3-1

Part Two
3-2

BASIC AUDITING CONCEPTS:

MATERIALITY, AUDIT RISK, AND
EVIDENCE
 Chapter 3
3-3

CHAPTER 3
MATERIALITY AND RISK
3-4 MATERIALITY AND AUDIT RISK

 AuG-7, Applying materiality and audit risk concepts in conducting and audit,
provides the auditor with professional guidance in considering materiality and audit
risk when planning and performing an audit in accordance with GAAS.
 The wording of the auditor's report recognizes both of these concepts by including
the following terms:
 reasonable assurance
 in all material respects.
3-5 MATERIALITY

A misstatement or the aggregate of all misstatements in financial statements is

considered to be material if, in light of surrounding circumstances, it is
probable that the decision of a person who is relying on the financial
statements, and who has a reasonable knowledge of business and economic
activities ( the user), would be changed or influenced by such misstatement or
the aggregate of all misstatements.
3-6 STEPS IN APPLYING
MATERIALITY
 Step 1: Establish a preliminary judgment about materiality.
 Step 2: Document misstatements identified during the audit
examination.
 Step 3: Estimate the likely misstatement and compare to materiality.
3-7 THE STRATEGIC SYSTEMS
APPROACH

 Use knowledge of business.

 Assess internal and external environments.
3-8 FACTORS

 The client’s strategic objectives.

 The client’s strategic advantages over its competitors.
 Risks that threaten achievement of the client’s objectives.
 Critical issues facing the industry.
3-9 AUDIT RISK

 Audit risk is the risk that the auditor will fail to express a reservation in his or
her opinion on financial statements that are materiality misstated.
 Auditor business risk is the exposure to loss or injury to professional practice
from litigation, adverse publicity, or other events arising in connection with
financial statements audited and reported on.
3-
10
THE AUDIT RISK MODEL

AR = IR x CR x DR
3-
11
INHERENT RISK (IR)

 Inherent risk is the susceptibility of an assertion to material misstatement

in the financial statements in the absence of internal controls.
 At the beginning of an engagement, the auditor must assess specific
factors related to the client that may increase or decrease the likelihood of
material misstatement occurring.
3-
12
CONTROL RISK (CR)

 Control risk is the risk that material misstatements will not be prevented or
detected on a timely basis by the entity’s internal control.
 Chapter 6 contains a detailed discussion of this topic.
3-
13
DETECTION RISK (DR)

 Detection risk is the risk that the substantive audit procedures will not detect
a material misstatement that exists in an account balance or class of
transactions.
 Detection risk is composed of two risks or uncertainties:
 Sampling risk
 Nonsampling risk
3-
14
USE OF THE AUDIT RISK MODEL

1. Setting a planned level of audit risk.

2. Assessing inherent risk and control risk.
3. Solving the audit risk equation for the
appropriate level of detection risk.
3-
15 AN EXAMPLE

Set planned audit risk for accounts receivable at .05. Assume further that the
auditor assesses inherent risk to be .80 and control risk is 60. To determine the
level of detection risk for auditing accounts receivable, the audit risk model is
solved:
AR = IR x CR x DR
DR = AR / (IR x CR)

Thus, DR is set at approximately .10 [DR = .05/(.80 x .60)] for testing the
accounts receivable balance.
 3- LIMITATIONS OF THE
16
AUDIT RISK MODEL

 The audit risk model assumes that the components of the model (IR, CR, and DR) are
independent of each other. However, in practice, the risk of a material misstatement
(IR) occurring may be a function of the client’s internal controls (CR).
 The auditor’s assessments of IR and CR may be different from the actual levels of IR
and CR.
 The audit risk model does not consider the possibility of nonsampling risk.
 3-
17
DETECTION OF MISSTATEMENT
DUE TO ERROR OR FRAUD

 Errors are unintentional misstatements or omissions of amounts or disclosures and

may involve
 Mistakes in gathering or processing accounting data from which financial statements are
prepared.
 Unreasonable accounting estimates arising from oversight or misinterpretation of facts.
 Mistakes in the application of accounting principles.
3-
18
DETECTION OF MISSTATEMENT
DUE TO ERROR OR FRAUD (cont.)

 Fraud involves intentional misstatements that can be classified into two

types:
 fraudulent financial reporting
 misappropriation of assets.
3-
19
DETECTION OF MISSTATEMENT
DUE TO ERROR OR FRAUD (cont.)
 Fraudulent financial reporting may involve acts such as the following:
 Manipulation, falsification, or alteration of accounting records or supporting
documents from which the financial statements are prepared.
 Misrepresentation in, or intentional omission from, the financial statements of
events, transactions, or significant information.
 Intentional misapplication of accounting principles.
3-
20
DETECTION OF MISSTATEMENT
DUE TO ERROR OR FRAUD (cont.)

 Examples of misappropriation or defalcation include:

 Embezzling of cash receipts.
 Stealing assets.
 Causing the entity to pay for goods or services not received.
3-
21
DETECTION OF MISSTATEMENT
DUE TO ERROR OR FRAUD (cont.)

 Risk factors that relate to the possible presence of material misstatements in

the financial statements can be grouped into three categories:
 Management’s characteristics and influence over the control environment.
 Industry conditions.
 Operating characteristics and financial stability.
3-
22
DETECTION OF MISSTATEMENT
DUE TO ERROR OR FRAUD (cont.)

 Risk factors that relate to the misappropriation of assets can be grouped into
two categories:
 Susceptibility of assets to misappropriation.
 Controls.
 3- RESPONDING TO RISK FACTORS
23
AND ASSESSING DETECTION
RISK
 Based on the assessment of the risk factors that affect client business risk and the
risk of material misstatement, the auditor assess inherent risk and control risk.
 The auditor then determines the level of detection risk and designs audit procedures
to respond to the risk factors identified.
 3- DOCUMENTATION OF THE
24
AUDITOR’S RISK ASSESSMENT

 The auditor should document that the risk of material misstatement was assessed,
including how risk factors were considered.
 Where risk factors are identified, the documentation should describe
 the risk factors identified
 the auditor’s response to those risk factors.
 3- COMMUNICATION ABOUT
25
MATERIAL MISSTATEMENT

 Communications with Management

 Communications with the Audit Committee of the Board of Directors
 3- AUDITOR’S RESPONSIBILITY FOR
26
ILLEGAL ACTS

 Conduct the audit in accordance with GAAS

 Identify relevant laws and regulations
 Assess risk of misstatement from an illegal act
 Obtain written representation from management
 3- FACTORS TO CONSIDER WHEN
27 ASSESSING RISK OF AN ILLEGAL ACT

 Violations of such laws or regulations by the entity in the current or prior period
 Recent, well-publicized violations of such laws by others within the industry
 Active monitoring of such laws by a regulatory agency
 The complexity of such laws or regulations
 Management’s lack of experience in interpreting or applying such laws because they
are unusual or recently enacted
 3- CIRCUMSTANCES ENCOUNTERED
28 THAT MAY INDICATE ILLEGAL ACTS

 Unusually large cash receipts or payments, transfers to numbered bank accounts or

accounts in financial institutions with which the entity normally does not do business
 Unsupported payments
 Increased or unusual legal or consulting fees
 Allegations about illegal acts made by suppliers, creditors, or employees
 Payment of unusual fines or penalties
 Media comment