Audit Planning, Types of Audit Tests, and Materiality – Notes

Audit planning is the foundation of every successful audit.

It ensures that the audit is performed efficiently, effectively, and in compliance with professional standards.

This chapter explains:

1. How auditors plan and organize their audits.
2. The types of audit tests and evidence gathering methods.
3. The role of materiality in determining the nature, timing, and extent of audit procedures.

Client Acceptance and Continuance

Before beginning an audit engagement, the auditor must decide whether to accept a new client or continue with an existing one.

Key Factors Considered

1. Capability of the Firm

• Has the firm the required technical knowledge, experience, and resources?
• Does it have enough qualified staff to complete the engagement?

2. Compliance with Legal and Ethical Requirements

• The audit firm must be independent of the entity.
• Must follow ethical codes such as integrity, objectivity, and confidentiality.

3. Integrity of the Client

• Reputation of the client’s management and principal owners.
• Nature of the client’s business operations.
• Reasons for appointing the audit firm.

Auditors must also periodically review existing clients to decide whether to continue the engagement, especially after significant business events or disputes.

Preliminary Engagement Activities

Before fieldwork begins, auditors complete three preliminary activities:

1. Determine the Audit Engagement Team

Assign staff with appropriate experience and knowledge of the client’s industry.

2.  Assess Compliance with Ethical and Independence Requirements

Confirm that the audit team has no financial or personal conflict of interest.

3. Establish an Understanding with the Client

This formal understanding includes three key elements:

Engagement Letter – A written contract outlining the scope, responsibilities, and limitations of both auditor and client.

Internal Audit Function – Evaluate whether the client’s internal audit system is effective and reliable.

Audit Committee – A subcommittee of the board responsible for financial reporting and ensuring auditor independence.

Planning the Audit

Audit planning determines how an audit will be conducted in an efficient and systematic manner.

Steps in the Audit Planning Process

1. Assess business risks.
2. Establish materiality.
3. Consider multi-location operations.
4. Determine the need for specialists.
5. Review legal and regulatory compliance.
6. Identify related parties.
7. Evaluate opportunities for value-added services.
8. Prepare the audit strategy, plan, and audit programs.

A well-structured plan ensures the audit team focuses on high-risk areas and gathers sufficient evidence to form an opinion.

Types of Audit Procedures

Audit evidence is collected through various audit tests designed to detect material misstatements due to fraud or error.

There are three primary types of audit procedures:

1. Risk Assessment Procedures

These are performed to identify and assess risks of material misstatement at both the financial statement and assertion levels.

Examples:

• Understanding internal control systems.
• Inquiries of management and staff.
• Analytical reviews and trend analyses.

2. Test of Controls

These tests evaluate whether the client’s internal controls are operating effectively in preventing or detecting misstatements.

Examples:

• Inspecting authorization documents.
• Reviewing reconciliations and approval procedures.
• Interviewing responsible staff.

If controls are found to be effective, auditors can reduce the extent of detailed testing.

3. Substantive Procedures

These are designed to detect material misstatements in account balances and disclosures.

Two main types:

Test of Details: Focuses on specific transactions and account balances to identify errors or fraud.
Example – Confirming accounts receivable balances with customers.

Analytical Procedures: Analyze relationships between financial and non-financial data to identify unusual trends or inconsistencies.
Example – Comparing gross profit margins year-over-year.

Materiality

Materiality determines which misstatements are significant enough to influence users’ decisions based on the financial statements.

A misstatement is material if its omission or misrepresentation could reasonably influence the judgment of a financial statement user.

Steps in Applying Materiality

1. Determine Overall Materiality

• The maximum amount the auditor believes financial statements could be misstated without affecting user decisions.

2. Determine Tolerable Misstatement

• The portion of overall materiality allocated to specific accounts or disclosures.
• Helps establish the scope of audit procedures for individual balances.

3. Evaluate Audit Findings

• At the end of the audit, auditors compare total misstatements identified with the materiality threshold.
• If total misstatements exceed materiality, adjustments or disclosures are required.

Example

If overall materiality = ₹10,00,000
and tolerable misstatement = ₹2,00,000 per account,
then any account with errors > ₹2,00,000 will be tested further or corrected before issuing the audit opinion.

Summary

Stage	Key Objective	Main Activities
Client Acceptance & Continuance	Ensure auditor independence and client integrity	Evaluate firm’s capability, compliance, and client reputation
Preliminary Engagement	Prepare for the engagement	Team selection, ethical check, engagement letter
Planning the Audit	Design effective strategy	Identify risks, assess materiality, document plan
Types of Audit Tests	Gather audit evidence	Risk assessment, test of controls, substantive procedures
Materiality	Evaluate significance of errors	Determine thresholds and evaluate findings

FAQs About Audit Planning and Materiality

1. What is audit planning?

It’s the process of establishing the overall audit strategy and developing a detailed plan for obtaining evidence.

2. Why is client acceptance important?

To ensure the auditor works with reputable clients and maintains independence and ethical standards.

3. What is the difference between tests of control and substantive testing?

Tests of control check internal control effectiveness, while substantive tests check for actual misstatements in financial data.

4. What is overall materiality?

The highest level of misstatement the auditor believes will not affect financial statement users’ decisions.

5. What is tolerable misstatement?

The smaller materiality threshold used for testing individual account balances or disclosures.

6. Why are analytical procedures used?

They help identify unusual relationships or trends that may signal possible misstatements or fraud.