Materiality and Risk

Chapter 9

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Learning Objective 1
Apply the concept of materiality to the audit.

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Materiality
It is a major consideration in determining the appropriate audit report to issue.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Materiality
The auditors responsibility is to determine whether financial statements are materially misstated. If there is a material misstatement, the auditor will bring it to the clients attention so that a correction can be made.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Steps in Applying Materiality

Step Set preliminary judgment 1 about materiality Planning extent of tests

Allocate preliminary Step judgment about 2 materiality to segments

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Steps in Applying Materiality

Step Estimate total 3 misstatement in segment Step Estimate the 4 combined misstatement Compare combined Step estimate with judgment 5 about materiality
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Evaluating results

Learning Objective 2
Make a preliminary judgment about what amounts to consider material.

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Set Preliminary Judgment About Materiality

Auditors decide early in the audit the combined amount of misstatements of the financial statements that would be considered material. This preliminary judgment is the maximum amount by which the auditor believes the statements could be misstated and still not affect the decisions of reasonable users.
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Factors Affecting Judgment

Materiality is a relative rather than an absolute concept. Bases are needed for evaluating materiality. Qualitative factors also affect materiality.

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Guidelines
Accounting and auditing standards do not provide specific materiality guidelines to practitioners. Professional judgment is to be used at all times in setting and applying materiality guidelines.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Learning Objective 3
Allocate preliminary materiality to segments of the audit during planning.

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Allocate Preliminary Judgment About Materiality to Segments

This is necessary because evidence is accumulated by segments rather than for the financial statements as a whole. Most practitioners allocate materiality to balance sheet accounts. SAS 107 (AU 312)

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Learning Objective 4
Use materiality to evaluate audit findings.

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Estimated Total Misstatement and Preliminary Judgment

Estimated Misstatement Amount
Known Misstatement Tolerable and Direct Misstatement Projection Sampling Error

Account

Total

Cash Accounts receivable Inventory Total estimated misstatement amount Preliminary judgment about materiality N/A = Not applicable Cash audited 100 percent

$ 4,000 20,000 36,000

$ 2,000 12,000 31,500

N/A 6,000 15,750

$ 2,000 18,000 47,250

$45,500
$50,000

$16,800

$62,300

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Estimated Total Misstatement and Preliminary Judgment

Net misstatements in the sample ($3,500) Total sampled ($50,000) Total recorded population value ($450,000) = Direct projection estimate of misstatement ($31,500)

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Learning Objective 5
Define risk in auditing.

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Risk
Auditors accept some level of risk in performing the audit.

An effective auditor recognizes that risks exist, are difficult to measure, and require careful thought to respond.
Responding to risks properly is critical to achieving a high-quality audit.
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Risk and Evidence

Auditors gain an understanding of the clients business and industry and assess client business risk. Auditors use the audit risk model to further identify the potential for misstatements and where they are most likely to occur.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Illustration of Differing Evidence Among Cycles

Sales and collection cycle A B C D Inherent risk Control risk Acceptable audit risk Medium Medium Low Acquisition Payroll and and payment personnel cycle cycle High Low Low Medium Low Low Low High
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Planned Medium detection risk

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

Illustration of Differing Evidence Among Cycles

Inventory and warehousing cycle A B C D Inherent risk Control risk Acceptable audit risk High High Low Low Capital acquisition and repayment cycle Low Medium Low Medium
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Planned detection risk

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

Learning Objective 6
Describe the audit risk model and its components.

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Audit Risk Model for Planning

PDR = AAR (IR CR) where: PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Learning Objective 7
Consider the impact of engagement risk on acceptable audit risk.

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Impact of Engagement Risk on Acceptable Audit Risk

Auditors decide engagement risk and use that risk to modify acceptable audit risk. Engagement risk closely relates to client business risk.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Factors Affecting Acceptable Audit Risk

The degree to which external users rely on the statements The likelihood that a client will have financial difficulties after the audit report is issued The auditors evaluation of managements integrity
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Methods Practitioners Use to Assess Acceptable Audit Risk

Factors External users reliance on financial statements Methods Used to Assess Acceptable Audit Risk

Examine financial statements Read minutes of the board Examine form 10K Discuss financing plans with management

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Methods Practitioners Use to Assess Acceptable Audit Risk

Factors Likelihood of financial difficulties Management integrity Methods Used to Assess Acceptable Audit Risk
Analyze

financial statements for difficulties using ratios Examine inflows and outflows of cash flow statements

See Chapter 8 for client acceptance and continuance

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2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

Learning Objective 8
Consider the impact of several factors on the assessment of inherent risk.

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Factors Affecting Inherent Risk

Nature of the clients business Results of previous audits Initial versus repeat engagement Related parties Nonroutine transactions Judgment required to correctly record account balances and transactions Makeup of the population Factors related to fraudulent financial reporting Factors related to misappropriation of assets
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2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

Learning Objective 9
Discuss the relationship of risks to audit evidence.

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Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence

Acceptable audit risk
D D I I

Factors influencing risks

Inherent risk

Planned detection risk

I

Planned audit evidence

D

Control risk
D = Direct relationship; I = Inverse relationship
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Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence

Auditors can change the audit to respond to risks

The engagement may require more experienced staff

The engagement will be reviewed more carefully than usual

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Audit Risk for Segments

Both control risk and inherent risk are typically set for each cycle, each account, and often even each audit objective, not for the overall audit.

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Tolerable Misstatement, Risks, and Balance-related Audit Objectives

It is common to assess inherent and control risk for each balance-related audit objective It is not common to allocate materiality to objectives

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Measurement Limitations
One major limitation in the application of the audit risk model is the difficulty of measuring the components of the model.

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Relationships of Risk to Evidence

Situation
Acceptable Inherent audit risk risk Control risk Planned detection risk Amount of evidence required

1 2

High Low

Low Low

Low Low

High Medium

Low Medium

3
4 5

Low
Medium High

High
Medium Low

High
Medium Medium

Low
Medium Medium

High
Medium Medium

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Tests of Details of Balances Evidence Planning Worksheet

Auditors develop various types of worksheets to aid in relating the considerations affecting audit evidence to the appropriate evidence to accumulate.

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Learning Objective 10
Discuss how materiality and risk are related and integrated into the audit process.

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Relationship of Tolerable Misstatement and Risks to Planned Evidence

Acceptable audit risk Inherent risk Control risk Tolerable misstatement
D = Direct relationship; I = Inverse relationship
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D Planned detection risk

D I

Planned audit evidence

Audit Risk Model for Planning

AcAR = IR CR AcDR where: AcAR = Achieved audit risk IR = Inherent risk CR = Control risk AcDR = Achieved detection risk

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Audit Risk Models for Planning Evidence and Evaluating Results

D Acceptable audit risk Compare Achieved audit risk Inherent risk Control risk Achieved detection risk

Substantive audit evidence

D = Direct relationship I = Inverse relationship
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I
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Revising Risks and Evidence

The auditor must revise the original assessment of the appropriate risk. The auditor should consider the effect of the revision on evidence requirements, without the use of the audit risk model.

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End of Chapter 9

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