Materiality Audit Strategy & Plan PDF

MATERIALITY, AUDIT STRATEGY AND AUDIT PLAN MATERIALITY In auditing, the concept of materiality recognises that some matters, either individually or in aggregate, are important to users making economic decisions based on an entity’s financial statements. This could include decisions that involve in...

MATERIALITY, AUDIT STRATEGY AND AUDIT PLAN MATERIALITY In auditing, the concept of materiality recognises that some matters, either individually or in aggregate, are important to users making economic decisions based on an entity’s financial statements. This could include decisions that involve investing in, purchasing, doing business with or lending money to, an entity. When a misstatement or omission of information in the financial statements is significant enough to change or influence such a decision, a material misstatement has occurred. A misstatement is defined as any difference between the actual amounts, classification, presentation or disclosure of a reported financial statement line item and the amount, classification, presentation or disclosure that is required for the item to be in accordance with the applicable financial reporting framework. Misstatements can arise due to error or fraud. Applying the concept of materiality appropriately enables the auditor to focus their attention and effort on the high-risk areas of the entity’s financial statements. ISA 320 provides guidance on how auditors apply the concept of materiality in planning and performing the audit. The figure below illustrates how materiality is considered throughout an audit: This unit specifically deals with how an auditor determines and applies materiality in the first two phases (risk assessment, risk response) of an audit. During the audit reporting phase at the conclusion of an audit, overall materiality is applied to evaluate the effect of any identified misstatements on the financial statements and the appropriateness of the auditor’s opinion. Determining Materiality Step 1: Understand the users of the financial statements As per the definition of materiality, auditor consider what could be material for USERS. So the first step to determine materiality is to understand and identify who is the user of the financial statement. Step 2: Identify the benchmark most important to the users. As there are so many elements of the financial statements. Determining the benchmark requires careful consideration of available information on the focus of the users of the financial statements. Example: The engagement team of Company A is in the planning phase. One of the key phase of planning is to determine materiality. While obtaining the understanding of the entity and its environment you came across with the following facts: - The entity is a listed entity in the textile business. - The Company does not have any significant borrowing from lenders/banks. - As per the draft financial statement, the Company has reported the profit. - The Company has a history of paying dividends. The engagement partner has determined that due to the fact that the entity is listed and does not have any extensive borrowing therefore users of the financial statements are shareholders and shareholders focus more on profit before tax. It is the most appropriate benchmark for the user because economic decisions of the user such as sale and purchase of shares and dividend income are based on profit before tax. Examples of Some of the Applicable Benchmarks Benchmark Justification - Listed entity with issued equity securities Profit Before Tax - Dividend paying entity - Profit oriented entity - Not-for-profit entity Revenue - A company incurring losses Where primary user is bank and focused on the ability of the entity Cash Flow from Operations to repay - Public sector entity Expenses - Not for profit entity Total Asset Highly leveraged entity, assets secured against financing Step 3: Determine the appropriate percentage to apply to the selected benchmark. Benchmark Percentage Profit Before Tax 5% Revenue 1% to 5% Total Asset Up to 1% Cash flow from operations 3% to 5% Levels of Materiality ISA 320 describes four materiality levels, which can be broadly categorised as follows: - Overall materiality. - Performance materiality. - Specific materiality. - Specific performance materiality. Overall Materiality Overall materiality refers to materiality for the financial statements as a whole. It is the dollar amount that the auditor sets for the financial statements, above which any misstatement (individual or in aggregate) would result in the financial statements being materially misstated. The auditor establishes overall materiality based on their understanding of the financial information needs of the users, as a group, of the financial statements. In doing so, the auditor assumes that users have a reasonable knowledge of business, economic activities and accounting, and that they use reasonable diligence in studying and making reasonable decisions based on the financial statements. Example – Overall materiality Assume that the economic decisions of a group of users of financial statements would be influenced by a misstatement of Rs. 200,000 in the financial statements. This amount would be the overall materiality set by the auditor. Any individual misstatement or aggregate of individually immaterial misstatements that exceeds this Rs. 200,000 amount would result in the financial statements being materially misstated. Performance Materiality Performance materiality is based on overall materiality but set at a lower amount. The auditor uses performance materiality to determine: - which items in the financial statements to select for testing - the nature, timing and extent of audit procedures. Financial statements are materially misstated when the total amount of uncorrected and undetected misstatements exceeds overall materiality. The risk of this occurring can be reduced by setting a materiality benchmark at an amount lower than overall materiality (i.e. performance materiality) when determining the audit work to be performed. Example – Performance materiality Assume that overall materiality for an audit is set at Rs. 200,000 and audit procedures are planned to detect all misstatements in excess of Rs. 200,000. It is quite possible that a misstatement of Rs. 160,000, for example, will go undetected. Also assume that three misstatements exist of Rs. 160,000, Rs. 60,000 and Rs. 50,000 respectively (i.e. Rs. 270,000 in total). As each of these amounts are below Rs. 200,000, the auditor would not select them for testing and, therefore, the financial statements would be materially misstated (if management does not correct the misstatements). However, if performance materiality is set at Rs. 150,000 (75% × Rs. 200,000), it is more likely that at least the Rs. 160,000 error will be detected. Even if only the Rs. 160,000 error is identified and corrected, the total of remaining misstatements of Rs. 110,000 would be less than the overall materiality and the financial statements as a whole would not be materially misstated, even if management does not correct the remaining misstatements. ISA 320 provides no specific guidance on how to calculate performance materiality (i.e. the extent of this reduced amount). This is left to the auditor’s professional judgement, and is affected by issues such as the: - auditor’s understanding of the entity - auditor’s experience in prior year audits - nature and extent of misstatements identified in prior year audits - auditor’s expectations in the current year - risk assessment. The following table provides some percentages that are commonly used in practice to calculate performance materiality: Performance materiality Risk of material misstatement as a percentage of overall materiality High 50–60% Medium 65–75% Low 80–90% Relationship between the risk of material misstatement and performance materiality Performance materiality determines the extent of audit procedures that the auditor will carry out in response to a risk of material misstatement they have identified. An inverse relationship exists between the acceptable performance materiality level and the risk of material misstatement. This is illustrated as follows: Examples – Inverse relationship between performance materiality and risk of material misstatement (ROMMs) Example 1: Low ROMMs, high performance materiality Where an entity has a history of unmodified audit opinions, operates in a stable industry and has robust internal controls, then, excluding other factors, it is likely that the auditor would assess the entity as having a low ROMMs. This low risk assessment would lead the auditor to set performance materiality higher than they would for a similar entity with weaker internal controls. Example 2: High ROMMs, low performance materiality If an entity operates in a volatile industry such as the oil and gas exploration industry, has a history of weak internal controls and requires adjustments to its financial statements each year as a result of audit findings, it is likely that the auditor would assess the entity as having a high ROMMs. The auditor, therefore, would set performance materiality low enough to ensure that audit risk is reduced to an acceptable level. Example – Determine materiality for a listed entity in a stable environment A listed for-profit entity in the manufacturing industry, which has robust internal controls and a history of unmodified auditor’s reports, produces the following key results: Gross revenue = Rs. 120 million. Net profit before tax = Rs. 20 million. Total assets = Rs. 150 million. Net assets = Rs. 80 million. The current economic climate is stable and the entity’s results are comparable with its competitors in the industry. When determining materiality levels, the auditor would be likely to consider the factors set out below. Materiality for the financial statement levels Overall materiality Given that the entity is a listed for-profit entity, users of its financial statements are likely to be focused on profit. Therefore, ‘net profit before tax’ appears to be an appropriate benchmark to use. The stable economic environment and the fact that the company’s results are comparable with its competitors both support using this benchmark, which is unlikely to be volatile. Being a listed entity, there is a larger volume of users (shareholders), more regulation and a higher pressure to meet financial expectations. The auditor may therefore decide to apply a lower percentage to the chosen benchmark. Using their professional judgement, the auditor may decide to apply 5% to net profit before tax. This would result in an overall materiality amount of Rs. 1 million (i.e. Rs. 20 million × 5% = Rs.1 million). Performance materiality Given the stable economic environment, its effective internal controls and history of unmodified auditor’s reports, the entity’s preliminary risk assessment may be quite low. However, the auditor would still set a performance materiality level that is less than the overall materiality level to increase the chance of detecting misstatements. Using their professional judgement, the auditor may decide to set performance materiality at 80% of overall materiality. Therefore, the auditor will use performance materiality of Rs. 800,000 (i.e. Rs. 1 million × 80%) to determine the nature, timing and extent of further audit procedures. Revising materiality during an audit It is important to understand that the materiality calculated at the planning stage of an audit may not necessarily remain unchanged throughout the audit. During the course of the audit, information may come to light that requires the auditor to revise the original materiality levels. OVERALL AUDIT STRATEGY AND AUDIT PLAN Considering the results of pre-engagement activities, risk assessment procedures and determination of materiality, the auditor establishes an overall audit strategy and develops a tailored audit plan (or audit program) for the engagement. ISA 300 sets out the requirements for audit planning. Benefits of audit planning Audit planning is critical as it ensures that the audit engagement is performed in an efficient and effective manner in accordance with the ISAs, and that audit risk has been reduced to an acceptably low level. The planning stage of an audit is arguably the most important phase in ensuring an efficient, effective audit. Having an adequate, well-documented plan benefits the audit in many ways, ensuring that: - the audit effort is directed at high-risk areas - audit procedures performed are relevant in addressing the identified risks - audit staff are well-informed and know what is expected of them. - In practice, the audit partner and other senior members of the engagement take an active role in the planning phase of the audit. Audit strategy The main purpose of establishing the audit strategy is to set the scope, timing and direction of the audit engagement and guide the development of the audit program. In establishing the audit strategy, the auditor considers the following: - The characteristics and scope of the engagement. (E.g. What is the applicable financial reporting framework? Are there any industry-specific reporting requirements? What are the locations?) - Reporting objectives (E.g. Is a statutory audit of stand-alone financial statements required in addition to an audit for consolidation purposes?) - Reporting timetable and the timing and nature of communications with those charged with governance. (E.g. When are the financial statements due to be approved?) - The expected use of audit evidence obtained in previous audits. (E.g. Is the auditor expecting to rely on the operating effectiveness of controls?) - Factors that are significant in directing the audit team’s efforts. (E.g. preliminary identification of significant risks, areas of heightened professional skepticism) - The results of previous audits. (E.g. Were material misstatements or significant deficiencies in controls identified?) - The nature, timing and extent of resources. (E.g. Is it necessary to use an engagement quality control reviewer or auditors’ experts? When is the data prepared by the client available?) - Approach i.e. control based approach or substantive. Please see the details below. Audit program The audit program is more detailed than the audit strategy in that it includes the nature, timing and extent of audit procedures to be performed by engagement team members. The audit program is a record of all the procedures the auditor intends to perform in order to obtain sufficient appropriate audit evidence in an audit engagement. The audit program is developed based on the overall audit strategy, and includes a description of: - the nature, timing and extent of planned risk assessment procedures - the nature, timing and extent of planned audit procedures - other planned audit procedures that are required to be carried out so that the engagement complies with the relevant ISAs. Determining a response to the risk of material misstatement at the financial statement level In determining the audit strategy and audit program, the auditor considers whether risks of material misstatement at the financial statement level have been identified. The auditor’s overall responses to risk of material misstatement due to either error or fraud may include the following: - Emphasizing the need to apply a high level of professional skepticism. - Assigning more experienced staff to the complex areas of an audit, or assigning specialists or experts. - Providing more supervision to staff. - Incorporating unpredictability in the selection of nature, timing and extent of audit procedures. - Conducting more procedures at period end instead of at interim periods, or planning audit procedures that provide more persuasive audit evidence. Determining the audit approach One of the audit strategy decisions is determining the appropriate audit approach. This essentially means a decision as to whether the auditor will take a controls-based approach or perform substantive procedures only. If the auditor has concluded that controls relevant to the audit have been effectively designed and implemented for a particular process, the auditor can choose to adopt a controls-based approach for that process. This involves the auditor selecting those controls on which they intend to place reliance and testing the operating effectiveness of the selected controls. The auditor must obtain evidence that the selected controls are operating effectively throughout the audit period in order to rely on those controls and to reduce the risk of material misstatement. This audit approach can be called a ‘controls-based approach’, ‘combined approach’ or ‘mixed approach’. However, note that even if a controls-based approach is taken, the auditor must always perform some substantive procedures for each material class of transactions, account balance and disclosure. If the auditor’s conclusion is that controls for a particular process have not been designed effectively or have not been implemented effectively throughout the audit period, the auditor would assess control risk as high and would not take a controls-based approach for that process. In this instance, the auditor performs substantive procedures only. This is called a ‘substantive approach’. The smaller the audit, the more likely it is that the auditor would perform substantive procedures only. The figure below summarises the auditor’s considerations relating to which audit approach to take: Audit procedures There are two main types of audit procedures that auditors use to obtain audit evidence – tests of controls and substantive procedures – as illustrated in the following figure: Example – Difference between a test of controls and a test of details Class of transaction Key assertion Example audit Type of audit at risk procedure procedure Select a sample of purchase transactions during the financial year and check that the three- way match of suppliers’ invoices, Purchases Accuracy purchase orders and Test of controls goods received notes has been performed by the accountant. This test of controls provides evidence that the control over purchases process is operating effectively  to ensure that only valid and accurate purchase invoices will be processed for payment Select a sample of purchase transactions recorded during the financial year in the sub-ledger, and agree the amounts of Purchases Accuracy Test of details purchases to suppliers’ invoices. This test of details provides evidence that amounts recorded in the financial statements are appropriate Audit Programme Auditors consider several factors and apply guidance included in multiple different Auditing Standards when designing an audit program and individual audit procedures. These factors are summarised in the table below: Consideration Explanation An audit procedure is designed to respond to an identified risk of material Reason misstatement and must therefore address that specific risk. (objective) Risks of material misstatement at an assertion level are assessed in order to determine the nature, timing and extent of audit procedures The nature of an audit procedure refers to its purpose (test of control or substantive procedure) and its type (inspection, observation, enquiry, Nature confirmation, recalculation, reperformance or analytical procedure). The nature of the audit procedure is the most important factor in responding to the assessed risk. The timing of an audit procedure has two aspects: Timing - The time at which the procedure is performed (at planning, at interim periods, close to period end or after period end). - The period to which the audit evidence applies. Extent The extent of an audit procedure has two aspects:  number of items to be selected for testing and the number of audit procedures to be performed. Audit programs use multiple types of procedures to address different types of risks or to obtain sufficient appropriate evidence over a particular risk, as one procedure on its own would rarely be sufficient. The considerations relating to the nature, timing and extent of audit procedures can be summarised as follows: Case study – Audit strategy and audit program The case study scenario involves the audit senior for A1 Auditors (A1) working on the 30 June 20X3 audit engagement of CoffeeCupz Limited, a company listed on the Australian Securities Exchange (ASX), which has been a client of A1 for a number of years. Step Audit file reference Obtain or update an understanding of the entity P1 and its environment Identify and assess risks at the P2 financial statement level Determine materiality P3 Obtain or update an understanding of internal P4 controls Identify and assess risks of material misstatement at the P5 assertion level Identify and assess significant P6 risks and other risks Prepare audit program P7 After each step, ‘auditor reflection points’ will be provided to give clarity on the direction of the audit up to that particular point in time. The first step (P1) is for the auditor to obtain or update their understanding of the entity and its environment. Client: CoffeeCupz Limited Engagement: Year ended 30 June 20X3 Audit phase: Planning (P) Date: 15 May 20X3 Audit step P1: Obtain or update understanding of the entity and its environment CoffeeCupz Limited (‘CoffeeCupz’ or the ‘client’) is a profit-oriented listed entity on the Australian Securities Exchange (ASX) and has been operating for over 15 years. A1 have been the auditors for the previous three years and an unmodified audit opinion has been issued for each of these engagements and unmodified conclusions issued for respective half-year review engagements. The client’s operations have not changed significantly since the prior year. CoffeeCupz designs, produces and delivers customised coffee cups and containers to café chains, sole traders and baristas across Australia. The coffee industry continues to grow in Australia, but with a number of new competitors entering the coffee cup market over recent years, the client is experiencing increased competition in the market. As a result, the client has reported decreasing revenues for the past two years and recorded a loss of $35,000 in the prior year. Refer to step P2 for a further detailed risk assessment at the financial statement level. CoffeeCupz does not have any specific regulatory requirements. It prepares financial statements under International Financial Reporting Standards (IFRS). There have been no changes to the accounting Standards that impact on the client this year. Operations. The client’s main revenue stream continues to be the sale of customised coffee containers to various café chains, with the remainder of revenue coming from one-off sales to sole traders and baristas. The most significant assets continue to be inventory and a warehouse facility that is being revalued internally this year. Payroll continues to be the only process that is outsourced by the client. Objectives and strategies. As a result of reviewing the minutes of meetings of the board and audit committee, A1 notes that the client’s main financial objective for year ended 30 June 20X3 was to return to a profitable position and record a net profit before tax. Measurement and financial review. The client continues to use revenue as a benchmark for measuring performance in the market but adopts profit before tax as its primary indicator of financial success from a shareholder’s perspective.  All of the above information was discussed as part of the initial internal team planning meeting held on 14 May 20X3. Step prepared by: A N Auditor Reviewed by: A Partner Date: 16 May 20X3 Auditor reflection points At this stage, the auditor will already be formulating an audit strategy. As a result of A1 updating its understanding of the entity and the industry, there are a number of key points and potential risks here that will impact on the strategy and, ultimately, the audit program. In this example, these factors include (but are not limited to) the following: CoffeeCupz recorded a loss in the prior year but has an objective of generating a profit in the current year. There is a significant amount of inventory on hand. There is a significant property, plant and equipment (PPE) balance that is going to be revalued internally and recorded at balance date. The payroll function is outsourced. Although the factors above will directly impact on the audit strategy, the auditor must assess the results of the other planning procedures before they can start determining the audit strategy. This example continues with step P2 ‘Risk assessment at the financial statement level’. Client: CoffeeCupz Limited Engagement: Year ended 30 June 20X3 Audit phase: Planning (P) Date: 20 May 20X3 Audit step P2: Risk assessment at the financial statement level A1 has assessed the risks of material misstatement at the financial statement level. Such risks are considered pervasive, as they may impact on many areas of the financial statements. In order to make this assessment, A1 has undertaken a number of procedures. As part of planning, the following procedures have been undertaken: Review of management accounts for 10 months ending 30 April 20X3. Review of financial performance against budgeted numbers. Discussions held with management and finance team. Review of minutes of board meetings and audit committee meetings. Walk-throughs performed on significant processes Findings. As a result of the above procedures, A1 notes that the impact of increased competition in the coffee cup industry continues to have a detrimental impact on the client’s revenue and profit figures. A loss was recorded for the 10 months ending 30 April 20X3. However, management still expects to generate a profit for the 12-month period and the budget reflects this. Cash reserves are decreasing to meet short-term obligations but the client remains in a positive net asset position (total assets less total liabilities) as at 30 April 20X3. The entire payroll function continues to be outsourced, and salaries and wages continue to be a significant expense for the client. The client has effectively designed controls around payroll data provided to the service organisation, and management continues to have oversight of the whole payroll process. Historically, minimal or no controls have been in place around inventory, PPE and accounts payable. This continues to be the case, despite A1’s recommendations in prior years. Conclusion. A1 notes a potential risk relating to going concern due to inherent risks relating to the client’s ability to continue operating for a period of at least 12 months. This is considered a significant risk. In addition, CoffeeCupz has effective process level controls in the area of payroll, but these are absent across the other key business processes.  The risk of material misstatement at the financial statement level, therefore, is considered high. Refer to step P5 for specific responses. Step prepared by: A N Auditor Reviewed by: A Partner Date: 21 May 20X3 Auditor reflection points Note the importance of audit planning at this stage. The two steps above were undertaken and documented before the year end, but still have provided the reader with a significant volume of critical information that both sets the scene for the audit and provides direction for the audit engagement itself. The concept of materiality, discussed earlier in this unit, will now be addressed in step P3 ‘Materiality’.  Client: CoffeeCupz Limited Engagement: Year ended 30 June 20X3 Audit phase: Planning (P) Date: 10 June 20X3 Audit step P3: Materiality A1 has obtained the trial balance and management accounts for the 11 months ending 31 May 20X3. Taking into consideration the significant decreases in profit in previous years, and in line with A1 audit methodology, overall materiality will be calculated as 1% of total revenue. A1 will obtain the total revenue figure for the 11 months ending 31 May 20X3 and extrapolate that figure for a 12-month period. Materiality will then be calculated at 1% of that extrapolated figure. Performance materiality will be calculated as 75% of overall materiality. Any misstatements that represent less than 5% of overall materiality will be considered clearly trivial and not be recorded on the summary of misstatements. Revenue for 11 months: $11,303,000 Extrapolated for 12 months: $12,330,550 Overall materiality: $123,300 Performance materiality: $92,475 Step prepared by: A N Auditor Reviewed by: A Partner Date: 11 June 20X3 Auditor reflection points Materiality has now been calculated, which allows the auditor to properly ‘scope’ the audit and complete the remaining planning procedures. This is the threshold you might use to develop substantive testing procedures. This may include substantive testing for those balances >$92,475 and analytical procedures for those balances