Ch1. Considering Materiality and Risk

Chapter
Chapter11
Considering
Considering
Materiality
Materialityand
and
Risk
Risk
Copyright © 2014 Pearson Education

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.
1-2
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
1-3 process. Copyright © 2014 Pearson Education
Apply the concept of materiality to the audit.
1-4
Major consideration in determining
the appropriate audit report
Referenced in auditor’s responsibility

section of the audit report
What is meant by the term “material”?
1-5
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.
1-6
1-7
2
Make a preliminary judgment about what
amounts to consider material.
1-8
Auditors set materiality thresholds early in the
engagement.
Thresholds represent the maximum amount

that statements could be misstated and still
not affect users’ decisions.
1-9
Materiality is a relative rather
than an absolute concept.
Benchmarks are needed for

evaluating materiality.
Qualitative factors also

affect materiality.
1-10
Considerations that may render material a
quantitatively small misstatement include:
Loan covenants Changing trend
Management compensation
Financial statement users Conceals an illegal act
1-11
Accounting and auditing standards do not
provide specific materiality guidelines.
Professional judgment is used to set and

apply materiality guidelines.
1-12
3
Determine performance materiality
during planning.
1-13
Evidence is accumulated by segments
rather than for the financial statements
as a whole.
Most practitioners allocate materiality

to balance sheet accounts.
1-14
4
Use materiality to evaluate audit findings.
1-15
Auditor can determine the misstated
amount in an account (“Known”)
Two types of “Likely” misstatements:

 Judgmental differences
 Projections of misstatements from
audit samples
1-16
1-17
Estimated Net misstatements in Sample ($3,500)
× Total recorded
Misstatement = Total sampled ($50,000) population value
($31,500)
($450,000)
1-18
5
Define risk in auditing.
1-19
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.
1-20
Auditors need to understand the client’s
business and assess business risk.
The audit risk model helps identify the

potential and likelihood of misstatements.
1-21
PDR = AAR ÷ (IR × CR)
where: PDR = Planned detection risk
AAR = Acceptable audit risk
IR = Inherent risk
CR = Control risk
1-22
1-23
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
1-24
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
1-25
6
Describe the audit risk model and
its components.
1-26
Planned
Inherent
Detection
Risk
Risk
Acceptable
Control Audit
Risk Risk
1-27
7
Consider the impact of engagement risk
on acceptable audit risk.
1-28
What is Engagement Risk?
1-29
Auditors decide engagement risk and use
that risk to modify acceptable audit risk.
Engagement risk closely relates to client

business risk.
1-30
 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
1-31
1-32
8
Consider the impact of several factors on
the assessment of inherent risk.
1-33
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
1-34
9
Discuss the relationship of risks
to audit evidence.
1-35
Acceptable audit risk
D D I
Factors I
Planned
Inherent I Planned
influencing detection
risk audit
risks risk evidence
I D
Control risk
1-36
37
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
1-38
Both control risk and inherent risk are
typically set for each cycle, each
account, and often each audit
objective, not for the overall audit.
1-39
It is common to assess inherent and control
risk for each balance-related audit objective
It is not common to allocate materiality

to objectives
1-40
1-41
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
1-42
Auditors develop various types of worksheets
to aid in relating the considerations affecting
audit evidence to the appropriate evidence
to accumulate.
1-43
10
Discuss how materiality and risk are related
and integrated into the audit process.
1-44
Acceptable
audit risk D D I
Planned I Planned
Inherent detection risk audit evidence
risk I
I D I
Control
risk
Performance
materiality
D = Direct relationship; I = Inverse relationship
1-45
46
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.
1-47

Ch1. Considering Materiality and Risk

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Chapter

Copyright © 2014 Pearson Education

Referenced in auditor’s responsibility

What is meant by the term “material”?

Auditor will bring material misstatements to the

Thresholds represent the maximum amount

Benchmarks are needed for

Qualitative factors also

Loan covenants Changing trend

Financial statement users Conceals an illegal act

Professional judgment is used to set and

Most practitioners allocate materiality

Two types of “Likely” misstatements:

Risks exist, are difficult to

Proper risk response is critical

The audit risk model helps identify the

where: PDR = Planned detection risk

AAR = Acceptable audit risk

Engagement risk closely relates to client

The likelihood that a client will have

The auditor’s evaluation of

The engagement may require more

The engagement will be reviewed more

It is not common to allocate materiality

The auditor should consider the effect

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