2.2 Overview of the Audit Process Auditing Planning Knowledge, Analytics, Materiality

Summary

This video script delves into the intricacies of audit planning and risk assessment within a risk-based audit approach. It outlines the benefits of audit planning, emphasizing its role in focusing on important areas, identifying potential problems, and ensuring the audit is organized and managed effectively. The script also covers the process of obtaining knowledge of the business, preliminary analytical procedures, and a detailed explanation of materiality, including overall, performance, and specific materiality levels, highlighting their significance in audit planning and decision-making.

Takeaways

• 📘 The video discusses the importance of audit planning and its role in the risk assessment phase of the risk-based audit approach.
• 🔍 Audit planning is essential for focusing on important areas, identifying potential problems, and organizing the audit engagement effectively and efficiently.
• 🛠 Benefits of audit planning include assisting in proper assignment of work, facilitating direction, supervision, review, and coordination of the engagement team's work.
• 🔑 The auditor should obtain knowledge of the business to identify and understand events, transactions, and practices that may significantly affect the financial statements.
• 👀 Knowledge of the business is obtained through previous experience, discussions with entity personnel, internal audits, legal advisors, and other sources.
• 📊 Preliminary analytical procedures are used to identify unusual relationships and red flags in the financial data before testing begins.
• 📐 Materiality is defined as the magnitude of an omission or misstatement that would influence the decision-making of financial statement users.
• 📈 There are different types of materiality including overall materiality, performance materiality, and specific materiality, each serving different purposes in the audit process.
• 🧮 The computation of overall materiality involves selecting a benchmark and applying a percentage, which is a matter of the auditor's professional judgment.
• ✂️ Performance materiality is set at an amount lower than overall materiality to capture uncorrected misstatements and is determined by applying a 'haircut' percentage to overall materiality.
• 🎯 Specific materiality is set for particular items that require special attention and is used when the auditor deems it necessary for certain classes of transactions or account balances.

Q & A

What are the primary benefits of audit planning?

The primary benefits of audit planning include ensuring appropriate attention is given to important areas of the audit, identifying and resolving potential problems in a timely manner, especially in high-risk areas, and organizing and managing the audit engagement effectively and efficiently.

What is the purpose of the mnemonic 'PIE' in the context of audit planning?

The mnemonic 'PIE' stands for Potential problems, Important areas, and Effective and efficient audit. It helps to remember the primary benefits of audit planning.

What are the secondary benefits of audit planning?

Secondary benefits of audit planning include assisting in the proper assignment of work to engagement team members, facilitating direction, supervision, and review of the team's work, and coordinating work done by auditors of components, such as branches, subsidiaries, or divisions.

What is the mnemonic 'ADC' used for in audit planning?

The mnemonic 'ADC' stands for Assignment, Direction, Supervision, Review, and Coordination. It helps to remember the secondary benefits of audit planning.

What are the six activities involved in audit planning?

The six activities involved in audit planning are knowledge of the business, preliminary analytical procedures, materiality, and three other activities that are not mentioned in the provided script.

What is the importance of obtaining a knowledge of the business in audit planning?

Obtaining a knowledge of the business is crucial for identifying and understanding events, transactions, and practices that may significantly affect the financial statements or the audit report. It helps in establishing materiality judgments, identifying areas of special audit consideration, and designing further audit procedures.

What is the role of PSA 315 in obtaining knowledge of the business?

PSA 315 requires the auditor to obtain a knowledge of the business sufficient to identify and understand significant effects on the financial statements. It is the standard for 'getting to know you' (GTKY) in the audit process.

How can an auditor obtain knowledge of the business?

An auditor can obtain knowledge of the business through previous experience with the entity or its industry, discussions with people within the entity, internal audit personnel, other auditors, legal advisors, publications, legislations, regulations, and by visiting the entity's premises and reviewing documents produced by the entity.

What are the three phases of analytical procedures in an audit?

The three phases where analytical procedures can be performed in an audit are the planning phase, the testing phase, and the completion phase.

Why are analytical procedures performed in the planning phase of an audit?

Analytical procedures are performed in the planning phase to assist the auditor in planning the nature, timing, and extent of other auditing procedures, and to identify any red flags or unusual relationships that may require further investigation.

What is the definition of materiality in the context of auditing?

In auditing, materiality is defined as the magnitude of an omission or misstatement of accounting information that, in the judgment of a reasonable person relying on that information, would have been changed or influenced by the omission or misstatement.

What are the different types of materiality mentioned in the script?

The different types of materiality mentioned in the script are overall materiality (also known as planning materiality or general materiality level), performance materiality (also known as tolerable misstatement or scoping materiality), and specific materiality (or individual materiality).

How is overall materiality determined?

Overall materiality is determined by selecting a benchmark, such as profit before tax or sales, and applying a percentage to it, based on the auditor's professional judgment.

What is the purpose of performance materiality?

Performance materiality, which is an amount less than overall materiality, is used to determine which financial statement line items to be tested. It helps to ensure that the auditor captures any uncorrected misstatements that, when aggregated, may be considered material.

Why is specific materiality set for particular items?

Specific materiality is set for particular classes of transactions, account balances, or disclosures that require special attention due to the nature of the item or the expectations of the users of the financial statements.

How does the auditor's choice of benchmark and percentage affect the materiality levels?

The choice of benchmark and percentage directly affects the calculation of materiality levels. Different benchmarks and percentages will result in different materiality levels, which in turn influence the extent of substantive tests and the auditor's approach to identifying and evaluating misstatements.

Outlines

00:00

📘 Introduction to Audit Planning and Risk Assessment

The script begins with a brief introduction to audit planning and its significance in the context of the audit process. It highlights that the current discussion is part of the risk assessment phase in a risk-based audit approach. The importance of audit planning is underscored by its role in ensuring appropriate attention to significant areas of the audit, identifying potential problems, and organizing the audit engagement efficiently. The benefits of audit planning are summarized using the mnemonic 'PiPE' for primary benefits (Potential problems, Important areas, and Effective & efficient audit) and 'ADC' for secondary benefits (Assignment, Direction, Supervision, Review, and Coordination). The script also outlines six activities involved in audit planning, with a focus on the first four in this segment: knowledge of the business, preliminary analytics, materiality, and the rest to be discussed in subsequent videos.

05:01

🔍 Understanding the Business and Its Impact on Auditing

This paragraph delves into the necessity of obtaining knowledge of the business as per PSA 315, emphasizing the importance of understanding the client's business, industry, and accounting and internal control systems. It discusses various ways to obtain this knowledge, such as previous experience, discussions with entity personnel, and reviewing documents. The use of this knowledge in establishing materiality judgments, identifying areas of special audit consideration, and developing expectations for analytical procedures is explained. The paragraph also introduces the concept of 'GTKY' (Getting To Know You) as a process to understand the client's business and its accounting and internal control systems through inquiring, inspecting, and observing.

10:02

📊 Preliminary Analytical Procedures and Their Role in Audit Planning

The script introduces preliminary analytical procedures as a crucial part of audit planning, which involves evaluating relationships among financial and non-financial data to identify expected patterns and detect unusual relationships or red flags. It explains that analytical procedures are performed across all three phases of an audit—planning, testing, and completion—with different objectives in each phase. The planning phase uses analytics to plan the nature, timing, and extent of other auditing procedures, while the testing phase gathers evidential matter about specific account balances or transactions. The completion phase reviews financial information to determine if additional testing is needed. The paragraph emphasizes the importance of analytical procedures in the audit process.

15:03

📉 Materiality in Auditing: Definitions and Types

This paragraph provides an in-depth discussion on the concept of materiality in auditing, defining it as the magnitude of an omission or misstatement that could influence the decision-making of financial statement users. It differentiates between various types of materiality, including overall materiality (also known as planning materiality or general materiality level), performance materiality (tolerable misstatement or scoping materiality), and specific materiality (individual materiality for particular items). The script explains how overall materiality is determined using a benchmark and a percentage, while performance materiality is a reduced percentage of overall materiality to account for aggregated misstatements. Specific materiality is set for items requiring special attention. The paragraph also illustrates these concepts with an example using a client's financial data.

20:04

📋 Determining Materiality Levels and Their Significance

The script continues the discussion on materiality by explaining how to compute overall materiality using profit before tax or sales as benchmarks and applying professional judgment to select a percentage. It discusses factors that may influence the choice of benchmark and the percentage to apply, such as the nature of the entity, the components of the financial statements, and legal or regulatory requirements. The paragraph also explains how performance materiality is calculated as a percentage of overall materiality, using a 'haircut' or 'cushion' to determine a stricter level for high-risk engagements. The importance of materiality in establishing the extent of substantive tests, evaluating potential and actual misstatements, and defining the threshold for required adjustments to financial statements is highlighted.

25:04

📝 Conclusion on Materiality and Transition to Next Video

The final paragraph wraps up the discussion on materiality, emphasizing its importance in audit planning and decision-making. It provides a brief recap of the concepts covered in the video and encourages viewers to take notes before proceeding to the next video. The script indicates that the next video will cover the remaining three activities of audit planning, creating an anticipation for continued learning.

Keywords

💡Audit Planning

Audit planning is the initial phase of the audit process where auditors prepare for the work to be conducted. It is integral to the risk-based audit approach and helps in identifying and focusing on significant areas of the audit. In the script, audit planning is discussed as a requirement by auditing standards, with both primary and secondary benefits, such as ensuring potential problems are timely identified and resolved, and facilitating the organization and management of the audit engagement.

💡Risk Assessment

Risk assessment is a phase in the risk-based audit approach where auditors evaluate potential risks that may affect the financial statements. The script mentions that audit planning and risk assessment procedures are closely linked, with the latter involving the identification of high-risk areas that require focused attention and resources during the audit.

💡Materiality

Materiality in auditing refers to the threshold at which misstatements or omissions in financial statements become significant enough to influence the decisions of users relying on that information. The script explains different types of materiality, including overall materiality, performance materiality, and specific materiality, and how they are determined based on professional judgment and various factors.

💡Preliminary Analytical Procedures

Preliminary analytical procedures are evaluations of financial information to identify relationships and trends among data, performed early in the audit process. The script describes how these procedures are used to plan the nature, timing, and extent of other auditing procedures, helping auditors to identify unusual relationships or 'red flags' before testing begins.

💡Knowledge of Business

Gaining a knowledge of the business is a requirement under PSA 315 and is crucial for auditors to understand the entity's operations and transactions that could significantly affect the financial statements. The script emphasizes the importance of 'getting to know you' (GTKY) as part of the audit process, which involves understanding the client's business, industry, and accounting and internal control systems.

💡Professional Judgment

Professional judgment is the application of relevant knowledge, experience, and personal expertise by the auditor in making informed decisions. The script frequently refers to professional judgment in determining benchmarks for materiality, selecting the appropriate percentage for performance materiality, and assessing the risks associated with the audit engagement.

💡Internal Controls

Internal controls are the policies and procedures implemented by an entity to ensure the reliability of financial reporting, compliance with laws and regulations, and the effectiveness of operations. The script mentions that understanding the accounting and internal control systems is part of the GTKY process and is essential for designing and performing audit procedures.

💡Audit Standards

Audit standards are the rules and guidelines established by professional bodies that auditors must follow when conducting an audit. The script refers to audit planning as a requirement by these standards, emphasizing the structured approach to performing an audit effectively and efficiently.

💡Substantive Tests

Substantive tests are auditing procedures performed to gather evidence about the accuracy and completeness of information presented in the financial statements. The script explains how the level of materiality affects the extent of these tests, with stricter auditors performing more substantive tests when the materiality level is lower.

💡Audit Opinion

An audit opinion is the auditor's formal conclusion about the fairness and accuracy with which the financial statements represent an entity's financial position and operations. The script mentions that if misstatements exceed the materiality level and are not adjusted by the client, the auditor will modify their opinion, reflecting on the reliability of the financial statements.

Highlights

Introduction to audit planning and its importance within the risk assessment phase of the risk-based audit approach.

Explanation of the benefits of audit planning, including focusing on important areas and identifying potential problems in a timely manner.

The mnemonic 'PIE' to remember the primary benefits of audit planning: Potential problems, Important areas, and Effective and efficient audit.

Secondary benefits of audit planning such as assisting in work assignment and coordination among auditors.

The mnemonic 'ADC' for remembering secondary benefits: Assignment, Direction, supervision, review, and Coordination.

Six activities involved in audit planning, with a focus on materiality and preliminary analytics in this segment.

Knowledge of the business as a requirement by PSA 315 and its significance in the audit process.

Methods of obtaining knowledge of the business, including previous experience, discussions, and inspections.

The use of knowledge about the business to establish materiality judgments and identify areas of special audit consideration.

Understanding the accounting and internal control system through inquiries, inspections, and observations.

Importance of understanding the major classes of transactions and the accounting process for effective auditing.

Introduction to preliminary analytical procedures and their role in the planning phase of the audit.

The expectation of relationships in financial statements and how analytical procedures help identify unusual patterns.

Different phases where analytical procedures can be applied: planning, testing, and completion.

Definition and importance of audit materiality in influencing the decision-making of financial report users.

Different types of materiality: overall materiality, performance materiality, and specific materiality.

Illustration of how to calculate overall materiality using a benchmark and a percentage.

The concept of performance materiality as a lower threshold than overall materiality to capture uncorrected misstatements.

Setting specific materiality levels for particular items that require special attention in the audit.

Importance of materiality in determining the extent of substantive tests and evaluating potential misstatements.

Transcripts

hello again friends welcome back are you

ready for audit planning but before we

go into audit planning let me just very

quickly pull out the phases of the audit

process that we used as the starting

point for our discussion so the last

video we talked about pre-engagement

activities and right about now we are

going to talk about audit planning

together with risk assessment procedures

so we are still in the risk assessment

phase of the risk-based audit approach

remember we said risk assessment risk

response and then conclusion and

Reporting so after we are able to

complete our discussion on audit

planning and a segue into risk

assessment procedures then we would have

already ticked off the risk assessment

phase of the risk-based audit approach

now audit planning is required by our

auditing standards and there are

benefits attributed to audit planning we

categorize this as the primary benefits

and the secondary benefits primary

benefits would involve helping ensure

that appropriate attention is devoted to

important areas of the audit especially

now where we have embraced a risk-based

audit approach where we said we will

focus our attention resources and

energies on important areas of the audit

so planning could help us do that it

would also help ensure that potential

problems especially those problems which

are attached to highrisk areas are

identified and resolved on a timely

basis and audit planning also helps

ensure that the audit engagement is

properly organized and and managed in

order to be performed in an effective

and efficient manner we may remember the

primary benefits of Planning by the

pneumonic Pi P for potential problems I

for important areas and E for Effective

and efficient audit added to that we

also have secondary benefits to planning

which would include Assistance or to

assist in proper assignment of work to

engagement team members say for example

you have identified a highrisk area and

so therefore you may may want to assign

a more seasoned Auditor in that

particular area it would also help

facilitate the direction supervision and

review of the work of the engagement

team this is where you instruct you

journey together with them and then you

review the work that they have done

audit planning would help ensure that

that is done efficiently and it also

assists in coordination of work done by

Auditors of components do you remember

the Auditors of the branches or the

subsidiaries or the divisions even for

example work with other accountants like

internal Auditors and even experts so

planning would help assist in that and

perhaps we can remember the secondary

benefits of Planning by the nimonic ADC

not ABC but ADC assignment Direction

supervision review and coordination all

right so those are the benefits of

planning now there are six steps or not

steps but there are six activities that

will be performed in audit planning but

since we said that we will try to limit

our videos to 25 to 30 minutes each I

have a feeling that for this video let's

target up to materiality so that's uh

knowledge of the business preliminary

analytics materiality and then the rest

we will talk about in the next video all

right so let's go ahead to talk about

knowledge of the business knowledge of

the business is a requirement that is

embodied in PSA

315 by the way PSA 315 already has a

2019 revision so I am cordially inviting

you to pay BSA 315 2019 revision a visit

if you haven't done so yet now PSA 315

states that the auditor should obtain a

knowledge of the business sufficient to

enable the auditor to identify and

understand the events transactions and

practices that may have a significant

effect on the financial statements or on

the examination or the audit report now

just imagine walking into or going into

a relationship wouldn't you want to get

to know that person first similar to an

audit I would like to call PSA 315 as

the standards on gtky getting to know

you so our audit standards also require

us to get to know our client and this

process of getting to know our client is

what we call obtaining a knowledge of

the business now perhaps you might want

to ask how do we obtain the knowledge no

so for example if you were on the gtky

phase how would you obtain the knowledge

well you can obtain the knowledge from

previous experience with the entity and

its industry if you ever had the

opportunity or the chance to have worked

with that entity before or may not

necessarily be the same entity but then

the industry in which it operates you

could also obtain the knowledge from

discussions with people within the

entity or internal audit Personnel if

the client has an internal audit

Department other Auditors and with legal

and other advisors or knowledgeable

people

Outside The Entity take note at this

point we're obtaining the knowledge of

the business in the previous video we

talked about determining or evaluating

the Integrity of management this one is

different because we're going to obtain

knowledge of the business you may also

obtain the knowledge from Publications

legislations regulations when you need

when you read for example industry

newsletters and such or visits to the

entity's premises and plan facilities

this might be one activity you would

enjoy doing no when you do an ocular

visit of the premises and the plant

facilities and whatever documents

produced by The Entity will also help

you obtain knowledge of the entity this

will give you an idea as to what their

major transactions are who their major

customers are what their major

operations revolve around them so that

is how you obtain the knowledge now

assuming you have already obtained the

knowledge of course we have to use that

knowledge Now using that knowledge would

involve establishing and evaluating

materiality judgments which is part of

our discussion in this segment so

knowledge about the business will help

us establish what is the appropriate

materiality level considering the

appropriateness in the selection and

application of accounting policies and

the adequacy of FS disclosures we recall

that the one responsible for selection

and application of accounting policies

and the disclosures in the fs is still

management but as auditors we come in to

consider whether they are appropriate

identifying areas of special audit

consideration such as for example do

they have specialized inventories can

you imagine if your client's inventories

are precious gems and stones of course

it would be beyond our expertise as CPAs

right so you will identify areas of

special audit consideration and this

will also help you develop expectations

for use in analytical procedures such as

uh information or knowledge as to

whether how the industry is doing are

they somehow presenting or is the

industry in general somehow presenting a

Rosy picture of what will happen in the

next few years or are we seeing a

downturn of events in that said industry

so this will help you develop estimates

or expectations rather later on when we

talk about analytical procedures this

could also help you design and perform

further audit procedures to reduce audit

risk more on that later and to evaluate

the sufficiency and appropriateness of

the audit evidence obtained needless to

say it is really necessary for the

auditor to do a gtky with the client now

we are also not only tasked it is we are

not only required to obtain a knowledge

of the business and its industry but

more importantly also to obtain an

understanding of the accounting and

internal control system precisely the

reason why you will be having a separate

module dedicated solely to internal

control considerations but it is part of

the

gtky understand the entity understand

its industry and understand its

accounting and internal control systems

if we're going to arrange it so the

broadest will of course be the industry

then the entity or the business and then

its internal control system accounting

and internal control system so in this

case how will you obtain it okay how

will you obtain understanding of the

accounting and internal control system

we mainly obtain it by the The Big Three

I call this the big three inquire

inspect observe and later on you will

get to understand why I call this the

big three because they are present in

whatever category of procedures the

auditor will perform but in this case

you perform

gtky you understand the entity the

accounting and internal control system

of the entity by these big three inquire

inspect observe inquiries of appropriate

management supervisory or other

personnel with various organizational

within various organizational levels

inspection of documents and records and

of course observation of the entity's

activities and operations now what do

you need to understand take note we are

becoming more specific here we are

really embracing going into the

accounting and internal control system

therefore we need to understand what are

the major classes of transactions how

are these transactions initiated in

other words what is the starting point

of these transactions when there is a

purchase made for examp example what's

the starting document or what's the

starting activity do they have a

purchase requisition or do they merely

call up to make the requests what are

significant accounting records

supporting documents and accounts what

are their subsidiary ledgers that they

are using what are the special journals

that they are using what is the

accounting and financial reporting

process then the evaluation of their

internal controls and we have to

remember at this point when we are still

doing the gtky when we EV evaluate the

internal controls we're mainly looking

at two

things design and implementation of the

controls and then what are the type of

internal controls involved okay but do

not worry internal controls will have

its own time to shine when we talk about

it in a separate module so essentially

that is about knowledge of the business

next we need to talk about preliminary

analytical procedures if you're one who

is so fond of like comparing last year's

figures versus this year's figures or

flexing your knowledge on how to compute

for the ratios and you're how you're

able to memorize the formula for the

ratios no so this might be the activity

for you so preliminary analytical

procedures is anchored on analytical

procedures as a whole when we talk about

analytical procedures they consist of

evaluations of financial information

made by a study of plausible

relationships among both financial and

non-financial data the idea being that

we perform analytical procedures because

we expect relationships to be present in

the financial statements and I think you

will agree with me on this we do expect

that there are relationships in the

accounts in the financial statements why

well we start by an appreciation of the

double entry system of accounting right

there is no one

Standalone accounting entry there are

always always at least two accounts

which are affected so because of that we

expect relationships to be present and

we expect that we'll be able to predict

those relationships or that they exist

in a predictable pattern of sorts now

analytical procedures are so widely used

in the audit that it can be performed in

all three phases of the audit what do I

mean by that it can be performed in the

planning phase it can be performed in

the testing phase and it can be

performed in the completion phase now

whenever you are asked whenever you you

encounter multiple choice questions

about analytical procedures you best

look at which particular phase is it

applied because the purpose will depend

on the phase that it is applied for

example if you talk about analytics

performed in the planning phase so the

purpose is to assist the auditor in

planning the nature timing and extent of

other auditing procedures since it is

performed at the planning phase prior to

any testing analytics performed in the

planning phase is help helpful for the

auditor to determine if there are any

red flags or unusual relationships that

are seen prior to testing because of

that it will help the auditor respond to

these red flags or these unusual

relationships now analytical procedures

can also be performed in the testing

phase the testing phase happens in the

risk response phase so in the testing

phase when performed as a substantive

test the purpose is to obtain evidential

matter about particular assertions

related to account balances or classes

of transactions so imagine in the

planning phase you just got to see the

red flags the high-risk areas the

unusual relationships in the testing

phase you get to gather evidential

matter about specific assertions of

balances and

transactions the third phase where

analytics may be performed is in the

overall review phase so as an overall

review of the financial information in

the final review stage of the audit this

will help the auditor determine if

additional testing is still needed if

the auditor gets to see still some

unusual relationships even after the

testing has been done even after

evidence Gathering has been performed

and there still exists unusual

relationships it may be assigned for the

auditor to test more so as an overall

review of the financial information

analytics may also be done so you get to

see they can be performed in the

planning testing and completion phase

and they are required to be performed in

both planning and completion it is only

in the testing phase that they are not

required all right so that's analytical

procedures and now let's move on to

materiality now I know most of you are

very interested to talk about

materiality especially since even as

early as our first accounting subject we

have already heard about materiality so

this time the focus is more on audit

material it and we get to Define this

side by side with the accounting

definition of materiality so in your in

your Intermediate Accounting you must

have defined materiality as information

is material if omitting misstating or

obscuring it could reasonably be

expected to influence decisions that the

primary users of general purpose

Financial reports make on the basis of

those reports which provide financial

information about a specific reporting

entity if we go to the the audit side

materiality is defined as the magnitude

or an Omission or misstatement the

magnitude of an Omission or misstatement

of accounting information that in the

Judgment of a reasonable person relying

on that information would have been

changed or influenced by the Omission or

misstatement so since we are already on

the auditor shoes so our concern will be

more on the misstatements omissions okay

or sins of omissions or sins of

commission

so an Mission or misstatement of

accounting information that would affect

the in or that would influence the

decision making of the users of the

information now there are different

types of materiality and perhaps this is

one where you have encountered in your

textbooks if you have already read your

textbooks but there are different types

of materiality there is what we call

overall materiality performance

materiality and then specific

materiality now just hang in there we're

going to try and Ill illustrate these

three different types of materiality

there are terms that we can use for

these different types when we talk about

overall materiality this may also be

called planning materiality but this is

also sometimes called the general

materiality level okay so when we talk

about overall materiality it's the

smallest aggregate amount of

misstatement applicable to all financial

statements so the basis is that amount

that could misstate a financial

statement okay the focus is financial

statements it helps determine whether

the proposed adjusting entries are

significant at the end of the audit when

you are able to summarize already all of

the proposed adjusting entries and for

those entries which management does not

adjust you compare it with the overall

materiality if it exceeds the overall

materiality level then that means the

financial statements are materially

misstated okay now how to compute for

the overall materiality you find a

benchmark and then you multiply that one

with a percentage we will talk about the

computation later there is also what we

call Performance materiality performance

materiality is sometimes called the

tolerable misstatement or the scoping

materiality this is an amount less than

the overall materiality the idea being

that well some misstatements may be

immaterial individually but once

aggregated they may already be

considered as material so in order to

feel a little bit more confident no so

we set an amount less than the overall

materiality and this is calculated as a

certain percentage of your overall

materiality in order to capture any

uncorrected misstatements think about it

as applying a haircut okay or a cushion

to the overall materiality to arrive at

a lesser amount now the performance

materiality is used in determining FS

line items to be tested that is why it

is called a scoping materiality now the

auditor may also wish to come up with a

specific materiality or individual

materiality now the specific materiality

is an amount set by the auditor for

particular or specific classes of

transactions account balances or

disclosures take note that this will

only be applicable or used for the

specific items that the auditor deems to

need its own materiality consideration

in other words it's kind of like those

accounts which would require special

attention and because of that they have

a special specific individual

materiality so just um let's just

illustrate so that we would more or less

get a better feel of what are these

different types of materiality all of

our illustrations by the way are lifted

from the aesc bulletin 001 series of

2010 so you may also want to pay that a

visit so assuming that these are these

are the details pertinent to our client

there's total assets of 1 million total

liabilities of 7 ,000 total Equity of

300,000 so assets equal liabilities plus

Equity sales of 800,000 cost of sales

600,000 therefore op operating and

operating expenses of 50,000 this will

give us profit before tax of 150,000

assuming income tax provision is 45,000

and the profit for the year is 105,000

let's start by talking about overall

materiality we recall that overall

materiality can be arrived at by using a

benchmark and multiply that by a

percentage as to what Benchmark to use

and what percentage to apply ladies and

gentlemen it will be a matter of the

auditor's professional judgment we do

have some rules of thumb so to speak but

the standards do not prescribe a

specific benchmark it will really be up

to the auditor to apply his or her

professional judgment now let's assume

that our client is business oriented

okay here are some factors that may

affect the choice of The Benchmark for

example the components of the financial

statements or the elements of the fs if

there are certain areas that the focus

that the users tend to focus more on for

example if the users would try to

evaluate or assess the performance of an

entity then they would most likely look

at profit or sales right the nature of

the entity is it a profit oriented

entity is it a charitable institution

what is the ownership structure of the

ENT

what is the volatility of The Benchmark

identified and are there any laws and

regulations that need to be factored in

for example in the case of the

Securities and Exchange Commission in

its memorandum circular number 8 series

of 2009 they consider to be significant

accounts if it is equivalent to 5% of

balance sheet or income statement line

items if this is a listed company mutual

fund or other issuers of security ities

to the public including pre-need

companies insurance

companies however if the corporation is

neither of those it's not listed it's

not a mutual fund it's not a preed

company then the threshold shall be 10%

or more so we do get to look at

requirements or Provisions coming from

laws and regulations but in the case of

our illustration assume that the only

thing we know is that the business is

profit oriented if it is profit oriented

you may want to use as a benchmark The

Profit before tax or the sales so let's

present both okay as an illustration so

if the auditor determines that the

profit before tax is a better Benchmark

then the auditor will use 150,000 but if

the auditor thinks sales is a better

Benchmark then may use 800,000 based on

professional judgment the auditor will

also come up with a percentage assuming

5% of profit before tax or 1% of sales

therefore in this case our overall

materiality assuming you are using

profit before tax is 7,500 if you're

using sales then the overall materiality

is 8,000 that means any misstatement

amounting to 7,500 and above or 8,000

and above depending on which one you

will choose in any one of the financial

statements will already render it to be

materially misstated okay and so

therefore we might ask management to

adjust so that the amount will be less

than material or if management does not

adjust then we will modify our opinion

so that is overall materiality again

apply this is the amount that could

misstate any one of the financial

statements then we move on to

Performance materiality now we said

performance materiality is an amount

lower than overall materiality and so to

this we take our overall materiality and

then multiply it by a percentage where

we have reduced it by the haircut

percentage or the cushion again again

how do you determine the haircut or the

cushion percentage it's a matter of

Auditor's judgment so factors that may

affect the choice of the percentage

would be the overall engagement risk

whether you are strict or you are chill

the history of booked audit adjustments

meaning to say how willing is the client

to adjust based on your audit findings

based on you know your experience with

the client in the past and if there are

any fraud risks needless to say that

risks that we have identified will drive

what particular percentage we will use

as the haircut or the cushion so

assuming that performance materiality

haircut or cushion is 25 or 50% again

this is all a matter of professional

judgment so in this case in the previous

illustration we had the auditor was

considering whether to use profit before

tax or sales our previously computed

overall materiality was 7,500 if based

on profit before tax and 8,000 if based

on sales now if the auditor chooses a

cushion that is at

25% that means the performance

materiality will be

75% of the overall materiality because

we do have 100% minus the cushion or

minus the haircut so that means 100%

minus 25% that would be 75% multiplied

by

7,500 the performance materiality if you

have chosen a cushion at 25% is

5,625 however if you have chosen a

cushion of 50% so 100 minus 50% is 50%

so 7,500 * 50% will give you performance

materiality at

3,750 now the same computations would

hold true if the auditor used sales as a

benchmark okay so again we're presenting

both possibilities whether the auditor

will choose profit before tax or sales

whether e the auditor would choose

cushion at 25% or at 50% but perhaps in

order to better appreciate this one

let's let's ask ourselves which one will

you

choose uh with the computations that we

have had between the uh performance

materiality at 25% cushion and

performance materiality at 50% cushion

which one will you choose if the

engagement has a high risk so imagine

this one you have decided to accept an

engagement that had so so many red flags

and because they had so many red flags

and you still decided to accept it then

the auditor would then most likely

choose to be more strict right the

auditor will be stricter why because you

have decided to accept a highrisk client

and when the auditor becomes stricter

remember this one which particular

materiality level will you choose is it

the higher amount of materiality or the

lower amount of materiality which in

which of these instances higher amount

or lower amount is the auditor more

strict and if in case you need to review

the concepts on this it's found actually

in our first segment right our first few

videos so in this case the lower the

materiality the stricter the auditor

actually is so the more strict you are

then you go for a bigger cushion okay

now in this case we would choose the

3,750 or the 4,000 again just so we

would be able to Recall why we are

choosing this one imagine if your

materiality level is

3,750 the moment that the misstatement

reaches

3,751 then you would already see that

the financial statements are materially

misstated yes but if you have chosen a

materiality level of

5,625 even if you have seen a

misstatement amounting to 5,000 you

would still be okay why because because

you're in chill mode why are you in

chill mode chill mode because the

engagement is a low risk and so even if

it reaches 5,000 you're still fine

you're still okay but had you chosen the

cushion at 50% even at 3,751 you would

already be in panic mode so therefore

the stricter the auditor is the lower is

the amount of materiality that will be

chosen true to our discussion also in

the last video so in this case which one

will you choose for a highrisk

engagement the performance materiality

with a lower amount now we also said

that there is such a thing as a specific

materiality so to illustrate let us

assume further that the auditor has

assessed that there are specific users

who expect a lesser level of

misstatement in management compensation

in other words users tend to be very

particular about management compensation

they tend to be quite strict with

regards management compens ation assume

therefore that adopting a 50% threshold

of uh performance materiality is

appropriate so to present remember a

while back we did have uh overall

materiality

7,500 let's just take a look at profit

before tax okay overall materiality

7,500 uh performance materiality at 25%

cushion

5,625 at 50% cushion

3,750 assuming we would like to set a

specific materiality for the account

balance on management compensation so

our specific materiality for management

compensation at a higher okay level

would be

2,813 at a lower materiality level

1,875 remember again that the lower the

materiality level the stricter you

become so the

2,813 and the 1,875 5 is only applicable

for management compensation only special

specific

individual so whenever the auditor

examines management compensation then

the materiality level that will be used

is either

2813 or

1,875 now you might be a bit confused

because we're presenting a lot of

options here so just to simplify things

let us assume that as an auditor you

have determined that profit before tax

is the better measure so because profit

before tax is the better measure or

criteria so we will use an overall

materiality of

7,500 let us assume that the client is a

highrisk engagement okay it's into a

highrisk engagement and because it's a

high-risk engagement then we will choose

preliminary or sorry uh performance

materiality at

3750 and let us assume as well that

there is a high risk pertaining to

management compensation and because of

that we will choose a specific

materiality for management compensation

amounting to

1,875 okay so as to what criteria or

Benchmark to use what particular

percentage to use again it is a matter

of professional judgment okay what is

the importance of materiality well it

helps establish the extent of

substantive tests we have to remember

the stricter we

become the Lesser or the lower is the

amount of materiality that we will

choose and the stricter we become the

more substantive tests we will perform

we also identify as part of the

importance of materiality that it is

able to evaluate potential and actual

misstatements at the end of the day this

is the amount where we compare the

misstatements with and when the

misstatements would exceed this amount

then we would already say that the fs is

materially misstated and like what we

have said it defines the Threshold at

which the auditor would require the

client to make an adjustment to the

financial statements so imagine a while

back we said overall materiality is

7,500 so let's just say for example you

were able to find likely misstatements

totaling 10,000 so that means you will

require the client to adjust by

2,500 so that the financial statements

will not be materially misstated if the

client does not adjust then the auditor

will modify his or her opinion so that

is materiality so I think we are

exceeding a bit from our Target 30

minutes but I would say we're still okay

so we're going to cut our discussion a

little bit now now is the time for you

to take that sheet of paper and that

ball pen and to start writing down notes

before you start the next video again a

reminder to everyone watching this video

this is now the moment where you write

down notes all right and I'll see you in

the next video to discuss the remaining

three activities for audit planning