Audit Risk Materiality

1. Audit Risk & Materiality

2. Risk & Materiality The �Backbone� of the audit process Risk and Materiality guide evidence collection Both affect the nature, timing, and/or the extent of our tests Essentially, we are interested in gathering enough evidence to limit the probability (i.e. risk) a misstatement of a particular size (i.e. materiality) will occur.

3. Primary Risks Audit Risk � the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated (AU 312.02). Auditor Business Risk (engagement risk) � the risk that an auditor incurs loss or injury to his or her professional practice from litigation, adverse publicity, or other events arising in connection with financial statements audited and reported on (AU 312.02, fn 2). Client Business Risk � the risk that an audit client�s economic condition will deteriorate in the future. How do these risks relate to each other? 3

4. Concerns Surrounding Risk-Based Auditing Weil, J. 2004. A Change in How Auditors Work. Wall Street Journal. March 25. 4

5. Review Definitions Audit risk Control risk Inherent risk Detection risk Materiality Audit risk is the risk that the auditor gives an inappropriate audit opinion when the financial statements are materially misstated. Audit risk has three components: inherent risk, control risk and detection risk. Control risk�Control risk is the risk that a misstatement that could occur in an account balance or class of transactions and that could be material, individually or when aggregated with misstatements in other balances or classes, will not be prevented or detected and corrected on a timely basis by the accounting and internal control systems. Detection risk�Detection risk is the risk that an auditor�s substantive procedures will not detect a misstatement that exists in an account balance or class of transactions that could be material, individually or when aggregated with misstatements in other balances or classes. Sampling vs. Nonsampling Risk Inherent risk�Inherent risk is the susceptibility of an account balance or class of transactions to misstatement that could be material, individually or when aggregated with misstatements in other balances of classes, assuming that there were no related internal controls. An item is considered material if knowledge of the misstatement would affect the decision of a reasonable user.Audit risk is the risk that the auditor gives an inappropriate audit opinion when the financial statements are materially misstated. Audit risk has three components: inherent risk, control risk and detection risk. Control risk�Control risk is the risk that a misstatement that could occur in an account balance or class of transactions and that could be material, individually or when aggregated with misstatements in other balances or classes, will not be prevented or detected and corrected on a timely basis by the accounting and internal control systems. Detection risk�Detection risk is the risk that an auditor�s substantive procedures will not detect a misstatement that exists in an account balance or class of transactions that could be material, individually or when aggregated with misstatements in other balances or classes. Sampling vs. Nonsampling Risk Inherent risk�Inherent risk is the susceptibility of an account balance or class of transactions to misstatement that could be material, individually or when aggregated with misstatements in other balances of classes, assuming that there were no related internal controls. An item is considered material if knowledge of the misstatement would affect the decision of a reasonable user.

6. The Audit Risk Model AR = IR x CR x DR Audit risk is set at some acceptable level Detection risk is a risk that dictates the amount of audit evidence that must be obtained - we must ACHIEVE this! Inherent and control risks are measured

7. Audit Risk Model DR = AR / IR x CR If IR = 75%, CR = 100%, and AR = 5% DR = 6.7% DR is inversely related to the amount of evidence required, so If we change IR to 100% what should happen? If CR is reduced to 50% what happens? DR = 5% and more evidence will be required DR = 13% less evidence is requiredDR = 5% and more evidence will be required DR = 13% less evidence is required

8. Advanced Audit Risk First, are IR and CR independent of each other? In other words can they be evaluated in isolation? To help you answer this question, first answer, what is the purpose of internal control?

10. A couple of problems with the model Another Issue: All inherent risks are not controllable Examples? If this is the case, then� 100% (IR) X 50% (CR) = 50%? Lets work through the implications of this together Fraud Are the risks independent of each other?Fraud Are the risks independent of each other?

11. Practical Implications Mathematical approach can yield optimistic estimates of DR. The preventative nature of controls can actually makes IR somewhat dependent on CR

12. Other Issues Fraud Risk?

13. Materiality A relative concept Appropriate base amount Qualitative factors � SAB 99 Contractual issues Trend in earnings/Net Income vs. Net Loss General guidelines Greater of Total Assets or Total Revenue for planning materiality - Income before taxes is also common Individual Items < 5% usually immaterial - 5-10 �considerable judgment� should be used General guidelines Greater of Total Assets or Total Revenue for planning materiality - Income before taxes is also common Individual Items < 5% usually immaterial - 5-10 �considerable judgment� should be used

14. Qualitative Materiality Factors SEC Staff Accounting Bulletin No. 99 � Materiality arises from an item capable of precise measurement or from an estimate masks change in earnings or other trends hides failure to meet analysts� expectations changes loss to income concerns a segment/division that has a significant role in the consolidated entity affects compliance with regulatory requirements affects compliance with loan covenants increases management�s compensation involves concealing an illegal act � consider the market�s reaction to the information 14

15. Materiality Uses in the audit Preliminary Materiality Allocated to audit segments � Usually to balance sheet items Tolerable misstatement May be revised if there is a change in factors used to determine preliminary judgment (e.g. if based on PY before CY numbers are known).

16. Materiality Difficulties Dealing with items that are �close� 5-10% Qualitative Issues What if the auditor disagrees over an estimate? Outsider views? Should Materiality be disclosed?

17. Materiality and AS 5 17