Accounting and Financial Control Department Auditing W 2017

Tutorial (10): Materiality and Risk

1. Audit Risk Model:

By applying the audit risk model, the auditor is able to identify the different kind
of risk that he could face during the audit process. Also, by applying that model he is able
to decide the amount of evidence that he should accumulate for each cycle.

Planning Detection
Risk (PDR) = Acceptable Audit Risk (AAR)
Inherent Risk (IR) X Control Risk (CR)

AAR = PDR X IR X CR

2. Components of the Audit Risk Model:

A. Planning (Acceptable) Detection Risk (PDR):
- Is a measure of how willing the auditor is to accept that undiscovered material
misstatements in a given segment.

B. Inherent Risk (IR):

- Is a measure of the auditor expectation of the likelihood (possibility) of the existence of
material misstatements (error or fraud) in a segment before considering the effectiveness
of the company internal control (how strong or weak the internal control is).

C. Control Risk (CR):

- Is a measure of the auditor expectation of the likelihood (possibility) of the existence of
material misstatements (error or fraud) in a segment after considering the effectiveness
of the company internal control (how strong or weak the internal control is).

D. Acceptable Audit Risk:

- Is a measure of how willing the auditor is to accept that the financial statements may be
materially misstated after an audit is completed and unqualified opinion is issued.

3. Relationship between evidence and each kind of risk

Kind Of Risk Evidence

Inherent Risk Direct
Control Risk Direct
Planned detection Risk Inverse
Acceptable Audit Risk Inverse

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 Accounting and Financial Control Department Auditing W 2017

4. Relationship between each kind of risk and PDR

Kind Of Risk PDR

Inherent Risk Inverse
Control Risk Inverse
Acceptable Audit Risk Direct

5. Factors that affect Acceptable Audit Risk

1. The degree of which external users rely on the financial statements:

a. Client size.

b. Distribution of ownership.

c. Nature and amounts of liabilities.

2. The possibility that the client will have financial difficulties after the audit report
is issued:

a. Liquidity position.

b. Profits (losses) in previous years.

c. Methods of Financing.

d. Nature of client’s operations.

e. Management Competence.

3. Auditor’s evaluation of Management integrity:

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Exercise Sheet
Question 1:

Following are six situations that involve the audit risk model as it is used for
planning audit evidence requirements. Numbers are used only to help you
understand the relationships among factors in the risk model

Risk 1 2 3 4 5
Acceptable Audit Risk 5% 5% 5% 5% 1%
Inherent Risk 100% 40% 60% 20% 100%
Control Risk 100% 60% 40% 30% 100%
Planned Detection Risk ------ ---- ---- ---- -----

Required:
A- Explain what each of the four risk means?

B- Calculate planned detection risk for each situation.

C- Which situation requires the greatest amount of evidence and which requires
the least?

D- Using your knowledge of the relationships among the foregoing factors, state
the effect on planned detection risk (increase or decrease) of changing each of the
following factors while the other two remain constant:
1- A decrease in acceptable audit risk.
2- A decrease in control risk.

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 Accounting and Financial Control Department Auditing W 2017

3- A decrease in inherent risk

4- An increase in control risk and a decrease in inherent risk of the same amount.
Question 2:
Below are eight independent risk factors:
1. The client lacks sufficient working capital to continue operations.
2. The company is publicly traded.
3. The auditor has identified numerous material misstatements during prior year
audit engagements.
4. The client is one of the industry’s largest based on its size and market share.
5. The client engages in several material transactions with entities owned by family
members of several of the client’s senior executives.
6. The allowance for doubtful accounts is based on significant assumptions made by
management.
7. There has been a dispute between the client and the previous auditor.
8. Most of the client’s inventory items represent computers and hardware which are
found to be obsolete due to rapid technological changes in the industry.

Required: Identify which of the following audit risk model components relates most
directly to each of the above eight risk factors along with stating the effect on such risk
(increase or decrease):
 Acceptable Audit Risk.
 Inherent Risk.

Answer:

Risk Factor Related Audit Risk Model Component Effect on the risk
1.

2.

3.

4.

5.

6.

7.

8.