LECTURE

07
AUDIT & ASSURANCE
Risk And Materiality
 AUDITOR’S RISK
ASSESSMENT PROCESS
 Auditor’s Risk Assessment Process
 The auditor performs risk assessment procedures to provide
a basis for the identification and assessment of risks of
material misstatement.
 Inquiries (i.e. asking questions and getting answers) of:

 management;

 appropriate individuals within the internal audit function

 others who may have information (Ex-employees or

suppliers)
 Analytical procedures,: may help identify the existence of
unusual transactions or events, and amounts, ratios, and
trends that might indicate matters that have audit
implications. Unusual or unexpected relationships that are
identified may assist the auditor in identifying risks of
material misstatement, especially risks of material
misstatement due to fraud
 Observation and inspection
 RISK ASSESSMENT
Understanding the entity and its environment
The auditor is required to identify and assess the risks of
misstatement, whether due to fraud or error, through understanding
the entity and its environment, including its internal controls.
 Relevant industry, regulatory and other external factors, including the
applicable financial reporting framework.
 The nature of the entity, including its operations, ownership, and types of
current and planned investments.
 The entity’s selection and application of accounting policies, including
whether they are appropriate for its business and consistent with the
industry
 The measurement and review of the entity’s financial performance.
 RISK ASSESSMENT
Understanding the accounting and internal control systems
ISA 315 requires the auditor to obtain an understanding of internal
controls relevant to the audit. Although most of the entity’s internal
controls will relate to financial reporting, not all will be relevant to the
audit.
 THE FINANCIAL STATEMENT
ASSERTIONS
Financial statement assertions are statements or claims that
companies make about the fundamental accuracy of the
information in their financial statements.
These assertions are set out in ISA 315 and fall into the following
categories:
I. Assertions about classes of transactions and events and related
disclosures for the period under audit (i.e. income statement
assertions)
II. Assertions about account balances and related disclosures at the
period end (i.e. statement of financial position assertions)

Muhammad Sadam
 THE FINANCIAL STATEMENT ASSERTIONS
CLASSES OF TRANSACTIONS AND EVENTS
• Occurrence: Transactions and events that have been recorded or disclosed have
occurred and relate to the entity.
• Completeness: There are no unrecorded transactions, events and disclosures.
• Accuracy: Amounts and other data relating to recorded transactions and events
have been recorded appropriately and related disclosures have been
appropriately measured and described.
• Cut-off: Transactions and events have been recorded in the correct accounting
period.
• Classification: Transactions and events have been recorded in the proper
accounts.
• Presentation:Transactions and events are appropriately aggregated or
disaggregated and clearly described and related disclosures are relevant and
understandable
Muhammad Sadam
 THE FINANCIAL STATEMENT ASSERTIONS
ACCOUNT BALANCES
• Existence: Assets, liabilities and equity interests exist.
• Rights and obligations: The entity holds or controls the rights to assets,
and liabilities are those of the entity.
• Completeness: There are no unrecorded assets, liabilities or equity
interests and all related disclosures have been included.
• Accuracy, valuation and allocation: Assets, liabilities and equity interests
are included in the financial statements at appropriate amounts and any
resulting valuation or allocation adjustments are appropriately recorded
and related disclosures have been appropriately measured and described.
• Classification: Assets, liabilities and equity interests are appropriately
aggregated or disaggregated and clearly described, and related
disclosures are relevant and understandable.
Muhammad Sadam
 EXAMPLE: TRANSACTION& EVENTS AND
DISCLOSURE ASSERTIONS:
I. Occurrence: All sales invoices reflected in the accounting records
relate to goods dispatched by the entity during the current year.
The figure for “Revenue” in the financial statements agrees to the
sales account in the nominal ledger.
II. Completeness: All goods dispatched have been invoiced and all
such sales invoices have been entered into the accounting records.
All entries in the sales account in the nominal ledger have been
included within “Revenue”.
III. Accuracy: All invoices have been correctly priced and discounts
properly applied, and they have been accurately entered in the
accounting records. The sales account in the nominal ledger has
been properly added to arrive at the “Revenue” figure in the
financial statements.
When auditor is determining materiality, the auditor should consider
what could be material for user not management
Muhammad Sadam
 MATERIALITY
 Definition Of Materiality
 “Misstatement, including omissions, are considered to be
material if they, individually or in aggregate, could
reasonably be expected to influence the economic decision
of the users taken on the basis of the Financial statement.”

 Exam Tip: Never use the word like we “calculate” the materiality. It’s
not the clerical exercise. We always “determine” materiality because
it is a matter of professional judgement.
 MATERIALITY
 It is reasonable for the auditor to assume that users:
 Have a reasonable knowledge of business and economic activities
and accounting and a willingness to study the information in the
financial statements with reasonable diligence;
 Understand that financial statements are prepared, presented and
audited to levels of materiality;
 Recognize the uncertainties inherent in the measurement of amounts
based on the use of estimates, judgment and the consideration of
future events; and
 Make reasonable economic decisions on the basis of the information
in the financial statements
 MATERIALITY
Determining Materiality: If the determination of materiality
is not the mechanical exercise, then how should we determine
materiality?
Steps For Determining Materiality
STEP 01: Understand the ownership structure and users of the financial
statements.
STEP 02: Determine the elements of the financial statements.
STEP 03: Identify the benchmark of most importance to users
STEP 04: Determine the appropriate percentage to apply to the selected
benchmark
STEP 05: Determine performance materiality and clearly trivial threshold
 STEPS FOR DETERMING
MATERIALITY
STEP 01: Understand the ownership structure and users of
the financial statements.
 Materiality is initially determined at planning stage so during that

phase had we ever consider who the user of the FS is?

 Auditor is required to obtain an understanding of the entity and its

economic environment, the industry in which it operates, its

ownership structure including the means by which the entity is
financed to determine the users of the financial statements
 STEPS FOR DETERMING
MATERIALITY - EXAMPLE
 As an audit partner you are planning the audit of A
Company. While obtaining the understanding of the
entity and its environment you came across with the
following facts.
 Company is a listed entity
 Company does not have any external borrowing

 Based on the above facts Engagement Partner has

concluded that User of the financial statements are
shareholders
 STEPS FOR DETERMING
MATERIALITY - EXAMPLE
 As an audit partner you are planning the audit of
Company B. While obtaining the understanding of the
entity and its environment you came across with the
following facts.
 Company is a listed entity
 Company had obtained heavy financing from Banks
 Debt equity ratio is 80: 20
 STEPS FOR DETERMING
MATERIALITY - EXAMPLE
 As an audit partner you are planning the audit of
Company B. While obtaining the understanding of the
entity and its environment you came across with the
following facts.
 Company is a listed entity
 Company had obtained heavy financing from Banks
 Debt equity ratio is 80: 20

 Based on the above facts Engagement Partner has

concluded that User of the financial statements are
Banks / Lenders
 STEPS FOR DETERMING
MATERIALITY - EXAMPLE
 As an audit Partner you are planning the audit of Company
C. While obtaining the understanding of the entity and its
environment you came across with the following facts.
 Company is the non-for-profit organization
 Company’s business is to provide the education service to the
Pakistan
 Company is not listed neither obtained loans from banks
 Company is a listed entity
 STEPS FOR DETERMING
MATERIALITY
STEP 02: Determine the elements of the financial
statements.
 Next step is to determine the elements of financial statements
such as PPE, Inventory, Borrowings, Intangible, Net asset, Total
Asset, Revenue, Gross Profit, Expenses and etc.

 Example:
 If we are doing the audit of Bank, PPE and Inventory may not be the
elements of the financial statements therefore we could not determine
materiality based on the PPE and Inventory.
 If we are doing the audit of Manufacturing Company, PPE and Inventory
might be the elements of the financial statements therefore we may
determine materiality based on the PPE and Inventory.
 STEPS FOR DETERMING
MATERIALITY
STEP 03: Identify the benchmark of most important to users
 To determine the benchmark requires careful consideration of
available information on the focus of the users of the financial
statements.

 Example:
 The engagement team of Company A is in the planning phase. While obtaining
the understanding of the entity and its environment you came across with the
following facts.
 The entity is a listed entity in the textile business.
 The Company does not have any significant borrowing from lenders / banks
 As per the draft financial statement, Company has reported the profit
 The Company has history to pay dividend
 STEPS FOR DETERMING
MATERIALITY
STEP 03: Solution
 The engagement partner has determined that due to the
fact that the entity is listed and does not have any
extensive borrowing therefore user of the financial
statements are shareholder and shareholder focus more on
Profit before tax. It is the most appropriate benchmark for
the user because economic decision of the user such as
sale and purchase of shares and dividend income are based
on profit before tax.
 STEPS FOR DETERMING
MATERIALITY
STEP 03: Example
 The engagement team of Company B is a listed entity that
engaged in the business of power generation. While obtaining the
understanding of the entity and its environment you came across
with the following facts.
 It has been investing heavily in plant and machinery over the past years
 The investment has been financed ongoing through borrowings from
banks.
Solution
 The engagement partner using the professional judgement has determined
that user of the financial statements are lenders / banks. The main focus of
the readers of the entity’s financial statements is net assets because if the
company fails to repay the loan the bank may recover the amount by selling
the assets of the Company.
 STEPS
FOR
DETERMI
NG
MATERIAL
ITY
 STEPS FOR DETERMING
MATERIALITY
STEP 04: Determine the appropriate percentage to
apply to the selected benchmarks
 Once the appropriate benchmark is identified, a percentage is applied
to assist in determination of materiality. There is a relationship and
involves the exercise of professional judgement to determine a
percentage to be applied to a chosen benchmark.
 STEPS FOR DETERMING
MATERIALITY
STEP 04: STEP 05: Determine Performance Materiality
What is Performance Materiality?
 The amount 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.
 Planning the audit solely to detect individually material
misstatements overlooks the fact that the aggregate of individually
immaterial misstatements may cause the financial statements to be
materially misstated.
 STEPS FOR DETERMING
MATERIALITY
STEP 04: STEP 05: Determine Performance Materiality
How to determine performance materiality?
 The determination of Performance Materiality involves the exercise of
professional judgement and is not a simple mechanical calculation. It
is affected by the:
 Auditor’s understanding of the entity and its environment
 Nature and extent of misstatements identified in previous audits and thereby
auditor’s expectation in relation to misstatements in the current period
 The reliability of Entity’s internal control over financial reporting
 Increased engagement risk
 Any changes in the business
 PERFORMANCE MATERIALITY
Example:
 The Engagement Partner has determined Materiality for Company A
amounting to Rs. 5,000,000 for the current period audit and the
engagement team is about to determine performance materiality
next. Company is engaged in the trading of high brand clothes and
there have been no significant changes in the entity’s business,
internal control, risks of material misstatement or management. The
entity has been our client for the last five years and the uncorrected
misstatements is approximately Rs. 1,500,000 in the prior years.

 The engagement team determines performance materiality to be Rs.

3,500,000 (Rs. 5,000,000- 1,500,000).
 PERFORMANCE MATERIALITY
Materiality level for particular class of transaction, account balance
and disclosure:
 Misstatements of lesser amounts than materiality for the financial
statements as a whole could reasonably be expected to influence the
economic decisions of users taken on the basis of the financial statements
 Whether law, regulation or the applicable financial reporting framework
affect users’ expectations regarding the measurement or disclosure of
certain items (for example, related party transactions, and the
remuneration of management and those charged with governance).
 The key disclosures in relation to the industry in which the entity operates
(for example, research and development costs for a pharmaceutical
company).
 Whether attention is focused on a particular aspect of the entity’s business
that is separately disclosed in the financial statements (for example, a
newly acquired business).
Muhammad Sadam