When performing an audit, auditors are required to determine the client’s significant classes of transactions, account balances, and disclosures. Using the PPC approach, as outlined in our various audit guides, such as PPC’s Guide to Nonpublic Companies, we use the term significant audit area interchangeably with significant class of transactions, account balance, or disclosure.
What Makes an Audit Area Significant?
AU-C 315.12 indicates that a class of transactions, account balance, or disclosure is significant if there are one or more relevant assertions. Typically, the determination of significant audit areas is made concurrently with identifying relevant assertions.
Relevant assertions are those assertions about a class of transactions, account balance, or disclosure where there is an identified Risk of Material Misstatement (RMM). Risks of material misstatement occur when the following two conditions exist:
- Likelihood —There is a reasonable possibility a misstatement occurs.
- Magnitude —If the misstatement occurred, there is a reasonable possibility of that misstatement being material.
When determining whether an assertion is relevant, auditors shouldn’t consider related controls. In other words, make the determination based on the identification of inherent risk factors and the assessment of inherent risk before the assessment of control risk.
As you can see, when determining whether there is a risk of material misstatement, the concept of reasonable possibility is important. AU-C 315.A12 indicates that there is a reasonable possibility when the likelihood of material misstatement is more than remote. Sometimes, the level of likelihood is referred to as more than a slight chance. Auditors often develop an expectation of relevant assertions considering the likelihood and magnitude of potential misstatement through previous experience with the entity, results of prior-year audit procedures, and initial results of risk assessment procedures.
If you determine, based on the assessment of inherent risk alone, that a material class of transactions, account balance, or disclosure, isn’t significant, it means that you’ve determined that there are no relevant assertions. In such cases, under the auditing standards, you’re required to stand back and evaluate whether your determination remains appropriate before designing further procedures.
Why Is It Important to Identify Significant Audit Areas?
The determination of whether an audit area is a significant affects the selection of an appropriate audit approach. Using the PPC approach, for each significant audit area (i.e. those with relevant assertions), the auditor will:
- Assess whether an identified risk is a significant risk (including fraud risk) based on the inherent risk assessment for each relevant assertion.
- Document the assessment of inherent and control risk for each relevant assertion as high, moderate, or low.
- Determine the assessment of the risk or material misstatement based on the assessed combined effect of inherent and control risk.
- Select the audit approach and develop the audit plan taking into account the assessed RMM and determinations of significant or fraud risks by relevant assertion.
| Practical Consideration: Determining whether classes of transactions, account balances, and disclosures are significant is also important because it provides the basis for the scope of the auditor’s understanding of the information system component of the entity’s system of internal control. |
Is It Appropriate to Use a Limited Procedures Approach for a Significant Audit Area?
Under SAS No. 145, a significant class of transactions, account balance, or disclosure exists if there is one or more relevant assertions (AU-C 315.12). An assertion is relevant if it has an identified risk of material misstatement, even if that risk is “Low”. For an audit area to be not significant (and use limited procedures under the PPC methodology) there may not be any relevant assertions.
| Practical Consideration: Under the PPC methodology, limited procedures consist of two things: (1) risk assessment procedures done during initial planning and (2) final analytical procedures performed in the overall review stage of the audit. If the auditor performs other substantive procedures, this would be classified as “Basic”. |
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