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Lecture 3
Materiality and Audit Risk
2
Learning Outcomes
Explain the concept of materiality and audit risk
Describe various factors that influence the
determination of materiality level
Describe ,identify and apply the components of
audit risk
Describe the limitation of audit risk model
Explain the relationship between materiality and
audit risk
3 Audit Risk -ISA
ISA 200- Overall Objectives of the Independent Auditor and
the Conduct of an Audit in Accordance with International
Standards on Auditing
ISA 315- (Revised), Identifying and Assessing the Risks of
Material Misstatement through Understanding the Entity and
Its Environment
ISA 330- The Auditor’s Responses to Assessed Risks
Audit risk
4
4
5 Audit Risk
Risk is a fundamental concept that underlies the
audit process
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Audit Risk Model
Dependent on the
Also referred to as
company & its
the risk of material
industry
misstatement
Inherent risk
Is the possibility that a material misstatement could occur in an assertion, either
individually or when aggregated with other misstatements, assuming there are no
related controls
Inherent risk exists independently of the audit of financial statements and thus auditors
cannot change the actual level of inherent risk
As defined by auditing standards, inherent risk is confined to the risk of material misstatement
Inherent risk
17
Control risk is a function of the effectiveness of the internal control structure as good
controls reduce risk
24
Detection Risk
Detection risk
This is the risk that the auditor will not detect a misstatement that exists in an assertion
that could be material, either individually or when aggregated with other
misstatements.
Detection risk
Is the risk that an auditor’s substantive procedures will not detect any
material misstatements that exist in an assertion, either individually or
when aggregated with other misstatements
Detection risk is a function of the effectiveness of substantive
procedures and their application by an auditor and thus is fundamental
to the amount of audit work undertaken
Unlike inherent and control risk, the actual level of detection risk is
controllable by the auditor through:
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29
Having Determined
Audit Risk
Inherent Risk
Control Risk
Client No. AR IR CR DR
1 5% 40% 50% 25%
2 5% 60% 80% 10%
3 10% 50% 25% 80%
4 10% 80% 50% 25%
31 Assessment of DR-Qualitative
method
Client No. Audit Risk Inherent Risk Control Risk Detection Risk
36
37 Limitations of the AR model.
The actual level of audit risk may be greater than the
audit risk indicated by the formula.
The assessment of IR and CR may be higher or lower
than the actual IR and CR that exist for the client.
The audit risk model also does not specifically
consider the possibility of auditor error
38 Fraud RISK
Fraud from the auditor’s perspective , involves
intentional misstatements that can be classified into 2
types
(i)Misstatements arising from fraudulent financial
reporting
(ii)Misstatements arising from misappropriation of
assets
Fraudulent financial reporting
39
ISA 260
Fraud identified should be brought to the attention
of appropriate level of management
Fraud involving senior management and fraud that
causes material misstatement of FS should be
reported directly to those charged with governance
of the entity such as BOD.
Identifying Client Business Risk
50
Business
Businessrisksrisks
'result
'resultfrom
fromsignificant
significantconditions,
conditions,events,
events,circumstances
circumstances
ororactions
actionsthat
thatcould
couldadversely
adverselyaffect
affectthe
theentity's
entity'sability
ability
totoachieve
achieveitsitsobjectives
objectivesand
andexecute
executeitsitsstrategies,
strategies,oror
from the setting of inappropriate objectives
from the setting of inappropriate objectives and and
strategies.'
strategies.'
The entity’s strategies and related business
52 risks
52
Business Risk
Business risk (continued)
Business risks can be split into three categories to enable better identification:
•Financial risk
•Operational risk
•Compliance risk
Risk 14
Financial risks
These are the risks arising from the company's financial activities or the financial
consequences of operations. Examples include the following.
•Business continuity problems (ie going concern)
•Overtrading
•Credit risk
•Interest risk
•High cost of capital
•Unrecorded liabilities
Change in interest rate
Fluctuation of foreign exchange rates
Business Risk
Operational risk
These are the risks arising from the operations of the business such as stockouts, physical
disasters, loss of key staff, poor brand management and loss of orders.
• Developments in the industry
• New products and services
• Expansion of the business
• e.g. a potential business risk might be that the estimated demand associated with an expansion
has not been accurately estimated
• Current and prospective financing requirements
• e.g. a business risk is loss of financing due to inability to meet debt covenant requirements
Business Risk
Compliance risk
These are the risks arising from non compliance with laws, regulations, policies,
procedures and contracts. Examples include the following.
•Breach of listing rules
•Breach of national legislation
•Litigation risk
•Sales tax problems
•Tax penalties
•Health and Safety risks
Change in Government policies and rules and regulations
sanctions imposed by public or regulatory bodies (eg Bursa Malaysia and the
professional accounting bodies)
Risk consideration in Evaluating Audit
Results
An assessment of audit risk, that recognises the components of
audit risks, should be undertaken at the audit planning stage and
later integrated into the audit of individual account balances or
transaction classes.
It is an important aspect of the analytical procedures, which
underpin all cost-effective audits, and should also occur at the final
audit of the financial report, and in the assessment of the firm as a
going concern.
Thus, risk analysis techniques should be applied at the micro level
in the audit of account balances and at the macro level in an overall
appraisal of the firm and its financial report.
Business risk vs Audit Risk
Business risk vs Audit Risk
Business risk vs Audit Risk
Audit strategies
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Audit strategies (cont.)
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Audit strategies (cont.)
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The auditor’s response to the results of
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the risk assessment-ISA 330
Particular classes of
transactions, account
balances or disclosures,
if any
69
Materiality for Financial Statements as a Whole
71
72
Materiality
Materiality underlies the application of
auditing standards and thus has a pervasive
effect in a financial statement audit
Auditors must consider materiality in
planning the audit and evaluating the fair
presentation (Review stage) of the
financial statements
72
73
The concept of materiality
The concept of materiality links ISAs 320, 450
and 700.
It is applied in both planning and performing the
audit & review; in evaluating the effect of
identified misstatements on the audit and of
uncorrected misstatements,
if any, on the financial statements; and in
forming the opinion on the financial statements.
ISA 450
ISA 450 Evaluation of misstatements identified during the audit
•The auditor has a requirement to communicate in a timely fashion all misstatements
identified during the audit to those charged with governance to ensure that no
management bias exists in the decision taken on what constitutes an 'immaterial
misstatement' and hence what is and is not corrected as a result of the audit.
Management must also provide written representations that all uncorrected errors are
immaterial.
The auditor shall include in the audit documentation:
– The amount below which misstatements would be regarded as clearly trivial
– All misstatements accumulated during the audit and whether they have been
corrected
– The auditors conclusion as to whether uncorrected misstatements are material,
individually or in aggregate, and the basis for that conclusion
75
Risk-based audit
In performing a risk-based audit,the auditor needs to
consider materiality when:
Performing risk assessment procedures
Determine the nature,event and timing of further
audit procedures based on the assessed risk
Evaluating the effect of identified misstatements on
the auditor’s report.
Materiality
76
76
77
TWO LEVEL OF
MATERIALITY IN AUDIT
PLANNING
Level 1 : Financial statement level (overall
materiality), because the auditor expresses an opinion
on the financial statements taken as a whole.
Level 2 : Account balances and class of transactions
level (account balances level), because the auditor
verifies account balances in reaching an overall
conclusion on the fairness of the financial statements.
Applying Materiality
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3 STEPS
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Materiality-Guidelines
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