ACCT 4240: Auditing

1. ACCT 4240: Auditing Materiality and Risk

2. Determine Planning Materiality • Materiality: the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement (AU§312.06).

3. Determine Planning Materiality • Auditor must use judgment to estimate what level of precision is important to financial statement users. • Estimate may be based on prior history and/or projected financial amounts. • Typical “rules of thumb”: • 5% of pretax income. • ½% of revenues. • ½% of total assets. • 1% of total equity.

4. Staff Accounting Bulletin 99 • Rules of thumb should only be the start of determining materiality. • SAB 99 points out that rules of thumb do not appear anywhere in the professional literature or in the law. • SAB 99 suggests a number of issues that may cause a quantitatively small item to be material.

5. An Item May Be Material if it: • Arises from an item incapable of being measured precisely, or from an inherently imprecise estimate. • Conceals a change in the trend in earnings. • Hides a failure to meet analysts' expectations. • Changes a loss into income, or vice versa.

6. An Item May Be Material if it: • Concerns a significant segment of the firm. • Affects compliance with regulatory requirements. • Affects compliance with debt covenants or other contractual requirements. • Increases management compensation through bonus plan arrangements.

7. An Item May Be Material if it: • Involves concealment of unlawful activity. • Exhibits price volatility in response to disclosure of an item. • Appears to be an intentional misstatement. The qualitative and quantitative aspects of each misstatement should be considered separately and aggregated with other misstatements to determine whether the financial statements as a whole are misleading.

8. Legality of Misstatements • Even small deliberate misstatements may violate Sections 13(b)(2)–(7) of the Securities Exchange Act of 1934. • Failure to correct a known misstatement may be illegal, based on: • the significance of the misstatement. • how the misstatement arose. • the cost of correcting the misstatement. • the clarity of the related authoritative accounting guidance.

9. Auditor Response • Auditors are required to report illegal acts to the firm's audit committee under Section 10A(b)(1) of the Securities Exchange Act of 1934. • Because an intentional misstatement may be illegal, the auditor is required to act, regardless of whether the misstatements are material.

10. Tolerable Misstatements • Evidence is gathered by segments rather than for financial statements as a whole. • Many auditors allocate materiality only across balance sheet accounts. • Example approach (not used by all): • Amount allocated to any one account cannot exceed 60% of total. • Total of all amounts cannot exceed twice overall planning materiality level.

11. Materiality Levels Based on a Variable Percentage of Total Assets or Revenue

12. Materiality Levels Based on a Variable Percentage of Total Assets or Revenue

13. Risk • Audit Risk: The risk that the auditor may unknowingly fail to appropriately modify an opinion on financial statements that are materially misstated • Auditor’s Business Risk: The risk of financial loss resulting from audit outcomes • Litigation (regardless of whether auditor is right or wrong) • Loss of reputation

14. Relationship of Risks

15. Audit Risk Model AR = IR x CR x DR where: AR = Audit Risk IR = Inherent Risk CR = Control Risk DR = Detection Risk

16. Audit Risk = Inherent Risk x Control Risk X Detection Risk The Audit Risk Model • Inherent Risk: The susceptibility of an account or transaction to error. • Control Risk: The risk that the control system will fail to prevent or detect a material error. • Control system designed by management based on cost/benefit considerations. • All systems have an inherent level of error occurrence. • Auditor attempts to estimate inherent error level so appropriate audit procedures can be performed. • Detection Risk: The risk that substantive procedures will fail to detect a material misstatement.

17. Assess Inherent Risk at the Assertion Level • Number of nonroutine transactions • Degree of management judgment required • Susceptibility to misappropriation • Makeup of the population • Number of misstatements found in prior audits

18. Assess Control Risk at the Assertion Level • Control risk (CR) estimate is based on: • An assessment of the effectiveness of the internal accounting control system. • The auditor’s intention to rely on those controls in order to reduce audit effort. • If CR is less than 100%, the auditor must: • Obtain an understanding of internal control. • Evaluate how it should function. • Test the controls for effectiveness.

19. Assess Control Risk at the Assertion Level • Estimate of Control Risk arrived at through: • Inquiry of client personnel. • Observation. • Compliance tests of controls.

20. Identify Audit Procedures • Auditor has three variables that affect detection risk: • Nature of procedures. • Extent of procedures (i.e. number of items examined). • Timing of procedures.

21. Relationship of Audit Procedures • For low inherent risk and low control risk: • Less rigorous procedures may be used. • Analytical procedures. • Tests of details and balances. • Extent of procedures may be reduced. • Procedures may be performed further from company year-end.

22. Allowable Detection Risk versus Audit Procedures AR TD = IR x CR Low Medium High Nature Stronger Less Strong Extent More Items Fewer Items Timing Close to Interim Near Year-end Interim Well Year-end Before Year- end

23. Risk Components Matrix

24. Audit Evidence-Gathering Decisions • Nature: Selecting the audit procedures that will be applied. • Extent: The number of items to audit. • Timing: When the tests will be performed. • Interim. • Year-end or final.

25. Types of Misstatements • Errors: An unintentional misstatement of the financial statements • Fraud: An intentional misstatement of the financial statements • Misappropriation of assets (defalcations) • Fraudulent financial reporting • Illegal Acts: Violations of laws or government regulations

26. Misstatements • Misstatements may result from: • Mathematical errors • Omissions of appropriate information • Misunderstandings • Misapplication of GAAP • Incorrect summarizations and descriptions

27. Types of Audit Procedures • Direct tests: The account itself is being tested. • Indirect tests: The relationships of accounts are tested.

28. Planning Audit Procedures Audit Objectives Logically suggest Audit procedures Influenced by: Risk assessment Materiality Knowledge of client’s: Accounting system Control procedures Business environment Which are documented to comprise Audit programs

29. Relative Costs of Audit Procedures Relative Cost Low High Procedure Analytical procedures Inquiry Observation/Physical examination Examination of documents and records/Mechanical accuracy tests Confirmation

30. Mechanical Accuracy Test (Recalculation) • Footing • Crossfooting • Extensions (e.g. price x quantity)

31. Inspection • Physical examination of assets • Examination of documents and records • Internal documents • External documents • Audit trail • Vouching (G/L to transaction) • Tracing (Transaction to G/L)

32. Confirmations • Accounts receivable must be confirmed, unless: • Accounts receivable are immaterial. • Confirmations would be ineffective. • The combined assessed level of inherent risk and control risk is low, and the assessed level, in conjunction with the evidence expected to be provided by analytical procedures or other substantive tests of details, is sufficient to reduce audit risk to an acceptable level.

33. Confirmations • Positive confirmations require response regardless of whether information is correct or incorrect. • Information to be confirmed may be included or may be left blank. • Nonresponses require alternative audit procedures or must be treated as an exception.

34. Confirmations • Negative confirmations ask for a response only if the information is incorrect. • Large number of small accounts. • Combined assessed inherent risk and control risk is low. • No reason to believe that recipients are unlikely to give them consideration.

35. Other Audit Procedures • Analytical procedures • Scanning • Computing and comparisons • Observation of activities, conditions, or other evidence • Inquiry of client personnel

36. Next Time Audit Planning