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Understanding Materiality and Audit Risk

Explore the significance of materiality in auditing, including judgment factors, evidence accumulation, and risk assessment models. Learn about the relationship between risk and materiality for effective audits.

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Understanding Materiality and Audit Risk

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  1. CHAPTER 8 MATERIALITY AND RISK

  2. MATERIALITY • THE MAGNITUDE OF AN OMISSION OR MISSTATEMENT…THAT MAKES IT PROBABLE THAT THE JUDGMENT OF A REASONABLE PERSON WOULD BE CHANGED OR INFLUENCED BY THE ITEM.

  3. PRELIMINARY JUDGMENT ABOUT MATERIALITY • PROFESSIONAL JUDGMENT • AMOUNT OF MISSTATEMENT PRESENT AND NOT INFLUENCE USERS • PLANNING DECISION • APPROPRIATE LEVEL OF EVIDENCE • HIGHER MATERIALITY, LOWER EVIDENCE • FACTORS AFFECTING JUDGMENT • RELATIVE RATHER THAN ABSOLUTE • BASES FOR COMPARISON • QUALITATIVE FACTORS

  4. ALLOCATE PLANNING MATERIALITY TO SEGMENTS • EVIDENCE IS ACCUMULATED BY SEGMENT • AMOUNT IF EVIDENCE IS INVERSLY RELATED TO MATERIALITY • TOLERABLE MISSTATEMENT • NO ONE WAY TO ALLOCATE • MATERIALITY REVISED DURING AUDIT

  5. ESTIMATE MISSTATEMENT • RESULTS OF AUDIT PROJECTED TO ACCOUNT BALANCE • PROJECTION • STATISTICAL OR NONSTATISTICAL • DIRECT PROJECTION • ALLOWANCE FOR SAMPLING RISK • ESTIMATE OF COMBINED MISSTATEMENT • COMPARE WITH MATERIALITY • EXPAND AUDIT WORK OR ACCEPT RESULT

  6. RISK • UNCERTAINTY IN THE AUDIT FUNCTION • COMPETENCE OF EVIDENCE • STRENGTH OF INTERNAL CONTROLS • FAIRNESS OF FINANCIAL STATEMENTS

  7. AUDIT RISK MODEL • AR = IR * CR * DR • AR = AUDIT RISK • RISK THAT AUDITOR REACHES THE WRONG CONCLUSION • IR = INHERENT RISK • RISK THAT MATERIAL MISSTATEMENTS OCCUR BECAUSE OF NATURE OF ITEM AUDITED • CR = CONTROL RISK • RISK THAT CLIENT’S INTERNAL CONTROLS WILL NOT PREVENT OR DETECT MISSTATEMENT • DR = DETECTION RISK • RISK THAT AUDIT PROCEDURES WILL BE INEFFECTIVE

  8. PLANNED DETECTION RISK • MEASURE OF RISK THAT AUDITOR’S PROCEDURES WILL NOT FIND MATERIAL MISSTATEMENTS THAT EXIST IN FINANCIAL STATEMENTS • ACCEPTABLE AUDIT RISK • RISK THAT AUDITOR IS WILLING TO ACCEPT THAT AUDIT OPINION WILL BE INCORRECT • RELIANCE OF USERS ON F/S • LIKELIHOOD OF FINANCIAL DIFFICULTIES • MANAGEMENT INTEGRITY

  9. ASSESSMENT OF INHERENT RISK • EXPECTATION OF MATERIAL MISSTATEMENTS BEFORE INTERNAL CONTROLS • FACTORS • NATURE OF BUSINESS • FRAUD • RESULTS OF PREVIOUS AUDITS • INITIAL ENGAGEMENT • RELATED PARTIES • NONROUTINE TRANSACTIONS • JUDGMENT IN PROPER ACCOUNTING • SUSCEPTABILITY TO ASSET MISAPPROPRIATION • MAKEUP OF POPULATION

  10. OTHER MATERIALITY AND RISK CONSIDERATIONS • AUDIT RISK MODEL APPLIED TO SEGMENTS • CONTROL RISK AND INHERENT RISK SET • EACH CYCLE • EACH ACCOUNT BALANCE • EACH AUDIT OBJECTIVE • AUDIT RISK USUSALLY SET FOR WHOLE

  11. MEASUREMENT PROBLEMS AND MODEL • DIFFICULT TO QUANTIFY RISKS ACCURATELY AS %-AGES • MOST AUDITORS USE SUBJECTIVE MEASURES LIKE “LOW” • RELATION OF EVIDENCE TO RISK IS SUBJECTIVE ALSO • CONCERN ABOUT OVER- OR UNDER-AUDITING

  12. RELATIONSHIP OF RISK AND MATERIALITY • RISK IS UNCERTAINTY • MATERIALITY IS SIZE • RISK OF MATERIAL MISSTATEMENT • RISK THAT MISSTATEMENT OF CERTAIN SIZE EXISTS IN ITEM BEING AUDITED • AS MATERIALITY DECREASES, RISK INCREASES • RISK MODEL IS PRIMARILY A PLANNING TOOL • IMPORTANT RELATIONSHIP IS RISK - EVIDENCE

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