MaterialityMateriality

Audits provide Audits provide reasonable reasonable assuranceassurance that the financial that the financial statements are free of statements are free of material material misstatementsmisstatements..

User FocusUser Focus

Materiality is defined in terms of Materiality is defined in terms of financial statement usersfinancial statement users

• Therefore no hard and fast rulesTherefore no hard and fast rules

• Need to consider Need to consider multiple usersmultiple users and and multiple basesmultiple bases

FIGURE 9 - 1FIGURE 9 - 1 Steps in Applying MaterialitySteps in Applying Materiality

Estimatetotal misstatement

in segment

Step3

Estimatethe combinedmisstatement

Step4

Comparecombined

estimate withpreliminary or

revised judgmentabout materiality

Step5

Set preliminary

judgment aboutmateriality

Step1

Allocatepreliminary

judgment aboutmaterialityto segments

Step2

Planning extent of testsPlanning extent of tests

Evaluating resultsEvaluating results

Set Preliminary Judgment About Set Preliminary Judgment About MaterialityMateriality

Base Base XX (function of client)(function of client)

PercentagePercentage(function of audit risk)(function of audit risk)

----------------------------

= = Preliminary estimate of materialityPreliminary estimate of materiality

Materiality PercentageMateriality Percentage

Typically 3-6% for net income, lower Typically 3-6% for net income, lower percentages for larger bases such as percentages for larger bases such as assets or revenuesassets or revenues

High risk Low %High risk Low %

Low risk High %Low risk High %(less evidence; less assurance)(less evidence; less assurance)

Increase in Increase in Less Less

materiality materiality evidenceevidence required required

Materiality/Evidence Materiality/Evidence RelationRelation

As lower acceptable levels of audit risk and As lower acceptable levels of audit risk and materiality are established, the auditor materiality are established, the auditor should plan more work on individual should plan more work on individual accounts to:accounts to:

1. Find smaller errors.1. Find smaller errors.

2. Find larger errors.2. Find larger errors.

3. Increase tolerable error in accounts.3. Increase tolerable error in accounts.

4. Increase materiality in the accounts.4. Increase materiality in the accounts.

Figure 9-3Figure 9-3 Balance (000) TMBalance (000) TMCash 828 6Cash 828 6AR 18,957 265AR 18,957 265Inventory 29,865 265Inventory 29,865 265Current Assets 1,377 60Current Assets 1,377 60P,P&E 10,340 48P,P&E 10,340 48AP 4,720 108AP 4,720 108Notes 28,300 0Notes 28,300 0Accruals 5,884 132 Accruals 5,884 132 Equity 22,463 Equity 22,463 0 0 Total (materiality = 442) 884Total (materiality = 442) 884

Factors affecting tolerable Factors affecting tolerable misstatementmisstatement

Larger allocationLarger allocation Smaller allocationSmaller allocation

Large balanceLarge balance Small balanceSmall balance

Errors expectedErrors expected Few errors Few errors expected expected

Costly to test orCostly to test or Less costly to testLess costly to testTestable with APTestable with AP

Steps in Applying MaterialitySteps in Applying MaterialityPlanning phase Set preliminary judgment Planning phase Set preliminary judgment

Allocate materiality Allocate materiality to segments to segments

Evaluating Evaluating Estimate total Estimate total resultsresults misstatement in segmentmisstatement in segment

Estimate combined Estimate combined misstatementmisstatement

Compare combined Compare combined misstatement to misstatement to materiality estimatemateriality estimate

Projecting ErrorsProjecting Errors

Balance in accts. receivable: Balance in accts. receivable: 1,000,0001,000,000

Accts. receivable tested:Accts. receivable tested: 250,000250,000

Overstatement errors:Overstatement errors: 10,00010,000

Projected error = Projected error =

(10,000/250,000) x 1,000,000(10,000/250,000) x 1,000,000 ==

40,00040,000 + allowance for sampling error+ allowance for sampling error

TolerableTolerable Est. of Total Est. of Total MisstatementMisstatement Misstmt. Misstmt.

Over- Under-Over- Under- Over- Under- Over- Under-AccountAccount stmt. stmt. stmt. stmt. stmt. stmt. stmt. stmt.CashCash 2,000 2,000 3,000 3,000 2,000 2,000 -0- -0-

A/RA/R 12,00012,000 18,00018,000 4,000 4,000 19,000 19,000

InventoryInventory 8,000 8,000 14,00014,000 3,000 3,000 10,000 10,000

PrepaidsPrepaids 3,000 3,000 5,000 5,000 2,000 2,000 1,000 1,000

TotalTotal 25,00025,000 40,00040,000 11,000 11,000 30,000 30,000

Preliminary estimate of materiality:Preliminary estimate of materiality:Overstatements Overstatements = = 12,50012,500 Understatements Understatements = = 20,00020,000

Options When Projected Errors Options When Projected Errors Exceed MaterialityExceed Materiality

• Record an adjustmentRecord an adjustment

– Usually limited to actual errorsUsually limited to actual errors

• Perform more testingPerform more testing

– Better error estimateBetter error estimate

– Lower sampling riskLower sampling risk

• Qualify OpinionQualify Opinion

Options Applied to Prob. 9-25Options Applied to Prob. 9-25

Projected understmt. errorsProjected understmt. errors $30,000 $30,000

MaterialityMateriality 20,00020,000

Min. necessary error reduction 10,000Min. necessary error reduction 10,000

Auditor could record adjustment for at least Auditor could record adjustment for at least $10,000 and/or perform additional testing $10,000 and/or perform additional testing (focusing on AR and inventory because largest (focusing on AR and inventory because largest

projected errors)projected errors)

Audit Risk ModelAudit Risk Model

PDR = PDR = AARAAR

IR x CRIR x CRwhere:where:PDRPDR = Planned detection risk= Planned detection riskAARAAR = Acceptable audit risk= Acceptable audit riskIRIR = Inherent risk= Inherent riskCRCR = Control risk= Control risk

or: or: AAR = IR x CR x PDRAAR = IR x CR x PDR

Planned Detection RiskPlanned Detection Risk

Risk that the Risk that the auditorauditor fails to detect fails to detect a material errora material error

• Determines amount of evidenceDetermines amount of evidence

• Dependent variableDependent variable because it is because it is determined by other risk model determined by other risk model factorsfactors

Decrease Decrease More evidence More evidence

PDRPDR required required

Acceptable Audit RiskAcceptable Audit Risk

Risk that the auditorRisk that the auditor fails to fails to modify opinion when f/s are modify opinion when f/s are misstatedmisstated

• Depends upon use of financial Depends upon use of financial statementsstatements

• Client’s financial positionClient’s financial position

Inherent RiskInherent Risk

Likelihood of error in a segment Likelihood of error in a segment (without considering effectiveness (without considering effectiveness of controls)of controls)

• Varies Varies by accountby account (errors are more (errors are more likely in some accounts than likely in some accounts than others)others)

• Varies Varies by objectiveby objective within accounts within accounts

Inherent Risk FactorsInherent Risk Factors

• Nonroutine transactionsNonroutine transactions

• Management estimatesManagement estimates

• Net realizable value issuesNet realizable value issues

• Subject to theft or manipulationSubject to theft or manipulation

Control RiskControl Risk

Risk that client’s internal controls Risk that client’s internal controls fail to detect an errorfail to detect an error

To assess control risk below To assess control risk below maximum:maximum:

• Must study and document controlsMust study and document controls

• Must test their effectivenessMust test their effectiveness

9-24 (b)9-24 (b)

Inherent risk and control risk differ from Inherent risk and control risk differ from planned detection risk in that they:planned detection risk in that they:

1. Arise from the misapplication of audit 1. Arise from the misapplication of audit procedures.procedures.

2. May be assessed in either quantitative or 2. May be assessed in either quantitative or nonquantitative terms.nonquantitative terms.

3. Exist independently of the financial 3. Exist independently of the financial statement audit.statement audit.

4. Can be changed at the auditor’s discretion.4. Can be changed at the auditor’s discretion.

Assessing Fraud RiskAssessing Fraud Risk

In addition to risk model assessment, auditors In addition to risk model assessment, auditors must assess risk of fraud on every must assess risk of fraud on every engagement related to:engagement related to:– Fraudulent financial reportingFraudulent financial reporting– Misappropriation of assetsMisappropriation of assets

These risk assessments may be incorporated in These risk assessments may be incorporated in the risk model assessments or considered the risk model assessments or considered separately.separately.

The “Fraud Triangle”The “Fraud Triangle”

OpportunitiesWeak Board of DirectorsWeak Internal Controls

Attitudes/RationalizationsLack of a Code of Conduct

Disregard for Financial Reporting

Incentives/PressuresTight Debt Covenants

Unrealistic Analyst Expectations

AAR =AAR = IR IR xx CRCR x PDR x PDRAuditAudit Risk anRisk an Risk internalRisk internal Risk Risk

thethe RiskRisk error willerror will controls won’tcontrols won’t auditorauditor

occuroccur detect itdetect it won’t won’t detect itdetect it

IR x CR = Risk of Material MisstatementIR x CR = Risk of Material Misstatement

Factor Assessment LevelFactor Assessment Level CommentComment

AAR Entire auditAAR Entire audit Based on use of f/s Based on use of f/s IRIR Objective level Objective level Assessed based Assessed based

each cycle/account on likelihoodeach cycle/account on likelihood of error of error

CRCR Objective level Depends on Objective level Depends on each cycle/ existence and each cycle/ existence and

account effectiveness of account effectiveness of controls controls

PDR Objective levelPDR Objective level Determined by Determined by each cycle/ each cycle/ other risk model other risk model

accountaccount factors factors

PDR = PDR = AAR AAR

IR x CRIR x CRPDR decreases PDR decreases Evidence Evidence

increasesincreasesEverything else can be expressed as a Everything else can be expressed as a

function of DRfunction of DR1.1. AAR decreases - AAR decreases - PDR decreases (evid. inc.)PDR decreases (evid. inc.)

2.2. IR decreasesIR decreases - - PDR increases (evid. dec.)PDR increases (evid. dec.)

3.3. CR decreasesCR decreases - - PDR increases (evid. dec.)PDR increases (evid. dec.)

Materiality PercentageMateriality Percentage

High AAR High %High AAR High %

(low risk audit) (low risk audit)

Low AAR Low %Low AAR Low %(high risk audit)(high risk audit)

Problem 9 - 32 #1 = min. evidenceProblem 9 - 32 #1 = min. evidenceSituationSituation

RiskRisk 11 22 33 44 55 66

AARAAR HH HH LL LL HH MM

IRIR LL HH HH LL MM MM

CRCR LL LL HH HH MM MM

PDRPDR HH MM LL LL MM MM

PlannedPlanned

EvidenceEvidence LL MM HH HH MM MM

Problem 9 - 32 #3 = max. evidenceProblem 9 - 32 #3 = max. evidenceSituationSituation

RiskRisk 11 22 33 44 55 66

AARAAR HH HH LL LL HH MM

IRIR LL HH HH LL MM MM

CRCR LL LL HH HH MM MM

PDRPDR H H MM LL LL MM MM

PlannedPlanned

EvidenceEvidence LL MM HH HH MM MM

Effect onEffect on Effect onEffect on

Change in factorChange in factor PDR PDR EvidenceEvidence

1. Increase in AAR1. Increase in AAR IncreaseIncrease DecreaseDecrease

2. Increase in CR2. Increase in CR DecreaseDecrease IncreaseIncrease

3. Increase in PDR3. Increase in PDR NANA DecreaseDecrease

4.4. Increase in IR Increase in IR DecreaseDecrease IncreaseIncrease

5. Increase in IR,5. Increase in IR, No effect*No effect* No effectNo effect

Decrease in CR inDecrease in CR in

same amountsame amount

CR IR AAR PECR IR AAR PE

a. Increase LTD a. Increase LTD N N N N D D I I

(First answer to collected homework given as an (First answer to collected homework given as an example)example)