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Chapter 9

Considering
Materiality and
Risk

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Apply the concept of materiality to the


audit.
Make a preliminary judgment about what
amounts to consider material.
Determine performance materiality during
planning.
Use materiality to evaluate audit findings.
Define risk in auditing.
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Describe the audit risk model and its


components.
Consider the impact of engagement risk on
acceptable audit risk.
Consider the impact of several factors on
the assessment of inherent risk.
Discuss the relationship of risks to audit
evidence.
Discuss how materiality and risk are related
and integrated into the audit process.
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Apply the concept of materiality to the audit.

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Major consideration in determining


the appropriate audit report
Referenced in auditors responsibility
section of the audit report
What is meant by the term material?

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Auditors responsibility = determine whether


financial statements are materially misstated.

Auditor will bring material misstatements to the


clients attention so corrections can be made.

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Make a preliminary judgment about what
amounts to consider material.

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Auditors set materiality thresholds early in the


engagement.

Thresholds represent the maximum amount


that statements could be misstated and still
not affect users decisions.
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Materiality is a relative rather


than an absolute concept.
Benchmarks are needed for
evaluating materiality.
Qualitative factors also
affect materiality.

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Considerations that may render material a


quantitatively small misstatement include:
Loan covenants

Changing trend

Management compensation
Financial statement users

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Conceals an illegal act

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Accounting and auditing standards do not


provide specific materiality guidelines.

Professional judgment is used to set and


apply materiality guidelines.

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Determine performance materiality
during planning.

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Evidence is accumulated by segments


rather than for the financial statements
as a whole.

Most practitioners allocate materiality


to balance sheet accounts.

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Use materiality to evaluate audit findings.

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Auditor can determine the misstated


amount in an account (Known)
Two types of Likely misstatements:

Judgmental differences

Projections of misstatements from


audit samples

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Estimated
Misstatement
($31,500)

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Net misstatements in Sample ($3,500)


Total recorded
= Total sampled ($50,000)
population value
($450,000)

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Define risk in auditing.

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Auditors accept some level of


risk in performing the audit.
Risks exist, are difficult to
measure, and require careful
thought in response.
Proper risk response is critical
to achieving a high-quality audit.

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Auditors need to understand the clients


business and assess business risk.

The audit risk model helps identify the


potential and likelihood of misstatements.

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PDR = AAR (IR CR)


where:

PDR = Planned detection risk

AAR = Acceptable audit risk


IR = Inherent risk
CR = Control risk

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Sales and
collection
cycle

Acquisition Payroll and


and payment personnel
cycle
cycle

Inherent
risk

Medium

High

Low

Control
risk

Medium

Low

Low

Acceptable
audit risk

Low

Low

Low

Planned
Medium
detection risk

Medium

High

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Inventory and
warehousing
cycle

Capital acquisition
and repayment
cycle

Inherent
risk

High

Low

Control
risk

High

Medium

Acceptable
audit risk

Low

Low

Planned
Low
detection risk

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Medium
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Describe the audit risk model and
its components.

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Planned
Detection
Risk

Inherent
Risk

Control
Risk

Acceptable
Audit
Risk

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Consider the impact of engagement risk
on acceptable audit risk.

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What is Engagement Risk?

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Auditors decide engagement risk and use


that risk to modify acceptable audit risk.

Engagement risk closely relates to client


business risk.

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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 auditors evaluation of
managements integrity

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Consider the impact of several factors on
the assessment of inherent risk.

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Nature of Clients
Business
Industry practices
Non-routine transactions
Makeup of the population

Audit Experience
Prior audit results
Initial vs. repeat engagement
Audit judgment required to
correctly record balances and
transactions

Culture
Related parties
Factors related to fraudulent
financial reporting
Factors related to
misappropriation of assets
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Discuss the relationship of risks
to audit evidence.

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Acceptable audit risk


D

Factors
influencing
risks

Inherent
risk

Planned
detection
risk

Planned
audit
evidence
D

Control risk
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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

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Both control risk and inherent risk are


typically set for each cycle, each
account, and often each audit
objective, not for the overall audit.

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It is common to assess inherent and control


risk for each balance-related audit objective
It is not common to allocate materiality
to objectives

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One major limitation in the audit risk model is


the difficulty of measuring the components
of the model.

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Known

Unknown

Preliminary
Assessed Level
of Risk

Actual level of
risk achieved
on the audit

+/-

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Auditors develop various types of worksheets


to aid in relating the considerations affecting
audit evidence to the appropriate evidence
to accumulate.

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Discuss how materiality and risk are related
and integrated into the audit process.

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Acceptable
audit risk
Inherent
risk

D
Planned
detection risk
I

D
I

Planned
audit evidence
D

Control
risk
Performance
materiality
D = Direct relationship; I = Inverse relationship
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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.

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Copyright

All rights reserved. No part of this publication may be reproduced,


stored in a retrieval system, or transmitted, in any form or by any
means, electronic, mechanical, photocopying, recording, or otherwise,
without the prior written permission of the publisher. Printed in the
United States of America.
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