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Chapter 9
Materiality and Audit Risk
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Under which auditing approach(es) are auditors required to obtain an understanding of the internal controls?
Giselle
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Which section of the Auditing Standards requires auditors to obtain an understanding of the internal controls?
Elizabeth W
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Why are auditors always required to obtain and understanding of the internal controls?
Eric
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.03 The objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels through understanding the entity and its environment, including the entity's internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement.
AU-C 315 Understanding the Entity & Its Environment & Assessing RoMM
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we are always required to obtain an understanding of the Internal Control
to identify & assess the RoMM risks of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels
through understanding the entity and its environment, including the entity's internal control, thereby to provide a basis for designing and implementing responses to the assessed RoMM.
planning phase
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Analytical Procedures
during the planning phase
• understand the client’s industry and business
• to identify potential misstatements
• attention directing
• design audit procedures that reduce the risk we might fail to detect a material misstatement
page 94
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AICPA
December 2006
109Statementon AuditingStandards
Understanding the Entity and its Environment andAssessing the Risks of MaterialMisstatement
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Under what audit approach(es) are auditors required to obtain sufficient appropriate audit evidence?
Ellen
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Which section of the Auditing Standards requires auditors to obtain sufficient appropriate evidence?
Dev
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.04 The objective of the auditor is to design and perform audit procedures that enable the auditor to obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the auditor's opinion.
AU-C 500Audit Evidence
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How do we obtain audit evidence?
Jennifer
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What is the definition of audit risk?
Brenda
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Audit risk. The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated.
Audit risk is a function of the risks of material misstatement and detection risk.
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What is the definition of Materiality?
Ryan M
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AU Section 312 Audit Risk and Materiality in Conducting an Audit Source: SAS No. 107. Effective for audits of financial statements for periods beginning on or after Dec. 15, 2006. Earlier application is permitted.
.04 The auditor's consideration of materiality is a matter of professional judgment and is influenced by his perception of the needs of a reasonable person who will rely on the financial statements. The perceived needs of a reasonable person are recognized in the discussion of materiality in Financial Accounting Standards Board Statement of Financial Accounting Concepts No. 2, Qualitative
Characteristics of Accounting Information, which defines materiality as "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."
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Performance Materiality
Performance Materiality
tolerable error
tolerable misstatement
The allocation of the preliminary judgment about materiality to segments (account balances or classes of transactions)
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Michael
Describe a Significant Class of Transactions ?
Describe a Transaction Cycle?
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Class of Transactions
Accounts receivable xxx.xx
Sales xxx.xx
Revenue & Collection Cycle
Accounts receivable xxx.xx
Sales xxx.xx
Cash xxx.xx
Accounts receivable xxx.xx
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cash accounts receivable sales250 800
300450 200 550 450 550350 275 200 350 200550 100 100 550 100200 450 375 200 375100 300 190 100 190375 190 480 375 480190 320 365 190 365
330 845 2,260
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Audit Risk Model
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What are the elements of the “Audit Risk Model”?
Steffan
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the Audit Risk Model
AAR = IR * CR * PDRpage 128
Materiality and Risk
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the Audit Risk Model
AAR = IR * CR * PDR
Risk of Material Misstatement
RoMM = combines IR * CR
Materiality and RiskPage 1
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Audit Risk Model
.
.
CR of assessmentour offunction a is PDR of level planned the
iprelationsh inversehen constant t a is ARA assume
* rearrange
RoMM
cf(CR)PDR
IR*CRc
PDR
CRIRAAR
PDRPDRCRIRAAR
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Which Component(s) of Audit Risk do you think the auditor might be able to reduce?
Which Component(s) of Audit Risk do you think the auditor would be unable to reduce?
Elizabeth
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RoMMAAR = IR CR PDR
transactions balances
analytical procedures (planning)
substantive tests of transactions
substantive analytical procedures
tests of details of balances
tests of controls
environmental client auditor
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Obtain engagementUnderstand the client AU-C
315Analytical procedures
Understand the internal controls Risk assessment Testing AU-C 500
Tests of controls (transactions) Substantive tests of transactions Substantive Analytical proceduresSubstantive tests of details of balances
Reporting AU-C 700
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Describe the relationship between Control Risk and the planned level of Detection Risk?
The mathematical relationship
Suiting
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Audit Risk Model
high CR if
effective are controls the
showing evidence need we low CR if )(
CR
cCRfDR
What type of audit procedures will we perform to obtain appropriate evidence that controls are effective?
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Audit Risk Model
level Low a toreduced bemust PDR high CR if
Highremain toPDRfor OK isit low CR if )(
CR
cCRfDR
What type of audit procedures will we perform to obtain appropriate evidence to reduce Detection Risk to a low level?
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Audit Risk Model
Tests eSubstantiv extensive need we low PDR if
Tests eSubstantivour limit can wehigh PDR if )(
CR
cCRfDR
What type of audit procedures will we perform to obtain appropriate evidence if Planned Detection Risk is high?
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What is the definition of Control Risk
Steve
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Control risk. The risk that a misstatement that could occur in an assertion about a class of transaction, account balance, or disclosure and that could be material, either
individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity's internal control.
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What is the definition of
Planned Detection Risk
Catherine
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Planned Detection risk.
The risk that the audit evidence for a segment will fail to detect misstatements exceeding tolerable misstatement.
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Detection risk. The risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements.
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Brian
If we assess CR = Low, what does that tell us about the level of PDR …. ?
If we assess CR = High, what does that tell us about the level of PDR …. ?
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If we assess CR = Max, what does that imply about the effectiveness of the Internal Controls?
Alejandro
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If we assess CR = Low, what does that imply about the effectiveness of the Internal Controls?
Sandra
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Polina
If we assess Control Risk as Low, what type of evidence would be appropriate for our audit procedures need to generate?
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Chesley
If PDR = High, what does that imply about Control Risk …. ?
If PDR = Low, what does that imply about Control Risk …. ?
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preliminary Control Risk assessmentsignificant classes of Transactions
occur complete accuracy classify cutoff
Credit sales Low Low Low Low MaxCash receipts Low Low Low Low LowPayroll Low Low Max Low MaxCash Disburse Low Low Low Low LowPurchasing Low Low Low Low Low
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when we assess Control Risk less than Max
Control
activity
Test of
Control Proc
Results
Of ToC
Occur Low
Complete Low
Accuracy Low
Classification Low
Cutoff Max Max Max Max
Credit Sales Transactions
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High Risk Areas and Transactions
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1. Related Party Transactions
2. Non Routine Transactions
3. Judgement -Actg Estimates
4. Complex Transactions
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1. Related Party Transactions
high risk
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Related Party Transactions
high risk - page 86 & 135
One of the parties is in a position to exert significant influence over another party
Related parties can structure transactions to conceal problems in the financial statements
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2. Non Routine Transactions
high risk
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3. Judgement -Actg Estimates
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Auditing accounting estimates
high risk
p. 135 (judgment required)
Keep track of differences (page 360)
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Auditing accounting estimates
With estimates, there often is no right answer
• Keep track of differences between the estimate and what auditor finds reasonable
• Evaluate differences taken together
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4. Complex Transactions
high risk
page 77 - ENRON
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Katherine
In your statistics class, why does a larger sample increase your level of confidence?
How does evidence reduce risk?
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Accounts Receivable Project
Sample Results Tolerable Misstatement
1. Known misstatement
2. Projection of sample results to the population
3. Allowance for sampling risk
• Estimates– Difference between auditor’s estimate– Book Value (management’s estimate
Page 125-126
$3,500$3,500*(450,000/50,000) = $31,500
$15,750$47,250
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Please describe Professional Skepticism ?
Tracy
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An attitude that includes a questioning mind, being alert to conditions that may indicate possible misstatement due to fraud or error, and a critical assessment of audit evidence.
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Given the definition of Audit Risk
what is the relationship between
Materiality and Audit Risk?
???
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Evaluation of Sample Results
Critical Value = μ + Zβ* Sx/√n 2,295.47 + 1.04 *1,390.09 / √ 44 = 2,513.42
We are unable to conclude that Accounts Receivable is not materially overstated because the sample mean of $2,425.56 is less than the $2,513.42 critical value.
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Sample Projected Allowance for Sampling Risk Projected
Book Results to = Zβ*sx/√n Error
Population RIAA 15.0% plusAllowance
balance 2,371,983.60 2,371,983.60 Zβ 1.04
size 930 44 930 std dev 1,390.09sum 106,724.85 std error 209.56
average 2,425.56 2,255,775.24 allow 217.95 202,690.25
projected overstatement 116,208.36 projected allowance 202,690.25 318,898.62
averageBV 2,550.52
sample 2,425.56
error 124.96 217.95 342.90x930 318,898.62
