CHAPTER 8 MATERIALITY AND RISK MATERIALITY THE MAGNITUDE

CHAPTER 8 MATERIALITY AND RISK

MATERIALITY • THE MAGNITUDE OF AN OMISSION OR MISSTATEMENT…THAT MAKES IT PROBABLE THAT THE JUDGMENT OF A REASONABLE PERSON WOULD BE CHANGED OR INFLUENCED BY THE ITEM.

PRELIMINARY JUDGMENT ABOUT MATERIALITY • PROFESSIONAL JUDGMENT • AMOUNT OF MISSTATEMENT PRESENT AND NOT INFLUENCE USERS • PLANNING DECISION – APPROPRIATE LEVEL OF EVIDENCE – HIGHER MATERIALITY, LOWER EVIDENCE • FACTORS AFFECTING JUDGMENT – RELATIVE RATHER THAN ABSOLUTE – BASES FOR COMPARISON – QUALITATIVE FACTORS

ALLOCATE PLANNING MATERIALITY TO SEGMENTS • EVIDENCE IS ACCUMULATED BY SEGMENT • AMOUNT IF EVIDENCE IS INVERSLY RELATED TO MATERIALITY • TOLERABLE MISSTATEMENT • NO ONE WAY TO ALLOCATE • MATERIALITY REVISED DURING AUDIT

ESTIMATE MISSTATEMENT • RESULTS OF AUDIT PROJECTED TO ACCOUNT BALANCE – PROJECTION • STATISTICAL OR NONSTATISTICAL • DIRECT PROJECTION • ALLOWANCE FOR SAMPLING RISK • ESTIMATE OF COMBINED MISSTATEMENT • COMPARE WITH MATERIALITY – EXPAND AUDIT WORK OR ACCEPT RESULT

RISK • UNCERTAINTY IN THE AUDIT FUNCTION – COMPETENCE OF EVIDENCE – STRENGTH OF INTERNAL CONTROLS – FAIRNESS OF FINANCIAL STATEMENTS

AUDIT RISK MODEL • AR = IR * CR * DR – AR = AUDIT RISK – RISK THAT AUDITOR REACHES THE WRONG CONCLUSION – IR = INHERENT RISK – RISK THAT MATERIAL MISSTATEMENTS OCCUR BECAUSE OF NATURE OF ITEM AUDITED – CR = CONTROL RISK – RISK THAT CLIENT’S INTERNAL CONTROLS WILL NOT PREVENT OR DETECT MISSTATEMENT – DR = DETECTION RISK – RISK THAT AUDIT PROCEDURES WILL BE INEFFECTIVE

• PLANNED DETECTION RISK – MEASURE OF RISK THAT AUDITOR’S PROCEDURES WILL NOT FIND MATERIAL MISSTATEMENTS THAT EXIST IN FINANCIAL STATEMENTS • ACCEPTABLE AUDIT RISK – RISK THAT AUDITOR IS WILLING TO ACCEPT THAT AUDIT OPINION WILL BE INCORRECT • RELIANCE OF USERS ON F/S • LIKELIHOOD OF FINANCIAL DIFFICULTIES • MANAGEMENT INTEGRITY

• ASSESSMENT OF INHERENT RISK – EXPECTATION OF MATERIAL MISSTATEMENTS BEFORE INTERNAL CONTROLS – FACTORS • • • NATURE OF BUSINESS FRAUD RESULTS OF PREVIOUS AUDITS INITIAL ENGAGEMENT RELATED PARTIES NONROUTINE TRANSACTIONS JUDGMENT IN PROPER ACCOUNTING SUSCEPTABILITY TO ASSET MISAPPROPRIATION MAKEUP OF POPULATION

OTHER MATERIALITY AND RISK CONSIDERATIONS • AUDIT RISK MODEL APPLIED TO SEGMENTS – CONTROL RISK AND INHERENT RISK SET • EACH CYCLE • EACH ACCOUNT BALANCE • EACH AUDIT OBJECTIVE – AUDIT RISK USUSALLY SET FOR WHOLE

• MEASUREMENT PROBLEMS AND MODEL – DIFFICULT TO QUANTIFY RISKS ACCURATELY AS %-AGES – MOST AUDITORS USE SUBJECTIVE MEASURES LIKE “LOW” – RELATION OF EVIDENCE TO RISK IS SUBJECTIVE ALSO – CONCERN ABOUT OVER- OR UNDERAUDITING

• RELATIONSHIP OF RISK AND MATERIALITY – RISK IS UNCERTAINTY – MATERIALITY IS SIZE – RISK OF MATERIAL MISSTATEMENT • RISK THAT MISSTATEMENT OF CERTAIN SIZE EXISTS IN ITEM BEING AUDITED – AS MATERIALITY DECREASES, RISK INCREASES • RISK MODEL IS PRIMARILY A PLANNING TOOL – IMPORTANT RELATIONSHIP IS RISK EVIDENCE