Materiality and Risk Chapter 9 2010 Prentice Hall

Learning Objective 1 Apply the concept of materiality to the audit. © 2010 Prentice

Materiality It is a major consideration in determining the appropriate audit report to issue.

Materiality The auditor’s responsibility is to determine whether financial statements are materially misstated. If

Steps in Applying Materiality Step Set preliminary judgment 1 about materiality Allocate preliminary Step

Steps in Applying Materiality Step Estimate total 3 misstatement in segment Step Estimate the

Learning Objective 2 Make a preliminary judgment about what amounts to consider material. ©

Set Preliminary Judgment About Materiality Auditors decide early in the audit the combined amount

Factors Affecting Judgment Materiality is a relative rather than an absolute concept. Bases are

Guidelines Accounting and auditing standards do not provide specific materiality guidelines to practitioners. Professional

Learning Objective 3 Allocate preliminary materiality to segments of the audit during planning. ©

Allocate Preliminary Judgment About Materiality to Segments This is necessary because evidence is accumulated

Learning Objective 4 Use materiality to evaluate audit findings. © 2010 Prentice Hall Business

Estimated Total Misstatement and Preliminary Judgment Estimated Misstatement Amount Account Cash Accounts receivable Inventory

Estimated Total Misstatement and Preliminary Judgment Net misstatements in the sample ($3, 500) ÷

Learning Objective 5 Define risk in auditing. © 2010 Prentice Hall Business Publishing, Auditing

Risk Auditors accept some level of risk in performing the audit. An effective auditor

Risk and Evidence Auditors gain an understanding of the client’s business and industry and

Illustration of Differing Evidence Among Cycles Sales and collection cycle Acquisition Payroll and payment

Illustration of Differing Evidence Among Cycles Inventory and warehousing cycle Capital acquisition and repayment

Learning Objective 6 Describe the audit risk model and its components. © 2010 Prentice

Audit Risk Model for Planning PDR = AAR ÷ (IR × CR) where: PDR

Learning Objective 7 Consider the impact of engagement risk on acceptable audit risk. ©

Impact of Engagement Risk on Acceptable Audit Risk Auditors decide engagement risk and use

Factors Affecting Acceptable Audit Risk Ø The degree to which external users rely on

Methods Practitioners Use to Assess Acceptable Audit Risk Factors External users’ reliance on financial

Methods Practitioners Use to Assess Acceptable Audit Risk Factors Methods Used to Assess Acceptable

Learning Objective 8 Consider the impact of several factors on the assessment of inherent

Factors Affecting Inherent Risk Ø Ø Ø Ø Ø Nature of the client’s business

Learning Objective 9 Discuss the relationship of risks to audit evidence. © 2010 Prentice

Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence Acceptable audit

Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence Ø Auditors

Audit Risk for Segments Both control risk and inherent risk are typically set for

Tolerable Misstatement, Risks, and Balance-related Audit Objectives Ø It is common to assess inherent

Measurement Limitations One major limitation in the application of the audit risk model is

Relationships of Risk to Evidence Acceptable Inherent audit risk Control risk Planned detection risk

Tests of Details of Balances Evidence Planning Worksheet Auditors develop various types of worksheets

Learning Objective 10 Discuss how materiality and risk are related and integrated into the

Relationship of Tolerable Misstatement and Risks to Planned Evidence Acceptable audit risk Inherent risk

Revising Risks and Evidence The auditor must revise the original assessment of the appropriate

End of Chapter 9 © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 9

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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. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 -4

Steps in Applying Materiality Step Set preliminary judgment 1 about materiality Allocate preliminary Step judgment about 2 materiality to segments © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Planning extent of tests 9 -5

Steps in Applying Materiality Step Estimate total 3 misstatement in segment Step Estimate the 4 combined misstatement Evaluating results Compare combined Step estimate with judgment 5 about materiality © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 -6

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. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 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. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 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. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 10

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. Ø SAS 107 (AU 312) © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 12

Estimated Total Misstatement and Preliminary Judgment Estimated Misstatement Amount Account Cash Accounts receivable Inventory Total estimated misstatement amount Preliminary judgment about materiality Known Misstatement and Direct Tolerable Misstatement Projection $ 4, 000 20, 000 36, 000 Sampling Error Total $ 2, 000 12, 000 31, 500 $ N/A 6, 000 15, 750 $ 2, 000 18, 000 47, 250 $45, 500 $16, 800 $62, 300 $50, 000 N/A = Not applicable Cash audited 100 percent © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 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) © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 15

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. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 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. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 18

Illustration of Differing Evidence Among Cycles Sales and collection cycle Acquisition Payroll and payment personnel cycle A Inherent risk Medium High Low B Control risk Medium Low C Acceptable audit risk Low Low D Planned Medium detection risk Medium High © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 19

Illustration of Differing Evidence Among Cycles Inventory and warehousing cycle Capital acquisition and repayment cycle A Inherent risk High Low B Control risk High Medium C Acceptable audit risk Low D Planned detection risk Low Medium © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 20

Audit Risk Model for Planning PDR = AAR ÷ (IR × CR) where: PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 22

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. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 24

Factors Affecting Acceptable Audit Risk Ø The degree to which external users rely on the statements Ø The likelihood that a client will have financial difficulties after the audit report is issued Ø The auditor’s evaluation of management’s integrity © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 25

Methods Practitioners Use to Assess Acceptable Audit Risk Factors External users’ reliance on financial statements Methods Used to Assess Acceptable Audit Risk Ø Ø Examine financial statements Read minutes of the board Examine form 10 K Discuss financing plans with management © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 26

Methods Practitioners Use to Assess Acceptable Audit Risk Factors Methods Used to Assess Acceptable Audit Risk Likelihood of financial difficulties Ø Analyze financial statements for difficulties using ratios Ø Examine inflows and outflows of cash flow statements Management integrity Ø See Chapter 8 for client acceptance and continuance © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 27

Factors Affecting Inherent Risk Ø Ø Ø Ø Ø 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 © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 29

Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence Acceptable audit risk D D Factors influencing risks Inherent risk I Planned detection risk I I I Planned audit evidence D Control risk D = Direct relationship; I = Inverse relationship © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 31

Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence Ø Auditors can change the audit to respond to risks Ø The engagement may require more experienced staff Ø The engagement will be reviewed more carefully than usual © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 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. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 33

Tolerable Misstatement, Risks, and Balance-related Audit Objectives Ø It is common to assess inherent and control risk for each balance-related audit objective Ø It is not common to allocate materiality to objectives © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 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. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 35

Relationships of Risk to Evidence Acceptable Inherent audit risk Control risk Planned detection risk 1 High Low 2 Low Low Medium 3 Low High 4 Medium Medium 5 High Low Medium Situation © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Amount of evidence required 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. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 37

Relationship of Tolerable Misstatement and Risks to Planned Evidence Acceptable audit risk Inherent risk Control risk D I Planned detection risk I D I I Planned audit evidence D I Tolerable misstatement D = Direct relationship; I = Inverse relationship © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 39

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. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 40