Materiality and Risk Chapter 9 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-1
Learning Objective 1 Apply the concept of materiality to the audit. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-2
Materiality It is a major consideration in determining the appropriate audit report to issue. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-3
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. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-4
Steps in Applying Materiality Step 1 Step 2 Set preliminary judgment about materiality Allocate preliminary judgment about materiality to segments Planning extent of tests 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-5
Steps in Applying Materiality Step 3 Estimate total misstatement in segment Step 4 Step 5 Estimate the combined misstatement Compare combined estimate with judgment about materiality Evaluating results 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-6
Learning Objective 2 Make a preliminary judgment about what amounts to consider material. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-7
Set Preliminary Judgment About Materiality 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. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-8
Factors Affecting Judgment Materiality is a relative rather than an absolute concept. Bases are needed for evaluating materiality. Qualitative factors also affect materiality. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-9
Guidelines Accounting and auditing standards do not provide specific materiality guidelines to practitioners. Professional judgment is to be used at all times in setting and applying materiality guidelines. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-10
Learning Objective 3 Allocate preliminary materiality to segments of the audit during planning. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-11
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 107 (AU 312) 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-12
Learning Objective 4 Use materiality to evaluate audit findings. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-13
Estimated Total Misstatement and Preliminary Judgment Account Tolerable Misstatement Estimated Misstatement Amount Known Misstatement and 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 $ 2,000 12,000 31,500 $45,500 $ N/A 6,000 15,750 $16,800 $ 2,000 18,000 47,250 $62,300 N/A = Not applicable Cash audited 100 percent 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-14
Estimated Total Misstatement and Preliminary Judgment Net misstatements in the sample ($3,500) Total sampled ($50,000) Total recorded population value ($450,000) = Direct projection estimate of misstatement ($31,500) 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-15
Learning Objective 5 Define risk in auditing. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-16
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. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-17
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. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-18
Illustration of Differing Evidence Among Cycles Sales and collection cycle Acquisition and payment cycle Payroll and personnel cycle Inherent A Medium High Low risk Control B Medium Low Low risk Acceptable C Low Low Low audit risk Planned D Medium Medium High detection risk 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-19
Illustration of Differing Evidence Among Cycles Inventory and warehousing cycle Capital acquisition and repayment cycle Inherent A High Low risk Control B High Medium risk Acceptable C Low Low audit risk Planned D Low Medium detection risk 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-20
Learning Objective 6 Describe the audit risk model and its components. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-21
Audit Risk Model for Planning PDR = AAR (IR CR) where: PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-22
Learning Objective 7 Consider the impact of engagement risk on acceptable audit risk. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-23
Impact of Engagement Risk on Acceptable Audit Risk Auditors decide engagement risk and use that risk to modify acceptable audit risk. Engagement risk closely relates to client business risk. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-24
Factors Affecting Acceptable 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 The auditor s evaluation of management s integrity 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-25
Methods Practitioners Use to Assess Acceptable Audit Risk Factors External users reliance on financial statements Methods Used to Assess Acceptable Audit Risk Examine financial statements Read minutes of the board Examine form 10K Discuss financing plans with management 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-26
Methods Practitioners Use to Assess Acceptable Audit Risk Factors Likelihood of financial difficulties Management integrity Methods Used to Assess Acceptable Audit Risk Analyze financial statements for difficulties using ratios Examine inflows and outflows of cash flow statements See Chapter 8 for client acceptance and continuance 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-27
Learning Objective 8 Consider the impact of several factors on the assessment of inherent risk. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-28
Factors Affecting Inherent Risk Nature of the client s business Results of previous audits Initial versus repeat engagement Related parties Nonroutine transactions Judgment required to correctly record account balances and transactions Makeup of the population Factors related to fraudulent financial reporting Factors related to misappropriation of assets 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-29
Learning Objective 9 Discuss the relationship of risks to audit evidence. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-30
Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence Acceptable audit risk D D I Factors influencing risks Inherent risk I Planned detection risk I Planned audit evidence I D Control risk D = Direct relationship; I = Inverse relationship 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-31
Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence Auditors can change the audit to respond to risks The engagement may require more experienced staff The engagement will be reviewed more carefully than usual 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-32
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. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-33
Tolerable Misstatement, Risks, and Balance-related Audit 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 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-34
Measurement Limitations One major limitation in the application of the audit risk model is the difficulty of measuring the components of the model. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-35
Relationships of Risk to Evidence Situation Acceptable audit risk Inherent risk Control risk Planned detection risk Amount of evidence required 1 High Low Low High Low 2 Low Low Low Medium Medium 3 Low High High Low High 4 Medium Medium Medium Medium Medium 5 High Low Medium Medium Medium 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-36
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. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-37
Learning Objective 10 Discuss how materiality and risk are related and integrated into the audit process. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-38
Relationship of Tolerable Misstatement and Risks to Planned Evidence Acceptable audit risk D D I Inherent risk Control risk I Planned detection risk I I Planned audit evidence D I Tolerable misstatement D = Direct relationship; I = Inverse relationship 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-39
Audit Risk Model for Planning AcAR = IR CR AcDR where: AcAR = Achieved audit risk IR = Inherent risk CR = Control risk AcDR = Achieved detection risk 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-40
Audit Risk Models for Planning Evidence and Evaluating Results Acceptable audit risk Compare Achieved audit risk D D Inherent risk Control risk Substantive audit evidence D Achieved detection risk D = Direct relationship I = Inverse relationship I 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-41
Revising Risks and Evidence The auditor must revise the original assessment of the appropriate risk. The auditor should consider the effect of the revision on evidence requirements, without the use of the audit risk model. 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-42
End of Chapter 9 2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 9-43