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Chapter 9

Materiality and Risk

AuditRisk

CPA

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Presentation Outline

I. Steps in Applying Materiality

II. Risk in Auditing

III. Planning Model Relationships

IV. !aluating Results

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Step 1 in Applying Materiality

Set preli$inary %udg$ent a&out $ateriality.

The preliminary judgment about materiality is the maximum amount

the auditor believes the statements could be misstated and still not

affect the decisions of reasonable users. Decided early in audit.

Permissible misstatements are often less for smaller clients.

Although the FASB and A!PA are un"illing to provide specific

materiality guidelines to practitioners# bases are needed for

evaluating materiality. See Figure $%& on page &'(.

)ualitative factors can affect materiality. See factors on pages

&'*%&'(.

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Step 2 in Applying MaterialityAllo(ate preli$inary %udg$ent a&out $ateriality to

seg$ents.

An allocation is necessary because evidence is accumulated by

segments rather than the financial statements ta+en as a "hole. The

allocation to account balances is +no"n as the tolerable misstatement.

,ost practitioners allocate materiality to balance sheet rather

than income statement accounts. This is because most income

statement misstatements have an e-ual effect on the balance sheet

because of the double%entry boo++eeping system.

The sum of the tolerable misstatement is allo"ed to exceed overall

materiality because /0 it is unli+ely that all accounts "ill be

misstated by the full amount of tolerable misstatement# and &0 some

accounts are overstated "hile others are understated# resulting in a

net amount that is li+ely to be less than overall materiality.

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Illustration o* +olera&le Misstate$ent

Allo(ation *or Current Assets

Tolerable

Account ,isstatement

!ash 1 *#222

Accounts receivable &2#222

nventory '3#222

Preliminary judgment

about materiality 1(2#222

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Step " in Applying Materiality

sti$ate total $isstate$ent in seg$ent.

4ne "ay to calculate the estimate of misstatement is to ma+e a direct

projection from the sample to the population.

1'#(22 net misstatement of the inventory sample

"'// 0 '//// 5#'//// "1'//

1(2#222 total inventory sampled

1*(2#222 total recorded population value for inventory

1'/#(22 direct projection estimate of misstatement

5

6

7

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Illustration o* sti$ating +otal

Misstate$ent in Seg$ent

Tolerable Direct Sampling

Account ,isstatement Projection 8rror Total

!ash 1 *#222 1 2 1 9:A 1 2Accounts receivable &2#222 / 3#222; /

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Tolerable Direct Sampling

Account ,isstatement Projection 8rror Total

!ash 1 *#222 1 2 1 9:A 1 2Accounts receivable &2#222 / 3#222; /

Step # in Applying Materiality

sti$ate the (o$&ined $isstate$ent.

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Tolerable Direct Sampling

Account ,isstatement Projection 8rror Total

!ash 1 *#222 1 2 1 9:A 1 2

Accounts receivable &2#222 / 3#222; /

Step ' in Applying MaterialityCo$pare (o$&ined esti$ate 3ith preli$inary or

re!ised %udg$ent a&out $ateriality.

Because the estimated combined misstatement exceeds the

preliminary judgment# the financial statements are not acceptable.

The auditor may perform additional audit procedures to reevaluatethe estimate# or re-uire adjustment for the estimated misstatements.

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II. Risk in Auditing

A. Co$ponents o* Audit Risk

4. A((epta&le Audit RiskC. Inherent Risk

5. Control Risk

. Planned 5ete(tion Risk

Audit

Risk

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A. Co$ponents o* Audit Risk

Inherent Risk

6IR7

Control Risk6CR7

5ete(tion Risk65R7

Audit Risk

6AR7

Sus(epti&ility o* an assertion to$aterial $isstate$ent assu$ing no

related internal (ontrols.

Risk o* $isstate$ents not &eing

dete(ted &y syste$ o* internal

(ontrol.

Risk o* $isstate$ents not &eingdete(ted &y the auditor.

Misstate$ent that re$ains

undete(ted &y the auditor.

Caught &y

internal

(ontrols

Caught &y

auditor

8ndete(ted

$isstate$ent

+otal

$isstate$ent

-

-

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4. A((epta&le Audit Risk

1. Relian(e &y ternal 8sers

2. :ikelihood o* ;inan(ial ;ailure

". Integrityo* Manage$ent

Audit

?is+

+he *ollo3ing *a(tors $ean that audit risk should &e

kept lo3er