arens12e 09

©2008 Prentice Hall Business Publishing, ©2008 Prentice Hall Business Publishing, Auditing 12/e,Auditing 12/e, Arens/Beasley/Elder Arens/Beasley/Elder 9 - 1

Materiality and Risk

Chapter 9

©2008 Prentice Hall Business Publishing, ©2008 Prentice Hall Business Publishing, Auditing 12/e,Auditing 12/e, Arens/Beasley/Elder Arens/Beasley/Elder 9 - 9 - 22

Learning Objective 1

Apply the concept of materiality

to the audit.


Materiality

It is a major consideration in determiningthe appropriate audit report to issue.


Materiality

The auditor’s responsibility is to determinewhether financial statements arematerially misstated.

If there is a material misstatement,the auditor will bring it to the client’sattention so that a correction can be made.


Steps in Applying Materiality

Planningextentof tests

Step1

Set preliminary judgmentabout materiality

Step2

Allocate preliminaryjudgment aboutmateriality tosegments


Steps in Applying Materiality

Evaluatingresults

Step3

Estimate totalmisstatement in segment

Step4

Estimate thecombined misstatement

Compare combinedestimate with judgmentabout materiality

Step5



Make a preliminary judgment

about what amounts to

consider material.


Set Preliminary Judgment About Materiality

This preliminary judgment is the maximumamount by which the auditor believes thestatements could be misstated and still notaffect the decisions of reasonable users.

Auditors decide early in the auditthe combined amount of misstatementsof the financial statements that wouldbe considered material.


Factors Affecting Judgment

Materiality is a relative ratherthan an absolute concept.

Bases are needed forevaluating materiality.

Qualitative factors alsoaffect materiality.


Guidelines

Accounting and auditing standardsdo not provide specific materialityguidelines to practitioners.

Professional judgment is to be usedat all times in setting and applyingmateriality guidelines.



Allocate preliminary materiality

to segments of the audit

during planning.


Allocate Preliminary Judgment About Materiality to Segments

This is necessary because evidence isaccumulated by segments rather thanfor the financial statements as a whole.

Most practitioners allocate materialityto balance sheet accounts.

SAS 107 (AU 312)



Use materiality to evaluate

audit findings.


Estimated Total Misstatement and Preliminary Judgment

CashAccounts receivableInventoryTotal estimated misstatement amountPreliminary 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

TolerableMisstatement

KnownMisstatementand DirectProjection

SamplingError TotalAccount

Estimated Misstatement Amount

N/A = Not applicableCash audited 100 percent


Estimated Total Misstatement and Preliminary Judgment

Net misstatements in the sample ($3,500)

× Total recorded population value ($450,000)

÷ Total sampled ($50,000)

= Direct projection estimate of misstatement ($31,500)



Define risk in auditing.


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.


Risk and Evidence

Auditors gain an understanding of theclient’s business and industry andassess client business risk.

Auditors use the audit risk model to furtheridentify the potential for misstatementsand where they are most likely to occur.


Illustration of Differing Evidence Among Cycles

Sales andcollectioncycle

Acquisitionand paymentcycle

Payroll andpersonnelcycle

InherentriskA Medium High Low

ControlriskB Medium Low Low

Acceptableaudit riskC Low Low Low

Planneddetection riskD Medium Medium High


Illustration of Differing Evidence Among Cycles

Inventory andwarehousingcycle

Capital acquisitionand repaymentcycle

InherentriskA High Low

ControlriskB High Medium

Acceptableaudit riskC Low Low

Planneddetection riskD Low Medium



Describe the audit risk model

and its components.


Audit Risk Model for Planning

PDR = AAR ÷ (IR × CR)

PDR = Planned detection risk

AAR = Acceptable audit risk

IR = Inherent risk

CR = Control risk

where:



Consider the impact of

engagement risk on

acceptable audit risk.


Impact of Engagement Risk on Acceptable Audit Risk

Auditors decide engagement risk and usethat risk to modify acceptable audit risk.

Engagement risk closely relates to clientbusiness risk.


Factors Affecting Acceptable Audit Risk The degree to which external users

rely on the statements

The likelihood that a client will havefinancial difficulties after theaudit report is issued

The auditor’s evaluation of management’s integrity


Methods Practitioners Use to Assess Acceptable Audit Risk

Methods Used to AssessAcceptable Audit Risk

External users’reliance onfinancialstatements

Examine financial statements Read minutes of the board Examine form 10K Discuss financing plans

with management

Factors


Methods Practitioners Use to Assess Acceptable Audit Risk

Likelihoodof financialdifficulties

Analyze financial statementsfor difficulties using ratios

Examine inflows and outflowsof cash flow statements

Managementintegrity

See Chapter 8 for clientacceptance and continuance

Methods Used to AssessAcceptable Audit RiskFactors



Consider the impact of several

factors on the assessment

of inherent risk.


Factors Affecting Inherent Risk

Nature of the client’s business Results of previous audits Initial versus repeat engagement Related parties Nonroutine 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



Discuss the relationship of

risks to audit evidence.


Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence

D = Direct relationship; I = Inverse relationship

Factorsinfluencing

risks

Acceptable audit risk

Planneddetection

risk

Plannedaudit

evidence

Inherentrisk

Control risk

I

D

I

ID

I D


Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence

The engagement may requiremore experienced staff

The engagement will be reviewedmore carefully than usual

Auditors can change the auditto respond to risks


Audit Risk for Segments

Both control risk and inherent risk areBoth control risk and inherent risk aretypically set for each cycle, eachtypically set for each cycle, eachaccount, and often even each auditaccount, and often even each auditobjective, not for the overall audit.objective, not for the overall audit.


Tolerable Misstatement, Risks,and Balance-related Audit Objectives

It is common to assess inherent and controlrisk for each balance-related audit objective

It is not common to allocate materialityto objectives


Measurement Limitations

One major limitation in the application of theaudit risk model is the difficulty of measuringthe components of the model.


Relationships of Risk to Evidence

Acceptableaudit risk

Inherentrisk

Controlrisk

Planneddetectionrisk

Amount ofevidencerequiredSituation

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


Tests of Details of Balances Evidence Planning Worksheet

Auditors develop various types of worksheetsto aid in relating the considerations affectingaudit evidence to the appropriateevidence to accumulate.



Discuss how materiality and risk

are related and integrated into

the audit process.


Relationship of Tolerable Misstatement and Risks toPlanned Evidence

D = Direct relationship; I = Inverse relationship

Acceptableaudit risk

Inherentrisk

Controlrisk

Tolerablemisstatement

Planneddetection risk

Plannedaudit evidence

I

DI

I I

I

D

D


Audit Risk Model for Planning

AcAR = IR AcAR = IR ×× CR CR ×× AcDR AcDR

AcAR = Achieved audit risk

IR = Inherent risk

CR = Control risk

AcDR = Achieved detection risk

where:


Audit Risk Models for Planning Evidence and Evaluating Results

Acceptableauditrisk

Inherentrisk

Controlrisk

Achieveddetection

risk

Substantiveaudit

evidence

Achievedauditrisk

Compare

D

I

D

D

D = Direct relationshipI = Inverse relationship


Revising Risks and Evidence

The auditor must revise the originalassessment of the appropriate risk.

The auditor should consider the effectof the revision on evidence requirements,without the use of the audit risk model.

©2008 Prentice Hall Business Publishing, ©2008 Prentice Hall Business Publishing, Auditing 12/e,Auditing 12/e, Arens/Beasley/Elder Arens/Beasley/Elder 9 - 43

End of Chapter 9