materiality and risk - knowledge & experience sharing · materiality and risk chapter 9 ©2012...

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5 - 5

Materiality and Risk

Chapter 9

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 2

Learning Objective 1

Apply the concept of materiality to the audit.

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Materiality

Major consideration in determining

the appropriate audit report

Referenced in audit report’s scope

paragraph

What is meant by the term “material”?

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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.

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Steps in Applying Materiality

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Learning Objective 2

Make a preliminary judgment about what

amounts to consider material.

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Set Preliminary Judgment About Materiality

Thresholds represent the maximum statements that could be misstated and still not affect users decisions.

Auditors set materiality thresholds early in the engagement.

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Factors Affecting Judgment

Materiality is a relative rather

than an absolute concept.

Bases are needed for

evaluating materiality.

Qualitative factors also

affect materiality.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 9

Qualitative Factors

Considerations that may render material a

quantitatively small misstatement include:

Changing trend

Financial statements users Conceals an illegal act

Loan covenants

Management compensation

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Guidelines

Accounting and auditing standards do not

provide specific materiality guidelines.

Professional judgment is used to set and

apply materiality guidelines.

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Learning Objective 3

Allocate preliminary materiality to segments

of the audit during planning.

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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)

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Learning Objective 4

Use materiality to evaluate audit findings.

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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

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Estimated Total Misstatement and Preliminary Judgment

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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)

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Learning Objective 5

Define risk in auditing.

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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.

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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.

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Audit Risk Model for Planning

PDR = AAR ÷ (IR × CR)

where: PDR = Planned detection risk

AAR = Acceptable audit risk

IR = Inherent risk

CR = Control risk

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Audit Risk Model for Planning

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Illustration of Differing Evidence Among Cycles

Sales and collection cycle

Acquisition and payment cycle

Payroll and personnel cycle

Inherent risk

A Medium High Low

Control risk

B Medium Low Low

Acceptable audit risk

C Low Low Low

Planned detection risk

D Medium Medium High

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Illustration of Differing Evidence Among Cycles

Inventory and warehousing cycle

Capital acquisition and repayment cycle

Inherent risk

A High Low

Control risk

B High Medium

Acceptable audit risk

C Low Low

Planned detection risk

D Low Medium

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Learning Objective 6

Describe the audit risk model and its components.

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Audit Risk Model Components

Planned Detection

Risk

Acceptable Audit Risk

Control Risk

Inherent Risk

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Learning Objective 7

Consider the impact of engagement risk on acceptable audit risk.

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Engagement Risk

What is Engagement Risk?

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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.

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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

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Methods Practitioners Use to Assess Acceptable Audit Risk

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Learning Objective 8

Consider the impact of several factors on the assessment of inherent risk.

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Factors Affecting Inherent Risk

Nature of Client’s

Business

Industry practices

Non-routine transactions

Makeup of the population

Culture Related parties

Factors related to fraudulent

financial reporting

Factors related to

misappropriation of assets

Audit Experience

Prior audit results

Initial vs. repeat engagement

Audit judgment required to

correctly record balances and

transactions

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Learning Objective 9

Discuss the relationship of risks to audit evidence.

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Relationship of Factors Influencing Risks to Risks and Risks to Planned

Evidence

D = Direct relationship; I = Inverse relationship

Factors influencing

risks

Acceptable audit risk

Planned detection

risk

Planned audit

evidence

Inherent risk

Control risk

I

D

I

I D

I D

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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

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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.

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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

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Risk and Evidence

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Measurement Limitations

One major limitation in the audit risk model is

the difficulty of measuring the components

of the model.

Preliminary Assessed Level

of Risk

Actual level of risk achieved on the audit

+/-

Known Unknown

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Relationships of Risk to Evidence

Acceptable audit risk

Inherent risk

Control risk

Planned detection risk

Amount of evidence required Situation

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

1

2

3

4

5

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 41

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.

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Learning Objective 10

Discuss how materiality and risk are related and integrated into the audit process.

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Relationship of Tolerable Misstatement and Risks to

Planned Evidence

D = Direct relationship; I = Inverse relationship

Acceptable audit risk

Inherent risk

Control risk

Tolerable misstatement

Planned detection risk

Planned audit evidence

I

D

I

I I

I

D

D

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 44

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.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 45

End of Chapter 9