MATERIALITY AND RISK

1
 OBJECTIVES
• Materiality
• Audit risk
• Business risk

2
DEFINITION OF MATERIALITY
Information is material if its omission or
misstatement could influence the economic
decisions of users taken on the basis of the
financial statements. Materiality depends on the
size of the item or error judged in the particular
circumstances of its omission or misstatement.
Thus, materiality provides a threshold or cut-off
point rather than being a primary qualitative
characteristic which information must have if it is to
be useful. (ISA 320, 2004)
3
 APPLICATION
• During accounts preparation

• Audit

– Planning

– Testing

– Final review
4
 DETERMINANTS OF
MATERIALITY
• Users of the information and their requirements.
• Absolute values.
• Relative volume.
• Expected precision.
• Statutory and other regulatory requirements.
• Materiality of principle.
• Critical points
• Nature of the item.
• Offset & aggregation.

5
 SETTING MATERIALITY
• Materiality – financial statements as a
whole

• Performance materiality – assess risks

and determine nature, timing and extent of
audit procedures

6
 EXAMPLE
A firm audits two companies in the same industry, with the
same customers, suppliers etc., and with similar levels of
turnover, profit and balance sheet figures. However,
Company A has extremely good accounting systems and
controls, whereas Company B does not, and, from past
experience, this is reflected in the firm finding several
misstatements during the course of their audit.

•Materiality will be the same for both companies.

•Performance materiality will be lower (and hence more
evidence will be needed) on the audit of Company B.

7
 BENCHMARKS
• Benchmarks used as a starting point
• Choice of benchmark
– Volatility
– User requirements
– Nature of the entity
– Ownership and financing
– Availability

8
 GUIDELINES
Unlikely to May be Probably
be material material
material
Normal net < 5% 5 – 10% >10%
profit
Turnover < ½% ½ - 1% >1%

Total < ½% ½ - 2% >2%

assets
9
 AUDIT RISK
The risk that an auditor may express an
inappropriate opinion on financial
information.

– Risk of incorrect acceptance

– Risk of incorrect rejection

10
 AUDIT RISK
• Inherent risk
• Control risk
• Detection risk

11
 INHERENT RISK
The susceptibility of an assertion to a
misstatement that could be material, either
individually, or when aggregated with other
misstatements, assuming there are no
related controls.

12
 INHERENT RISK

High > 60%

Moderate 40 – 60%

Low < 40%

13
 CONTROL RISK
The risk that a misstatement that could
occur in an assertion and that could be
material, either individually or when
aggregated with other misstatements, will
not be prevented, or detected and corrected,
on a timely basis by the entity’s internal
control

14
 CONTROL RISK

High > 40%

Moderate 20 – 40%

Low < 20%

15
 DETECTION RISK
The risk that the auditor will not detect a
misstatement that exists in an assertion that
could be material, either individually or when
aggregated with other misstatements.

– Sampling risk.
– Non sampling risk.
– Analytical review risk
– Substantive risk

16
AUDIT RISK MODEL

AR = IR X CR X DR

17
 APPLICATION OF MODEL
• Determine acceptable level of audit risk
• Assess inherent risk
• Assess and verify control risk
• Calculate detection risk
• Convert detection risk to assurance
required to determine level of work

18
 EXAMPLE 1
Company A is established in a stable industry. Internal
control systems are good, with no recent changes.

Audit risk (Set by partner) 5%

Inherent risk (judgement) 50%
Control risk (judgement) 30%
Detection risk 0.05/(0.5 x 0.3) 33%

Assurance required from substantive procedures 67%

19
 EXAMPLE 2
Company B is new in a high tech industry. Internal
controls are poor with a strong possibility of
management override.

Audit risk (Set by partner) 5%

Inherent risk (judgement) 100%
Control risk (judgement) 70%
Detection risk 0.05/(1.0 x 0.7) 7%

Assurance required from substantive procedures 93%

20
 ADVANTAGES OF MODEL
• Justification of audit decisions
• Increases audit efficiency by directing
attention appropriately.
• Logical approach ensures consideration
of major factors
• Improves consistency between audits
• Statistical calculations can be
incorporated into a computer package.
21
DISADVANTAGES OF MODEL
• Inherent risk is very judgemental
• Judgement required to apply model to
specific areas.
• Encourages a mechanical approach
• The formula was not intended to be used
as a mathematical formula.

22
BUSINESS RISK APPROACH
Reliable systems

Better management information

Fewer errors

23
 BUSINESS RISK
Business risks result from significant
conditions, events, circumstances, actions
or inactions that could adversely affect the
entity’s ability to achieve its objectives and
execute its strategies, or through the setting
of inappropriate objectives and strategies.

24
 CATEGORIES OF BUSINESS
RISK
Strategic Arises from being in a particular industry and geographical
area.

Operational Arises from the operational and administrative procedures

that the business uses to implement its strategy

Financial Arises from the financial structure of the business, from

transactions with third parties and from the financial systems
in place.

Compliance Arises from non-compliance with the laws, regulations

and other less formal societal expectations which, if infringed,
can damage a company

Environmental May be a subset of compliance risk but often requires

separate consideration.

25
 RISK MANAGEMENT
• Identify significant risks
• Prioritise risks
• Implement control strategies
– Accept
– Transfer
– Avoid
– Control
• Monitor
26
 AUDIT APPROACH
• Identify risks

• Relate risks to financial statement assertions.

• Consider whether material misstatement likely

– Potential impact
– Likelihood of occurrence

• Determine audit procedures

27
EVALUATION OF APPROACH
• Broader than audit risk
• Approach adds value
• Focus on a continuing relationship
• Responds to regulators concerns re
corporate governance
• Interesting for staff
• Is the auditor properly qualified?
• Possible impact on independence
28