CHAPTER 3

AUDIT PLANNING, TYPES OF AUDIT TESTS,

AND MATERIALITY

Answers to Review Questions

3-1 The auditor should inquire of the prospective client's bankers and attorneys, credit
agencies, and other members of the business community who may have knowledge about
the integrity of the prospective client and its management.

3-2 The successor auditor is responsible for initiating the communication with the
predecessor auditor. However, the successor auditor should request permission of the
prospective client before contacting the predecessor auditor. The successor auditor's
communication with the predecessor auditor should include questions related to the
integrity of management, disagreements with management over accounting and auditing
issues, and the predecessor auditor's understanding of the change in auditors.

3-3 An engagement letter is used to formalize the arrangement reached between the auditor
and client. It serves as a contract that outlines the responsibilities of both parties and is
intended to prevent misunderstandings between the two parties. The letter states the
responsibilities of the auditor and management, that the audit will be conducted in
accordance with auditing standards, that certain types of audit procedures will be
conducted and written representations will be obtained from management, and that the
audit may not detect all material errors and fraud. Exhibit 3-1 in the text contains a
sample engagement letter. In addition, the engagement letter might include:
Arrangements involving the use of specialists or internal auditors.
Any limitation of the liability of the auditor or client, such as indemnification to the
auditor for liability arising from knowing misrepresentations to the auditor by
management. (Note that regulatory bodies, such as the SEC, may restrict or prohibit
such liability limiting arrangements.)
Additional services to be provided relating to regulatory requirements.
Arrangements regarding other services (e.g., assurance, tax, or consulting services).

3-4 The following factors can be used to judge the competence of the internal auditors:
Educational level and professional experience.
Professional certification and continuing education.
Audit policies, procedures, and checklists.
Practices regarding their assignments.
The supervision and review of their audit activities.
The quality of their working paper documentation, reports, and recommendations.

Evaluation of their performance.
The objectivity of internal auditors can be determined by assessing the following factors:
The organizational status of the internal auditor responsible for the internal audit
function.
Policies to maintain internal auditors' objectivity about the areas audited.

3-5 An audit committee is a subcommittee of the board of directors composed of independent
members. The audit committee is responsible for the financial reporting and disclosure
process. The committee should encourage fair reporting from the perspective of the
stockholders, creditors, and employees. The audit committee should meet regularly with
the external and internal auditors, providing for the independence of the external and
internal auditors.

3-6 The auditor should be guided by the results of the client acceptance/continuance process,
procedures performed to gain the understanding of the entity, and preliminary
engagement activities. Additional steps that should be performed include the following:
Assess business risks.
Establish materiality.
Consider multilocations.
Assess the need for specialists.
Assess the possibility of illegal acts.
Identify related parties.
Consider additional value-added services.

3-7 The first type of illegal acts includes violations of laws and regulations, such as tax laws,
that are generally recognized as having a direct and material effect on the determination
of financial statement amounts. Other illegal acts are violations of laws or regulations
such as the Securities Acts, the Occupational Safety and Health Act, Food and Drug
Administration regulations, environmental protection laws, equal employment statutes,
and price fixing or other antitrust violations that may have a material but indirect effect
on the financial statements.
Circumstances that may indicate a possible illegal act include the following:
Unauthorized transactions, improperly recorded transactions, or transactions not
recorded in a complete or timely manner.
Investigation by a government agency, enforcement proceeding, or payment of
unusual fines or penalties.
Violations of laws or regulations cited in reports of examinations by regulatory
agencies.
Large payments for unspecified services to consultants, affiliates, or employees.
Sales commissions or agents' fees that appear excessive.
Large payments in cash or bank cashiers' checks.
Unexplained payments to government officials.
Failure to file tax returns or pay government duties.
3-8 The auditor can identify related parties by (1) evaluating the clients procedures for
identifying related parties, (2) requesting a list of related parties from management, and
(3) reviewing filings with the SEC and other regulatory agencies. Some additional audit
procedures that may identify transactions with related parties include:
Review the minutes of the board of directors and executive or operating committees
for information about material transactions authorized or discussed at their meetings.
Review conflict-of-interest statements obtained by the company from management.
Review the extent and nature of business transacted with major customers, suppliers,
borrowers, and lenders for indications of previously undisclosed relationships.
Review accounting records for large, unusual, or nonrecurring transactions or
balances, paying particular attention to transactions recognized at or near the end of
the reporting period.
Review confirmations of loans receivable and payable for indications of guarantees.
If guarantees are identified, determine their nature and the relationships of the
guarantor to the entity.

3-9 The engagement partner has the overall responsibility for the engagement and its
performance and should supervise the audit engagement team so that the work is
performed as directed and supports the conclusions reached. The engagement partner and
other engagement team members performing supervisory activities should
Inform engagement team members of their responsibilities, including:
o the objectives of the procedures that they are to perform;
o the nature, timing, and extent of procedures they are to perform; and
o matters that could affect the procedures to be performed or the evaluation
of the results of those procedures.
Direct engagement team members to bring any significant accounting and
auditing issues they identify to the attention of the engagement partner or other
engagement team members performing supervisory activities so they can evaluate
those issues and determine appropriate actions.
Review the work of engagement team members to evaluate whether:
o the work was performed and documented;
o the objectives of the procedures were achieved; and
o the results of the work support the conclusions reached.
3-10 The three general types of audit tests are risk assessment procedures, tests of controls, and
substantive tests.

Risk assessment procedures are used by the auditor to obtain an understanding of the
entity and its environment, including internal control. Examples include inquiries of
management and others, analytical procedures, and observation and inspection.

Tests of controls are audit procedures performed to test the operating effectiveness of
controls in preventing, or detecting and correcting, material misstatements at the relevant
assertion level. Examples of tests of controls include inquiries of appropriate client
personnel, inspection of documents and reports, observation of the application of a
specific internal control, and reperformance of the application of the control by the
auditor.

Substantive procedures are performed to detect material misstatements (i.e., monetary
errors) in a transaction class, an account balance, and disclosure components of the
financial statements. Examples of substantive procedures are (1) tests of details (i.e.,
substantive tests of transactions and test of details of account balances) and substantive
analytical procedures.

3-11 Professional standards provide very little specific guidance on how to assess what is
material to a reasonable user. As a result, auditing firms should develop policies and
procedures to assist their auditors in establishing materiality judgments for clients in
order to minimize the variability of such judgments by firm personnel. In other words,
firms would prefer to have their auditors establish similar materiality judgments for
clients with similar circumstances.

3-12 The three major steps in applying materiality are:

Step 1: Determine a materiality level for the overall financial statements. The auditor
should establish a materiality level for the financial statements taken as a whole. This will
be referred to as planning materiality. Planning materiality is the maximum amount by
which the auditor believes the financial statements could be misstated and still not affect
the decisions of users. Materiality, however, is a relative, not an absolute, concept.

Step 2: Determine tolerable misstatement. This step involves determining tolerable
misstatement based on planning materiality. Tolerable misstatement is the amount of
planning materiality that is allocated to an account or class of transactions so that the
auditor can plan the scope of audit procedures for the individual account balance or class
of transactions.

Step 3: Evaluate audit findings. Based on the results of the audit procedures conducted,
the auditor aggregates misstatements from each account or class of transactions. The
aggregate amount includes known and likely misstatements. In evaluating likely
misstatements, the auditor should be very careful in considering the risk of material
misstatement in accounts that are subject to estimation. Examples of such estimates
include inventory obsolescence, loan loss reserves, uncollectible receivables, and
warranty obligations. Seldom can accounting estimates be considered accurate with
certainty. If, based on the best audit evidence, the auditor believes the estimated amount
included in the financial statements is unreasonable, the difference between that estimate
and the closest reasonable estimate should be treated as a likely misstatement.

3-13 Total assets or total revenues may be better bases for entities in certain industries. For
example, in a not-for-profit entity, total revenues or total expenses might be more
appropriate benchmarks, while for asset-based entities (e.g., mutual funds) net assets
might be a better benchmark.

3-14 Qualitative factors that may affect the establishment of the planning materiality (step 1)
are shown in Table 3-5. Many of these qualitative factors are cited in SEC Staff
Accounting Bulletin No. 99, Materiality.

3-15 Qualitative factors that may affect the evaluation of audit findings (step 3) are shown in
Table 3-5. Many of these qualitative factors are cited in SEC Staff Accounting Bulletin
No. 99, Materiality.

Answers to Multiple-Choice Questions

3-16 d 3-21 d
3-17 d 3-22 d
3-18 aAppears to be the
best answer, but I
think stating some
reliance as opposed to
limited reliance
would be more clear.
3-23 a
3-19 c 3-24 d
3-20 b 3-25 d

Solutions to Problems

3-26 a. Prior to acceptance of the engagement, Tish & Field should have communicated with
the predecessor auditor regarding:
Information that might bear on the integrity of management.
Disagreements with management concerning accounting principles, auditing
procedures, or other similarly significant matters.
Communications to those charged with governance regarding fraud and
noncompliance with laws or regulations by the entity.
Communications to management and those charged with governance regarding
significant deficiencies and material weaknesses in internal control.
The predecessor auditor's understanding about the reasons for the change in
auditors.

b. The additional procedures Tish & Field should perform before accepting the
engagement include the following:
Obtain and review available financial information (annual reports, interim
financial statements, income tax returns, etc.).
Inquire of third parties about any information concerning the integrity of the
prospective client and its management. (Such inquiries should be directed to the
prospective clients bankers and attorneys, credit agencies, and other members of
the business community who may have such knowledge.)
Consider whether the prospective client has any circumstances that will require
special attention or that may represent unusual business or audit risks, such as
litigation or going concern issues.
Determine if the firm is independent of the client and able to provide the desired
service.
Determine if the firm has the necessary technical skills and knowledge of the
industry to complete the engagement.
Determine if acceptance of the client would violate any applicable regulatory
agency requirements or the Code of Professional Conduct.


c. The form and content of engagement letters may vary (refer to Exhibit 3-1), but they
would generally contain information regarding:
The objective of the audit.
The estimated completion date.
Management's responsibility for the financial statements.
The scope of the audit.
Other communication of the results of the engagement.
The fact that because of the test nature and other inherent limitations of an audit,
together with the inherent limitations of any system of internal control, there is an
unavoidable risk that even some material misstatement may remain undiscovered.
Access to whatever records, documentation, and other information may be
requested in connection with the audit.
Arrangements with respect to client assistance in the performance of the audit
engagement.
Expectation of receiving from management written confirmation concerning
representations made in connection with the audit.
Notification of any changes in the original arrangements that might be necessitated
by unknown or unforeseen factors.
A request for the client to confirm the terms of the engagement by acknowledging
receipt of the engagement letter.
The basis on which fees are computed and any billing arrangements.

3-29 a. An audit committee is a subcommittee of the board of directors that is responsible for
the financial reporting and disclosure process. Audit committees are required for
public companies subject to SOX and may be established by private companies. The
audit committee should be composed of independent members of the board.

b. Audit committees are formed to satisfy the shareholders' need for assurance that
directors are exercising due care in the performance of their duties. For public
companies they are required. They may also be formed so that a private company can
be more responsive to the needs of those interested in financial reporting. They may
also be formed to reinforce auditor's independence, particularly the appearance of
independence, from the management of a company whose financial statements are
being examined by the auditor.

c. The functions of an audit committee may include the following:
Selection of the independent auditor, discussion of audit fee with the auditor, and
review of the auditor's engagement letter.
Review of the independent auditor's overall audit plan (scope, purpose, and general
audit procedures).
Review of the annual financial statements before submission to the full board of
directors for approval.
Review of the results of the auditor's examination including experiences,
restrictions, cooperation received, findings, and recommendations. Matters that the
auditor believes should be brought to the attention of the directors or shareholders
should be considered.
Review of the independent auditor's evaluation of the company's internal control
systems.
Review of the company's accounting, financial, and operating controls.
Review of the reports of internal audit staff.
Review of interim financial reports to shareholders before the board of directors
approves them.
Review of company policies concerning political contributions, conflicts of interest,
and compliance with federal, state, and local laws and regulations, and
investigation of compliance with those policies.
Review of financial statements that are part of prospectuses or offering circulars;
review of reports before they are submitted to regulatory agencies.
Review of the independent auditor's observations of financial and accounting
personnel.
Participation in the selection and establishment of accounting policies; review the
accounting for specific items or transactions as well as alternative accounting
treatments and their effects.
Review of the impact of new or proposed pronouncements by the accounting
profession or regulatory bodies.
Review of the company's insurance program.
Review and discussion of the independent auditor's management letter.

3-31

Scenario 1:

a. Because Murphy & Johnson is a profit-oriented entity, net income before taxes is
likely to be the most appropriate benchmark for determining planning materiality.
Murphy & Johnsons auditor could use 3 5% of net income before operations for
determining planning materiality. If we assume that the auditor uses 5%, planning
materiality would be $1.05 million ($21 million .05). Assume further that the
auditors firm provides guidance that tolerable misstatement will be set 50% of
planning materiality or $525,000.

b. In this case, the two detected misstatements exceed planning materiality ($1.25
million versus $1.05 million). Thus, the auditor needs to propose an adjustment to the
financial statements. If both of the misstatements are known misstatements, the
auditor should request the client to book both misstatements. If the misstatements are
likely misstatements, the auditor will have to determine whether the misstatements
arose from an accounting estimate or an audit sample. In our example, the auditors
proposed adjustment would need to be at least $200,000 so that the remaining
misstatement would be equal to or less than $1.05 million. The auditor should also
understand the cause of the misstatements and determine the impact of the material
misstatements on the auditors assessment of fraud and control risk. If Murphy &
Johnson is a public company, subject to Sarbanes Oxley 404 requirements (see
Chapter 7), the material misstatements are strong indicators of material weaknesses in
controls.

Scenario 2:

a. Delta Investments is in the mutual fund industry and total assets would likely be the
most appropriate benchmark for determining planning materiality. Deltas auditor
could use .5% of total assets for determining planning materiality. If we assume that
the auditor uses .5%, planning materiality would be $21.5 million ($4.3 billion
.005). Assume further that the auditors firm provides guidance that tolerable
misstatement will be set 50% of planning materiality or $10.75 million.

b. The two detected misstatements are less than both tolerable misstatement and
planning materiality so no adjustment to the financial statements would be necessary.
However, the auditor should understand the cause of the misstatement and determine
the impact of the misstatements on the auditors assessment of fraud and control risk.
If either of the two misstatements were known misstatements, the auditor would
request that the client make an adjustment. If Delta Investments is a public company,
subject to Sarbanes Oxley 404 requirements (see Chapter 7), the misstatements may
represent significant weaknesses in controls.

Scenario 3:

a. Swell Computers is a profit-oriented entity and net income before taxes would
normally be the most appropriate benchmark for determining planning materiality.
However, Swells profit ($500,000 net income on $7 billion of revenue) is close to
breakeven. In this case, Swells auditor can use total assets or total revenues for the
base. Deltas auditor decides to use .5% of total assets for determining planning
materiality. Thus, planning materiality would be $11.0 million ($2.2 billion .005).
Assume further that the auditors firm provides guidance that tolerable misstatement
will be set 50% of planning materiality or $5.5 million. Note that other scenario
answers are feasible.

b. The detected misstatement is less than both tolerable misstatement and planning
materiality. However, in this instance the adjustment of $1.5 million turns a profit
into a loss. This is one of the qualitative factors that SAB No. 99 requires the auditor
to consider (see Table 3-8), so an adjustment to the financial statements would be
necessary. In addition, the auditor should understand the cause of the misstatement
and determine the impact of the misstatements on the auditors assessment of fraud
and control risk. If Swell Computer is a public company, subject to Sarbanes Oxley
404 requirements (see Chapter 7), the misstatements may represent significant
weaknesses in controls.