Materiality and Risk

Chapter 8

Learning Objective 1

Apply the concept of

materiality to the audit.

Materiality

The auditor’s responsibility is todetermine whether financial

statements are materially misstated.

If there is a material misstatement,the auditor will bring it to the client’s

attention so that a correction can be made.

Steps in ApplyingMateriality

Set preliminaryjudgment about

materiality.Planning

extentof tests

Allocate preliminaryjudgment about

materialityto segments.

Steps in ApplyingMateriality

Estimate totalmisstatement in segment.

Evaluatingresults

Estimate thecombined misstatement.

Compare combinedestimate with judgment

about materiality.

Make a preliminary judgment

about what amounts to

consider material.

Set Preliminary Judgment

This preliminary judgment is the maximumamount by which the auditor believes thestatements could be misstated and still notaffect the decisions of reasonable users.

Ideally, auditors decide early in the auditthe combined amount of misstatementsof the financial statements that would

be considered material.

Factors Affecting Judgment

Materiality is a relative ratherthan an absolute concept.

Bases are needed forevaluating materiality.

Qualitative factors alsoaffect materiality.

Allocate preliminary materiality

to segments of the audit

during planning.

Allocate Preliminary Judgment About Materiality to Segments

This is necessary because evidence isaccumulated by segments rather than

for the financial statements as a whole.

Most practitioners allocate materialityto balance sheet accounts.

SAS 39 (AU 350)

Use materiality to evaluate

audit findings.

Estimated TotalMisstatement Example

Net misstatement of the sample

$3,500 ÷ $50,000 × $450,000 = $31,500

Total recorded population value×

Total sampled÷

Direct projection estimate of misstatement=

Example of Estimatefor Sampling Error

Tolerable Direct SamplingAccount Misstatement Projection Error TotalCash $ 4,000 $ 0 $ N/A $ 0Accounts receivable 20,000 12,000 6,000* 18,000Inventory 36,000 31,500 15,750* 47,250Total estimated misstatement amount $43,500 $16,800 $60,300Preliminary judgment about materiality $50,000*estimate for sampling error is 50%

Define risk in auditing.

Auditors accept some level of riskin performing the audit.

An effective auditor recognizes thatrisks exist, are difficult to measure,

and require careful thought to respond.

Responding to risks properly is criticalto achieving a high-quality audit.

Risk and Evidence

Auditors gain an understanding of theclient’s business and industry and

assess client business risk.

Auditors use the audit risk model to furtheridentify the potential for misstatementsand where they are most likely to occur.

Example of DifferingEvidence Among Cycles

Sales andCollection

Acquisitionand Payment

Payroll andPersonnel

CycleInherent

riskA medium high low

ControlriskB medium low low

Acceptableaudit riskC low low low

Planneddetection riskD medium medium high

Example of DifferingEvidence Among Cycles

Inventory andWarehousing

Capital Acquisitionand Repayment

CycleInherent

riskA high low

ControlriskB high medium

Acceptableaudit riskC low low

Planneddetection riskD low medium

Describe the audit risk

model and its components.

Audit Risk Modelfor Planning

PDR = AAR ÷ (IR × CR)

PDR = Planned detection risk

AAR = Acceptable audit risk

IR = Inherent risk

CR = Control risk

Consider the impact of

engagement risk on

acceptable audit risk.

Impact of Engagement Riskon Acceptable Audit Risk

Auditors decide engagement risk and usethat risk to modify acceptable audit risk.

Engagement risk closely relates toclient business risk.

Factors AffectingAcceptable Audit Risk

The degree of which external usersrely on the statements

The likelihood that a client will havefinancial difficulties after the

audit report is issued

Factors AffectingAcceptable Audit Risk

The auditor’s evaluation of management’s integrity

Making the AcceptableAudit Risk Decision

External usersreliance onfinancial

statements

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

Methods to Assess RiskFactors

Making the AcceptableAudit Risk Decision

Methods to Assess Risk

Likelihoodof financialdifficulties

• Analyze financial statements for difficulties using ratios.• Examine inflows and outflows

of cash flow statements.

Factors

Managementintegrity

• See Chapter 7 for client acceptance and continuance.

Consider the impact of several

factors on the assessment

of inherent risk.

Major Factors WhenAssessing Inherent Risk

• Nature of the client’s business • Results of previous audits• Initial versus repeat engagement• Related parties• Nonroutine transactions• Judgment – correctly record account

balances and transactions• Makeup of the population

Consider information

gathered to assess the

likelihood of fraud.

Assessing Risks of Fraud

Three conditions are generally present.

1. Incentives/Pressures

2. Opportunities

3. Attitudes/Rationalization

Examples of Risks Factorsfor Fraudulent Reporting

1. Incentives/Pressures

Financial stability or profitability is threatened byeconomic, industry, or entity operating conditions.

Excessive pressure exists for managementto meet debt requirements.

Personal net worth is materially threatened.

2. Opportunities

There are significant accounting estimatesthat are difficult to verify.

There is ineffective oversight overfinancial reporting.

High turnover or ineffective accounting internalaudit, or information technology staff exists.

3. Attitudes/Rationalization

Inappropriate or inefficient communicationand support of the entity’s values is evident.

A history of violations of laws is known.

Management has a practice of making overlyaggressive or unrealistic forecasts.

Responding to theRisk of Fraud

Design and perform audit proceduresto address identified fraud risk.

Change the overall conduct of the auditto respond to identified fraud risk.

Perform procedures to address the riskof management override of controls.

Discuss the relationship

of risks to audit evidence.

Relationship of Risk Factors,Risk, and Evidence

FactorsInfluencing

Acceptable audit risk

Control risk

Inherentrisk

Planneddetection

Plannedaudit

evidence

D = Direct relationship; I = Inverse relationship

Changing the Audit inResponse to Risk

The engagement may requiremore experienced staff.

The engagement will be reviewedmore carefully than usual.

Audit Risk for Segments

Both control risk and inherent riskare typically set for each cycle,each account, and often eveneach audit objective, not for

the overall audit.

Relating Risk of Fraud toRisk Model Components

The risk of fraud can be assessedfor the entire audit or by cycle,

account, and objective.

Specific response could includerevising assessments of acceptable

audit risk, inherent risk, and control risk.

Tolerable Misstatement, Risks,and Balance-related Objectives

It is common to assess inherent and controlrisk for each balance-related audit objective.

It is not common to allocatemateriality to objectives.

Measurement Limitations

One major limitation in the applicationof the audit risk model is the difficulty

of measuring the components of the model.

Relationships of Riskto Evidence

Acceptable Planned Amount ofAudit Inherent Control Detection Evidence

Situation Risk Risk Risk Risk Required1 High Low Low High Low2 Low Low Low Medium Medium3 Low High High Low High4 Medium Medium Medium Medium Medium5 High Low Medium Medium Medium

Tests of Details of Balances Evidence Planning Worksheet

Auditors develop various types ofworksheets to aid in relating theconsiderations affecting auditevidence to the appropriate

evidence to accumulate.

Discuss how materiality and risk

are related and integrated

into the audit process.

Tolerable Misstatements,Risk, and Planned Evidence

Acceptableaudit risk

Inherentrisk

Controlrisk

Tolerablemisstatement

Planneddetection risk

Plannedaudit evidence

D = Direct relationship; I = Inverse relationship

Audit Risk Model forEvaluating Results

AcAR = IR × CR × AcDR

AcAR = Achieved audit risk

AcDR = Achieved detection risk

IR = Inherent risk

CR = Control risk

Revising Risksand Evidence

The audit risk model is primarily aplanning model and is therefore oflimited use in evaluating results.

Great care must be used in revisingthe risk factors when the actual results

are not as favorable as planned.

End of Chapter 8

Materiality and Risk

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