Materiarity, Audit Risk and Audit Test

MATERIARITY, AUDIT TESTS,
AND UDIT RISK
Dr. Mwiga Wiljonsi Mbesi - IFM

Learning Objectives
At the end of this module you should be able to:
 Describe materiality concept and its application in auditing
 Describe audit risk
 Describe audit tests
Dr. Mwiga Wiljonsi Mbesi 2

Materiality
ISA 320 on audit materiality states that:
 Information is material if its omission or misstatement could influence the

economic decision of users taken on the bases of financial statement.
 The assessment of what is material is a matter of professional judgment.
 Being a matter of judgment, materiality can be difficult matter in practice but

of great importance.
 Thus, great care should be taken before coming to a conclusion on matter of

materiality

Cont……
 Auditors should take materiality into account when considering the nature,
timing and extent of audit procedures.
 Materiality should be taken into account at the planning stage and consider if
the outcome of tests, enquiries or examination differ from expectation.
 Like the ISA 320, the companies Act provides that materiality is a matter of
professional judgment and it has both quantitative and qualitative
dimensions

Materiality – Quantitative estimates
 Figures can be material purely because of its size relative to another in the
accounts
 Auditors often set more form of percentage value on errors which will decide
if they are material or not. This can be for instance:
 5 to 10% of tax before tax
 1% of total turnover
 5% of net assets
However, this should not be taken as being prescriptive- the actual amount
decided on will be a matter of professional judgment.

Cont…..
There some methods by which auditors can assess whether or not items are
material:
 Compare the magnitude of the item with the overall view presented by the
account
 Compare the magnitude of the item with the magnitude of the same item in
the previous year
 Compare the magnitude of the item with the total of which it form a part(e.g.
debtors may include employees loans but if employees loans become
larger, that is material, then the description ‘debtors’ may be inadequate.
 Some items are always material e.g. Directors’ remuneration.

Materiality- Qualitative estimates
Despite its financial value, materiality can be estimated qualitatively. These relates
to the nature of the error or misstatement detected.
The following are examples of errors which are material by virtue of their nature :
 Omission or a disclosure required by the companies Act or accounting

standards
 An item which is misstated in the accounts e.g.. Short term loan classified as
long-term loan

Cont….
 An item which might affect the accounts but which has been omitted because
it cannot be quantified with reasonable degree of certainty e.g. outcome of the
court case.
In these cases auditors should remind the directors of their duties to comply
with the companies act and the accounting standards and rectify omission
or misstatement.

Audit test
In order to gather audit evidence auditors need to carry out audit test on
transactions and balances.
There are two forms of audit tests:
 Compliance tests
 Substantive test

Compliance test
 This is a test of controls and the application of internal control

procedures
 Are tests to obtain evidence about the effective operation of the

control environment, in particular the operation procedures

Cont….
The auditors will review the answers from:
1. Internal control evaluation questionnaire which will highlight areas of

weakness
2. Previous period’s audit files to identify any problem area encountered in

previous years
3. The letter of weakness sent to management that asks for the identification
areas of weakness

Substantive test
 Substantive tests included all tests other than test of control
 This is a test of transactions and balances
 It is a detailed test of transactions and balances (assets and liabilities)
 They are designed to obtain audit evidence to determine material

misstatements in the financial statements
 They also review the minutes of the directors meetings and enquiries

Cont….
Analytical tests(analytical procedures)
Analytical tests is also seen as a separate tests
For example:
Of a transaction – the sale of a piece of plant will require the auditors to
examine the copy, authorization, price, entry in the fixed asset register
etc
Of a balance – direct confirmation of the balance in deposit account

obtained from the bank etc

Assertion procedures
 Ascertain is a confident and forceful statement of fact or belief. Audit
procedures are performed in order to test financial statement
assertions.
 Basically, it is a declaration, contention, submission, or attestation

whether something is correct or not correct.
Management are expected to produce financial statements. By doing so

they assenting that:
 The individual items are correctly described,
 The fingered are fairly estimated,
 The accounts as a whole show a true and fair view.

Categories of Assertion
ISA 500
1. Assertion about classes of transactions and events for the period under
review, which includes:
Occurrence Transactions and events have been recorded related

to the organization, which is audited
Completeness All transactions and events have been recorded
Accuracy Data have been recorded appropriately
Cut-off Transactions and events have been recorded in the
appropriate accounting period
Classification Transactions and events have been recorded in the

proper accounts
Cont......
2. Assertion about account balances at the end of the period
Existence Assets, liabilities, equity interest exist
Rights and obligations Rights to company’s assets and liabilities
Completeness Assets, liabilities and equity have been recorded
Valuation and location Appropriate value of assets, liability and capital are
included in the financial statement

Cont...
3. Assertion about presentation and disclosure, which includes:
Occurrence, rights and All disclosure events, and transactions occurred and
obligations are of the company
Completeness All disclosures that should have been included in the

FS have been included
Classification and Financial information is properly presented,

understandability described and are clear
Accuracy and valuation Financial information is disclosed fairly and at proper

amount

Audit risk
ISA 315
 Audit risk is the risk that an auditor might give an incorrect or

inappropriate opinion on the financial statements.
 A wrong audit opinion is for instance saying the financial statements

show a true and fair view when in fact they do not or saying they do
not show true and fair view when, in fact they do.
 This can result in auditors’ liability which may damage the audit
firm’s reputation and payment of compensation for negligence.

Cont….
 It should be appreciated that, although they have common features,

audit risk is not the same as business risk
 Audit risk is the risk auditors have to asses, business risks are overall
of risks faced by business or organization in carrying its day to day
activities
 Audit risk should be assessed at both the organizational level (looking

at the financial statements as a whole), and at the transaction level
(verifying disclosure of individual components of the financial
statements such as value of stock and work in progress.
Audit risk model
AR = IR x CR x DR
Where:
AR= The risk that auditor will draw an invalid conclusion (The allowable
audit risk that a material misstatement might remain undetected for the
account balance and related assertions).
 IR = Inherent risk
 CR = Control risk
 DR = Detection risk
Inherent risk (IR)
IR is the risk which is derived from the nature of entity itself, its business
and its environment, or at the transaction level in the susceptibility of
the transactions to possible misstatement due to their nature or
complexity.

Inherent risk (IR)
Factors influencing inherence risk are:
 The nature of the entity’s business (construction business is more

volatile than fruit importing business)
 The quality and experience of the management
 The level of competition in the market
 The complexity of its operations

Inherent risk (IR)
 The cash situation of the business
 The trading history of the business
At the transaction level IR is affected by:
 The susceptibility to misappropriation
 The complexity of transactions
 The degree of judgment involved

Control risk (CR)
CR is the risk that the clients’ internal control procedures will fail to
prevent and detect material errors or misstatement.
CR is influenced by:
 The attitude of the directors and management towards internal control
(internal control environment)
 The level of supervision in the business
 The integrity of the staff and management
 The strengths of individual controls in each area of the system

Control risk (CR)
 New and inexperienced staff
 Changes in the accounting systems
 Additional locations
 New products

Detection risk
DR is the risk that the auditor’ own procedures and review of financial statements
will not detect material errors or misstatements (Detection risk, the risk that
the auditors’ procedures will fail to detect a material misstatement if it exists.

Evaluating audit risk
 The auditor will make primary assessment of the levels of inherent and
control risk
 This can be done by a simple subjective judgment, assessing risk as

High, medium or low
 Generally, auditors aims to have not more that 5% risk that the
financial statements are materially incorrect. That means that auditors
should have a confidence level of 95% certain that their opinion is the
correct one
 It should be understood that DR is variable in the sense that the

higher the IR and CR the more check the auditor has ton perform
An example
Suppose the auditors estimates that the level of inherent risk is 50%
and the level of control risk is 20% that is there is an 80% chance
that an error or mistake would be detected by the internal control
system.
By using the question we can determine the level of detection risk:
AR = IR x CR x DR
Therefore: DR = AR
IR x CR
With an audit risk of 5, the equation will be:
DR = 5% = 50%
50% x 20%
Auditors would then have to consider the level of audit work that
would maintain Detection risk at 50% level.
Cont……
 In order to properly evaluate the levels of IR and CR auditors need to

carry out the investigatory procedures including:
 Getting to know their client (as part of their planning procedure)
 Review their clients’ internal control system by documenting them

using ICQs, ICEQs and Flow chart

Cont……
 All auditors’ subsequent activities must be complete and stems from

this preliminary investigations and discovery work.
 It should be born in mind that if auditor’s work is incomplete or flawed

may well lead to :
 Inadequate testing of key areas
 Being misled by managers because of incomplete knowledge of

the business
 Fail to identify area where frauds could be committed

END OF PRESENTATION
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MATERIARITY, AUDIT TESTS,

AND UDIT RISK

Dr. Mwiga Wiljonsi Mbesi - IFM

At the end of this module you should be able to:

 Describe materiality concept and its application in auditing

 Describe audit risk

 Describe audit tests

Dr. Mwiga Wiljonsi Mbesi 2

ISA 320 on audit materiality states that:

 Information is material if its omission or misstatement could influence the

 The assessment of what is material is a matter of professional judgment.

 Being a matter of judgment, materiality can be difficult matter in practice but

 Thus, great care should be taken before coming to a conclusion on matter of

Dr. Mwiga Wiljonsi Mbesi 3

Dr. Mwiga Wiljonsi Mbesi 4

Dr. Mwiga Wiljonsi Mbesi 5

 Some items are always material e.g. Directors’ remuneration.

Dr. Mwiga Wiljonsi Mbesi 6

 Omission or a disclosure required by the companies Act or accounting

Dr. Mwiga Wiljonsi Mbesi 7

Dr. Mwiga Wiljonsi Mbesi 8

There are two forms of audit tests:

Dr. Mwiga Wiljonsi Mbesi 9

 This is a test of controls and the application of internal control

 Are tests to obtain evidence about the effective operation of the

Dr. Mwiga Wiljonsi Mbesi 10

The auditors will review the answers from:

1. Internal control evaluation questionnaire which will highlight areas of

2. Previous period’s audit files to identify any problem area encountered in

Dr. Mwiga Wiljonsi Mbesi 11

 Substantive tests included all tests other than test of control

 This is a test of transactions and balances

 It is a detailed test of transactions and balances (assets and liabilities)

 They are designed to obtain audit evidence to determine material

Dr. Mwiga Wiljonsi Mbesi 12

Analytical tests(analytical procedures)

Analytical tests is also seen as a separate tests

Of a balance – direct confirmation of the balance in deposit account

Dr. Mwiga Wiljonsi Mbesi 13

 Basically, it is a declaration, contention, submission, or attestation

Management are expected to produce financial statements. By doing so

Dr. Mwiga Wiljonsi Mbesi 14

Occurrence Transactions and events have been recorded related

Classification Transactions and events have been recorded in the

2. Assertion about account balances at the end of the period

Existence Assets, liabilities, equity interest exist

Rights and obligations Rights to company’s assets and liabilities

Completeness Assets, liabilities and equity have been recorded

Dr. Mwiga Wiljonsi Mbesi 16

3. Assertion about presentation and disclosure, which includes:

Completeness All disclosures that should have been included in the

Classification and Financial information is properly presented,

Accuracy and valuation Financial information is disclosed fairly and at proper

Dr. Mwiga Wiljonsi Mbesi 17

 Audit risk is the risk that an auditor might give an incorrect or

 A wrong audit opinion is for instance saying the financial statements

Dr. Mwiga Wiljonsi Mbesi 18

 It should be appreciated that, although they have common features,

 Audit risk should be assessed at both the organizational level (looking

Dr. Mwiga Wiljonsi Mbesi 21

Factors influencing inherence risk are:

 The nature of the entity’s business (construction business is more

 The quality and experience of the management