Planning, Risk Assessment and Materiality
The planning process
Planning is not a single event; it is continuous and iterative. It begins with client acceptance and continuance procedures (independence, competence, integrity, resources), continues through engagement letter agreement, and then to understanding the entity and its environment. Candidates must know the components of the business risk approach: industry, regulatory and other external factors; the nature of the entity; accounting policies; objectives, strategies and related business risks; and the measurement and review of financial performance.
Risk assessment
Understand the audit risk model: Audit risk = Inherent risk × Control risk × Detection risk. Identify significant risks (e.g. complex transactions, related parties, estimates, fraud), and link risks to assertions (occurrence, completeness, accuracy, cut-off, classification, existence, rights and obligations, valuation). The risk of material misstatement splits into inherent and control risk; the auditor manages detection risk through the nature, timing and extent of procedures. Know how analytical procedures are used at the planning stage (to identify unusual relationships) and later as substantive tests.
Materiality
Set overall materiality, performance materiality (usually a fraction, commonly 50–75%, of overall materiality) and triviality threshold. Common benchmarks: profit before tax (5%), total revenue (0.5–1%), total assets (1–2%), gross profit, or net assets. Qualitative factors (covenants, related-party transactions, sensitive remuneration) can make small amounts material.
Traps
- Treating planning as a one-off stage and ignoring the need to revise the plan.
- Confusing inherent risk (susceptibility before controls) with control risk (risk controls fail).
- Setting performance materiality above overall materiality - a classic error.
- Assuming a high risk means more testing of controls; sometimes a substantive approach is more efficient.
Worked example
Profit before tax is £2,000,000; benchmark 5% gives overall materiality of £100,000. Performance materiality at 75% is £75,000, and the triviality threshold at 5% of overall materiality is £5,000. Misstatements below £5,000 need not be accumulated individually, but all misstatements must be evaluated in aggregate at completion.