Gies College of Business at Illinois

Department of Accountancy
Lesson Overview

Financial Statement What is a financial statement audit?

Auditing How does the auditor plan the

financial statement audit?
Module 5 Lesson 1
How does the auditor perform a
Module 5 financial statement audit?
The Financial Statement
Mark Peecher Audit
Source: The Center for Audit Quality

What is a Financial What is a Financial What is a Financial

Statement (F/S) Audit? Statement (F/S) Audit? Statement (F/S) Audit?
Assessing the
What? accounting

Examining evidence
principles used and
estimates made by
Why?
?
Who? supporting the management
amounts and To form an opinion on whether the
It is conducted by a registered public disclosures in the
accounting firm company’s F/S Evaluating the F/S are free of material
overall financial misstatement
statement
presentation

Source: The Center for Audit Quality Source: The Center for Audit Quality Source: The Center for Audit Quality

What is a Financial Statement (F/S) How Does the Auditor How Does the Auditor Plan the Financial
Audit? Plan the Financial Statement (F/S) Audit?
Statement (F/S) Audit?
Reasonable assurance:
The auditor’s ultimate goal: Two important factors guide
Not practical to examine every transaction, control and event
the audit:
To provide F/S users with reasonable assurance that the No guarantee the all material misstatements will be detected
F/S prepared by management are fairly presented Reasonable assurance
Provide a reasonable, but not absolute, level of assurance
Internal control over financial reporting (ICFR) is important Materiality
to maintain by company management

Source: The Center for Audit Quality Source: The Center for Audit Quality Source: The Center for Audit Quality
How Does the Auditor Plan the Financial How Does the Auditor How Does the Auditor Plan the Financial
Statement (F/S) Audit? Plan the Financial Statement (F/S) Audit?
Statement (F/S) Audit? Components of audit risk:
Materiality:
Audit risk:
Involves both quantitative and qualitative considerations Inherent risk
The risk that the auditor expresses
Determining materiality is a matter of professional judgement an inappropriate audit opinion Control risk
What would a reasonable investor deem important? when the company’s F/S are Detection risk
materially misstated

Source: The Center for Audit Quality Source: The Center for Audit Quality Source: The Center for Audit Quality

How Does the Auditor Plan the Financial How Does the Auditor Plan the Financial How Does the Auditor Plan the Financial
Statement (F/S) Audit? Statement (F/S) Audit? Statement (F/S) Audit?

Assessing a company’s risks that the F/S The risk assessment process (cont’d):
contains material misstatements: The risk assessment process:
Inquiring about audit risk
An effective audit plan relies on the audit team’s ability to Obtain an understanding of the company and its environment
Obtain an understanding of the company’s internal controls
identify and assess the risk that the F/S do contain a Consider all information gathered (during acceptance and evaluation,
material misstatement, whether caused by error or fraud planning activities, prior audits, other non-audit activities performed) Perform analytic procedures (e.g. compare current F/S to prior year
F/S, compare financial ratios to prior year ratios)

Source: The Center for Audit Quality Source: The Center for Audit Quality Source: The Center for Audit Quality

How Does the Auditor Plan the Financial How Does the Auditor Plan the Financial How Does the Auditor Plan the Financial
Statement (F/S) Audit? Statement (F/S) Audit? Statement (F/S) Audit?
Audit planning is a continuous process
The risk assessment process (cont.’d): The risk assessment process (cont’d):
Conduct a discussion/brainstorming with engagement team members The results of the risk assessment completed during the
Inquire of internal audit personnel regarding fraud risks
planning stage determines the following:
Inquire of management and audit committee about knowledge of fraud
Inquire of other company personnel not directly involved in the financial
(actual, alleged, suspected), process for identifying and responding to fraud Scope of the audit
reporting process
risks
Nature, extent and timing (NET) of the audit tests to be
performed

Source: The Center for Audit Quality

How Does the Auditor Perform a Financial References
Statement (F/S) Audit? In-depth guide to public company auditing: The financial statement audit. (2011, May).
Center for Audit Quality. Retrieved from file:///Users/ywkreher/Downloads/in-
depth_guidetopubliccompanyauditing.pdf
To develop an audit strategy, the independent auditors
should:
Have a professionally skeptical mindset

Gather sufficient, appropriate audit evidence to support opinion about the Module 5 Lesson 2
F/S

Consider and determine whether to rely on internal controls for each of

Materiality Guidance of
the various components of the audit Major Public Accounting
Source: The Center for Audit Quality
Firms

The Auditor’s Ultimate Objective Summary of the Paper: Materiality Guidance

“Our results show a high level of consistency across the firms in

“The auditor’s ultimate objective is to obtain reasonable terms of the quantitative benchmarks (e.g., income before taxes, The paper presents the proprietary
assurance about whether the financial statements are free total assets or revenues, and total equity) used to determine overall materiality guidance of eight of the
of material misstatement” materiality, the related percentages applied to those benchmarks, largest U.S. public accounting firms
the percentages applied to overall materiality for determining
tolerable misstatement, and what constitutes a clearly trivial
misstatement.” – Eilifsen & Messier

Eilifsen, A. & Messier, Jr., W. F. (May 2015). Eilifsen, A. & Messier, Jr., W. F. (May 2015). Eilifsen, A. & Messier, Jr., W. F. (May 2015).

Materiality Guidance Results Results

The paper also shows: The quantitative benchmarks (e.g., Seven firms use a percentage of
income before taxes, total assets or overall materiality for determining
How firms’ determine multiple levels of quantitative materiality
revenues, and total equity) used to tolerable misstatement that fits in a
The firms’ guidance on the incorporation of qualitative factors in
determine overall materiality and 50-75% range, and one firm uses a
determining and evaluating materiality range of 70-90% percent
the related percentages applied to
Their guidance on handling detected and undetected misstatements those benchmarks are reasonably
How the firms’ guidance determines materiality levels in group audits
consistent across the eight firms

Eilifsen, A. & Messier, Jr., W. F. (May 2015). Eilifsen, A. & Messier, Jr., W. F. (May 2015). Eilifsen, A. & Messier, Jr., W. F. (May 2015).
Results Results Results
Seven of the firms establish a
clearly trivial misstatement to be
3-5% percent of overall materiality All of the firms provide detailed
and one firm uses a range of 5-8% Applying materiality on group audits
guidance on the evaluation of
percent closely parallels the guidance
detected misstatements including
provided in the standards
consideration of qualitative factors

Eilifsen, A. & Messier, Jr., W. F. (May 2015). Eilifsen, A. & Messier, Jr., W. F. (May 2015). Eilifsen, A. & Messier, Jr., W. F. (May 2015).

Results Three Phases of the Three Phases of the

Materiality Process Materiality Process
There are differences in how the
firms consider the possibility of Establish a materiality level for the
Establish
undetected misstatements when financial statements as a whole
evaluating uncorrected detected Determine (referred to as overall or planning
misstatements materiality)
Evaluate

Eilifsen, A. & Messier, Jr., W. F. (May 2015). Eilifsen, A. & Messier, Jr., W. F. (May 2015). Eilifsen, A. & Messier, Jr., W. F. (May 2015).

Three Phases of the Materiality Three Phases of the Tolerable Misstatement

Process Materiality Process Establish materiality levels for
Determine an amount less than particular accounts or
overall materiality that should be disclosures
used as a basis for designing audit
Evaluate audit results Evaluate whether or not
tests for accounts and disclosures
misstatements of lesser amounts
for the purpose of appropriately
than the established materiality
limiting the sum of the undetected
level would influence the judgement
misstatements (referred to as
of a reasonable investor
tolerable misstatement or
performance materiality)
Eilifsen, A. & Messier, Jr., W. F. (May 2015). Eilifsen, A. & Messier, Jr., W. F. (May 2015). Eilifsen, A. & Messier, Jr., W. F. (May 2015).
Tolerable Misstatement How Do Firms Determine How Do Firms Determine
Determine tolerable Tolerable Misstatement? Tolerable Misstatement?
misstatement Some of the factors included in the firms’
Fraud
guidance that would cause the auditor to
Determine tolerable misstatement To reiterate: risks
use a lower percentage for tolerable
at an amount or amounts that Seven firms in the study use a misstatement are:
reduce to an appropriately low level percentage of overall materiality that fits Overall
Overall engagement risk is considered high engage-
the probability that the total of in a 50 to 75 percent range, and one firm ment risk

uncorrected and undetected allows a range up to 90 percent (see Fraud risks

misstatements would result in table 4) A history
A history of identified misstatements in prior of
identified
material misstatement of the periods audits misstate-
ments
financial statements
Eilifsen, A. & Messier, Jr., W. F. (May 2015). Eilifsen, A. & Messier, Jr., W. F. (May 2015). Eilifsen, A. & Messier, Jr., W. F. (May 2015).

References
Eilifsen, A. & Messier, Jr., W. F. (May 2015). Materiality guidance of the major public
accounting firms. Auditing: A Journal of Practice & Theory (American Accounting
Association), 34(2), pp. 3-26. DOI: 10.2308/ajpt-50882.