements Identified During the Audit.

ISA 320: auditor must use professional judgement to determine the following materiality levels:
Overall materiality, performance materiality, specific materiality, and specific performance
materiality.
A numerical threshold (benchmark) is used as a starting point, a % is then applied to the chosen
benchmark to determine overall materiality, benchmarks could be the following: profit before tax,
total revenue, gross profit, total expenses, net assets. Factors to consider in benchmark:

Relevant fin data can be used to calculate the benchmark: prior period result, forecast for current
period. Benchmark can be normalized, ex: income from continuing operations could be adjusted
for: usual or non-recurring revenue / one off expense.
Appropriate percentage

% applied to revenue based or Asset based benchmark would generally be lower than profit-based
benchmark (Revenue and Asset are usually a higher figure compared to profit)

Listed for profit entity: users tend to focus on profit, thus profit from continuing activities is likely to
be an appropriate benchmark, factors are large volume of users, more regulation, higher pressure to
meet fin expectation.

Performance materiality: based on overall materiality but set at a lower amount, this is used to
determine which items in the fin statements to select for testing.

Fin statements are materially misstated when total amount of uncorrected and undetected
misstatements exceeds overall materiality. This risk can be reduced by setting materiality
benchmark at an amount lower than overall materiality (performance mat) when determining the
audit work to be performed (testing the item)
ISA 320 does not provide guidance on how to calculate performance materiality. Factors to
consider are: auditor’s understanding of the entity, prior year audit results (nature and extent of
misstatements)

Performance mat determines the extent of audit procedures that the auditor will carry out in
response to a risk of mat misstatement they have identified. If risk of material misstatement is low,
auditor will set high performance materiality level (company may have good internal control and in
stable industry). If risk of material misstatement is high, auditor will set low performance materiality
level to detect more misstatements (comp may be in a volatile industry, more risk to fraud)

Specific materiality: materiality of particular classes of transactions, account balances or

disclosures. There may be misstatements of amounts that are less than overall materiality that
would affect the economics decisions of users of fin statements (sensitive areas such as executives’
remuneration, travel and entertainment exp incurred by management)
Auditors usually calculate materiality for the 12 months in advance based on the results to date,
materiality will then be revised once actual annual results are available. Auditors are required to
document factors and judgements considered in determining materiality.

Materiality may be revised when new info come to light such as sale of a part of the business, or
there is a change in the auditor ‘s understanding of the entity and its operations such as actual fin
result is very different to forecasts. Changes to materiality level => changes in timing and extent of
audit procedures being modified.

ISA 300 Audit Planning

Audit planning is to ensure that audit effort is directed at high risk areas, procedures performed are
relevant in addressing the identified risks, and audit staff are well informed and know what is
expected of them.

Audit Strategy: is to set scope, timing and direction of the audit engagement

Audit program: more detailed version of the audit strategy, need to document any significant
changes made to audit strategy or program and reasons for such changes.
Responses to risks of error or fraud: Assign more experienced staff to complex areas of audit,
providing more supervision to staff, evaluating accounting policies selected by management (those
relate to subjective measurements or complex transactions), and conducting more procedures at the
end of the period instead of interim periods.

Determining the audit approach

Control based vs substantive procedures.

If auditor has concluded that controls have been effectively designed, and implemented, auditor can
rely on control based approach by testing the effectiveness of the selected controls (must provide
evidence that the selected controls are operating effectively throughout the audit period).

If control-based approach is taken, the auditor still has to perform some substantive procedures for
each material class of trans, account balance and disclosure.
Factors to consider
Case study: A1 Auditors is the auditor for Coffee Cupz Limited

Planning phase is undertaken pre balance date, the summary client audit plan is then presented to
the audit committee before year end.

Auditor reflection points will be provided to give clarity

Materiality level can be used to develop substantive testing procedures (those balances > $92,475
and analytical procedures for balances < $92,475.
Audit Plan Outline
ISA 300 requires auditor to update and change the overall audit strategy / plan as necessary during
the audit, as the auditor obtains new info and audit evidence during the audit, the initial risk
assessment may change.

ISA 330 Auditor ‘s responses to assessed risks.

ISA 315 (Revised) Identifying and assessing the risk of material misstatement through understanding
the entity and its environment.

WE 5.1: Calculating overall materiality, performance materiality and clearly trivial threshold

Determining benchmark
Clearly trivial threshold: insignificant misstatement which will not be recorded on the summary of
misstatements or communicated to those charged with governance.

WE 5.2: Evaluate the impact on audit strategy and audit program of info obtained during audit
planning.
WE 5.3: Accounts Receivable Audit

Inquired with credit controller => increases in debtor day was because some customers have
difficulty settling their accounts => ask what could go wrong.

Act rec control => limited segregation of duties over act rec functions.
ISA 330: Test of control should only be conducted if the auditor plan to rely on control, in this case it
should not be performed for act rec as the system indicated there were limited controls => obtain
assurance from substantive procedures (test of details)
Substantive analytical procedures: usually performed when risk of material misstatement is low and
there are adequate control procedures in place. The aud build their expectations and compare them
to client’s record => if high variance => investigate.

Ex: interest expense balance should be outstanding balance of borrowings x average interest rate.

Substantive tests of details: procedures that aud perform to test various audit assertions of
significant account balances, classes of trans and disclosures of the client’s fin statements.

Ex: test of details on expenses by vouching exp transactions to supporting documents such as
invoice, purchase order, and report.
Act 5.1: Identify materiality benchmarks

Consider the company ‘s objective, shareholders’ objective, listed / unlisted, and volatility of the
benchmarks.

ISA 320 para A4 lists a number of factors that affect ID and selection of an appropriate benchmark.

A5 states that various benchmarks may be appropriate => provided examples.

There is inverse relationship between risk of material misstatement and performance materiality.
Act 5.2: Revising materiality

1st step is to establish nature of the risk. As per ISA 320 paras 12 and 13, the aud is required to revise
levels of materiality if they know of new info that would have caused them to set materiality
differently.

ISA 320 para 10: aud should set lower mat level (specific materiality) for particular classes of trans,
acct balances or disclosures if misstatement of a lesser amount than the overall mat threshold could
influence decision of users.
Act 5.3: Developing an audit strategy and audit plan outline