MATERIALITY AND RISK SECTION 8. Importance of Materiality and Risk Materiality and risk underlie the application of all generally accepted auditing standards

MATERIALITY

AND

RISK

SECTION 8

Importance of Materiality and Risk

• Materiality and risk underlie the application of all generally accepted auditing standards

• Must consider materiality and risk in:

1. Planning

2. Evaluation of F/S

Materiality• Presented fairly in accordance with GAAP implies?

• From an accounting perspective, materiality involves the determination of what information should be reported

• From an auditing perspective?

• CICA Handbook definition:

• A matter of judgment

• Thus handbook requires the auditor to consider

• Circumstances of the company

• The users of the F/S

• The auditor makes a preliminary judgment about materiality levels in planning the audit

• May ultimately differ from materiality levels used in evaluating audit findings

• Materiality involves both qualitative and quantitative considerations

• In assessing the quantitative amount it is necessary to relate the nature and dollar amount to the F/S

• In planning, the auditor is usually concerned with just the quantitative

• Qualitative?

Financial Statement Materiality• It is necessary for the auditor to assess materiality on the F/S

because the auditor's opinion on fairness extends to the F/S taken as a whole

• Thus what does it mean when F/S are materially misstated?

• Error or fraud

• In planning there can be more than one level of materiality relating to the F/S

• Income statement materiality is often related to net income

• Any other choices?

• Balance sheet materiality is often related to total assets

• Other choices?

• The smallest aggregate level of errors considered material to any one of the F/S should be used for planning

• Why is this rule appropriate?

1. The nature of the financial statements

2. Auditing procedures

• As an example consider the auditing procedure to determine that year-end sales are recorded in the proper period

Account Balance Materiality• The maximum error that can exist in an account before it is

considered materially misstated

• Inverse relationship between materiality and audit evidence

• In making a preliminary judgment about materiality consider:

1. The likelihood of errors in the account

2. Expected audit costs

Calculating Materiality• Any quantitative assessment of materiality must give full

consideration to the surrounding circumstances as they exist at that time

• Ratios and percentages

• Guidelines:

1. 5% to 10% of net income before taxes2. 1% to 2% of total assets3. 1% of equity4. ½ % of gross revenue5. A variable percentage of gross revenue

If total revenue is

over but not over Materiality is

$ 0 $30 thousand $ 0 + .05

30 thousand 100 thousand 1,450 + .025

100 thousand 300 thousand 3,200 + .018

300 thousand 1 million 6,800 + .012

1 million 3 million 15,200 + .008

3 million 10 million 31,200 + .0054

10 million 30 million 69,000 + .0038

30 million 100 million 145,000 + .0025

100 million 300 million 320,000 + .00175

300 million 1 billion 670,000 + .0012

1 billion 3 billion 1,510,000 + .0008

3 billion 10 billion 3,110,000 + .00055

10 billion 30 billion 6,960,000 + .00038

30 billion …………. 14,560,000 + .00025

Source: Donald A. Leslie, “Materiality, the Concept and Its Application to Auditing.” (CICA, 1985 – p. 21)

Qualitative Factors

Should answer the following questions

1. Nature of the item?

2. Unusual or extraordinary?

3. Contingency?

4. Based on existing facts?

5. Relevant to F/S taken as a whole?

6. Relevant to the total of the accounts of which it forms a part?

7. Relevant to other related items?

Materiality in Tests of Controls• The significance of an internal control deviation

• Deviations in internal controls may increase the risk of errors occurring in the accounting records

• Such deviations do not necessarily give rise to errors

• But the auditor must consider the possible relation of the deviation errors to materiality

• The relationship between the value of the transaction containing the deviations and some multiple of materiality is of primary significance

1. The acceptable upper limit can be fixed at 5%

2. The acceptable upper limit can be given a frequency range of 3% to 8%

3. No criteria for the upper limit

Materiality in Tests of Transactions and Details of Balances

• Should be directly related to the established level of materiality

• Statistical sampling

• Remember the inverse relationship

• Primary objective of allocating materiality to accounts is to minimize audit costs without increasing audit risk

Allocating F/S Materiality to Accounts

• When the auditor’s preliminary judgment about F/S materiality is quantified, a preliminary estimate of materiality for each account may be obtained

• Allocations can be made to both the balance sheet and income statement accounts

• An illustrative example:

Cash $ 200,000Accounts Receivable 300,000Inventories 1,000,000Fixed Assets 2,700,000

• In this example, the auditor anticipates few errors in cash and plant assets and some errors in accounts receivables and inventories

• Assume that the preliminary estimate of F/S materiality is $100,000

MaterialityCash $ 200,000 $ 1,000Accounts Receivable 300,000 29,000Inventories 1,000,000 60,000Fixed Assets 2,700,000 10,000

$100,000

• This allocation may be revised

• What if $19,000 of errors were found in verifying accounts receivable?

MaterialityCash $ 200,000 $ 1,000Accounts Receivable 300,000 19,000Inventories 1,000,000 70,000Fixed Assets 2,700,000 10,000

$100,000

• What has a great impact on allocating materiality?

The Concept of Audit Risk

• Audit risk is the risk that the auditor may unknowingly fail to appropriately modify an opinion on the F/S that are materially misstated

• If the auditor desires a probability or certainty of rendering the correct opinion of 97%, what is the audit risk?

• The audit opinion is based upon the verification of account balances, thus audit risk must be related to account balances

Components of Audit Risk

• Three components:

1. Inherent risk

2. Control risk

3. Detection risk

Inherent Risk

• Some accounts may be susceptible to loss through fraud or theft

• Complex calculations for leases or pensions are more likely to contain errors

• Inherent risk also extends to factors that affect the financial statements as a whole

Control Risk

• A function of the effectiveness of the client’s system of internal control

• Effective controls over an account

• Control risk can never be zero

Detection Risk

• A function of the effectiveness of the auditor’s verification of account balances

• What influences detection risk?

• In estimating detection risk, the auditor should also consider the likelihood that errors will be made in judgment

• Inverse relation between the inherent risk and control risk for an account and the detection risk for that account

• DR IR

• DR 1/CR

• Inherent risk and control risk relate to the circumstances of the client, but detection risk is controlled by the auditor

The Audit Risk Model

• The three components can expressed in quantitative terms

• They can also be expressed in non-quantitative terms

• AR = IR x CR x DR

• Assume that the auditor made the following risk assessments in examining inventories

• Desired audit risk 5%

• Inherent risk 50%

• Control risk 50%

• DR = AR / (IR x CR)

= 0.05/(0.5 x 0.5)

= 0.2• The auditor may decide that the inherent risk cannot be

quantified and use a conservative approach

Inherent Risk Control Risk Detection Risk Audit risk

HIGH .70 .6 x .8 x.7 = .34

•Small Samples

•Few substantive tests

•Extensive reliance on IC

HIGH .80

•System poorly designed

•System poorly executed

•Not tested (CR = 1.00) LOW .30 .6 x .8 x .3 = .14

•Large samples

•Many substantive tests

HIGH .60 •No reliance on IC

•Assets susceptible to theft

•New client HIGH .70 .6 x .2 x .7 = .08

•Integrity doubtful •As above

•Non profitable and

needs financing LOW .20

•System well designed and

well executed

•Audit tests show system LOW .30 .6 x .2 x .3 = .04

effective •As above

Inherent Risk Control Risk Detection Risk Audit risk

HIGH .70 .4 x .8 x.7 = .22

•Small Samples

•Few substantive tests

•Extensive reliance on IC

HIGH .80

•System poorly designed

•System poorly executed

•Not tested (CR= 1.00) LOW .30 .4 x .8 x .3 = .10

•Large samples

•Many substantive tests

LOW .40 •No reliance on IC

•Assets not susceptible to

theft HIGH .70 .4 x .2 x .7 = .06

•Old client •As above

•Integrity believed high

•Profitable and easily LOW .20

financed •System well designed and

well executed

•Audit tests show system LOW .30 .4 x .2 x .3 = .02

effective •As above

Problem 1: Shown on the following three pages are the statements of earnings and financial position for Prairie Stores Corporation.

Required:

a. Use professional judgment in reaching a preliminary judgment about materiality based on revenue, net income before taxes, total assets, and shareholders equity. Your conclusions should be stated I terms of percentages and dollars.

b. Assume you complete the audit and conclude that your preliminary judgment about materiality has been exceeded. What should you do?

c. As discussed in part (b), likely net earnings from continuing operations before income taxes were used as a base for materiality when completing the audit. Discuss why most auditors use before tax net earnings instead of after tax net earnings when calculating materiality based on the income statement.

Statement of EarningsPrairie Stores Corporation

For the 53 Weeks For the 52 weeks ended:

Ended May 3, 2002 28-Apr-01 29-Apr-00

Revenue $ 8,351,149 $ 6,601,255 $ 5,959,587

Net sales 59,675 43,186 52,418

Other income 8,410,824 6,644,441 6,012,005

Costs and expenses

Cost of sales 5,197,375 4,005,548 3,675,369

Marketing, general, and administrative expenses 2,590,080 2,119,590 1,828,169

Provision for loss on restructured operations 64,100

Interest expense 141,662 46,737 38,546

7,993,217 6,171,875 5,542,084

Earnings from continuing operations before income taxes 417,607 472,566 469,921

Income taxes 196,700 217,200 214,100

Earnings from continuing operations 220,907 255,366 255,821

Provision for loss on discontinued operations, net of income taxes $ 20,700 - -

Net earnings $ 200,207 $ 255,366 $ 255,821

Statement of Financial PositionPrairie Stores Corporation

May 3, 2002 April 28,

2001

Assets

Current assets

Cash $ 39,683 $ 37,566

Temporary investments (at cost, which approximates market) 123,421 271,639

Receivables, less allowances of $16,808 in 2002 and $17,616 in 2001 899,752 759,001

Inventories

Finished product 680,974 550,407

Raw materials and supplies 443,175 1,124,149 353,795 904,202

Deferred income tax benefits 9,633 10,468

Prepaid expenses 57,468 35,911

Current assets $ 2,254,106 $ 2,018,787

Land, buildings, equipment, at cost, less accumulated amortization 1,393,902 1,004,455

Investments in affiliated companies and sundry assets 112,938 83,455

Goodwill and other intangible assets 99,791 23,145

Total assets $ 3,860,737 $3,129,842

Liabilities and Shareholders’ Equity

Current liabilities

Notes payable $280,238 $113,411

Current portion of long-term debt 64,594 12,336

Accounts and drafts payable 359,511 380,395

Accrued salaries, wages, and

vacations 112,200 63,557

Accrued income taxes 76,479 89,151

Other accrued liabilities including goods and services tax 321,871 269,672

Current liabilities 1,214,893 928,522

Long-term debt 730,987 390,687

Other noncurrent liabilities 146,687 80,586

Accrued income tax liability 142,344 119,715

Total liabilities 2,234,911 1,519,510

Shareholders’ equity

Common stock issued, 51,017 shares in 2002 and 50,992 in 2001 200,195 199,576

Retained earnings 1,425,631 1,410,756

Shareholders’ equity 1,625,826 1,610,332

Total liabilities and shareholders’ equity $ 3,860,737 $ 3,129,842

Problem 2: The following questions deal with the use of the audit risk model.

a. Assume that the auditor is doing a first-year municipal audit of Sackville, New Brunswick, and concludes that the internal control is not likely to be effective.

1) Explain why the auditor is likely to set both inherent and control risks at 100 percent for most segments.

2) Assuming (1), explain the relationship of audit risk to planned detection risk.

3) Assuming (1), explain the effect of planned detection risk on evidence accumulation compared with its effect if planned detection risk were larger.

b. Assume that the auditor is doing the third-year municipal audit of Sackville, New Brunswick, and concludes that internal controls are effective and in inherent risk is low.

1) Explain why the auditor is likely to set inherent risk and control risks for material segments at a higher level than, say, 40 percent, even when the two risks are low.

2) For the audit of fixed asset accounts, assume inherent and control risks of 50 percent each and an audit risk or 5 percent. Calculated planned detection risk.

3) For (2), explain the effect of planned detection risk on evidence accumulation compared with its effect if planned detection risk were smaller.

c. Assume that the auditor is doing the fifth-year municipal audit of Sackville, New Brunswick, and concludes that audit risk can be set high, and inherent and control risk should be set low.

1) What circumstances would result in these conclusions.

2) For the audit of repairs and maintenance, inherent and control risk are set at 20 percent each. Audit risk is 5 percent. Calculate planned detection risk.

3) How much evidence should be accumulated in this situation?

Problem 3: Using the audit risk model, state the effect on control risk, inherent risk, audit risk, and planned evidence for each of the following independent events. In each of the events (a) to (j), circle one letter for each of the three independent variables and planned evidence: I = increase, D = decrease, N = no effect, and C = cannot determine from the information provided. Explain your reasoning.

a. The client's management martially increased long-term contractual debt:

Control risk IDNC Audit risk IDNC

Inherent risk IDNC Planned evidence IDNC

b. The company changed from a privately held company to a publicly held company:



c. The auditor decided to assess control risk at a level below maximum; it was previously assessed at maximum:

Control risk IDNC Audit risk IDNCInherent risk IDNC Planned evidence IDNC

d. The account balance increased materially from the preceding year without apparent reason:



e. You determined through the planning phase that working capital, debt to equity ratio, and other indications of financial condition had improved during the past year:



f. This is the second year of the engagement and there were few misstatements in the previous year. The auditor also decided to increase reliance on internal control:


g. About halfway through the audit, you discover that the client is constructing its own building during idle periods, using factory personnel. This is the first time the client has done this and it is being done at your recommendation:



h. In discussions with management, you conclude that management is planning to sell the business in the next few months. Because of the planned changes, several key accounting personnel quit several months ago for alternative employment. You also observe that the gross margin percent has significantly increased compared with that of the preceding year:



i. There has been a change in several key management personnel. You believe that management is somewhat lacking in personal integrity, compared with the previous management. You believe it is still appropriate to do the audit:


j. In auditing inventory, you obtain an understanding of internal control and perform tests of controls. You find it significantly improved compared with that of the preceding year. You also observe that due to technology changes in the industry, the client’s inventory may be somewhat obsolete:



Problem 4: Some accountants have suggested that the auditor’s report should include a statement of materiality level and audit risk that the auditor used in conducting the audit.

Required:

a. The proponents of such disclosure believe that the information would be useful to users of the financial statements being reported on. Explain fully why you think they have this view.

b. Some accountants oppose such disclosure. Explain why you think they are not in favour of it.

c. What is you position on the issue?

Documents

MATERIALITY AND RISK SECTION 8. Importance of Materiality and Risk Materiality and risk underlie the application of all generally accepted auditing standards