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Understanding Materiality in Audits: An Essential Guide for Financial Statement Users

This comprehensive guide explains the concept of materiality in audits and its importance in providing reasonable assurance that financial statements are free of misstatements. Learn how to estimate, set, and allocate materiality, factors affecting tolerable misstatements, and steps in applying materiality effectively.

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Understanding Materiality in Audits: An Essential Guide for Financial Statement Users

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  1. Materiality • Audits provide reasonable assurance that the financial statements are free of material misstatements.

  2. User Focus • Materiality is defined in terms of financial statement users • Therefore no hard and fast rules • Need to consider multiple users and multiple bases

  3. Step 3 Step 4 Step 5 Step 1 Step 2 Estimate total misstatement in segment Estimate the combined misstatement Compare combined estimate with preliminary or revised judgment about materiality Set preliminary judgment about materiality Allocate preliminary judgment about materiality to segments FIGURE 9 - 1Steps in Applying Materiality Planning extent of tests Evaluating results

  4. Set Preliminary Judgment About Materiality • Base X (function of client) • Percentage (function of audit risk) • -------------- • = Preliminary estimate of materiality

  5. Materiality Percentage • Typically 3-6% for net income, lower percentages for larger bases such as assets or revenues • High risk Low % • Low risk High % • (less evidence; less assurance)

  6. Materiality/Evidence Relation • Increase in Less • materiality evidence required

  7. As lower acceptable levels of audit risk and materiality are established, the auditor should plan more work on individual accounts to: • 1. Find smaller errors. • 2. Find larger errors. • 3. Increase tolerable error in accounts. • 4. Increase materiality in the accounts.

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

  9. Factors affecting tolerable misstatement • Larger allocation Smaller allocation • Large balance Small balance • Errors expected Few errors expected • Costly to test or Less costly to test • Testable with AP

  10. Steps in Applying Materiality • Planning phase Set preliminary judgment Allocate materiality to segments • Evaluating Estimate total • results misstatement in segment • Estimate combined misstatement • Compare combined misstatement to materiality estimate

  11. Projecting Errors • Balance in accts. receivable: 1,000,000 • Accts. receivable tested: 250,000 • Overstatement errors: 10,000 • Projected error = • (10,000/250,000) x 1,000,000= • 40,000+ allowance for sampling error

  12. Tolerable Est. of Total Misstatement Misstmt. • Over- Under- Over- Under- • Account stmt. stmt. stmt. stmt. • Cash 2,000 3,000 2,000 -0- • A/R 12,000 18,000 4,000 19,000 • Inventory 8,000 14,000 3,000 10,000 • Prepaids 3,000 5,000 2,000 1,000 • Total 25,000 40,000 11,000 30,000 • Preliminary estimate of materiality: • Overstatements = 12,500 Understatements = 20,000

  13. Options When Projected Errors Exceed Materiality • Record an adjustment • Usually limited to actual errors • Perform more testing • Better error estimate • Lower sampling risk • Qualify Opinion

  14. Options Applied to Prob. 9-25 • Projected understmt. errors $30,000 • Materiality 20,000 • Min. necessary error reduction 10,000 • Auditor could record adjustment for at least $10,000 and/or perform additional testing (focusing on AR and inventory because largest projected errors)

  15. Audit Risk Model • PDR = AAR • IR x CR • where: • PDR= Planned detection risk • AAR = Acceptable audit risk • IR = Inherent risk • CR = Control risk • or: AAR = IR x CR x PDR

  16. Planned Detection Risk • Risk that the auditorfails to detect a material error • Determines amount of evidence • Dependent variable because it is determined by other risk model factors • Decrease More evidence • PDR required

  17. Acceptable Audit Risk • Risk that the auditorfails to modify opinion when f/s are misstated • Depends upon use of financial statements • Client’s financial position

  18. Inherent Risk • Likelihood of error in a segment (without considering effectiveness of controls) • Varies by account (errors are more likely in some accounts than others) • Varies by objective within accounts

  19. Inherent Risk Factors • Nonroutine transactions • Management estimates • Net realizable value issues • Subject to theft or manipulation

  20. Control Risk • Risk that client’s internal controls fail to detect an error • To assess control risk below maximum: • Must study and document controls • Must test their effectiveness

  21. 9-24 (b) • Inherent risk and control risk differ from planned detection risk in that they: • 1. Arise from the misapplication of audit • procedures. • 2. May be assessed in either quantitative or • nonquantitative terms. • 3. Exist independently of the financial • statement audit. • 4. Can be changed at the auditor’s discretion.

  22. Assessing Fraud Risk • In addition to risk model assessment, auditors must assess risk of fraud on every engagement related to: • Fraudulent financial reporting • Misappropriation of assets • These risk assessments may be incorporated in the risk model assessments or considered separately.

  23. The “Fraud Triangle” Opportunities Weak Board of Directors Weak Internal Controls Incentives/Pressures Tight Debt Covenants Unrealistic Analyst Expectations Attitudes/Rationalizations Lack of a Code of Conduct Disregard for Financial Reporting

  24. AAR = IRx CR x PDR • AuditRisk anRisk internal Risk the • Risk error willcontrols won’tauditor • occur detect it won’t • detect it • IR x CR = Risk of Material Misstatement

  25. Factor Assessment Level Comment • AAR Entire audit Based on use of f/s • IR Objective level Assessed based • each cycle/account on likelihood of error • CR Objective level Depends on each cycle/ existence and account effectiveness of controls • PDR Objective level Determined by each cycle/ other risk model account factors

  26. PDR = AAR • IR x CR • PDR decreases Evidence increases • Everything else can be expressed as a function of DR • 1. AAR decreases - PDR decreases (evid. inc.) • 2. IR decreases - PDR increases (evid. dec.) • 3. CR decreases - PDR increases (evid. dec.)

  27. Materiality Percentage • High AAR High % • (low risk audit) • Low AAR Low % • (high risk audit)

  28. Problem 9 - 32 #1 = min. evidence • Situation • Risk 12 3 4 5 6 • AAR H H LL H M • IR LH H L M M • CR L L H H M M • PDR HM L L M M • Planned • Evidence LM H H M M

  29. Problem 9 - 32 #3 = max. evidence • Situation • Risk 1 2 3 4 5 6 • AAR H H LL H M • IR L H HL M M • CR L L HH M M • PDR H M L L M M • Planned • Evidence L M H H M M

  30. Effect on Effect on • Change in factor PDR Evidence • 1. Increase in AAR Increase Decrease • 2. Increase in CR Decrease Increase • 3. Increase in PDR NA Decrease • 4. Increase in IR Decrease Increase • 5. Increase in IR, No effect* No effect • Decrease in CR in • same amount

  31. CR IR AAR PE • a. Increase LTD N N D I • (First answer to collected homework given as an example)

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