Professional Documents
Culture Documents
6
Planning
Chapter learning objectives
When you have completed this chapter you will be able to:
• identify and explain the need for planning an audit
• identify and describe the contents of the overall audit strategy
and the audit plan
• explain the difference between interim and final audit
• discuss the effect of fraud and misstatements on the audit
strategy and extent of audit work
• explain and describe the relationship between the overall audit
strategy and the audit plan
• explain how auditors obtain an initial understanding of the entity
and knowledge of its business environment
• define and explain the concepts of materiality and tolerable error
• compute indicative materiality levels from financial information
• develop and document an audit plan
• describe and explain the nature and purpose of analytical
procedures in planning.
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Planning
1 Why plan?
The auditor should plan the audit so that the engagement will be
performed in an effective manner.
An audit is:
• an expensive process
• a potentially complex project which needs to be managed effectively.
Although it is tempting to assume that it is simply a question of following a
tried and tested programme and that the important thing is to ‘get busy’, the
extra time spent planning the engagement properly will repay itself by:
• Ensuring the right team is selected for the assignment.
• Ensuring that staff are employed effectively rather than simply ‘given
something to do’.
• Ensuring the work is properly focused on material areas of risk.
• Identifying potential problem areas.
• Ensuring that the nature and quantity of the work done addresses the
risks and problem areas.
• Ensuring the work can be fully completed in time for the review process.
• Enabling deadlines to be met so that there is time for due consideration
of the important issues.
The planning process consists of a number of phases and activities:
• assessing risk
• developing the audit strategy
• selecting the audit team
• assessing materiality
• selecting appropriate audit procedures.
3 Assessing risk
The whole of the next chapter of these materials is devoted to the concept of
risk, but it is vital that you understand that it is the auditor’s
assessment of risk which underpins the whole audit.
It is the assessment of risk which determines:
• the audit strategy
• who should be on the audit team
• the potential impact of fraud
• the nature of the procedures to be carried out
• how much evidence needs to be gathered
so everything in the planning process is about the auditor’s response to
assessed risk.
There are two sources of information from which it is possible to assess
risk:
• Knowledge of the business (KOB) which we will consider later in this
chapter.
• Analytical procedures which we will consider in the chapter on
evidence.
It follows that there is a relationship between risk and materiality in that:
• the greater the risk of material misstatement
• the lower the level of materiality.
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The audit strategy sets the overall approach of the audit and covers:
• the scope
• the timing
• the direction
of the audit.
Scope
What is the financial reporting framework for the financial statements?
• National GAAP?
• International Accounting standards?
Are there industry specific or other special reporting requirements?
• Listed companies.
• Charities.
• Other regulated businesses such as banks and insurance companies.
Are there other factors which influence the overall approach to the audit?
• Multiple locations.
• Group audits.
Timing
Deadlines for:
• final reporting
• any interim report
• reports to management
• reports to those charged with governance.
The timing of:
• interim and
• final audit visits
to enable these deadlines to be met.
It is always good, when managing a project (even an audit) to start with the
completion date and work backwards.
If there is to be an interim as well as a final audit the timing has to be:
• Early enough:
– not to interfere with yearend procedures at the client and
– to give adequate warning of specific problems.
• Late enough:
– to enable sufficient work to be done to ease the pressure on the
final audit.
The interim audit will normally focus on:
• documenting systems
• evaluating controls
• some tests of details – usually tests of income and expenditure and,
perhaps, purchases and disposals of fixed assets.
It may be possible to:
• attend an interim inventory count or
• carry out an interim receivables circularisation,
providing the results can be satisfactorily ‘rolled forward’ to the balance
sheet date. (A roll forward reconciles the movements between the date of
the count or circularisation and the year end date.)
The final audit can then focus on:
• balance sheet areas
• finalisation of the financial statements and the audit report.
For an interim audit to be justified the client normally needs to be of a
sufficient size, although, if reporting deadlines are very tight it may be
possible to audit up to ‘Month 11’ and then ‘roll forward’ to the balance sheet
date.
Direction
The ‘direction’ of the audit covers the overall approach and concerns such
issues as:
• preliminary assessment of materiality
• preliminary identification of high risk areas
• preliminary identification of material components and account
balances.
Component – A division, branch, subsidiary, joint venture, associated
company or other entity whose financial information is included in financial
statements audited by the principal auditor.
• Decisions about whether assurance is expected to be derived from
reliance on controls or a fully substantive approach.
• The need for site visits and other logistical issues.
• The impact of recent developments at the client, in its industry, in
regulatory or financial reporting requirements.
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Possible different strategies could be:
• Final audit only.
• Interim and final.
• Reliance on controls with reduced reliance on substantive
procedures.
• Reliance on substantive procedures rather than on internal controls.
• Heavy reliance on analytical procedures rather than tests of details.
The nature of the client’s business and structure will have a huge impact
on the appropriate strategy.
• Clients with multiple sites, such as retail chains or manufacturers
with a number of factories, will require the planning of a programme
of site visits, perhaps on a rotational basis.
• Finance companies where the confirmation of a bewildering number
of bank balances is crucial to the audit.
• The need to use experts, e.g.
– specialist inventory checkers in the restaurant and pub trade or
for livestock
– surveyors and valuers for property companies
– actuaries for pension schemes.
NB. In the exam it is possible that you may be asked to come up with
different strategies for a single client. More likely, however (as in real life)
your understanding of this part of the syllabus will be tested by asking you to
come up with an appropriate strategy for a particular client.
There is no point:
• Recommending a receivables circularisation for a client with cash
sales.
• Suggesting an inventory count for a software company whose work
in progress consists of the unamortised costs of developing its
products.
Once the audit strategy has been decided upon, the next stage is to decide
how it is going to be carried out – we need the audit plan.
We also need to distinguish between:
• The plan itself – what needs to be done and how.
• Documenting the planning process (dealt with in the last section of this
chapter).
Based on the assessed:
• risk
• materiality.
It is possible to decide:
• what audit procedures are to be carried out
• who should do them
• how much work should be done (sample sizes, etc)
• when the work should be done.
The relationship between the audit strategy and the audit plan
Whilst the strategy sets the overall approach to the audit, the plan fills in the
operational details of how the strategy is to be achieved.
If the audit strategy and the plan depend on the assessed level of risk, the
auditor’s ability to assess that risk will depend on an understanding of all
aspects of the client’s business:
• what the client does
• the environment in which it does it
• its management, systems and governance
• who it interacts with (key customers, suppliers, etc).
The subheadings in the ‘operating environment’ box as well as ‘What they
do’, ‘Management’ and ‘Accounting policies’ are dealt with more fully below.
Systems and controls and significant risks are dealt with in other chapters.
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9 Sources of KOB
The sources
This discussion – effectively a planning meeting – is required by ISA 315.
In order to demonstrate that it has taken place and that the standard has
been complied with, there will need to be evidence, usually in the form of
minutes of the discussion meeting.
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Analytical procedures
Analytical procedures are usually carried out at three stages of the audit
process. They are mandatory at the planning and final review stages. At the
substantive testing stage, they are one of several methods for obtaining
evidence, so may not be appropriate in some circumstances.
Analytical procedures comprise the evaluation of financial information by
studying the relationship between this information and other financial and
nonfinancial data. They include comparison of financial information with
prior periods, budgets and forecasts and similar industries.
At the planning stage, analytical procedures are used for two main reasons:
• to help understand the client’s financial statements
• to help spot possible errors.
If errors look possible, the audit work will be directed towards those errors.
Basic analytical procedures could involve simply looking at the client’s trial
balance or draft financial statements to see if they appear in line with the
auditor’s expectations. However, auditors will typically go further than this:
• monitoring statistical trends in key figures and ratios
• asking the client why certain balances appear out of line with
expectations.
Computer programs are often used to select those balances that appear
furthest from expectations.
10 Materiality
What is materiality?
We have already seen the definition of materiality:
(material by nature).
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• If financial statements contain a material misstatement they cannot
show a true and fair view.
• Auditors therefore must design their audit procedures to reduce the risk
of material misstatement to an acceptable level.
• This means that auditors must decide on what they mean by ‘material’
before they design their procedures – hence its place in this chapter.
What are the implications for the work the auditors do?
Auditors will:
• Need to examine all items in the financial statements which are material
BUT
• they will also need to design tests to give assurance that material
amounts have not been omitted from the financial statements
AND
• they will need to allow for the fact that a number of immaterial errors
could together add up to a material misstatement.
Calculating materiality
Firms typically have a standard method for calculating a baseline materiality
figure as part of the planning process.
Common measures are:
• ½ – 1% of turnover
• 5 – 10% of results
• 1 – 2% of assets
but these are up to the judgment of the auditor.
As a result, different firms use different measures.
Any calculation done is very flexible, and may have to be reassessed during
the audit (if for example many large errors are found).
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Exam focus
Materiality is quite a difficult concept to explain.
Be familiar with the definition from ISA 320 quoted above remembering a
phrase like ‘influence the economic decisions of users’.
Take some time to think about why materiality is important, as indicated
above.
11 Tolerable error
What is tolerable error?
This means that in the case of tests of control, the auditors will accept a
certain number of instances of a failure to apply a control procedure and will
still conclude that the procedure is operating properly.
Tolerable error is considered during the planning stage, and for substantive
procedures, is related to the auditor's judgement about materiality.
This chapter has considered all aspects of the planning process. ISAs
require that all the elements of the audit should be documented, and so it is
clearly necessary to produce a record of the audit strategy and plan, which
can be referred to as the audit progresses and can be used in the
completion stages to ensure that everything has been done which ought to
have done.
Most firms will use ‘audit packs’ – preprinted or computerised documents
and checklists to ensure that the requirements of ISAs have been followed.
The plan usually consists of nine stages:
• For large audits much of the KOB information may be kept on a
permanent file and the audit plan may contain a summary or simply
cross refer to the permanent file.
• Increasingly KOB is being summarised in a planning memorandum
which is updated each year.
• With computerised audit systems where all background documents
may be scanned in, the distinction between current and permanent
audit files is being eroded.
• For large audits, the planning may be so complex that it needs to be
summarised in a separate memorandum.
• For small audits the summary may be all that is necessary.
Permanent file – a file of information which is relevant for more than one
year’s audit, e.g.
• Names of management, those charged with governance, shareholders.
• Systems information.
• Background to the industry and the client’s business.
• Title deeds.
• Directors’ service agreements
• Copies of contract and agreements.
Current file – a file containing the documentation and evidence for the
current audit.
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13 Chapter summary
1. Give six issues to be People – Who should make up the audit
considered as part of the team?
planning process for an
audit. Timing – What are the deadlines?
Focus – What are the key aspects of the
audit?
Problem areas – What issues are likely
to cause difficulties and how should they
be addressed?
Nature of work – What audit approach
should be used and what types of
procedures are appropriate?
Amount of work – Sample sizes, number
of tests etc. all driven by assessment of
risk and materiality.
2. State five things which Assess risk.
need to be done during the
planning process. Develop the audit strategy.
Select the audit team.
Assess materiality.
Select appropriate audit procedures.
3. State the two sources of Knowledge of the business.
information which enable
the auditor to assess risk. Analytical review.
4. What are the main Scope.
elements of an audit
strategy? Timing.
Direction.
5. What is the difference Whilst the strategy sets the overall
between the audit strategy approach to the audit, the plan fills in the
and the audit plan? operational details of how the strategy is
to be achieved.
6. State eight aspects of the client’s Choose from:
business which need to be explained
in the audit plan. • The industry
• The competition
• Technology
• Laws and regulations
• Stakeholders
• Acquisitions
• Disposals
• Financing
• Trading partners
• Related parties
• What the client does
• Management
• Systems
• Controls
• Significant risks
• Accounting policies.
7. State eight possible sources of Choose from:
knowledge of the business.
• The engagement partner
• The engagement manager
• Your firm’s industry experts
• Last year’s audit team
• Industry surveys
• The company's registry
• The internet
• Trade press
• Credit reference agencies
• Discussions with client’s
staff
• Observation of events and
processes at the client’s
premises
• The client’s website
• Brochures and other
publicity material.
8. Define materiality. ‘Information is material if its omission or
misstatement could influence the
economic decisions of users taken on the
basis of the financial statements’.
9. Why might calculated The property company’s balance sheet
materiality for a property will probably contain items with a higher
company be weighted value in comparison with the figures in its
towards different elements profit and loss account, than the
in the financial statements manufacturer, where the largest numbers
from a manufacturing are likely to be those for sales, purchases
company? and payroll.
As a result calculated materiality for the
property company will usually be weighted
in favour of the items in its balance sheet
– particularly the investment properties
and any related borrowings – whereas
materiality for the manufacturer is more
likely to be weighted in favour of its sales
figure
10. Define tolerable error. 'The maximum error in a population that
the auditor is willing to accept.'
11. What is the difference Materiality concerns the financial
between Materiality and statements as a whole.
tolerable error?
Tolerable error only concerns the
population being tested.
12. State the nine stages of Knowledge of the business.
the audit plan.
Preliminary analytical review.
Risk assessment.
Materiality.
Tolerable error.
Audit approach.
Independence.
Budget and staffing.
Timetable and deadlines.
13. Why is it important for the To decide on the audit approach.
auditor to plan?
To decide how much work to do.
To decide what type of work to do.
To decide on the composition of the
audit team.
To ensure that risk is reduced to an
acceptable level.