Materiality Messier Modify (1)

8/10/2019 Materiality Messier Modify (1)

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2000 The McGraw-Hill Companies, Inc.,Irwin/McGraw-Hill

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MATERIALITY

AND

AUDIT RISK


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MATERIALITY

Def (ISA 320):

Materiality is the magnitude of an omission or misstatementof 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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ISA 320 specifies 3 main characteristics of

materiality:

Misstatements are considered material if, individually or in the

aggregate, they could reasonably be expected to influence the

economic decisions of users based on the financial statements;

Judgements about materiality are made in the context of

surrounding circumstances, and are affected by the size

(quantitative - the monetary amount involved) and/or nature of

misstatements (qualitative); and

Judgements about materiality are based on considerations of

common financial information needs of users as a group.

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Materiality

Auditing standards require auditors to design the audit to

obtain reasonable assurance about whether the financial

statements as a whole are free from material misstatement,

whether due to fraud or error.

The concept of materiality is applied by the auditor when:

Planning and performing the audit;

Evaluating the effect of identified misstatements on the audit and of

uncorrected misstatements, if any, on the financial statements; and

Forming an opinion on the financial statements.

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STEPS IN APPLYING MATERIALITY

1: Establish a preliminary judgment about materiality.

2: Allocate the preliminary judgment about materiality to

account balances or class-of transactions.

3: Estimate the likely misstatement and compare to

materiality.

4: Estimate the combined misstatement

5: Compare combined estimate with preliminary or revised

judgement about materiality


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Set Preliminary Judgment about Materiality

This preliminary judgment is the maximum amount by whichthe auditor believes the statements could be misstated andstill not affect the decisions of reasonable users.

Setting a preliminary judgement helps auditor planning theappropriate evidence to accumulate.

Low materiality in term of dollar amount, more evidence is

required than for a high amount.

Ideally, auditors decide early in the audit the combinedamount of misstatements of the financial statements thatwould be considered material.


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Guideline

No specific guidance given in the ISAs.

ISA Guide Rules of Thumb suggests using percentages

ranging from 60% to 85% (of overall or specific materiality),

depending on the risk of material misstatements.

The higher the risk of material misstatements, the lower

percentage should be used.

Professional judgment is to be used at all times in setting and

applying materiality guidelines.

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Factors that may be considered in

establishing benchmarks include:

The elements of the financial statements

~ What are the major elementsassets, liabilities, equities etc.

Whether there are items on which users of the entitys financial

statements will pay attentionperformance (profit, revenue)

The nature of the entity

The entitys ownership structure and the way it is financed

Qualitative factors also affect materiality.

- Amount involving fraud

- Misstatement arising from contractual obligation

- Misstatement immaterial might be material due to change of trend

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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

Materiality allocatedTolerable Misstatement or error (ISA 530).

Most practitioners allocate materiality

to balance sheet accounts.Why????????

1. Most income stt misstatements have an equal effect on

the BS because of the double entry bookkeeping system

2. Because there are fewer BS than IS accounts in most

audits and most audit procedures focus on BS accounts.



Allocate Preliminary (cont)

Major difficulties in allocating materiality to BS accounts:

1. Auditors expect certain accounts to have more

misstatement than others

2. Both overstatement and understatements must be

considered

3. Relative audit costs affect the allocation

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Estimated Total Misstatement and Preliminary

Judgment

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

Tolerable

misstatement

Direct

projection

Sampling

error* TotalAccount

Estimated misstatement amount

*estimate for sampling error is 50%


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Estimated Total Misstatement and Preliminary

Judgment

Net misstatements in the sample

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

Total recorded population value

Total sampled

= Direct projection estimate of misstatement

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Conclusion

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Conclusion

What if Estimated combined misstatement larger than

prelimenary Judgement:

1

2

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AUDIT RISK

Audit risk is the risk that the auditor may unknowingly

fail to appropriately modify the opinion on financial

statements that are materiality misstated.

Auditor business risk is the exposure to loss or injury toprofessional practice from litigation, adverse publicity,

or other events arising in connection with financial

statements audited and reported on.

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THE AUDIT RISK MODEL

AR = IR x CR x DR

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INHERENT RISK (IR)

Inherent risk is the susceptibility of an assertion to

material misstatement, assuming no related internal

controls.

At the beginning of an engagement, the auditormust assess those specific factors related to the

client that may increase or decrease the likelihood

of material misstatement occurring.

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CONTROL RISK (CR)

Control risk is the risk that material misstatements

will not be prevented or detected on a timely basis by

the entitys internal controls. Chapter 6 contains a detailed discussion of this topic.

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DETECTION RISK (DR)

Detection risk is the risk that the auditor will not

detect a material misstatement that exists in the

financial statements.

Detection risk is composed of two risks or

uncertainties:

Sampling risk

Nonsampling risk

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USE OF THE AUDIT RISK MODEL

1. Set a planned level of audit risk.

2. Assess inherent risk and control risk.

3. Solve the audit risk equation for theappropriate level of detection risk.

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AN EXAMPLE

Set planned audit risk for accounts receivable at .05.

Assume further that the auditor assesses inherent risk to be

.80 and control risk is 60. To determine the level of detection

risk for auditing accounts receivable, the audit risk model issolved:

AR = IR x CR x DR

DR = AR / (IR x CR)

Thus, DR is set at approximately .10 [DR = .05/(.80 x .60)]

for testing the accounts receivable balance.

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ASSESSING CLIENT BUSINESS RISK

Client business risk is the risk that an entitys business

objectives will not be attained as a result of the external

and internal factors, pressures, and forces brought to

bear on the entity and, ultimately the risk associated

with the entitys survival and profitability.

Once the clients business risks have been determined,

the auditor must determine how those risks relate to

audit risk.

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THE RELATIONSHIP OF CLIENTBUSINESS RISK TO AUDIT RISK

Assess client business risk

Assess the risk of material misstatementdue to error or fraud

Factorsaffecting

IR

Factorsaffecting

CR

AR IR CR DR= X X

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The auditor must have a thorough understanding of the

clients industry, including knowledge about

The critical issues facing the industry.

The significant industry business risks.

The structure and profitability of the industry.

The relationship between the industry and the broad

economic business environment.


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The auditor must then understand how the client fits

within the industry, including knowledge about the

following:

The entitys position within the industry.

The entitys plans for increasing or maintaining market

share, profitability, and so on.

Threats to the entitys position in the industry.

How the entity deals with its customers and competitors.

How the entity measures and monitors performance.


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ASSESS THE RISK OF MATERIALMISSTATEMENT DUE TO

ERROR OR FRAUD

Errors are unintentional misstatements or omissions of

amounts or disclosures and may involve

Mistakes in gathering or processing accounting data

from which financial statements are prepared.

Unreasonable accounting estimates arising from

oversight or misinterpretation of facts.

Mistakes in the application of accounting principles.

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ERROR OR FRAUD

Fraudinvolves intentional misstatements that can be

classified into two types:

fraudulent financial reporting misappropriation of assets.

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ERROR OR FRAUD

Fraudulent financial reporting includes acts such as the

following:

Manipulation, falsification, or alteration of accountingrecords or supporting documents from which the financial

statements are prepared.

Misrepresentation in, or intentional omission from, the

financial statements of events, transactions, or significant

information.

Intentional misapplication of accounting principles.

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ERROR OR FRAUD

Misappropriation or defalcation includes the following:

Embezzling of cash receipts.

Stealing assets. Causing the entity to pay for goods or services not

received.

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ERROR OR FRAUD

Risk factors that relate to the presence of material

misstatements in the financial statements can be grouped into

three categories:

Managements characteristics and influence over the

control environment.

Industry conditions.

Operating characteristics and financial stability.

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ERROR OR FRAUD

Risk factors that relate to the misappropriation of assets can

be grouped into two categories:

Susceptibility of assets to misappropriation. Controls.

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Factors Affecting Acceptable Audit Risk

The degree to which external users rely on the statements

The likelihood that a client will have financial difficultiesafter the audit report is issued

The auditors evaluation of managements integrity


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Making the Acceptable Audit Risk Decision

Methods used to assess

acceptable audit risk

External usersreliance on

financial

statements

Examine financial statements. Read minutes of the board.

Examine form 10K.

Discuss financing plans

with management.

Factors


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Making the Acceptable Audit Risk Decision

Likelihoodof financial

difficulties

Analyze financial statementsfor difficulties using ratios.

Examine inflows and outflows

of cash flow statements.

Management

integrity

See Chapter 8 for client

acceptance and continuance.

Methods used to assess

acceptable audit riskFactors


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Factors Affecting Inherent Risk

Nature of the clients business

Results of previous audits Initial versus repeat engagement

Related parties

Non-routine transactions

Judgment required to correctly record account balancesand transactions

Makeup of the population


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Relationships of Risk to Evidence

Acceptableaudit risk

Inherentrisk

Controlrisk

Planneddetection

risk

Amount ofevidencerequiredSituation

HighLow

Low

Medium

High

LowLow

High

Medium

Low

LowLow

High

Medium

Medium

HighMedium

Low

Medium

Medium

LowMedium

High

Medium

Medium

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3

4

5

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DOCUMENTATION OF THEAUDITORS RISK ASSESSMENT

The auditor should document that the risk of material

misstatement and how risk factors were considered.

Where risk factors are identified, the documentation shoulddescribe

the risk factors identified

the auditors response to those risk factors.

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LIMITATIONS OF THEAUDIT RISK MODEL

The audit risk model assumes that the components of the

model (IR, CR, and DR) are independent of each other.

However, in practice, dependencies exist between these

components (the risk of an misstatement occurring, IR, may

be a function of internal controls, CR.

The auditors assessments of IR and CR may be different

from the actual levels of IR and CR.

The audit risk model does not consider the possibility of

nonsampling risk.

Documents

Materiality Messier Modify (1)