Materiality and Risk

Chapter 9

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5-5

 Learning Objective 1

Apply the concept of materiality to the audit.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9-2

 Materiality

Major consideration in determining

the appropriate audit report

Referenced in audit report’s scope

paragraph

What 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

 Steps in Applying Materiality

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9-5

 Learning Objective 2

Make a preliminary judgment about what

amounts to consider material.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9-6

 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

 Learning Objective 3

Allocate preliminary materiality to segments

of the audit during planning.

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 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.

 SAS 107 (AU 312)

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 12
 Learning Objective 4

Use materiality to evaluate audit findings.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 13

 Known and Likely Misstatements

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 Total Misstatement
and Preliminary Judgment

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 Estimated Total Misstatement
and Preliminary Judgment

Estimated Net misstatements in Sample ($3,500)

Misstatement = × Total recorded
Total sampled ($50,000) population value
($31,500)
($450,000)

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 16

 Learning Objective 5

Define risk in auditing.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 17

 Risk

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.

©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.

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 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

 Audit Risk Model for Planning

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 21

 Illustration of Differing Evidence
Among Cycles
Sales and Acquisition Payroll and
collection and payment personnel
cycle cycle cycle
Inherent
A Medium High Low
risk
Control
B Medium Low Low
risk
Acceptable
C Low Low Low
audit risk
Planned
D Medium Medium High
detection risk
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 22
 Illustration of Differing Evidence
Among Cycles
Inventory and Capital acquisition
warehousing and repayment
cycle cycle
Inherent
A High Low
risk
Control
B High Medium
risk
Acceptable
C Low Low
audit risk
Planned
D Low Medium
detection risk
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 23
 Learning Objective 6

Describe the audit risk model and

its components.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 24

 Audit Risk Model Components

Planned
Inherent
Detection
Risk
Risk

Acceptable
Control Audit
Risk Risk

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 Learning Objective 7

Consider the impact of engagement risk

on acceptable audit risk.

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 Engagement Risk

What is Engagement Risk?

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 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
 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 auditor’s evaluation of

management’s integrity

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 29

 Methods Practitioners Use to
Assess Acceptable Audit Risk

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 Learning Objective 8

Consider the impact of several factors on

the assessment of inherent risk.

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 Factors Affecting Inherent Risk
Nature of Client’s Audit Experience
Business
 Prior audit results
 Initial vs. repeat engagement
 Industry practices
 Audit judgment required to
 Non-routine transactions
 Makeup of the population correctly record balances and
transactions

Culture
 Related parties
 Factors related to fraudulent
financial reporting
 Factors related to
misappropriation of assets
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 32
 Learning Objective 9

Discuss the relationship of risks

to audit evidence.

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

D D I

Factors I Planned I Planned

Inherent
influencing detection audit
risk
risks risk evidence
I 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
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

©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
It is common to assess inherent and control
risk for each balance-related audit objective

It is not common to allocate materiality

to objectives

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 37

 Risk and Evidence

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 38

 Measurement Limitations

One major limitation in the audit risk model is

the difficulty of measuring the components
of the model.

Known Unknown
Preliminary Actual level of
Assessed Level +/- risk achieved
of Risk on the audit

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 39

 Relationships of Risk to
Evidence
Planned Amount of
Acceptable Inherent Control detection evidence
Situation audit risk risk risk risk required

1 High Low Low High Low

2 Low Low Low Medium Medium
3 Low High High Low High
4 Medium Medium Medium Medium Medium
5 High Low Medium Medium 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

 Learning Objective 10

Discuss how materiality and risk are related

and integrated into the audit process.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 42

 Relationship of Tolerable
Misstatement and Risks to
Planned Evidence
Acceptable
audit risk D D I
Planned I Planned
Inherent detection risk audit evidence
risk I
I D I
Control
risk

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

 End of Chapter 9

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 45