Materiality and Risk

Materiality and Risk Chapter 9

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

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.

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

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

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

Set Preliminary Judgment about Materiality 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.

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

Guidelines Accounting and auditing standards do not provide specific materiality guidelines to practitioners. Professional judgment is to be used at all times in setting and applying materiality guidelines.

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

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)

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

Estimated misstatement amount Account Tolerable misstatement Direct projection Sampling error* Total Cash Accounts receivable Inventory Total estimated misstatement amount Preliminary judgment about materiality $ 4,000 20,000 36,000 $50,000 $ 0 12,000 31,500 $43,500 $ N/A 6,000 15,750 $16,800 $ 0 18,000 47,250 $60,300 *estimate for sampling error is 50% Estimated Total Misstatement and Preliminary Judgment

Estimated Total Misstatement and Preliminary Judgment Net misstatements in the sample ÷ Total sampled × Total recorded population value = Direct projection estimate of misstatement $3,500 ÷ $50,000 × $450,000 = $31,500

Learning Objective 5 • Define risk in auditing.

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.

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.

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 Illustration of Differing Evidence Among Cycles

Illustration of Differing Evidence 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

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

Audit Risk Model for Planning PDR = AAR ÷ (IR × CR) where: PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk

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

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

Factors Affecting Acceptable Audit Risk The degree to which external users rely on the statements The likelihood that a client will have financial difficulties after the audit report is issued The auditor’s evaluation of management’s integrity

Factors Methods used to assess acceptable audit risk External users’ reliance on financial statements • Examine financial statements. • Read minutes of the board. • Examine form 10K. • Discuss financing plans • with management. Making the Acceptable Audit Risk Decision

Management integrity • See Chapter 8 for client • acceptance and continuance. Making the Acceptable Audit Risk Decision Factors Methods used to assess acceptable audit risk Likelihood of financial difficulties • Analyze financial statements • for difficulties using ratios. • Examine inflows and outflows • of cash flow statements.

Learning Objective 8 • Consider the impact of several • factors on the assessment • of inherit risk.

Factors Affecting Inherent Risk • Nature of the client’s business • Results of previous audits • Initial versus repeat engagement • Related parties • Nonroutine transactions • Judgment required to correctly record account balances and transactions • Makeup of the population

Learning Objective 9 • Discuss the relationship of • risks to audit 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 Relationship of Risk Factors,Risk, and Evidence

Relationship of Risk Factors,Risk, and Evidence Auditors can change the audit to respond to risks. The engagement may require more experienced staff. The engagement will be reviewed more carefully than usual.

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.

Relating Risk of Fraud to Risk 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.

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.

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

Situation Acceptable audit risk Inherent risk Control risk Planned detection risk Amount of evidence required 1 2 3 4 5 High Low Low Medium High Low Low High Medium Low Low Low High Medium Medium High Medium Low Medium Medium Low Medium High Medium Medium Relationships of Risk to Evidence

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.

Learning Objective 10 • Discuss how materiality and risk • are related and integrated into • the audit process.

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

Evaluating Results AcAR = IR × CR × AcDR where: AcAR = Achieved audit risk IR = Inherent risk CR = Control risk AcDR = Achieved detection risk

Inherent risk D Achieved audit risk Acceptable audit risk Compare Control risk D Substantive audit evidence Achieved detection risk D D = Direct relationship I = Inverse relationship I Audit Risk Models for Planning Evidence and Evaluating Results

Revising Risks and 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.

End of Chapter 9

Materiality and Risk