Advanced Auditing Materiality and the Audit Risk Model

1. Advanced Auditing Materiality and the Audit Risk Model Dr. Mohamed A. Hamada Lecturer of Accounting Information Systems

2. Audit Risk Auditors accept some level of risk in performing the audit. risks are difficult to measure, and require careful thought to respond.

3. Risk and Evidence Auditors gain an understanding of the client’s 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.

4. Audit Risk Model for Planning PDR = AAR ÷ (IR × CR) where: PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk

5. Planned detection risk PDR, is a measure of the risk that audit evidence for an account will fail to detect misstatements exceeding a tolerable amount. Acceptable audit risk AAR, is a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued.

6. Inherent risk is a measure of the auditor’s assessment of the likelihood that there are material misstatements in an account before considering the effectiveness of internal control. Control risk is a measure of the auditor’s assessment of the likelihood that misstatements exceeding a tolerable amount in an account will not be prevented or detected by the client’s internal controls.

7. Example : there are four situations that involve the audit risk model as it is used for planning audit evidence requirements in the audit of inventory. For each situation, calculate planned detection risk. Answer: 1. 1%; 2. 10%; 3. 50%; 4. 83.3%

8. 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 auditor’s evaluation of management’s integrity

9. Factors Affecting Inherent Risk • Nature of the client’s business • Results of previous audits • Initial versus repeat engagement • Related parties • Non-routine 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

10. Relationships of Risk to Evidence Situation Acceptable audit risk Inherent risk Control risk Planned detection risk Amount of evidence required 1 2 3 4 5 High Low Low Medium High Low Low High Medium Low Low Low High Medium Medium High Medium Low Medium Medium Low Medium High Medium Medium

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

12. Materiality The auditor’s responsibility is to determine 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.

13. Steps in Applying Materiality Step 1 Set preliminary judgment about materiality Planning extent of tests Step 2 Allocate preliminary judgment about materiality to segments

14. Steps in Applying Materiality Step 3 Estimate total misstatement in segment Step 4 Estimate the combined misstatement Evaluating results Step 5 Compare combined estimate with judgment about materiality

15. Estimated Total Misstatement and Preliminary Judgment Estimated Misstatement Amount Account Tolerable Misstatement Known Misstatement and Direct Projection Sampling Error Total Cash Accounts receivable Inventory Total estimated misstatement amount Preliminary judgment about materiality $ 4,000 20,000 36,000 $50,000 $ 2,000 12,000 31,500 $45,500 $ N/A 6,000 15,750 $16,800 $ 2,000 18,000 47,250 $62,300 N/A = Not applicable Cash audited 100 percent

16. 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)

17. End of Chapter 9