CHAPTER 5 - AUDIT PLANNING

QUESTION 1
What is audit planning?
PSA 300 (Redrafted),“Planning an Audit of Financial Statements", requires the auditor to plan the
audit work so that the audit will be performed in an effective manner. Planning refers to developing
a general strategy and a detailed approach for the expected nature, timing and extent of the audit.
The nature and extent of planning will vary according to the size of the entity, the complexity of the
audit, the key engagement team members' previous experience with the entity, and changes in
circumstances that occur during the audit engagement.
Planning is done continuously throughout the engagement because there may be changes in
conditions or unexpected results of audit procedures during the course of the audit.
Prior to the identification and assessment of the risks of material misstatement, the auditor should
consider the following matters during the planning stage of the audit:
a. The analytical procedures to be applied as risk assessment procedures.
b. The legal and regulatory framework applicable to the entity and how the entity is complying
with that framework.
c. The determination of materiality.
d. The involvement of experts and internal auditors.
e. The performance of other risk assessment procedures.
To enhance the effectiveness of the planning process, the engagement partner and other key
engagement team members should be involved, as their participation in the discussion among
engagement team members would assist in the consideration of the susceptibility of financial
statements to material misstatement.

QUESTION 2
What are the advantages of adequate 'audit planning?

Adequate planning of the audit work provides many advantages as it:

a. Helps ensure that appropriate attention is devoted to important areas of the audit.
b. Helps identify and resolve potential problems on a timely basis.
c. Permits the audit work to be properly organized and managed so that it is performed in an
effective and efficient manner.
d. Assists in the selection of engagement team members with appropriate levels of capabilities
and competence.
e. Facilitates in the direction and supervision of engagement team members and the review of
their work.
f. Helps in the coordination of work done by experts and auditors of components.

QUESTION 3
What is the purpose of establishing an overall audit strategy?
An overall audit strategy sets the scope, timing and direction of the audit and guides the
development of the audit plan. In developing an overall audit strategy, the auditor should:
a. Identify the characteristics of the engagement that define its scope.
b. Ascertain the reporting objectives of the engagement to plan the timing of the audit and the
nature of required communications.
c. Consider significant factors in directing the engagement team's efforts.
d. Consider the results of preliminary engagement activities.
e. Ascertain the nature, timing and extent of resources necessary to perform the engagement.

QUESTION 4
What are the contents of an audit plan?

After the overall audit strategy has been established, the auditor should develop and document an
overall audit plan to describe the detailed scope and conduct of the audit. While the record of the
overall audit plan needs to be sufficiently detailed to guide the development of the audit program,
its precise form and content will vary depending on the size of the entity, the complexity of the
audit, and the specific methodology and technology used by the auditor.
An audit plan should be able to describe the following matters:
a. The nature, timing and extent of planned risk assessment procedures.
b. The nature, timing and extent of planned further audit procedures(e.g., test of controls and
substantive procedures).
c. Other planned audit procedures that are required to be carried out so that the engagement
complies with PSAs.

QUESTION 5
Explain the nature, timing and extent of direction and supervision of engagement team members
and the review of their work.

The auditor should plan the nature, timing and extent of direction and supervision of engagement
team members and review of their work by considering the following factors.
a. Size and complexity of the entity.
b. Area of the audit.
c. Assessed risks of material misstatement.
d. Capabilities and competence of the individual team members performing the audit work.

QUESTION 6
Explain the concept of materiality.

Information is material if its omission or misstatement, individually or in the aggregate, could

reasonably be expected to influence the economic decisions of users taken on the basis of the
financial statements. Judgments about materiality are made in light of surrounding circumstances,
and often depends on the size and/or nature of a misstatement, or a combination of both. Thus,
materiality provides a threshold or cut-off point rather than being a fundamental qualitative
characteristic which information must have if it is to be useful.
The auditor's determination of materiality is a matter of professional judgment and involves
quantitative (size or amount of misstatements) as well as qualitative (e.g., misstatements resulting
from fraud are usually more material than misstatements caused by errors) considerations.
Materiality is expressed in relative rather than in absolute terms. As such, what is considered
material for one person may be adjudged as immaterial for others.
The International Accounting Standards Board (IASB) has amended the definition of materiality in
IFRS (became effective from January 1, 2020),as follows:
“Information is material if omitting, misstating or obscuring it could reasonably be expected to
influence the decisions that the primary users of general purpose financial statements make on the
basis of those financial statements, which provide financial information about a specific reporting
entity."

QUESTION 7
What is the auditor's responsibility with respect to materiality in an audit of financial statements?
The auditor should apply the concept of materiality both in planning(identifying and assessing the
risks of material misstatement) and performing the audit (determining the nature, timing and extent
of further audit procedures). In addition, materiality should also be considered in evaluating the
effect of uncorrected misstatements, if any, on the financial statements and in forming the opinion
in the auditor's report.
According to PSA 320 (Revised and Redrafted), “Materiality in Planning and Performing an Audit",
the auditor should consider materiality at three different levels when establishing the overall audit
strategy. These are:
a. Overall materiality (Materiality for the financial statements as a whole).
b. Specific Materiality (Materiality applied to particular classes of transactions, account balances or
disclosures).
c. Performance materiality.

QUESTION 8
Explain the significance of “overall materiality".

Materiality for the financial statements as a whole or overall materiality is the materiality
determined at the overall financial statement level. This materiality level assists the auditor in
determining whether the proposed audit adjustments are significant or not. If the audit adjustments
exceed this level, the auditor may require that the financial statements be adjusted.
In calculating overall materiality, the auditor should identify an appropriate benchmark, which could
either be an element of the financial statements (e.g. profit before tax, gross profit, revenue/sales),
or total assets or total equity. The auditor should then choose an appropriate percentage to be
applied to that benchmark. In determining the appropriate benchmark, the following factors are
often considered by the auditor:
a. Components of the financial statements.
b. Focus of the users of the financial statements.
c. Nature of the entity.
d. Ownership structure of the entity.
e. Volatility of the benchmark identified.
f. Laws and regulations (e.g., SEC).
In practice, the benchmark commonly used for profit-oriented companies is profit from continuing
operations before tax. However, when there are circumstances that give rise to an exceptional
increase or decrease affecting the chosen benchmark (i.e. non-recurring gain or loss), the auditor
may use a benchmark based on a normalized profit before tax from continuing operations.
In determining the overall materiality, the auditor should consider that the financial statements are
interrelated with each other. For instance, a misstatement in one account on the statement of
financial position could have a material effect in another account on the income statement. In
such case, the auditor considers materiality in terms of the smallest aggregate amount of
misstatement that could be material to any one of the financial statements. For instance, the
auditor might believe that misstatements amounting to P50,000 could materially affect the
statement of financial position, but thinks that misstatements would have to aggregate P70,000 in
order to materially affect the income statement. The auditor would use the lower figure of P30,000
in planning and deciding on the materiality level because this will give the auditor a reasonable
assurance that both financial statements are not materially misstated.

QUESTION 9
Explain the significance of "specific materiality'.

Materiality applied to particular classes of transactions, account balances or disclosures or specific

materiality is the amount set by the auditor for particular classes of transactions, account balances
or disclosures for which misstatements, well though lower than overall materiality, could
reasonably be expected to influence the economic decisions of users of the financial statements.
In determining the specific materiality, the auditor normally considers the following factors:
a. Laws and regulations.
b. Financial reporting framework.
c. Key industry disclosures of the entity.
d. Particular aspects of the entity's business.
e. Understanding of the view of those charged with governance and management.

QUESTION 10
Explain the significance of "performance materiality".
Performance materiality refers to the amount or amounts set by the auditor at less than materiality
for the financial statements as a whole to reduce to an appropriately low level the probability that
the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial
statements as a whole. Similarly, performance materiality relating to a materiality level determined
for a particular class of transactions, account balance or disclosure is set to reduce to an
appropriately low level the probability that the aggregate of uncorrected and undetected
misstatements in that particular class of transactions, account balance or disclosure exceeds the
materiality level for that particular class of transactions, account balance or disclosure.
Performance materially considers the fact that several individually immaterial misstatements may
cause the financial statements to be materially misstated. For instance, if P150,000 is considered
material, individually immaterial understatement of two asset accounts by P100,000 and P80,000,
respectively is, in total, a material misstatement.
Therefore, performance materiality will ordinarily be set at an amount below the overall materiality,
or the specific materiality if it applies.
Performance materiality is used in scoping of financial statement line items to be tested by the
auditor and ensures that significant accounts in the financial statements are covered by audit
testing. In determining performance materiality, the auditor should consider the following factors:
a. Nature of the entity's business and transactions.
b. Risk assessment procedures.
c. Nature and extent of misstatements identified in previous audits.

QUESTION 11
What is the meaning of audit risk?

Audit risk refers to the risk that the auditor expresses an inappropriate audit opinion when the
financial statements are materially misstated. For instance, the auditor may express an unmodified
opinion on financial statements that are actually materially misstated.
The definition of audit risk does not include the risk that the auditor might express an opinion that
the financial statements are materially misstated when they are not. Audit risk does not also
include the auditor's business risks, such as loss from litigation, adverse publicity, or other events
arising in connection with the audit.
The assessment of audit risks is based on audit procedures to obtain information necessary for
that purpose and evidence obtained throughout the audit, and is a matter of professional
judgment, rather than a matter capable of precise measurement.
Audit risk is a function of the following components:
a. Risks of material misstatement (RMM)
 Inherent risk
 Control risk
b. Detection risk

QUESTION 12
Define inherent risk.
Inherent risk refers to the susceptibility of an assertion about a class of transaction, account
balance or disclosure to a misstatement that could be material, either individually or when
aggregated with other misstatements, before consideration of any related controls.
Inherent risk is influenced by inherent risk factors. Depending on the degree to which the inherent
risk factors affect the susceptibility to misstatement of an assertion, the level of inherent risk varies
on a scale that is referred to as the 'spectrum of inherent risk'.
Examples of inherent risk are:
a. Some types of inventory (e.g., computers) are easily rendered obsolete because of
technological advancement. This renders the account to be susceptible to overvaluation.
b. Some assets involve higher risks than others. For example, liquid assets (e.g., cash and
trading securities) are more susceptible totheft than fixed assets.
c. Examples of situations that would give rise to the assessment of a higher level of inherent
risk:
 Large amount of cash is kept on hand.
 Inventory of small size and high value (such as precious gems)are being held.
 Large amounts of assets that are readily convertible to cash(trading securities) are
being held.
 Dissatisfied employees.
 A change in the lifestyle of employees.
d. Some balances are significantly based on estimates making them very subjective (e.g., bad
debts percentage).
e. Complex calculations (e.g., employee benefits) are more likely to be misstated than simple
calculations.
f. Some accounts involve relatively larger balances (e.g., cash).
g. Some accounts involve relatively more transactions (e.g. receivables).
h. Other information may also contribute to the assessment of inherent risk (e.g., the fact that
a company has never been audited before of that misstatements were found in the prior
audit).

QUESTION 13
Define control risk.
Control risk refers to the risk that a misstatement that could occur in an assertion about a class of
transaction, account balance or disclosure and that could be material, either individually or when
aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely
basis by the entity's controls.
Control risk is a function of the effectiveness of the design, implementation and maintenance of
controls by management to address identified risks that threaten the achievement of the entity's
objectives relevant to preparation of the entity's financial statements.

QUESTION 14
Define detection risk.
Detection risk is the risk that a material misstatement that has occurred will not be detected by the
auditor. It may also be defined as the risk that an auditor's substantive procedures will not detect a
misstatement that exists in an assertion that could be material, either individually or when
aggregated with other misstatements.
Detection risk relates to the nature, timing, and extent of the auditor’s procedures that are
determined by the auditor to reduce audit risk to an acceptably low level.

QUESTION 15
Explain the audit risk model.
Audit risk can be expressed mathematically using the following formula:
AR=IR x CR x DR
Where: AR=Audit risk for an account IR=Inherent risk CR=Control risk DR=Detection risk
It may also be presented as follows:
AR= RMM X DR
Where: RMM=Risk of Material Misstatement RMM= IRx CR
Audit risk may be assessed quantitatively (e.g., percentages) or qualitatively. For instance, an
auditor may set control risk at 70% α30%, or alternatively, state that control risk is at a high
(maximum) level or at a low (below maximum) level.
To illustrate, if IR is 80%, CR is 50%, and DR is 40%, then audit risk can be calculated by
multiplying the three components:
Audit Risk=.80x.50x.40=80x.50x.40=.1.16 or 16%
Because of the inherent limitations of an audit, the auditor could not reduce audit risk to zero.
There are always some risks that the assertions are susceptible to misstatements, that the client's
internal controls may not be able to prevent misstatements, or that the auditor may fail to detect
material misstatements. Hence, the auditor should plan and perform an audit to reduce audit risk
to an acceptably low level by designing and performing audit procedures to obtain sufficient
appropriate audit evidence to be able to draw reasonable conclusions on which to base an audit
opinion.
Acceptable level of audit risk is the amount of risk that the auditor is willing to accept. In practice,
the auditor usually predetermines an acceptable or desired level of audit risk and ascertains the
acceptable level of detection risk based on the assessed level of RMM (inherent and control risk).
This is embodied in the following equation (as derived from the audit risk model):
AR
DR
=
IRx CR

QUESTION 16
Explain the relationship among audit risk components.
The risks of material misstatement (inherent risk and control risk) are functions of the client and its
environment, and they exist independently of the audit.
Detection risk is a function of the effectiveness of an audit procedure and of its application by the
auditor and therefore can be changed at the auditor’s discretion. Detection risk, however, can only
be reduced but cannot be eliminated, because of the inherent limitations of an audit. Accordingly,
some detection risk will always be present.
During the audit, the auditor plans and performs audit procedures to determine the assessed
levels of inherent and control risks. The PSAs typically refer to 'risk of material misstatement',
rather than to inherent risk and control risk separately. However, PSA 315 (Revised 2019)requires
inherent risk to be assessed separately from control risk to provide a basis for designing and
performing further audit procedures to respond to the assessed risks of material misstatement.
For illustration purposes, there is an inverse relationship between the acceptable level of detection
risk and the risks of material misstatement for an account.
If the RMM are assessed to be high, then the acceptable level of detection risk that the auditor can
accept is low. For instance, if the account under audit is highly susceptible to fraud or errors (e.g.,
cash) and the client's internal control in handling such account is somewhat ineffective, the auditor
should minimize the risk that he will fail to detect material misstatements to be able to maintain the
planned audit risk level. Conversely, if the assessed level of RMM is low, then the auditor can
accept a high level of detection risk.

QUESTION 17
Explain the relationship between the acceptable level of detection risk and substantive
procedures.
Substantive procedures are procedures designed to detect material misstatements in the financial
statements. There is an inverse relationship between the acceptable level of detection risk and the
assurance provided from substantive procedures.
As the acceptable level of detection risk decreases, the assurance provided from substantive
procedures should increase. The auditor may:
a. Change the nature of substantive procedures by using more effective procedures
b. Change the timing of substantive procedures by performing at year-end rather than at an
interim date.
c. Change the extent of substantive procedures by examining a larger sample of items.

In contrast, as the acceptable level of detection risk increases, the assurance from substantive
procedures decreases
Accordingly, the auditor may:
a. Change the nature of substantive procedures by using less effective procedures
b. Change the timing of substantive procedures by performing them at an interim date rather
than at year-end
a. C. Change the extent of substantive procedures by examining a smaller sample of items.