8 - 1 ©2003 prentice hall business publishing, essentials of auditing 1/e, arens/elder/beasley...
TRANSCRIPT
8 - 1©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Materiality and Risk
Chapter 8
8 - 2©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 1
Apply the concept of
materiality to the audit.
8 - 3©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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.
8 - 4©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Steps in ApplyingMateriality
Step1
Set preliminaryjudgment about
materiality.Planning
extentof tests
Step2
Allocate preliminaryjudgment about
materialityto segments.
8 - 5©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Steps in ApplyingMateriality
Step3
Estimate totalmisstatement in segment.
Evaluatingresults
Step4
Estimate thecombined misstatement.
Compare combinedestimate with judgment
about materiality.
Step5
8 - 6©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 2
Make a preliminary judgment
about what amounts to
consider material.
8 - 7©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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.
8 - 8©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Factors Affecting Judgment
Materiality is a relative ratherthan an absolute concept.
Bases are needed forevaluating materiality.
Qualitative factors alsoaffect materiality.
8 - 9©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 3
Allocate preliminary materiality
to segments of the audit
during planning.
8 - 10©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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)
8 - 11©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 4
Use materiality to evaluate
audit findings.
8 - 12©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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=
8 - 13©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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%
8 - 14©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 5
Define risk in auditing.
8 - 15©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Risk
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.
8 - 16©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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.
8 - 17©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Example of DifferingEvidence Among Cycles
Sales andCollection
Cycle
Acquisitionand Payment
Cycle
Payroll andPersonnel
CycleInherent
riskA medium high low
ControlriskB medium low low
Acceptableaudit riskC low low low
Planneddetection riskD medium medium high
8 - 18©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Example of DifferingEvidence Among Cycles
Inventory andWarehousing
Cycle
Capital Acquisitionand Repayment
CycleInherent
riskA high low
ControlriskB high medium
Acceptableaudit riskC low low
Planneddetection riskD low medium
8 - 19©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 6
Describe the audit risk
model and its components.
8 - 20©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Audit Risk Modelfor Planning
PDR = AAR ÷ (IR × CR)
PDR = Planned detection risk
AAR = Acceptable audit risk
IR = Inherent risk
CR = Control risk
8 - 21©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 7
Consider the impact of
engagement risk on
acceptable audit risk.
8 - 22©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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.
8 - 23©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Factors AffectingAcceptable Audit Risk
The degree of which external usersrely on the statements
The degree of which external usersrely on the statements
The likelihood that a client will havefinancial difficulties after the
audit report is issued
8 - 24©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Factors AffectingAcceptable Audit Risk
The auditor’s evaluation of management’s integrity
8 - 25©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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
8 - 26©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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.
8 - 27©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 8
Consider the impact of several
factors on the assessment
of inherent risk.
8 - 28©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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
8 - 29©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 9
Consider information
gathered to assess the
likelihood of fraud.
8 - 30©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Assessing Risks of Fraud
Three conditions are generally present.
1. Incentives/Pressures
2. Opportunities
3. Attitudes/Rationalization
8 - 31©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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.
8 - 32©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Examples of Risks Factorsfor Fraudulent Reporting
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.
8 - 33©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Examples of Risks Factorsfor Fraudulent Reporting
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.
8 - 34©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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.
8 - 35©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 10
Discuss the relationship
of risks to audit evidence.
8 - 36©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Relationship of Risk Factors,Risk, and Evidence
FactorsInfluencing
Risks
Acceptable audit risk
Control risk
Inherentrisk
Planneddetection
risk
I
D
I
Plannedaudit
evidence
D
I
I
D
D = Direct relationship; I = Inverse relationship
8 - 37©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Changing the Audit inResponse to Risk
The engagement may requiremore experienced staff.
The engagement will be reviewedmore carefully than usual.
8 - 38©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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.
8 - 39©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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.
8 - 40©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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.
8 - 41©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Measurement Limitations
One major limitation in the applicationof the audit risk model is the difficulty
of measuring the components of the model.
8 - 42©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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
8 - 43©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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.
8 - 44©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Learning Objective 11
Discuss how materiality and risk
are related and integrated
into the audit process.
8 - 45©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Tolerable Misstatements,Risk, and Planned Evidence
Acceptableaudit risk
Inherentrisk
Controlrisk
Tolerablemisstatement
Planneddetection risk
Plannedaudit evidence
D = Direct relationship; I = Inverse relationship
I
D
I
I I
I
D
D
8 - 46©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
Audit Risk Model forEvaluating Results
AcAR = IR × CR × AcDR
AcAR = Achieved audit risk
AcDR = Achieved detection risk
IR = Inherent risk
CR = Control risk
8 - 47©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
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.
8 - 48©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
End of Chapter 8