Materiality and Risk

1. Materiality and Risk Chapter 9

2. Learning Objective 1 Apply the concept of materiality to the audit.

3. Materiality The auditor’s responsibility is to determine whether financial statements are materially misstated. If there is a material misstatement, the auditor will bring it to the client’s attention so that a correction can be made.

4. Steps in ApplyingMateriality Step 1 Set preliminary judgment about materiality. Planning extent of tests Step 2 Allocate preliminary judgment about materiality to segments.

5. Steps in ApplyingMateriality Step 3 Estimate total misstatement in segment. Step 4 Estimate the combined misstatement. Evaluating results Step 5 Compare combined estimate with judgment about materiality.

6. Learning Objective 2 Make a preliminary judgment about what amounts to consider material.

7. Set Preliminary Judgment Ideally, auditors decide early in the audit the combined amount of misstatements of the financial statements that would be considered material. This preliminary judgment is the maximum amount by which the auditor believes the statements could be misstated and still not affect the decisions of reasonable users.

8. Factors Affecting Judgment Materiality is a relative rather than an absolute concept. Bases are needed for evaluating materiality. Qualitative factors also affect materiality.

9. Learning Objective 3 Allocate preliminary materiality to segments of the audit during planning.

10. Allocate Preliminary Judgment About Materiality to Segments This is necessary because evidence is accumulated by segments rather than for the financial statements as a whole. Most practitioners allocate materiality to balance sheet accounts. SAS 39 (AU 350)

11. Learning Objective 4 Use materiality to evaluate audit findings.

12. Estimated TotalMisstatement Example Net misstatement of the sample ÷ Total sampled × Total recorded population value = Direct projection estimate of misstatement $3,500 ÷ $50,000 × $450,000 = $31,500

13. Example of Estimatefor Sampling Error Tolerable Direct Sampling AccountMisstatementProjectionErrorTotal Cash $ 4,000 $ 0 $ N/A $ 0 Accounts receivable 20,000 12,000 6,000* 18,000 Inventory 36,000 31,500 15,750* 47,250 Total estimated misstatement amount $43,500 $16,800 $60,300 Preliminary judgment about materiality $50,000 *estimate for sampling error is 50%

14. Learning Objective 5 Define risk in auditing.

15. Risk Auditors accept some level of risk in performing the audit. An effective auditor recognizes that risks exist, are difficult to measure, and require careful thought to respond. Responding to risks properly is critical to achieving a high-quality audit.

16. Risk and Evidence Auditors gain an understanding of the client’s business and industry and assess client business risk. Auditors use the audit risk model to further identify the potential for misstatements and where they are most likely to occur.

17. Example of DifferingEvidence Among Cycles Sales and Collection Cycle Acquisition and Payment Cycle Payroll and Personnel Cycle A Inherent risk medium high low B Control risk medium low low C Acceptable audit risk low low low D Planned detection risk medium medium high

18. Example of DifferingEvidence Among Cycles Inventory and Warehousing Cycle Capital Acquisition and Repayment Cycle A Inherent risk high low B Control risk high medium C Acceptable audit risk low low D Planned detection risk low medium

19. Learning Objective 6 Describe the audit risk model and its components.

20. Audit Risk Modelfor Planning PDR = AAR ÷ (IR × CR) Where PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk

21. Learning Objective 7 Consider the impact of risk on acceptable audit risk.

22. Impact of Engagement Riskon Acceptable Audit Risk Auditors decide engagement risk and use that risk to modify acceptable audit risk. Engagement risk closely relates to client business risk.

23. Factors AffectingAcceptable Audit Risk The degree of which external users rely on the statements The likelihood that a client will have financial difficulties after the audit report is issued

24. Factors AffectingAcceptable Audit Risk The auditor’s evaluation of management’s integrity

25. Making the AcceptableAudit Risk Decision Factors Methods to Assess Risk External users reliance on financial statements • Examine financial statements. • Read minutes of the board. • Examine form 10K. • Discuss financing plans • with management.

26. Making the AcceptableAudit Risk Decision Factors Methods to Assess Risk Likelihood of financial difficulties • Analyze financial statements for difficulties using ratios. • Examine inflows and outflows of cash flow statements. Management integrity • See Chapter 8 for client acceptance and continuance.

27. Learning Objective 8 Consider the impact of several factors on the assessment of inherent risk.

28. Major Factors WhenAssessing Inherent Risk • Nature of the client’s business • Results of previous audits • Initial versus repeat engagement • Related parties • Nonroutine transactions • Judgment – correctly record account • balances and transactions • Makeup of the population

29. Learning Objective 9 Consider information gathered to assess the likelihood of fraud.

30. Assessing Risks of Fraud Three conditions are generally present. 1. Incentives/Pressures 2. Opportunities 3. Attitudes/Rationalization

31. Examples of Risks Factorsfor Fraudulent Reporting 1. Incentives/Pressures Financial stability or profitability is threatened by economic, industry, or entity operating conditions. Excessive pressure exists for management to meet debt requirements. Personal net worth is materially threatened.

32. Examples of Risks Factorsfor Fraudulent Reporting 2. Opportunities There are significant accounting estimates that are difficult to verify. There is ineffective oversight over financial reporting. High turnover or ineffective accounting internal audit, or information technology staff exists.

33. Examples of Risks Factorsfor Fraudulent Reporting 3. Attitudes/Rationalization Inappropriate or inefficient communication and support of the entity’s values is evident. A history of violations of laws is known. Management has a practice of making overly aggressive or unrealistic forecasts.

34. Responding to theRisk of Fraud Design and perform audit procedures to address identified fraud risk. Change the overall conduct of the audit to respond to identified fraud risk. Perform procedures to address the risk of management override of controls.

35. Learning Objective 10 Discuss the relationship of risks to audit evidence.

36. Relationship of Risk Factors,Risk, and Evidence Acceptable audit risk D D I Factors Influencing Risks Inherent risk Planned detection risk Planned audit evidence I I I D Control risk D = Direct relationship; I = Inverse relationship

37. Changing the Audit in Response to Risk The engagement may require more experienced staff. The engagement will be reviewed more carefully than usual.

38. Audit Risk for Segments Both control risk and inherent risk are typically set for each cycle, each account, and often even each audit objective, not for the overall audit.

39. Relating Risk of Fraud toRisk Model Components The risk of fraud can be assessed for the entire audit or by cycle, account, and objective. Specific response could include revising assessments of acceptable audit risk, inherent risk, and control risk.

40. Tolerable Misstatement, Risks,and Balance-related Objectives It is common to assess inherent and control risk for each balance-related audit objective. It is not common to allocate materiality to objectives.

41. Measurement Limitations One major limitation in the application of the audit risk model is the difficulty of measuring the components of the model.

42. Relationships of Riskto Evidence Acceptable Planned Amount of Audit Inherent Control Detection Evidence Situation Risk Risk Risk Risk Required 1 High Low Low High Low 2 Low Low Low Medium Medium 3 Low High High Low High 4 Medium Medium Medium Medium Medium 5 High Low Medium Medium Medium

43. Tests of Details of Balances Evidence Planning Worksheet Auditors develop various types of worksheets to aid in relating the considerations affecting audit evidence to the appropriate evidence to accumulate.

44. Learning Objective 11 Discuss how materiality and risk are related and integrated into the audit process.

45. Tolerable Misstatements,Risk, and Planned Evidence Acceptable audit risk D D I Inherent risk Planned detection risk Planned audit evidence I I I D I Control risk Tolerable misstatement D = Direct relationship; I = Inverse relationship

46. Audit Risk Model for Evaluating Results AcAR = IR × CR × AcDR Where AcAR = Achieved audit risk AcDR = Achieved detection risk IR = Inherent risk CR = Control risk

47. Revising Risksand Evidence The audit risk model is primarily a planningmodel and is therefore of limited use in evaluating results. Great care must be used in revising the risk factors when the actual results are not as favorable as planned.

48. End of Chapter 9