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Materiality and Risk. Chapter 9. Learning Objective 1. Apply the concept of materiality to the audit. Materiality. Major consideration in determining the appropriate audit report Referenced in audit report’s scope paragraph What is meant by the term “material”?. Materiality.
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Materiality and Risk Chapter 9
Learning Objective 1 Apply the concept of materiality to the audit.
Materiality • Major consideration in determining • the appropriate audit report • Referenced in audit report’s scope • paragraph • What is meant by the term “material”?
Materiality Auditor’s responsibility = determine whether financial statements are materially misstated. Auditor will bring material misstatements to the client’s attention so corrections can be made.
Learning Objective 2 Make a preliminary judgment about what amounts to consider material.
Set Preliminary Judgment About Materiality Auditors set materiality thresholds early in the engagement. Thresholds represent the maximum statements that could be misstated and still not affect users decisions.
Factors Affecting Judgment Materiality is a relative rather than an absolute concept. Bases are needed for evaluating materiality. Qualitative factors also affect materiality.
Qualitative Factors Considerations that may render material a quantitatively small misstatement include: Loan covenants Changing trend Management compensation Financial statements users Conceals an illegal act
Guidelines Accounting and auditing standards do not provide specific materiality guidelines. Professional judgment is used to set and apply materiality guidelines.
Learning Objective 3 Allocate preliminary materiality to segments of the audit during planning.
Allocate Preliminary Judgment About Materiality to Segments Evidence is accumulated by segments rather than for the financial statements as a whole. Most practitioners allocate materiality to balance sheet accounts. • SAS 107 (AU 312)
Learning Objective 4 Use materiality to evaluate audit findings.
Known and Likely Misstatements Auditor can determine the misstated amount in an account (“Known”) • Two types of “Likely” misstatements: • Judgmental differences • Projections of misstatements from • audit samples
Estimated Total Misstatement and Preliminary Judgment Estimated Misstatement ($31,500) Net misstatements in Sample ($3,500)Total sampled ($50,000) × Total recorded population value ($450,000) =
Learning Objective 5 Define risk in auditing.
Risk • Auditors accept some level of • risk in performing the audit. • Risks exist, are difficult to • measure, and require careful • thought in response. • Proper risk response is critical • to achieving a high-quality audit.
Risk and Evidence Auditors need to understand the client’s business and assess business risk. The audit risk model helps identify the potential and likelihood of misstatements.
Audit Risk Model for Planning PDR = AAR ÷ (IR × CR) where: PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk
Illustration of Differing Evidence Among Cycles Sales and collection cycle Acquisition and payment cycle Payroll and personnel cycle A Inherent risk Medium High Low B Control risk Medium Low Low C Acceptable audit risk Low Low Low D Planned detection risk Medium Medium High
Illustration of Differing Evidence Among Cycles Inventory and warehousing cycle Capital acquisition and repayment cycle A Inherent risk High Low B Control risk High Medium C Acceptable audit risk Low Low D Planned detection risk Low Medium
Learning Objective 6 Describe the audit risk model and its components.
Audit Risk Model Components Inherent Risk Planned Detection Risk Acceptable Audit Risk Control Risk
Learning Objective 7 Consider the impact of engagement risk on acceptable audit risk.
Engagement Risk What is Engagement Risk?
Impact of Engagement Risk on Acceptable Audit Risk Auditors decide engagement risk and use that risk to modify acceptable audit risk. Engagement risk closely relates to client business risk.
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
Learning Objective 8 Consider the impact of several factors on the assessment of inherent risk.
Factors Affecting Inherent Risk • Nature of Client’s • Business • Industry practices • Non-routine transactions • Makeup of the population • Audit Experience • Prior audit results • Initial vs. repeat engagement • Audit judgment required to • correctly record balances and • transactions • Culture • Related parties • Factors related to fraudulent • financial reporting • Factors related to • misappropriation of assets
Learning Objective 9 Discuss the relationship of risks to audit evidence.
Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence Acceptable audit risk D D I Inherent risk Planned detection risk Planned audit evidence Factors influencing risks I I I D Control risk D = Direct relationship; I = Inverse relationship
Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence • Auditors can change the audit to respond • to risks • The engagement may require more • experienced staff • The engagement will be reviewed more • carefully than usual
Audit Risk for Segments Both control risk and inherent risk are typically set for each cycle, each account, and often even each audit objective, not for the overall audit.
Tolerable Misstatement, Risks,and Balance-related Audit Objectives • It is common to assess inherent and control • risk for each balance-related audit objective • It is not common to allocate materiality • to objectives
Measurement Limitations One major limitation in the audit risk model is the difficulty of measuring the components of the model. Unknown Known Actual level of risk achieved on the audit Preliminary Assessed Level of Risk +/-
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
Tests of Details of Balances Evidence Planning Worksheet Auditors develop various types of worksheets to aid in relating the considerations affecting audit evidence to the appropriate evidence to accumulate.
Learning Objective 10 Discuss how materiality and risk are related and integrated into the audit process.
Relationship of Tolerable Misstatement and Risks toPlanned Evidence Acceptable audit risk D D I Planned detection risk I Planned audit evidence Inherent risk I I D I Control risk Tolerable misstatement D = Direct relationship; I = Inverse relationship
Revising Risks and Evidence The auditor must revise the original assessment of the appropriate risk. The auditor should consider the effect of the revision on evidence requirements, without the use of the audit risk model.
