ch08-70-360

Copyright © 2007 Pearson Education Canada1

Chapter 8: Materiality and Risk

Copyright © 2007 Pearson Education Canada8-2

Chapter 8 objectives Consider how materiality is used to decide

on the amount of fieldwork to be collected List the different types of risks considered

during the audit process Identify the components of the audit risk

model Explain how inherent risk is assessed Discuss how the audit risk model is used

during the conduct of the audit

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Materiality is in the “eye of the beholder”

An audit is expected to obtain reasonable assurance that there is an absence of “material misstatement”

A material error is defined in the context of what a reasonable business user would think – would it affect his/her decision?



Steps in applying materiality during the audit



When you find a material misstatement

What would you do? If you ask the client to correct the material

misstatement and they refuse, what are your options?



Levels of misstatements (pp. 211-12)

1. Identified misstatements 2. Likely misstatements 3. Likely aggregate misstatements 4. Further possible misstatements



Materiality is set early

The preliminary judgment about materiality is set prior to the conduct of detailed audit testing, during planning

Helps in deciding the amount of evidence to collect

If there are substantial changes to the financial statements, then materiality may need to be revised



What affects the materiality decision?

Materiality is relative rather than absolute A base needs to be chosen Qualitative factors are used (emphasizing

the importance of knowledge of business) Firm guidelines or past practice



Potential bases for materiality

Revenue Net income before

taxes (NIBT) – also exclude EI

Total Assets Shareholders’

Equity



Practice problem 8-16 (p. 238)

Let’s take a look at a realistic set of financial statements

How would you calculate the materiality figure?

What base would you choose?



What is risk?

Risks arise when a situation involves uncertainty

Assessing risks includes assessing probabilities – what is the “risk” of rain today? What is the “risk” of a flood today?

Assessing risks is part of our daily lives – we constantly assess the likelihood of events when making decisions



Risk in auditing

The auditor accepts some level of uncertainty when performing an audit

There is always a small likelihood remaining that the financial statements may be in error

The audit risk model is used as part of a strategic auditing approach



Strategic auditing

An audit engagement is a tactical plan of action

Audit procedures are designed to satisfy audit objectives and to reduce the probability of errors or other misstatements in the financial statements



Audit risk model



Audit risk model formula

Audit risk = inherent risk x control risk x detection risk

AR = IR x CR x DR

The audit risk model is a planning model



Audit risk A measure of the auditor’s willingness (i.e.

the auditor chooses this number) to accept that the financial statements may be materially misstated even though a proper audit has been conducted

Audit ASSURANCE is the complement of audit risk

Complete assurance is impossible to achieve



Assessing Audit Risk

Factors:– Nature of users– Likelihood of

financial difficulties

– Management integrity

Also consider business risk



When audit risk goes down

What happens to the evidence to be collected?

What does this say about the nature of the users?

About potential lawsuits?



Inherent risk

A measure of the likelihood that there are material misstatements in a segment simply due to the nature of the segment (e.g. cash is more likely to be stolen than sheets of steel)

Internal controls are ignored in this assessment



Inherent risk is assessed at the account balance assertion level

Let’s look at a company like a big bank

What are it’s inherent risks for mortgages receivable?

For loan loss provisions?



Control risk

A measure of the likelihood that misstatements will NOT be detected or prevented by the internal control systems

This assessment is conducted because it is required by generally accepted auditing standards and also because it is needed to design the nature and extent of audit tests



Reliance on internal controls is a choice

The auditor is required to evaluate internal controls, not to rely upon them

Reliance may be necessary for certain types of systems (e.g. complex automated systems or paperless systems)

In other situations, the auditor may choose between internal control testing and tests of details



Control risk

What would we consider when assessing the control risk with respect to money deposited at an ATM?



Where reliance on internal controls occurs the auditor must

1. Obtain an understanding of internal controls 2. Evaluate control risk (the capacity for the

internal control to prevent or detect errors) 3. Design tests of controls and test the internal

controls (Certain controls may not need to be tested every year, such as programmed controls that have not changed since the prior year. They can be tested as infrequently as every three years.)



Setting control risk at 100%

This means that there is no reliance on internal controls, because control risk is at maximum (which means that the assurance from tests of controls will be zero)

This can occur either because of inadequate control systems or it may be too expensive to use tests of controls rather than tests of details



Planned detection risk

This represents the audit testing that is required on the part of the auditor (or team) to adequately assess the financial statements

Once audit risk is set, and control risk and inherent risk assessed, then detection risk can be calculated



Detection risk

This is the only part of the audit risk model that can be affected by the actions of the auditor




Three different scenarios

How would you set audit risk, inherent risk, control risk and detection risk?



Materiality, risk and evidence

Evidence collection needs to increase when:– Risk of errors increases– Materiality goes down




How would you defend your selection of a materiality level in court?


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