AUDITING THEORY (ACCTG 9)
Guangco, CPA
LECTURE NOTES: AUDIT PLANNING
AUDIT PLAN
PSA 300 (Redrafted): Planning and Audit of Financial Statements
states:
“The objective of the auditor is to plan the audit so that it will be
performed in an effective manner.”
Audit planning involves the establishment of the overall audit
strategy and detailed approach for the engagement and developing
an audit plan, in order to reduce audit risk to an acceptable level.
The auditor’s main objective in planning the audit is to determine
the scope of the audit procedures to be performed. The benefits of
adequate planning such as:
 To help ensure (a) that appropriate attention is devoted to
important areas of the audit, (b) that potential problems
are identified and resolved on a timely basis, and (c) that
the audit engagement is properly organized and managed
in order to be performed in an effective and efficient
manner
 To (a) assist in proper assignment of work to engagement
team members, (b) facilitate the direction and supervision
of engagement team members and the review of their
work; and (c) assist in coordination of work done by
auditors of components and experts.
The nature and extent of audit planning depends on the:
 Size of the entity and complexity of the entity
 The auditor’s previous experience with the entity
 Changes in circumstances that occur during the audit
engagement
AUDIT STRATEGY
PSA 300 (Redrafted) requires that the auditor establishes the overall
strategy for the audit. This overall audit strategy sets the scope,
timing and direction of the audit and guides the development of the
more detailed audit plan. In developing the audit strategy, the
auditor considers the results of the preliminary activities described
in the preceding topic. The process of establishing the audit strategy
involves
a. Identifying the characteristics of the engagement that
defines its scope. Examples are:
1. The financial reporting framework
2. Industry specific reporting requirements
3. The locations of the components of the entity.
b. Ascertaining the reporting objectives of the management
to plan the timing of the audit and the nature of the
communication required such as:
1. Deadlines for interim and final reporting
2. Key dates and organization of meetings with
management and those charged with governance to
discuss the nature and extent of audit work
3. Discussion with management regarding the expected
communication on the status of audit work
throughout the engagement.
c. Considering the important factors that will determine the
focus and direction of the engagement teams efforts, such
as:
1. Determination of appropriate materiality levels
2. Preliminary identification of areas where there may
be higher risk of material misstatement.
3. Preliminary identification of material components and
account balances.
4. Evaluation of whether the auditor may plan to obtain,
evidence regarding the effectiveness of internal
control, and
5. Identification of recent significant entity-specific,
industry, financial reporting or other relevant
developments.
d. Considering the results of preliminary engagement
activities and, where applicable, whether knowledge
gained on other engagements performed by the
engagement partner for the entity is relevant
e. Ascertaining the nature, timing and extent of resources
necessary to perform the engagement.
Developing an Overall Audit Strategy
The auditor should gain sufficient understanding about the entity
and its environment first including its internal control first to
formulate an overall audit strategy for the upcoming engagement.
Compiled by: Ray Patrick S.
Christ the King College
The best audit strategy is the approach that results in the most
efficient audit – that is, an effective audit performed at the least
possible cost. An audit should be made regarding:
 How much evidence to accumulate
 How and when this should be done
When developing an audit strategy, the auditor must consider
carefully the appropriate levels of materiality and audit risk.
UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT
PSA 315 (Redrafted), Identifying and Assessing the Risks of
Material Misstatements through Understanding the Entity and Its
Environment, requires the auditor to obtain sufficient understanding
of the entity and its environment including its internal control. Such
understanding involves obtaining knowledge about the entity’s:
a. Industry, regulatory, and other external factors, including
financial reporting framework
b. Nature of the entity, including entity’s selection and
application of accounting policies.
c. Objectives and strategies and the related business risks
that may result in a material misstatement of the financial
statements
d. Measurement and review of the entity’s performance
e. Internal control
The auditor should perform the following risk assessment
procedures to obtain an understanding of the entity and its
environment, including its internal control:
 Inquiries of management and others within the entity who
in the auditor’s judgment may have information that is
likely to assist in identifying risks of material misstatement
due to fraud or error.
 Analytical procedures
 Observation and inspection
Analytical procedures involve of significant ratios and trends,
including the resulting investigation of fluctuations and relationship
that are inconsistent with other relevant information or deviate
from predicted amounts. It may be used for the following purposes:
 As a planning tool, to determine the nature, timing and
extent of other auditing procedures.
 As a substantive test to obtain corroborative evidence
about particular assertions related to the account balance
or transaction class
 As an overall review of the financial statements in the
completion phase of the audit
Sources of Information
The auditor can obtain knowledge of the industry and the entity
from a number of sources. These may include:
 Review of prior years’ working papers
 Tour of client’s facilities
 Discussion with people within and outside the entity
 Reading books, periodicals, and other publications related
to the client’s industry.
 Reading corporate documents and financial reports.
The auditor should also ensure that assistants to an audit
engagement obtain sufficient knowledge of the client’s business and
industry to enable them to carry out the work delegated to them.
Uses of information obtained
Knowledge of the client’s business is a frame of reference within
which the auditor exercises professional judgment. Understanding
business and using this information appropriately assists the auditor
in:
 Assessing risks and identifying potential problems.
 Planning and performing the audit effectively and
efficiently
 Evaluating audit evidence as well as the reasonableness of
client’s representations and estimates
 Providing better service to the client
The better the auditor understands the client’s operations, the more
efficient the examination is likely to be, and the greater the value of
the client of the auditor’s services.
MATERIALITY
PSA 320 (Clarified), Materiality in Planning and Performing an
Audit, establishes and deals with the auditor’s responsibility to apply
the concept of materiality in planning and performing and audit of
financial statements.
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AUDITING THEORY (ACCTG 9)
LECTURE NOTES: AUDIT PLANNING
Materiality is defined in the Financial Reporting Standards Council’s
“Framework for the Preparation and Presentation of Financial
Statements,” in the following terms: “Information is material if its
omission or misstatement could influence the economic decision of
users taken on the basis of the financial statements.”
Materiality may be viewed as:
 The largest amount of misstatement that the auditor
could tolerate in the financial statements
 The smallest aggregate amount that could misstate the
financial statement
Importance of Materiality in Planning an Audit
The auditor should make preliminary estimate of materiality to
determine the amount of evidence to accumulate. There is inverse
relationship between materiality and evidence. This means, more
evidence will be required for a low peso amount of materiality than
for a high peso amount.
Uses of Materiality
According to PSA 320, materiality should be considered by the
auditor:
 In the planning stage, to determine the scope of audit
procedures; and
 In the completion phase of the audit, to evaluate the
effect of misstatements on the financial statements.
Levels of Materiality
The auditor assesses materiality at two levels:
 First is the overall materiality (or materiality level for the
financial statement as a whole)
 Second is the specific materiality (or materiality level for
particular classes of transactions, account balances, or
disclosures)
Performance materiality is used by the auditor to reduce the risk to
an appropriate low level that the accumulation of uncorrected and
unidentified misstatements exceeds overall materiality or specific
materiality. Performance materiality is set at a lower amount than
overall specific materiality. The objective to perform more audit
work than would be required by the overall or a specific materiality
to:
 Ensure that misstatements less than overall or specific
materiality are detected, so as to appropriately reduce the
probability that the aggregate of uncorrected errors and
undetected misstatements exceeds materiality for the
financial statements as a whole
 Provide a margin or buffer for possible undetected
misstatements. This buffer is between detected but
uncorrected misstatements in the aggregate and the
overall or specific materiality.
Relationship between Materiality and Audit Risk
There is an inverse relationship between materiality and the level
of audit risk that is, the higher the materiality level, the lower the
audit risk.
AUDIT RISK
Audit risk refers to the risk that the auditor gives an inappropriate
audit opinion on the financial statements.
Audit Risk = Inherent Risk x Control Risk x Detection Risk
As the desired level of audit risk decreases, the auditor should design
more effective substantive procedures.
The auditor should use professional judgment to assess audit risk
and to design audit procedures to ensure it is reduced to an
acceptably low level. When designing substantive audit procedures,
the auditor should consider three main issues:
 What level of assurance does the auditor wish to attain
that the financial statements do not contain material
misstatement? As this level of assurance increases, the
scope of the auditor’s substantive test increases.
 How susceptible is the account to material misstatement?
As the susceptibility of the account of material
misstatement increases, the scope of the auditor’s
substantive tests also increases.
 How effective is the client’s internal control in preventing
or detecting misstatements? As the effectiveness of the
client’s internal control increases, the scope of auditor’s
substantive tests decreases.
Compiled by: Ray Patrick S. Guangco, CPA
Christ the King College
Inherent risk is the susceptibility of an account balance or class of
transactions to a material misstatement assuming that there were
no internal controls.
PSA 315 (Redrafted), Identifying and Assessing the Risks of
Material Misstatements through Understanding the Entity and Its
Environment, requires the auditor to assess inherent risk at the
financial statement and account balance or transaction class levels.
Factors that affect the risk of misstatement at the financial
statement level include:
 The management integrity
 Management Characteristics (e.g aggressive attitude
toward financial reporting)
 Operating Characteristics (e.g profitability of the entity
relative to its industry is inadequate)
 Industry Characteristics (e.g the industry is experiencing a
large number of business failures)
Factors affecting inherent risk at the account balance level include:
 Susceptibility of the account to theft.
 Complexity of calculation related to account.
 The complexity underlying transaction and other events.
 The degree of judgment involved determining account
balances.
As the assessed level of inherent risk increases, the auditor should
design more effective substantive procedures.
Control risk is the risk that a material misstatement that could occur
in an account balance or class of transaction will not be prevented or
detected and corrected on a timely basis by accounting and internal
control systems. It is related to the effectiveness of the client’s
internal control. If the entity’s internal control is effective, the
assessed level of control risk decreases. Thus, as the assessed level of
control risk increases, the auditor should design more effective
substantive procedures.
Detection risk is the risk that an auditor’s substantive procedure will
not detect a material misstatement. Detection risk is a function of
the effectiveness of the auditor’s substantive procedures. As the
acceptable level of detection risk decreases, the assurance directly
provided from substantive tests increases. Hence, the auditor should
design more effective audit procedures in order to achieve the
desired level of assurance. Unlike inherent and control risks, the
auditor can control the level of detection risks by performing more
effective substantive procedures. The acceptable level of detection
risk is inversely related to the assessed level of both inherent and
control risk.
Steps in Using the Audit Risk Model
1. Set the desired level of Audit Risk.
2. Assess the level of Inherent Risk.
In making this assessment, the auditor will rely primarily on his
knowledge of the client’s business and industry, and the results
preliminary analytical procedures.
3. Assess the level of Control Risk.
Assessment of control risk would involve studying and
evaluating the effectiveness of the client’s accounting and
internal control systems.
4. Determine the acceptable level of Detection Risk
Detection Risk = Audit Risk / (Inherent Risk x Control Risk)
5. Design Substantive Tests
Substantive tests are audit procedures designed to
substantiate the account balances or to detect material
misstatements in the financial statements. Thus, a lower
acceptable level of detection risk increases the assurance to be
provided by substantive tests. To obtain greater assurance, the
auditor will have to modify the scope of his substantive tests
such as:
 Performing more effective substantive procedures
(Nature)
 Performing year-end procedures (Timing)
 Using larger sample size (Extent)
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