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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,

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learning objective 1
Learning Objective 1

Apply the concept of

materiality to the audit.

materiality
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.

steps in applying materiality

Step

1

Set preliminary

judgment about

materiality.

Planning

extent

of tests

Step

2

Allocate preliminary

judgment about

materiality

to segments.

Steps in ApplyingMateriality
steps in applying materiality1

Step

4

Estimate the

combined misstatement.

Evaluating

results

Step

5

Compare combined

estimate with judgment

about materiality.

Steps in ApplyingMateriality

Step

3

Estimate total

misstatement in segment.

learning objective 2
Learning Objective 2

Make a preliminary judgment

about what amounts to

consider material.

set preliminary judgment
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.

factors affecting judgment
Factors Affecting Judgment

Materiality is a relative rather

than an absolute concept.

Bases are needed for

evaluating materiality.

Qualitative factors also

affect materiality.

learning objective 3
Learning Objective 3

Allocate preliminary materiality

to segments of the audit

during planning.

allocate preliminary judgment about materiality to segments
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
Learning Objective 4

Use materiality to

evaluate audit findings.

estimated total misstatement and preliminary judgment

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 judgment1

÷

Total sampled

×

Total recorded population value

=

Direct projection estimate of misstatement

Estimated Total Misstatement and Preliminary Judgment

Net misstatements in the sample

$3,500 ÷ $50,000 × $450,000 = $31,500

learning objective 5
Learning Objective 5

Define risk in auditing.

slide15
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
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.

example of differing evidence 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

Example of DifferingEvidence Among Cycles
example of differing evidence among cycles1

B

Control

risk

high

medium

C

Acceptable

audit risk

low

low

D

Planned

detection risk

low

medium

Example of DifferingEvidence Among Cycles

Inventory and

warehousing

cycle

Capital acquisition

and repayment

cycle

A

Inherent

risk

high

low

learning objective 6
Learning Objective 6

Describe the audit risk

model and its components.

audit risk model for planning
Audit Risk Modelfor Planning

PDR = AAR ÷ (IR × CR)

where:

PDR = Planned detection risk

AAR = Acceptable audit risk

IR = Inherent risk

CR = Control risk

learning objective 7
Learning Objective 7

Consider the impact of

engagement risk

on acceptable audit risk.

impact of engagement risk on acceptable audit risk
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.

factors affecting acceptable audit risk
Factors AffectingAcceptable 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

factors affecting acceptable audit risk1
Factors AffectingAcceptable Audit Risk

The auditor’s evaluation of

management’s integrity

making the acceptable audit risk decision

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 AcceptableAudit Risk Decision
making the acceptable audit risk decision1
Making the AcceptableAudit 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.

Management

integrity

  • See Chapter 8 for client acceptance and continuance.
learning objective 8
Learning Objective 8

Consider the impact of several

factors on the assessment

of inherent risk.

major factors when assessing inherent risk
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
learning objective 9
Learning Objective 9

Discuss the relationship

of risks to audit evidence.

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

Relationship of Risk Factors,Risk, and Evidence
changing the audit in response to risk
Changing the Audit in Response to Risk

The engagement may require

more experienced staff.

The engagement will be reviewed

more carefully than usual.

audit risk for segments
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
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.

tolerable misstatement risks and balance related objectives
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
Measurement Limitations

One major limitation in the application

of the audit risk model is the difficulty

of measuring the components of the model.

relationships of risk to evidence

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 Riskto Evidence
tests of details of balances evidence planning worksheet
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
Learning Objective 10

Discuss how materiality and

risk are related and integrated

into the audit process.

tolerable misstatements risk and planned evidence

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
audit risk model for evaluating results
Audit Risk Model for Evaluating Results

AcAR = IR × CR × AcDR

where:

AcAR = Achieved audit risk

IR = Inherent risk

CR = Control risk

AcDR = Achieved detection risk

revising risks and evidence
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.