9 - 1 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Materiality and Risk Chapter 9

9 - 1©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Materiality and RiskMateriality and Risk

Chapter 9Chapter 9


Learning Objective 1Learning Objective 1

Apply the concept of materialityApply the concept of materiality

to the audit.to the audit.


MaterialityMateriality

The auditor’s responsibility is toThe auditor’s responsibility is todetermine whether financialdetermine whether financialstatements are materially misstated.statements are materially misstated.

If there is a material misstatement,If there is a material misstatement,the auditor will bring it to the client’sthe auditor will bring it to the client’sattention so that a correction can be made.attention so that a correction can be made.


Steps in Applying MaterialitySteps in Applying Materiality

StepStep11

Set preliminarySet preliminaryjudgment aboutjudgment aboutmateriality.materiality.

PlanningPlanningextentextentof testsof tests

StepStep22

Allocate preliminaryAllocate preliminaryjudgment aboutjudgment aboutmaterialitymaterialityto segments.to segments.


Steps in Applying MaterialitySteps in Applying Materiality

EvaluatingEvaluatingresultsresults

StepStep33

Estimate totalEstimate totalmisstatement in segment.misstatement in segment.

StepStep44

Estimate theEstimate thecombined misstatement.combined misstatement.

Compare combinedCompare combinedestimate with judgmentestimate with judgmentabout materiality.about materiality.

StepStep55



Make a preliminary judgmentMake a preliminary judgment

about what amounts toabout what amounts to

consider material.consider material.


Set Preliminary Judgment about Set Preliminary Judgment about MaterialityMateriality

This preliminary judgment is the maximumThis preliminary judgment is the maximumamount by which the auditor believes theamount by which the auditor believes thestatements could be misstated and still statements could be misstated and still notnotaffect the decisions of reasonable users.affect the decisions of reasonable users.

Ideally, auditors decide early in the auditIdeally, auditors decide early in the auditthe combined amount of misstatementsthe combined amount of misstatementsof the financial statements that wouldof the financial statements that wouldbe considered material.be considered material.


Factors Affecting JudgmentFactors Affecting Judgment

Materiality is a relative ratherMateriality is a relative ratherthan an absolute concept.than an absolute concept.

Bases are needed forBases are needed forevaluating materiality.evaluating materiality.

Qualitative factors alsoQualitative factors alsoaffect materiality.affect materiality.


GuidelinesGuidelines

Accounting and auditing standardsAccounting and auditing standardsdo not provide specific materialitydo not provide specific materialityguidelines to practitioners.guidelines to practitioners.

Professional judgment is to be usedProfessional judgment is to be usedat all times in setting and applyingat all times in setting and applyingmateriality guidelines.materiality guidelines.



Allocate preliminary materialityAllocate preliminary materiality

to segments of the auditto segments of the audit

during planning.during planning.


Allocate Preliminary Judgment Allocate Preliminary Judgment About Materiality to SegmentsAbout Materiality to Segments

This is necessary because evidence isThis is necessary because evidence isaccumulated by segments rather thanaccumulated by segments rather thanfor the financial statements as a whole.for the financial statements as a whole.

Most practitioners allocate materialityMost practitioners allocate materialityto balance sheet accounts.to balance sheet accounts.

SAS 39 (AU 350)SAS 39 (AU 350)



Use materiality to evaluateUse materiality to evaluate

audit findings.audit findings.


Estimated Total Misstatement and Estimated Total Misstatement and Preliminary JudgmentPreliminary Judgment

CashCashAccounts receivableAccounts receivableInventoryInventoryTotal estimatedTotal estimated misstatement amountmisstatement amountPreliminary judgmentPreliminary judgment about materialityabout materiality

$ 4,000$ 4,000 20,00020,000 36,00036,000

$50,000$50,000

$ 0$ 0 12,00012,000 31,50031,500

$43,500$43,500

$ N/A$ N/A 6,0006,000 15,75015,750

$16,800$16,800

$ 0$ 0 18,00018,000 47,25047,250

$60,300$60,300

TolerableTolerablemisstatementmisstatement

DirectDirectprojectionprojection

SamplingSamplingerrorerror** TotalTotalAccountAccount

Estimated misstatement amountEstimated misstatement amount

*estimate for sampling error is 50%*estimate for sampling error is 50%


Estimated Total Misstatement and Estimated Total Misstatement and Preliminary JudgmentPreliminary Judgment

Net misstatements in the sampleNet misstatements in the sample

$3,500 ÷ $50,000 $3,500 ÷ $50,000 ×× $450,000 = $450,000 = $31,500 $31,500

×× Total recorded population value Total recorded population value

÷ Total sampled÷ Total sampled

= Direct projection estimate of misstatement= Direct projection estimate of misstatement



Define risk in auditing.Define risk in auditing.


RiskRisk

Auditors accept some level of riskAuditors accept some level of riskin performing the audit.in performing the audit.

An effective auditor recognizes thatAn effective auditor recognizes thatrisks exist, are difficult to measure,risks exist, are difficult to measure,and require careful thought to respond.and require careful thought to respond.

Responding to risks properly is criticalResponding to risks properly is criticalto achieving a high-quality audit.to achieving a high-quality audit.


Risk and EvidenceRisk and Evidence

Auditors gain an understanding of theAuditors gain an understanding of theclient’s business and industry andclient’s business and industry andassess client business risk.assess client business risk.

Auditors use the audit risk model to furtherAuditors use the audit risk model to furtheridentify the potential for misstatementsidentify the potential for misstatementsand where they are most likely to occur.and where they are most likely to occur.


Illustration of Differing Evidence Illustration of Differing Evidence Among CyclesAmong Cycles

Sales andSales andcollectioncollectioncyclecycle

AcquisitionAcquisitionand paymentand paymentcyclecycle

Payroll andPayroll andpersonnelpersonnelcyclecycle

InherentInherentriskriskAA MediumMedium HighHigh LowLow

ControlControlriskriskBB MediumMedium LowLow LowLow

AcceptableAcceptableaudit riskaudit riskCC LowLow LowLow LowLow

PlannedPlanneddetection riskdetection riskDD MediumMedium MediumMedium HighHigh


Illustration of Differing Evidence Illustration of Differing Evidence Among CyclesAmong Cycles

Inventory andInventory andwarehousingwarehousingcyclecycle

Capital acquisitionCapital acquisitionand repaymentand repaymentcyclecycle

InherentInherentriskriskAA HighHigh LowLow

ControlControlriskriskBB HighHigh MediumMedium

AcceptableAcceptableaudit riskaudit riskCC LowLow LowLow

PlannedPlanneddetection riskdetection riskDD LowLow MediumMedium



Describe the audit risk modelDescribe the audit risk model

and its components.and its components.


Audit Risk Model for PlanningAudit Risk Model for Planning

PDR = AAR ÷ (IR PDR = AAR ÷ (IR ×× CR) CR)

PDRPDR = Planned detection risk = Planned detection risk

AARAAR = Acceptable audit risk = Acceptable audit risk

IRIR = Inherent risk = Inherent risk

CRCR = Control risk = Control risk



Consider the impact ofConsider the impact of

engagement risk onengagement risk on

acceptable audit risk.acceptable audit risk.


Impact of Engagement Risk on Impact of Engagement Risk on Acceptable Audit RiskAcceptable Audit Risk

Auditors decide engagement risk and useAuditors decide engagement risk and usethat risk to modify acceptable audit risk.that risk to modify acceptable audit risk.

Engagement risk closely relates to clientEngagement risk closely relates to clientbusiness risk.business risk.


Factors Affecting Acceptable Factors Affecting Acceptable Audit RiskAudit Risk

The degree to which external usersThe degree to which external usersrely on the statementsrely on the statements

The likelihood that a client will haveThe likelihood that a client will havefinancial difficulties after thefinancial difficulties after theaudit report is issuedaudit report is issued

The auditor’s evaluation of The auditor’s evaluation of management’s integritymanagement’s integrity


Making the Acceptable Audit Risk Making the Acceptable Audit Risk DecisionDecision

Methods used to assessMethods used to assessacceptable audit riskacceptable audit risk

External users’External users’reliance onreliance onfinancialfinancialstatementsstatements

• Examine financial statements.Examine financial statements.• Read minutes of the board.Read minutes of the board.• Examine form 10K.Examine form 10K.• Discuss financing plansDiscuss financing plans

with management.with management.

FactorsFactors


Making the Acceptable Audit Risk Making the Acceptable Audit Risk DecisionDecision

LikelihoodLikelihoodof financialof financialdifficultiesdifficulties

• Analyze financial statementsAnalyze financial statementsfor difficulties using ratios.for difficulties using ratios.

• Examine inflows and outflowsExamine inflows and outflowsof cash flow statements.of cash flow statements.

ManagementManagementintegrityintegrity

• See Chapter 8 for clientSee Chapter 8 for clientacceptance and continuance.acceptance and continuance.

Methods used to assessMethods used to assessacceptable audit riskacceptable audit riskFactorsFactors



Consider the impact of severalConsider the impact of several

factors on the assessmentfactors on the assessment

of inherit risk.of inherit risk.


Factors Affecting Inherent RiskFactors Affecting Inherent Risk

Nature of the client’s business Nature of the client’s business Results of previous auditsResults of previous audits Initial versus repeat engagementInitial versus repeat engagement Related partiesRelated parties Nonroutine transactionsNonroutine transactions Judgment required to correctly recordJudgment required to correctly record

account balances and transactionsaccount balances and transactions Makeup of the populationMakeup of the population



Discuss the relationship ofDiscuss the relationship of

risks to audit evidence.risks to audit evidence.


Relationship of Risk Factors,Relationship of Risk Factors,Risk, and EvidenceRisk, and Evidence

D = Direct relationship; I = Inverse relationshipD = Direct relationship; I = Inverse relationship

FactorsFactorsinfluencinginfluencing

risksrisks

Acceptable audit riskAcceptable audit risk

PlannedPlanneddetectiondetection

riskrisk

PlannedPlannedauditaudit

evidenceevidence

InherentInherentriskrisk

Control riskControl risk

II

DD

II

IIDD

II DD


Relationship of Risk Factors,Relationship of Risk Factors,Risk, and EvidenceRisk, and Evidence

The engagement may require moreThe engagement may require moreexperienced staff.experienced staff.

The engagement will be reviewed moreThe engagement will be reviewed morecarefully than usual.carefully than usual.

Auditors can change the audit to respond to risks.Auditors can change the audit to respond to risks.


Audit Risk for SegmentsAudit Risk for Segments

Both control risk and inherent risk areBoth control risk and inherent risk aretypically set for each cycle, eachtypically set for each cycle, eachaccount, and often even each auditaccount, and often even each auditobjective, not for the overall audit.objective, not for the overall audit.


Relating Risk of Fraud to Risk Relating Risk of Fraud to Risk Model ComponentsModel Components

The risk of fraud can be assessed for theThe risk of fraud can be assessed for theentire audit or by cycle, account, and objective.entire audit or by cycle, account, and objective.

Specific response could includeSpecific response could includerevising assessments of acceptablerevising assessments of acceptableaudit risk, inherent risk, and control risk.audit risk, inherent risk, and control risk.


Tolerable Misstatement, Risks,Tolerable Misstatement, Risks,and Balance-related Objectivesand Balance-related Objectives

It is common to assess inherent and controlIt is common to assess inherent and controlrisk for each balance-related audit objective.risk for each balance-related audit objective.

It is not common to allocate materialityIt is not common to allocate materialityto objectives.to objectives.


Measurement LimitationsMeasurement Limitations

One major limitation in the application of theOne major limitation in the application of theaudit risk model is the difficulty of measuringaudit risk model is the difficulty of measuringthe components of the model.the components of the model.


Relationships of Risk to EvidenceRelationships of Risk to Evidence

AcceptableAcceptableaudit riskaudit risk


ControlControlriskrisk

PlannedPlanneddetectiondetection

riskrisk

Amount ofAmount ofevidenceevidencerequiredrequiredSituationSituation

HighHigh

LowLow

LowLow

MediumMedium

HighHigh

LowLow

LowLow

HighHigh

MediumMedium

LowLow

LowLow

LowLow

HighHigh

MediumMedium

MediumMedium

HighHigh

MediumMedium

LowLow

MediumMedium

MediumMedium

LowLow

MediumMedium

HighHigh

MediumMedium

MediumMedium

11

22

33

44

55


Tests of Details of Balances Tests of Details of Balances Evidence Planning WorksheetEvidence Planning Worksheet

Auditors develop various types of worksheetsAuditors develop various types of worksheetsto aid in relating the considerations affectingto aid in relating the considerations affectingaudit evidence to the appropriateaudit evidence to the appropriateevidence to accumulate.evidence to accumulate.



Discuss how materiality and riskDiscuss how materiality and risk

are related and integrated intoare related and integrated into

the audit process.the audit process.


Tolerable Misstatements, Risk, Tolerable Misstatements, Risk, and Planned Evidenceand Planned Evidence

D = Direct relationship; I = Inverse relationshipD = Direct relationship; I = Inverse relationship

AcceptableAcceptableaudit riskaudit risk



TolerableTolerablemisstatementmisstatement

PlannedPlanneddetection riskdetection risk

PlannedPlannedaudit evidenceaudit evidence

II

DD

II

II II

II

DD

DD


Evaluating ResultsEvaluating Results

AcAR = IR AcAR = IR ×× CR CR ×× AcDR AcDR

AcAR AcAR = Achieved audit risk= Achieved audit risk

IRIR = Inherent risk = Inherent risk

CRCR = Control risk = Control risk

AcDRAcDR = Achieved detection risk = Achieved detection risk


Audit Risk Models for Planning Audit Risk Models for Planning Evidence and Evaluating ResultsEvidence and Evaluating Results

AcceptableAcceptableauditauditriskrisk



AchievedAchieveddetectiondetection

riskrisk

SubstantiveSubstantiveauditaudit

evidenceevidence

AchievedAchievedauditauditriskrisk

CompareCompare

DD

II

DD

DD

D = Direct relationshipD = Direct relationshipI = Inverse relationshipI = Inverse relationship


Revising Risks and EvidenceRevising Risks and Evidence

The audit risk model is primarily aThe audit risk model is primarily aplanningplanning model and is therefore ofmodel and is therefore oflimited use in evaluating results.limited use in evaluating results.

Great care must be used in revisingGreat care must be used in revisingthe risk factors when the actual resultsthe risk factors when the actual resultsare not as favorable as planned.are not as favorable as planned.


End of Chapter 9End of Chapter 9

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9 - 1 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Materiality and Risk Chapter 9