Materiality and Risk Chapter 9 2012 Prentice Hall

Learning Objective 1 Apply the concept of materiality to the audit. © 2012 Prentice

Materiality ØMajor consideration in determining the appropriate audit report ØReferenced in audit report’s scope

Materiality Auditor’s responsibility = determine whether financial statements are materially misstated. Auditor will bring

Steps in Applying Materiality © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9

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

Set Preliminary Judgment About Materiality Auditors set materiality thresholds early in the engagement. Thresholds

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

Qualitative Factors Considerations that may render material a quantitatively small misstatement include: Loan covenants

Guidelines Accounting and auditing standards do not provide specific materiality guidelines. Professional judgment is

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

Allocate Preliminary Judgment About Materiality to Segments Evidence is accumulated by segments rather than

Learning Objective 4 Use materiality to evaluate audit findings. © 2012 Prentice Hall Business

Known and Likely Misstatements Auditor can determine the misstated amount in an account (“Known”)

Estimated Total Misstatement and Preliminary Judgment © 2012 Prentice Hall Business Publishing, Auditing 14/e,

Estimated Total Misstatement and Preliminary Judgment Estimated Net misstatements in Sample ($3, 500) ×

Learning Objective 5 Define risk in auditing. © 2012 Prentice Hall Business Publishing, Auditing

Risk ØAuditors accept some level of risk in performing the audit. ØRisks exist, are

Risk and Evidence Auditors need to understand the client’s business and assess business risk.

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

Audit Risk Model for Planning © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley

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. © 2012 Prentice

Audit Risk Model Components Planned Detection Risk Inherent Risk Control Risk Acceptable Audit Risk

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

Engagement Risk What is Engagement Risk? © 2012 Prentice Hall Business Publishing, Auditing 14/e,

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 © 2012 Prentice Hall Business Publishing,

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

Factors Affecting Inherent Risk Nature of Client’s Business Ø Industry practices Ø Non-routine transactions

Learning Objective 9 Discuss the relationship of risks to audit evidence. © 2012 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 ØAuditors can

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

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

Risk and Evidence © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 -

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

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 © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9

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Materiality ØMajor consideration in determining the appropriate audit report ØReferenced in audit report’s scope paragraph ØWhat is meant by the term “material”? © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 -3

Materiality Auditor’s responsibility = determine whether financial statements are materially misstated. Auditor will bring material misstatements to the client’s attention so corrections can be made. © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 -4

Set Preliminary Judgment About Materiality Auditors set materiality thresholds early in the engagement. Thresholds represent the maximum statements that could be misstated and still not affect users decisions. © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 -7

Factors Affecting Judgment Materiality is a relative rather than an absolute concept. Bases are needed for evaluating materiality. Qualitative factors also affect materiality. © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 -8

Qualitative Factors Considerations that may render material a quantitatively small misstatement include: Loan covenants Changing trend Management compensation Financial statements users Conceals an illegal act © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 -9

Guidelines Accounting and auditing standards do not provide specific materiality guidelines. Professional judgment is used to set and apply materiality guidelines. © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 10

Allocate Preliminary Judgment About Materiality to Segments 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) © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 12

Known and Likely Misstatements Auditor can determine the misstated amount in an account (“Known”) Two types of “Likely” misstatements: Ø Judgmental differences Ø Projections of misstatements from audit samples © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 14

Estimated Total Misstatement and Preliminary Judgment Estimated Net misstatements in Sample ($3, 500) × Total recorded = Misstatement Total sampled ($50, 000) population value ($31, 500) ($450, 000) © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 16

Risk ØAuditors accept some level of risk in performing the audit. ØRisks exist, are difficult to measure, and require careful thought in response. ØProper risk response is critical to achieving a high-quality audit. © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 18

Risk and Evidence Auditors need to understand the client’s business and assess business risk. The audit risk model helps identify the potential and likelihood of misstatements. © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 19

Audit Risk Model for Planning PDR = AAR ÷ (IR × CR) where: PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 20

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 © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 22

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 Low detection risk © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley Medium 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. © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 28

Factors Affecting Acceptable Audit Risk Ø The degree to which external users rely on the statements ØThe likelihood that a client will have financial difficulties after the audit report is issued ØThe auditor’s evaluation of management’s integrity © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 29

Factors Affecting Inherent Risk Nature of Client’s Business Ø Industry practices Ø Non-routine transactions Ø Makeup of the population Audit Experience Ø Prior audit results Ø Initial vs. repeat engagement Ø Audit judgment required to correctly record balances and transactions Culture Ø Related parties Ø Factors related to fraudulent financial reporting Ø Factors related to misappropriation of assets © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 32

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 © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 34

Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence ØAuditors can change the audit to respond to risks ØThe engagement may require more experienced staff ØThe engagement will be reviewed more carefully than usual © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 35

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. © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 36

Tolerable Misstatement, Risks, and Balance-related Audit Objectives ØIt is common to assess inherent and control risk for each balance-related audit objective ØIt is not common to allocate materiality to objectives © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 37

Measurement Limitations One major limitation in the audit risk model is the difficulty of measuring the components of the model. Known Unknown Preliminary Assessed Level of Risk Actual level of risk achieved on the audit +/- © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 39

Relationships of Risk to Evidence Acceptable Inherent audit risk Control risk Planned detection risk 1 High Low High 2 Low Low Medium 3 Low High Low 4 Medium Medium 5 High Situation Low Amount of evidence required Low High Medium © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 40

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. © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 41

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 © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 43

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. © 2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 44