copyright © 2014 pearson education chapter 9 considering materiality and audit risk

Copyright © 2014 Pearson Education

Chapter 9

Considering Materiality and

Audit Risk

Chapter 9

Considering Materiality and

Audit Risk

Copyright © 2014 Pearson Education9-2

Apply the concept of materiality to the audit.

Make a preliminary judgment about what amounts to consider material.

Determine performance materiality during planning.

Use materiality to evaluate audit findings.

Define risk in auditing.


Describe the audit risk model and its components.

Consider the impact of engagement risk on acceptable audit risk.

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

Discuss the relationship of risks to audit evidence.

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


Apply the concept of materiality to the audit.Apply the concept of materiality to the audit.

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Major consideration in determiningthe appropriate audit report

Referenced in auditor’s responsibility section of the audit report

What is meant by the term “material”?


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.


Make a preliminary judgment about what Make a preliminary judgment about what amounts to consider material.amounts to consider material.

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Auditors set materiality thresholds early in theengagement.

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


Materiality is a relative ratherthan an absolute concept.

Benchmarks are needed forevaluating materiality.

Qualitative factors alsoaffect materiality.


Considerations that may render material a quantitatively small misstatement include:

Loan covenants Changing trend

Management compensation

Financial statement users Conceals an illegal act


Accounting and auditing standards do not provide specific materiality guidelines.

Professional judgment is used to set and apply materiality guidelines.


Determine performance materialityDetermine performance materialityduring planning.during planning.

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Evidence is accumulated by segments rather than for the financial statements as a whole.

Most practitioners allocate materialityto balance sheet accounts.


Use materiality to evaluate audit findings.Use materiality to evaluate audit findings.

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Auditor can determine the misstated amount in an account (“Known”)

Two types of “Likely” misstatements: Judgmental differences Projections of misstatements from

audit samples


Estimated Misstateme

nt($31,500)

=Net misstatements in Sample ($3,500)Total sampled ($50,000)

× Total recorded population value ($450,000)


Define risk in auditing.Define risk in auditing.

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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.


Auditors need to understand the client’s business and assess business risk.

The audit risk model helps identify the potential and likelihood of misstatements.


PDR = AAR ÷ (IR × CR)

where: PDR = Planned detection risk

AAR = Acceptable audit risk

IR = Inherent risk

CR = Control risk


Sales andcollectioncycle

Acquisitionand paymentcycle

Payroll andpersonnelcycle

InherentriskA

B Controlrisk

C

D

Acceptableaudit risk

MediumMedium

MediumMedium HighHigh LowLow

LowLow LowLow

LowLow

Planneddetection risk MediumMedium

LowLow LowLow

MediumMedium HighHigh


A

B

C

D

Inventory andwarehousingcycle

Capital acquisitionand repaymentcycle

Inherentrisk

Controlrisk


Planneddetection risk

HighHigh LowLow

HighHigh

LowLow

LowLow

MediumMedium

LowLow

MediumMedium


Describe the audit risk model and Describe the audit risk model and its components.its components.

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Planned Detection

Risk

InherentRisk

Control Risk

Acceptable Audit Risk


Consider the impact of engagement risk Consider the impact of engagement risk on acceptable audit risk.on acceptable audit risk.

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What is Engagement Risk?


Auditors decide engagement risk and use that risk to modify acceptable audit risk.

Engagement risk closely relates to client business risk.


The degree to which external usersrely on the statements

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

The auditor’s evaluation of management’s integrity


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

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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


Discuss the relationship of risks Discuss the relationship of risks to audit evidence.to audit evidence.

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Acceptable audit risk

Inherentrisk

Planneddetection

risk

Plannedaudit

evidence

Control risk

I

D

I

DD

Factorsinfluencing

risks


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


Both control risk and inherent risk aretypically set for each cycle, eachaccount, and often each auditobjective, not for the overall audit.


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

It is not common to allocate materiality to objectives


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


Auditors develop various types of worksheets to aid in relating the considerations affectingaudit evidence to the appropriate evidence to accumulate.


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

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Inherentrisk

Controlrisk

Performancemateriality

D = Direct relationship; I = Inverse relationship

Planneddetection risk

Plannedaudit evidence

I

II D I

IDD


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.


Copyright

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copyright © 2014 pearson education chapter 9 considering materiality and audit risk

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