Manila * Cavite * Laguna * Cebu * Cagayan De Oro * Davao

Since 1977

AT.3605 SOLIMAN/UY/AGUILA/RICAFRENTE
Audit Planning and Materiality May 2024

Topic Outline • The following are the major activities and procedures
performed in audit planning and risks assessment:
a) Planning the Audit of Financial Statements
b) Accept Client and Perform Initial Planning Activities 1. Accept client and perform initial planning
c) Understand the Client’s Business and Industry\ activities.
d) Perform Preliminary Analytical Procedures 2. Understand the client business and industry.
e) Materiality 3. Perform preliminary analytical procedures.
f) Materiality for the Financial Statements as a Whole 4. Set preliminary judgment of materiality and
g) Determine Performance Materiality performance materiality.
h) Estimate Misstatement and Compare with Preliminary 5. Identify significant risks due to fraud or error.
Judgment 6. Assess inherent risk.
7. Understand internal control and assess control
risk.
Planning the Audit of Financial Statements 8. Finalize overall audit strategy and audit plan.

• The nature and extent of the above planning activities

• The auditor should plan the audit so that it will be will vary according to:
performed in an effective manner, i.e., to obtain
• the size and complexity of the entity.
reasonable assurance that the financial statements
are free from material misstatement.
• the key engagement team members’ previous
experience with the entity; and
• In addition, adequate planning also helps keep the • the changes in circumstances that occur during
cost of an audit at a reasonable level and to avoid the audit engagement.
misunderstandings with the client.
Changes to Planning Decisions during the Course of
• Audit planning involves: the Audit
a. establishing the overall audit strategy (which sets
• The auditor shall update and change the overall audit
the scope, timing, and direction of the audit); and
strategy and the audit plan as necessary during the
b. developing an audit plan (a detailed approach for
course of the audit.
the expected nature, timing, and extent of the
audit).
• The establishment of the overall audit strategy and
Benefits of Audit Planning the detailed audit plan are not necessarily discrete or
sequential processes but are closely interrelated since
changes in one may result in consequential changes
• Appropriate attention to important areas of the audit.
to the other.
• Identify and resolve potential problems timely.
• Organize and manage the audit engagement so that Acceptable Audit Risk, Client Business Risk, and the
it is performed in an effective and efficient manner. Risk of Material Misstatement
• Assist in the proper selection of engagement team
members and the assignment of work to them. • Much of the early planning activities deal with
• Facilitate the direction and supervision of engagement obtaining information to help auditors assess these
team members and the review of their work. risks (acceptable audit risk, client business risk, and
• Assist, where applicable, in coordination of work done the risk of material misstatement).
by auditors of components and experts.
• Acceptable audit risk is a measure of how willing
Overview of Audit Planning and Risk Assessment the auditor is to accept that the financial statements
Activities may be materially misstated after the audit is
completed and an unmodified opinion has been
• Planning is not a discrete phase of an audit, but rather issued. The lower the acceptable audit risk, the more
a continual and iterative process. Planning, however, certain the auditor wants to be about the fairness of
includes consideration of the timing of certain the client’s financial statements. Usually, riskier
activities and audit procedures that need to be clients such as listed entities and entities in complex
completed prior to the performance of further audit industries are assigned with lower acceptable audit
procedures, i.e., tests of controls and substantive risk because auditors want to become more certain
audit procedures. about the accuracy of the audit. For entities that are
considered as lower risk clients, like privately held

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companies with minimal investors and creditors, the 4. The auditor uses knowledge gained from the
auditor can assign higher acceptable audit risk since understanding of the client's business and industry to
fewer stakeholders are expected to scrutinize the assess
financial statements. a. client business risk. c. inherent risk
b. control risk. d. audit risk
• Client business risk is the risk that the entity fails
to achieve its objectives or execute its strategies. 5. As acceptable audit risk is decreased, the likely cost
Business risk can arise from factors such as significant of conducting an audit increases.
changes in industry conditions or events such as
regulatory changes, or from the setting of The risk of material misstatement is the risk that the
inappropriate objectives or strategies. For example, financial statements contain a material misstatement
the auditor may identify declines in economic due to fraud or error prior to the audit.
conditions that adversely affect sales and the a. True, False c. True, True
collectability of accounts receivable. b. False, True d. False, False

• The risk of material misstatement is the risk that

the financial statements contain a material Accept Client and Perform Initial Planning
misstatement due to fraud or error prior to the Activities
conduct of the audit. The risk of material
misstatement is a function of the susceptibility of the • Initial audit planning involves the following activities,
financial statements (as a whole or in individual all of which should be done early in the audit:
accounts) to misstatement, and the effectiveness of a. The auditor decides whether to accept a new client
the client's controls in preventing or detecting and or continue serving an existing one. This
correcting the misstatements. determination is typically made by an experienced
auditor who is in a position to make important
• Assessing acceptable audit risk, client business risk decisions. The auditor wants to make this decision
and the risk of material misstatement is crucial in early, before incurring any significant costs that
audit planning. It influences the nature of audit cannot be recovered.
procedures, the volume of evidence required, and the b. The auditor identifies why the client wants or
selection of staff based on experience. needs an audit. This information is likely to affect
the remaining parts of the planning process.
✎ Concept check: Answer questions no. 1 to 5. c. To avoid misunderstandings, the auditor obtains
an understanding with the client about the terms
1. The audit plan sets the scope, timing and direction of of the engagement.
the audit, and guides the development of the more d. The auditor develops the overall strategy for the
detailed audit strategy. audit, including engagement staffing and any
required audit specialists.
The audit strategy is more detailed than the audit plan
and includes the nature, timing and extent of audit • The auditor shall only undertake or continue audit
procedures to be performed by engagement team engagement where the auditor:
members in order to obtain sufficient appropriate • is competent to perform the engagement and has
audit evidence to reduce audit risk to an acceptably the capabilities, time and resources to do so;
low level.
• complies with relevant ethical requirements; and
a. True, True c. False, False
• considers the integrity of the client.
b. True, False d. False, True
New Client Investigation
2. Which of the following is not one of the three main
reasons why the auditor should properly plan
• CPA firms investigate new clients for acceptability,
engagements?
examining their business reputation, financial
a. To enable the auditor to obtain sufficient
stability, and relations with previous CPA firms. An
appropriate evidence.
auditor does not want to associate itself with a client
b. To avoid misunderstandings with the client.
whose management lacks integrity. At the same time,
c. To help keep audit costs reasonable.
the auditor should only accept engagements that they
d. To enable proper on-the-job training of
are competent to perform. Finally, ethical
employees.
requirements, especially regarding independence,
must be considered and met before accepting a client.
3. In what order should the following steps occur?
A. Set preliminary judgment of materiality and
• When taking over from another CPA firm, the new
performance materiality.
(successor) auditor must communicate with the
B. Understand the client's business and industry.
predecessor auditor. This helps in deciding whether to
C. Perform preliminary analytical procedures.
accept the engagement by uncovering issues like
D. Accept the client and perform initial audit
client integrity or disputes over accounting principles.
planning.
The successor auditor normally inquires the following
a. D, B, C, A c. B, D, A, C
from the predecessor auditor about the prospective
b. B, A, C, D d. D, C, B, A
client:

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• Integrity of management audit progresses, the auditor may gain additional

• Disagreements with management about audit insights into the reasons for the audit and how the
procedures or accounting principles financial statements will be utilized, which can impact
• Communication with Audit Committee about the assessment of acceptable audit risk.
fraud, illegal acts, or internal control
• Understanding as to the Reasons for change in Obtain an Understanding with the Client
auditor
• A clear understanding of the engagement terms
• If a client will not permit the communication or the between the client and the CPA firm is essential, and
predecessor will not provide a comprehensive auditing standards mandate this understanding be
response, the successor should consider that fact in formalized in an engagement letter. The
ultimately deciding whether to accept or reject the engagement letter outlines the objectives of the
client engagement. engagement, responsibilities of both the auditor and
management, the financial reporting framework used,
• The responsibility to initiate communication lies with the expected audit report form and content, and any
the successor auditor, but the predecessor must limitations of the engagement.
respond, respecting client confidentiality and
obtaining client permission before sharing • It is in the interest of both the client and the auditor
information. If a client refuses communication or the that the auditor sends the engagement letter,
predecessor's response is limited, the successor preferably before the commencement of the audit to
auditor should reconsider the engagement, unless help avoid misunderstandings with respect to the
further extensive investigation justifies it. engagement.

• Successor auditors may also conduct investigations • For listed companies, the audit committee selects and
through local attorneys, other CPAs, banks, and even hires the external auditor and hence signs the
professional investigators to understand the client's engagement letter. In private companies, the
background and management reputation. engagement letter is typically signed by the
management.
• Auditors must ensure that the financial reporting
framework used by the client for preparing financial • The engagement letter also details any restrictions on
statements is appropriate, considering the entity's the auditor's work, deadlines for audit completion,
nature, the financial statements' purpose, and any assistance from client personnel, schedules for the
relevant laws or regulations. Common financial auditor, and fee agreements. It also informs the client
reporting frameworks in the Philippines include that the auditor cannot guarantee the detection of all
Philippine Financial Reporting Standards (PFRS) and instances of fraud.
PFRS for SMEs.
• The information in the engagement letter is crucial for
Continuing Client audit planning, influencing the timing of tests and the
total time required for the audit and other services.
• CPA firms evaluate existing clients annually to decide The CPA firm must adapt to unexpected
if they should continue providing audit services. circumstances or lack of client assistance, potentially
Reasons to discontinue may include previous conflicts extending the engagement duration. Client-imposed
over audit scope, type of opinion, unpaid fees, or restrictions can impact the audit procedures and
other issues. A critical reason for discontinuing a client potentially the type of audit opinion issued.
is if the auditor determines the client lacks integrity.
Even without previous issues, a CPA firm might decide Limitation on Scope Prior to Audit Engagement
to stop auditing a client due to excessive risk, such as Acceptance
potential regulatory conflicts that could lead to the
client's financial failure and subsequent lawsuits • The auditor shall not accept an audit engagement, if
against the firm. management or those charged with governance
imposes a limitation on the scope of work that will
Identify Client’s Reasons for Audit result to disclaimer of opinion unless required by law
or regulation to do so.
• The main factors influencing acceptable audit risk are
the potential users of the financial statements and the Develop Overall Audit Strategy
purposes for which they will use these statements.
More evidence is typically gathered by the auditor for • After understanding the client's audit reasons, the
financial statements that will be extensively used, auditor should develop a preliminary audit strategy,
such as those of publicly held companies, companies documenting the scope, timing, and direction of the
with significant debt, and businesses planning to sell audit, which then guides the audit plan. This strategy
in the near future. takes into account the nature of the client’s business,
industry, and areas of higher risk for significant
• Understanding the most likely uses of the statements misstatements. The auditor also considers other
can be achieved through prior experience with the factors like the number of client locations and the past
client and discussions with its management. As the effectiveness of client controls in shaping the audit

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approach. This helps in determining the required

resources, including staffing for the engagement. 9. It is in the interest of both client and auditor that the
auditor sends an audit engagement letter, preferably
Selecting Staff for Engagement before
a. The performance of substantive testing.
• Staff selection is crucial for compliance with auditing b. The commencement of the engagement.
standards and audit efficiency. Staff must have c. The completion of audit.
appropriate competence and knowledge about the d. Before the issuance of audit report.
client's industry. Large audits may require multiple
partners and staff with varied experience levels, 10. Which is usually included in an engagement letter?
possibly involving individuals from different offices, The objectives of the Identification of the
including international locations. Specialists in areas engagement financial reporting
like statistical sampling, business valuation, and IT framework used by
risk assessment might also be involved. Smaller management
audits might need only one or two staff members. a. Yes Yes
b. No No
Consider the Need for Experts or Specialist c. Yes No
d. No Yes
• If specialized knowledge is required for the audit,
consulting with a specialist may be necessary. 11. When a change in the type of engagement from higher
Auditing standards govern the selection and review of to lower level of assurance is reasonably justified, the
specialists, who may be affiliated with the client, the report based on the revised engagement
audit firm, or independent. Examples include diamond a. Should not contain a separate paragraph that
experts for valuing diamonds or actuaries for refers to the original engagement.
insurance loss reserves. b. Should not refer to any procedures that may have
been performed in the original engagement.
• The auditor must understand the client's business to c. Omits reference to the original engagement.
determine if a specialist is needed, assess their d. All of the above
qualifications, and understand the objectives and
scope of their work. The auditor should also evaluate 12. If a change in the type of engagement from higher to
the specialist's relationship with the client to ensure lower level of assurance is not justified, the auditor
objectivity. should
a. Continue with the revised engagement, but make
• Using a specialist does not change the auditor's explicit reference about the original engagement.
responsibility for the audit, and the audit report b. Continue with the revised engagement, and not
should not refer to the specialist unless it affects the make explicit reference about the original
audit opinion. engagement.
c. Refuse to agree to management’s request on the
✎ Concept check: Answer questions no. 6 to 13. change of engagement and continue with the
original engagement.
6. Initial audit planning involves four matters. Which of d. Withdraw from the engagement.
the following is not one of these?
a. Develop an overall audit strategy. 13. The preliminary audit strategy
b. Request that bank balances be confirmed. a. is set before the auditor understands the client's
c. Schedule engagement staff and audit specialists. reasons for the audit.
d. Identify the client's reason for the audit. b. guides the development of the audit plan.
c. is determined after the engagement staffing is
7. Which of the following will an auditor least likely set.
discuss with the former auditors of a potential client d. is the detailed steps to be followed for the
prior to acceptance? substantive audit tests.
a. Integrity of management.
b. Reasons for changing audit firms.
c. Disagreements with management regarding Understand the Client’s Business and Industry
accounting principles.
d. Methods to be used in selecting items for testing. • A comprehensive understanding of the client's
8. If permission from client to discuss its affairs with the business, industry, and operations is critical for the
proposed auditor is denied by the client, the auditor to effectively conduct an audit. One of the key
predecessor auditor should: principles in auditing standards emphasizes the
a. Keep silent of the denial. importance of this understanding for risk assessment:
b. Disclose the fact that the permission to disclose
is denied by the client. "The auditor identifies and assesses risks of material
c. Disclose adequately to proposed auditor all misstatement, whether due to fraud or error, based on an
noncompliance made by the client. understanding of the entity and its environment, including
d. Seek legal advice before responding to the the entity's internal control."
proposed auditor

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• Auditing standards require that auditors perform risk indicate operational inefficiencies, inventory that may
assessment procedures to understand client's be unsalable, posing financial risks. Interacting with
business and industry. This understanding should be non-accounting employees during the tour and the
sufficient and appropriate to identify and assess the audit process further aids the auditor in gaining a
risk of material misstatements in the financial deeper understanding of the client's business and
statements and includes both management inquiries enhancing the assessment of various business risks.
and analytical procedures.
Identify Related Parties

• Related party transactions are important for auditors

because accounting standards mandate their
disclosure in financial statements if they are material.
A related party is defined as an affiliated company, a
principal owner of the client, or any party that can
influence the client's management or operating
policies. Related party transactions are transactions
Industry and External Environment among related parties whether a price is charged or
not. Common examples include transactions between
• Auditors obtain understanding of the client’s industry a parent and subsidiary, equipment exchanges
to be able to assess industry-specific risks, Common between companies owned by the same person, and
industry risks and unique reporting requirements. loans to officers. A less common example is significant
o Industry-specific risks. Auditors assess risks management influence by a key customer.
unique to industries like financial services and
technology, which can affect client business risk • These transactions aren't arm's-length, posing a risk
and influence the decision to accept of being valued differently than transactions with
engagements. independent third parties. Due to disclosure
o Common industry risks. Familiarity with requirements, lack of independence, and potential for
industry-wide risks, such as inventory fraudulent reporting, auditors often assess high risks
obsolescence in retail computer or gadget for related party transactions.
products or collection risks in consumer loans,
helps auditors assess client-specific risks and • Auditors need to identify all related parties early in the
material misstatements. engagement and include them in permanent audit
o Specific reporting requirements. Auditors need files. Disclosures should detail the nature of the
to understand industry-specific accounting relationship, transaction descriptions, amounts, and
requirements, like those for financial institutions balances with related parties. Auditing standards
and other specialized industries, to ensure require auditors to ask management to identify
clients' compliance with these standards. related parties and transactions, and understand the
controls for identifying, authorizing, and approving
• Knowledge of the client's external factors, including these transactions.
economic volatility, competition, and regulatory
requirements, is vital for comprehensive risk • Auditors should inquire with governance bodies, like
assessment and effective audit planning. the board of directors, about concerns regarding
related party relationships and transactions.
Business Operations and Processes Reviewing SEC filings and examining shareholders'
listings can reveal principal stockholders and potential
• Auditors need to understand factors like primary related parties.
revenue sources, key customers and suppliers,
financing sources, and related party information, as Management and Governance
these can highlight areas of increased client business
risk. • An auditor needs to assess management's philosophy
and operating style, including its approach to
Tour Client Facilities and Operations identifying and responding to risks. These aspects
significantly impact the risk of material misstatements
• Conducting a tour of the client's facilities offers in financial statements.
valuable insights into their business operations. This
firsthand observation allows the auditor to observe • A company's governance structure, encompassing its
operational processes directly and meet and interact organizational setup and activities of the board of
with key personnel outside of the accounting directors and audit committee, plays a crucial role in
department. managing risks. An effective board of directors is key
in ensuring the company takes appropriate risks,
• Viewing the physical facilities enables the auditor to avoiding unnecessary or excessive risks. The audit
evaluate physical safeguards over assets, understand committee contributes to risk management by
the context of accounting data related to assets like overseeing financial reporting, helping to mitigate the
in-process inventory and factory equipment. This chances of aggressive accounting practices.
firsthand knowledge equips the auditor to better
identify risks, such as unused equipment that might

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• To understand the client's governance system, ✎ Concept check: Answer questions no. 14 to 22.
auditors should understand how the board and audit
committee operate. This includes reviewing the 14. In order to obtain an understanding of the client's
company's code of ethics and corporate minutes business, the audit firm will consider
for insights into their oversight and decision-making a. inherent and control risk of the client.
processes. b. audit risk to the CPA firm.
c. the client's business risk and the risk of material
Client Objectives and Strategies misstatements in the financial statements.
d. the CPA firm's potential ongoing revenue from the
• Auditors should understand the client's strategies to audit client.
achieve organizational objectives, particularly in areas
such as: 15. Many risks are common to all clients in certain
1. Reliability of financial reporting. industries.
2. Effectiveness and efficiency of operations.
3. Compliance with laws and regulations. Management's philosophy and operating style
influence the risk of material misstatements in the
• Despite management efforts, business risks can financial statements.
threaten the achievement of these objectives. a. True, False c. True, True
Understanding the client's objectives and strategies is b. False, True d. False, False
crucial for assessing client business risk and the risk
of misstatements in financial statements. 16. Most auditors assess the risk of material misstatement
as high for related parties and related-party
• Auditors should familiarize themselves with the transactions because
client's contracts and legal obligations, including long- a. of the unique classification of related-party
term notes and bonds payable, stock options, pension transactions required on the balance sheet.
plans, supply and government contracts, royalty b. of the lack of independence between the parties.
agreements, union contracts, and leases. Most c. of the unique classification of related-party
contracts are examined during specific phases of the transactions required on the income statement.
audit. For example, pension plan provisions are d. it is required by generally accepted accounting
emphasized during the audit of unfunded pension principles.
liabilities. Reviewing and obtaining these documents
early in the engagement helps the auditor gain a 17. Which of the following would most likely not be
better perspective of the organization and assess risks classified as a related-party transaction?
more effectively. Later, these documents are a. an advance of one week's salary to an employee
examined in detail during the tests of individual audit b. sales of merchandise between affiliated
areas. companies
c. loans or credit sales to the principal owner of the
Measurement and Performance client company
d. exchanges of equipment between two companies
• A client's performance measurement system often owned by the same person
includes key performance indicators (KPIs) that
extend beyond basic financial statement figures. 18. A tour of the client's facilities provides the auditor an
These KPIs are tailored to the client's specific opportunity to
objectives and can encompass metrics like market a. meet key personnel.
share, sales per employee, unit sales growth, website b. observe operations.
unique visitors, same-store sales, country-specific c. assess physical safeguards over assets.
sales, and sales per square foot for retailers. d. all of the above.

• The inherent risk of financial statement 19. An official record of meetings of the board of directors
misstatements may increase if the client sets and stockholders is included in the corporate
unrealistic objectives or if the performance a. bylaws.
measurement system promotes aggressive b. charter.
accounting practices. c. minutes.
d. license.
• Performance measurement also involves ratio
analysis and benchmarking against key competitors. 20. Which of the following best describes the corporate
It's important for auditors to either conduct ratio minutes of an entity?
analysis or review the client's key performance ratios a. official record of the meetings of the board of
as part of understanding the business. Performing directors and the stockholders
preliminary analytical procedures, which include b. unofficial record of the meeting of the board of
evaluating these ratios, is a crucial step in the audit directors
planning process. This approach helps auditors in c. official record of management meeting with
identifying potential areas of risk and planning their investors and creditors of the company
audit procedures accordingly. d. unofficial record of the board of directors'
meetings

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enable auditors to plan the audit more effectively by

21. Auditors should understand client objectives related to focusing resources on areas that pose greater risks.
a. reliability of financial reporting.
b. effectiveness and efficiency of operations. ✎ Concept check: Answer questions no. 23 to 28.
c. compliance with laws and regulations.
d. all of the above. 23. The auditors use analytical procedures during the
course of an audit. The most important phase of
22. When analyzing a client's performance measurement performing these procedures is the:
system, a. Vouching of all data supporting various ratios.
a. only income statement numbers are used. b. Investigation of significant variations and unusual
b. inherent risk of financial statement misstatements relationships.
may be decreased if the performance c. Comparison of client-computed statistics with
measurement system encourages aggressive industry data on a quarterly and full-year basis.
accounting. d. Recalculation of industry date.
c. the auditor is likely to decrease the extent of
testing if the client has set unreasonable 24. Analytical procedures used in planning an audit should
objectives. focus on
d. ratio analysis and benchmarking against key a. Reducing the scope of tests of controls and
competitors are utilized. substantive tests.
b. Providing assurance that potential material
misstatements will be identified.
Perform Preliminary Analytical Procedures c. Enhancing the auditor’s understanding of the
client’ s business required to identify areas of
• Auditors are required to perform preliminary heightened risk.
analytical procedures as part of risk assessment d. Assessing the adequacy of the available evidence.
procedures to better understand the client's business
and industry, and to assess client business risk. 25. Which of the following would not be classified as an
During planning, auditors often analyze aggregated analytical procedure?
data to observe trends, patterns, and inconsistencies. a. benchmarking the company's profitability ratios
This analysis can include comparisons of current data against others in the industry
with historical data, budgets, or industry standards to b. preparing common size financial statements
identify significant or unexpected variances. c. calculating income statement account balances as
Aggregated data helps in identifying areas that may a percent of sales when the level of sales has
require more detailed audit attention. changed from the prior year
d. reconciling equipment dispositions with the
• Analytical procedures help in directing the auditor's equipment master schedule
focus to areas of higher risk or potential concern. For
instance, significant fluctuations in revenue or 26. Which of the following nonfinancial information would
expenses compared to previous periods can prompt a an auditor most likely consider in performing
more detailed examination. analytical procedures during the planning phase of an
audit?
• Common-size financial statements convert absolute a. Turnover of personnel in the accounting
financial data into percentages of a common base department.
figure, like total assets or sales. This standardization b. Objectivity of audit committee members.
allows for easier comparison across time periods or c. Square footage of selling space.
with industry peers. These statements help in d. Management's plans to repurchase stock.
identifying trends and relationships that may not be
apparent in the raw financial data. 27. When performing planning analytical procedures for a
client the auditor detected that the gross profit
• Ratios like liquidity ratios including activity ratios, percentage had declined by 50% from the previous
solvency ratios, and profitability ratios provide year to the year currently under audit. The auditor
insights into the financial health and operational should
efficiency of the client. Auditors use these ratios to a. investigate the possibility the client may have
compare with industry averages, historical data, or made an error in their cost of goods sold
the client’s own budgeted figures to spot anomalies. computation.
Comparing the client's financial metrics with industry b. assist management in developing greater cost
or sector benchmarks helps in assessing the client’s efficiencies in their product line.
performance relative to its peers. This comparison can c. prepare a going concern opinion for the client.
reveal deviations from industry norms, which might d. advise the client to have extensive disclosure to
signal areas of risk or misstatement. alleviate investor concerns.

• Analytical procedures assist auditors in the risk 28. Auditors try to identify predictable relationships when
assessment process by highlighting areas where the using analytical procedures. Which of the following
risk of material misstatement might be higher. They accounts would most likely yield the highest level of

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evidence regarding relationships that involve a. Management of the entity.

transactions? b. Users of the financial statements.
a. Accounts payable c. Payroll expense c. Auditor of the financial statements.
b. Accounts receivable d. Advertising expense d. Regulatory bodies.

31. Which one of the following statements is incorrect

Materiality concerning the concept of materiality?
a. Materiality is determined by references to
• After preliminary analytical procedures, the next step guidelines established by the AASC and PICPA.
in audit planning is making a preliminary judgment b. Materiality depends on the size and nature of an
about materiality for the audit of financial statements. item or misstatement relative to other items in the
Materiality influences the type of audit report issued financial statements.
and relates to the concept that misstatements, c. Materiality thresholds may change between the
individually or collectively, could impact the economic planning and review stages of an audit.
decisions of users based on the financial statements. d. Materiality is a matter of professional judgment.

• Auditors must identify material misstatements and 32. When dealing with materiality,
inform the client for correction. If the client refuses to a. if the client refuses to correct a material
correct material misstatements, the auditor may need misstatement, the auditor is required to adjust the
to issue a qualified or adverse opinion, depending on financial statements.
the misstatement's materiality and pervasiveness. b. management is responsible for determining
whether financial statements are materially
• Materiality judgments depend on understanding the misstated.
financial statement users and their decision-making c. materiality must be determined as a percentage
processes. Materiality levels may vary based on the of sales.
nature of the decisions, such as those in a merger and d. the auditor must bring any material
acquisition agreement. However, in practice, auditors misstatements to the client's attention.
may not fully know all users or their decisions, making
materiality a complex professional judgment.
Materiality for the Financial Statements as a
• The general steps in establishing materiality judgment Whole
are as follows:
• Auditors are required to establish an initial judgment
1. Set Materiality for Financial Statements as a of materiality early in the audit while developing the
Whole: Determine the overall materiality level for overall audit strategy. This is known as the
the financial statements. preliminary judgment about materiality. It is
2. Determine Performance Materiality: Assess termed "preliminary" because it may change during
materiality for segments of the audit, like classes the audit process based on new information or
of transactions, account balances, and insights gained. This judgment must be documented
disclosures. in the audit files, as it forms a crucial part of the audit
3. Estimate Total Misstatement in Segment: planning process.
Throughout the engagement, estimate the
misstatement amount in each segment. • The preliminary judgment about materiality for the
4. Estimate the Combined Misstatement: Near the financial statements as a whole is the maximum
end of the audit, calculate the total estimated amount by which the auditor believes the statements
misstatement from all segments. could be misstated and still not affect the decisions of
5. Compare Combined Estimate with Preliminary or reasonable users. This judgment is one of the most
Revised Judgment about Materiality: Evaluate if important decisions the auditor makes, and it requires
the total estimated misstatement exceeds the considerable professional judgment.
predetermined materiality level, which may
necessitate adjustments or revisions in the audit • The amount set for preliminary materiality directly
approach. influences the amount of evidence the auditor needs
to gather. A lower materiality threshold means more
✎ Concept check: Answer questions no. 29 to 32. evidence is required while a higher materiality
threshold means less evidence may be obtained.
29. Which of the following is part of planning?
• Auditors may adjust the preliminary judgment about
a. Set materiality for the financial statements as a
materiality during the audit, termed as the revised
whole.
judgment of materiality. This revision usually occurs
b. Estimate total misstatement in the segment.
due to changes in factors that influenced the initial
c. Estimate the combined misstatement.
judgment or new developments, such as the
d. Compare the combined estimated with
availability of current financial statements or
preliminary judgment.
significant qualitative events like debt issuance. The
auditor's initial judgment about materiality is shaped
30. Materiality is a matter of professional judgment
by several factors, including the financial statement
influenced by the needs of

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context, the nature of the client’s business, and the ✎ Concept check: Answer questions no. 33 to 39.
economic environment.
33. Why do auditors establish a preliminary judgment
Factors Affecting Preliminary Materiality Judgment about materiality?
a. to determine the appropriate level of staff to
Several factors affect the auditor's preliminary judgment assign to the audit
about materiality for a given set of financial statements. b. so the client can know what records to make
available to the auditor
Materiality is a relative Rather Than an Absolute Concept c. to help plan the appropriate evidence to
accumulate
• A misstatement of a given magnitude might be d. to finalize the control risk assessment
material for a small company, whereas the same peso 34. In determining a materiality level for the financial
mis statement could be immaterial for a large one. statements as a whole, a percentage is often applied
This makes it impossible to establish peso value to a chosen benchmark as a starting point in that
guidelines for a preliminary judgment about determination. Which of the following factors may
materiality that are applicable to all audit clients. affect the identification of an appropriate benchmark?
There is no a. The elements of the financial statements (e.g.,
assets, liabilities, equity, income, expenses).
Benchmarks are Needed for Evaluating Materiality b. Whether there are items on which the attention of
the users of the particular entity’s financial
• Materiality is not absolute but relative, depending on statements tends to be focused (e.g., for the
the context of the financial information. This purpose of evaluating financial performance users
necessitates benchmarks to determine the materiality may tend to focus on profit, revenue or net
of misstatements. For businesses focused on profit, assets).
profit income before taxes is often the primary c. The nature of the entity, where the entity is at in
benchmark for materiality. It is seen as a crucial piece its life cycle, and the industry and economic
of information for users. environment in which the entity operates.
d. All of the above.
• In cases where profit is highly variable or does not
provide a stable basis, other benchmarks may be 35. In determining a materiality level for the financial
more appropriate. Not-for-profit organizations often statements as a whole, a percentage is often applied
use different benchmarks due to their distinct financial to a chosen benchmark as a starting point in that
structures. Other common benchmarks include net determination. Which of the following factors may
sales, gross profit, total assets, or net assets. Auditors affect the identification of an appropriate benchmark?
must consider whether misstatements materially a. Entity’s ownership structure and financing.
affect the reasonableness of other financial b. Volatility of the benchmark.
benchmarks, such as current assets, total assets, c. The need to normalize the benchmark.
current liabilities, and owners' equity. d. All of the above.

• Auditing standards require that auditors document 36. The auditor establishes a materiality level for the
their preliminary judgment about materiality and the financial statements as a whole when developing the
rationale behind the chosen benchmark in the audit overall audit strategy. But identified misstatements
files. below this level are not necessarily immaterial due to
qualitative considerations, such as
Qualitative Factors Also Affect Materiality a. b. c. d.
Possible bias of Yes Yes Yes Yes
• The significance of misstatements to users can vary, management
even for amounts of equal peso value, depending on The cumulative effect in the Yes Yes Yes No
the nature of the misstatement. future
Regulatory or contractual
• For example, misstatements resulting from fraud are requirements Yes Yes Yes Yes
generally viewed as more serious than unintentional Occurrence of fraud or Yes No No Yes
errors of the same amount. This is because fraud illegal acts
directly questions the honesty and reliability of Whether the misstatement
management or personnel. Also, even minor conceals a negative trend Yes Yes No No
misstatements can become material if they have in profitability
implications for contractual obligations. Finally,
Misstatements that alter a consistent trend in 37. Which of the following is the primary basis used to
earnings might be considered material. A notable decide materiality for a profit-oriented entity?
instance is if a company that has been showing a a. net sales
steady income increase suddenly reports a decrease, b. net assets
or if a misstatement changes a reported loss into a c. profit before tax
profit. d. all of the above

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38. When determining materiality, consider accounts receivable fairly stated if it is

a. the preliminary judgment about materiality can be misstated by P5 million or less. In other engagement
increased, but not decreased during the audit. standards (such as the PCAOB auditing standards in
b. auditing standards provide specific materiality the US) refer to this amount as tolerable
guidelines to practitioners. misstatement, whereas Philippine Standards on
c. only one benchmark can be used. Auditing (PSA) define tolerable misstatement as the
d. the application of guidelines requires considerable application of performance materiality to a particular
professional judgment. sampling procedure. For consistency, we will use the
term performance materiality rather than tolerable
39. CPA firms can establish policy guidelines to help their misstatement to be consistent with the PSAs.
auditors determine materiality.
40. Having set the level of materiality for the financial
Profit before taxes is the normal base used to statements as a whole, the auditor now turns his
determine materiality for a not-for-profit organization. attention to determining performance materiality.
a. True, False c. True, True Which of the following statements about performance
b. False, True d. False, False materiality is NOT true?
a. Performance materiality is used to reduce the risk
that the aggregate of uncorrected and undetected
Determine Performance Materiality misstatements exceeds materiality for the
financial statements as a whole to an acceptable
• Performance materiality is defined as the amount(s) level
set by the auditor at less than materiality for the b. Performance materiality refers to the amounts set
financial statements as a whole to reduce to an by the auditor at higher than the materiality level
appropriately low level the probability that the for particular classes of transactions, account
aggregate of uncorrected and undetected balances or disclosures where the materiality level
misstatements exceeds materiality for the financial might otherwise mean that such items are not
statements as a whole. tested.
c. Once the materiality for the financial statements
• Since auditors gather evidence in segments (like as whole has been set, a lower level of
account balances or transactions) rather than for the performance materiality is determined by the
entire financial statements, performance materiality auditor using his or her professional judgement.
assists in determining the necessary level of audit d. The performance materiality level is affected by
evidence. It is inversely related to the amount of the auditor's understanding of the entity and the
evidence required; lower performance materiality nature and extent of misstatements identified in
means more evidence is needed. prior audits.

Setting Performance Materiality: ✎ Concept check: Answer questions no. 41 to 45.

• Often set at 50-75% of the overall materiality for the 41. Performance materiality should be considered when
financial statements. It can vary for different a. Identifying and assessing the risks of material
transaction classes, account balances, or disclosures, misstatements
especially in areas needing more focus. Factors like b. Determining the nature, timing and extent of
overall audit assurance and audit evidence cost also auditor’s further procedures
influence performance materiality levels. c. Both a and b
d. Neither a nor b
• Materiality is then allocated to various segments of
audit in a process called the allocation of the 42. Which of the following terms refers to the application
preliminary judgment about materiality to segments. of performance materiality when performing variables
If auditors do not use a standard percentage and audit sampling procedure (i.e., test of details)?
consider audit assurance and the cost of audit a. Tolerable deviation rate.
evidence in determining performance materiality, b. Tolerable misstatement.
most practitioners allocate materiality to statement of c. Expected deviation rate.
financial position accounts rather than comprehensive d. Expected misstatement.
income statement accounts, because most
comprehensive income statement misstatements 43. Auditors commonly allocate materiality to balance
have an equal effect on the statement of financial sheet accounts rather than income statement
position due to the nature of double-entry accounting. accounts because most income statement
misstatements have a(n) _____ effect on the balance
• The determination of performance materiality is based sheet.
on professional judgment and reflects the amount of a. Reduced c. Equal
misstatement an auditor is willing to accept in a b. Undetermined d. Increased
particular segment. For example, if an auditor decides
to allocate P5 million of a total preliminary judgment 44. Which of the following is an incorrect statement
about materiality of P10 million to accounts regarding the allocation of the preliminary judgment
receivable, this means the auditor is willing to about materiality to balance sheet accounts?

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a. Auditors expect certain accounts to have more ✎ Concept check: Answer questions no. 46 to 50.
misstatements than others.
b. The allocation has virtually no effect on audit costs 46. Auditors are ________ to document the known and
because the auditor must collect sufficient likely misstatements in the financial statements under
appropriate audit evidence. audit.
c. Auditors expect to identify overstatements as well a. permitted
as understatements in the accounts. b. required
d. Relative audit costs affect the allocation. c. not allowed
d. strongly encouraged
45. The materiality level for the financial statements as a
whole (or the materiality level for a particular class of 47. ________ misstatements are those where the auditor
transactions, account balance or disclosure, if can determine the amount of the misstatement in the
applicable) may need to be revised (adjusted either account.
downward or upward) as a result of the following a. Potential
a. a change in circumstances that occurred during b. Likely
the audit c. Known
b. new information d. Projected
c. a change in the auditor’s understanding of the
entity and its operations as a result of performing 48. Likely misstatements can result from
further audit procedures.
d. all of the above Computation of Differences Projections of
the sampling between misstatements
error for the cash management's based on an
Estimate Misstatement and Compare with account and an auditor's auditor's tests of
judgment about a sample from a
Preliminary Judgment
account balances population
a. No Yes Yes
• The initial two (2) steps involve setting materiality for
b. Yes Yes No
the financial statements as a whole and determining
performance materiality for audit segments. These c. No No Yes
are crucial in the planning phase of the audit. The last d. Yes No No
three (3) steps are the result of executing audit tests
and are detailed in subsequent topics. They involve 49. When evaluating the audit findings, the auditor should
estimating and combining misstatements and be satisfied that the
comparing them with materiality. a. amount of known misstatement is documented in
the management representation letter.
• During audit procedures for each segment, auditors b. estimate of the total known and likely
document identified misstatements. These are misstatements is less than a material amount.
classified into two types: known misstatements and c. estimate of the total likely misstatement includes
likely misstatements. Known misstatements also sample error.
called as “factual misstatements” are misstatements d. amount of known misstatement is acknowledged
with quantifiable amounts, such as an incorrectly and recorded by the client.
recorded sales transaction identified during accounts
receivable confirmation. 50. The preliminary judgment on materiality is compared
to the total estimated misstatement amount to
• There are two types of likely misstatements: determine if an account balance is materially
• Differences in Judgment or “judgmental misstated.
misstatements”: These occur from differing
opinions between management and auditors on Total estimated misstatements include known
estimates of account balances, like allowances for misstatements and projected misstatements plus a
uncollectible accounts or warranty liabilities. sampling error.
• Projections from Samples or “projected a. True, False c. True, True
misstatements”: When auditors test a sample and b. False, True d. False, False
find misstatements, they project these findings to
estimate the total misstatements in the entire ***End***
population, like estimating inventory
misstatements from a sampled test.

• The projected misstatement amounts for each

account are aggregated. This combined likely
misstatement is then compared with the set
materiality level (step 5 of the process) to evaluate
their significance relative to the overall financial
statements.

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