2.2 Overview of the Audit Process Auditing Planning Knowledge, Analytics, Materiality
Summary
TLDRThis 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
📘 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.
🔍 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.
📊 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.
📉 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.
📋 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.
📝 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.
Mindmap
Keywords
💡Audit Planning
💡Risk Assessment
💡Materiality
💡Preliminary Analytical Procedures
💡Knowledge of Business
💡Professional Judgment
💡Internal Controls
💡Audit Standards
💡Substantive Tests
💡Audit Opinion
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
Ver Más Videos Relacionados
2.3 Overview of the Audit Process Audit Planning Risk Assessment
Risk of Material Misstatement
Audit Planning | Understanding the Entity and its Environment | Hermosilla, Tiu, Salosagcol
Audit Risk Model
2.4 Overview of the Audit Process Audit Planning Audit Strategy vs Plan vs Program
4.2 Audit Procedures
5.0 / 5 (0 votes)