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Chapter 8: Materiality and Risk

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Copyright © 2007 Pearson Education Canada
Chapter 8 objectives
 Consider how materiality is used to decide
on the amount of fieldwork to be collected
 List the different types of risks considered
during the audit process
 Identify the components of the audit risk
model
 Explain how inherent risk is assessed
 Discuss how the audit risk model is used
during the conduct of the audit
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Materiality is in the “eye of the
beholder”
 An audit is expected to obtain reasonable
assurance that there is an absence of
“material misstatement”
 A material error is defined in the context of
what a reasonable business user would
think – would it affect his/her decision?

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Steps in applying materiality during
the audit

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When you find a material
misstatement
 What would you do?
 If you ask the client to correct the material
misstatement and they refuse, what are
your options?

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Levels of misstatements
(pp. 211-12)
 1. Identified misstatements
 2. Likely misstatements
 3. Likely aggregate misstatements
 4. Further possible misstatements

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Materiality is set early
 The preliminary judgment about
materiality is set prior to the conduct of
detailed audit testing, during planning
 Helps in deciding the amount of evidence
to collect
 If there are substantial changes to the
financial statements, then materiality may
need to be revised

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What affects the materiality
decision?
 Materiality is relative rather than absolute
 A base needs to be chosen
 Qualitative factors are used (emphasizing
the importance of knowledge of business)
 Firm guidelines or past practice

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Potential bases for materiality
 Revenue
 Net income before
taxes (NIBT) –
also exclude EI
 Total Assets
 Shareholders’
Equity
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Practice problem 8-16 (p. 238)
 Let’s take a look at a realistic set of
financial statements
 How would you calculate the materiality
figure?
 What base would you choose?

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What is risk?
 Risks arise when a situation involves
uncertainty
 Assessing risks includes assessing
probabilities – what is the “risk” of rain
today? What is the “risk” of a flood today?
 Assessing risks is part of our daily lives –
we constantly assess the likelihood of
events when making decisions

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Risk in auditing
 The auditor accepts some level of
uncertainty when performing an audit
 There is always a small likelihood
remaining that the financial statements
may be in error
 The audit risk model is used as part of a
strategic auditing approach

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Strategic auditing
 An audit engagement is a tactical plan of
action
 Audit procedures are designed to satisfy
audit objectives and to reduce the
probability of errors or other misstatements
in the financial statements

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Audit risk model

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Audit risk model formula
 Audit risk = inherent risk x control risk x
detection risk

 AR = IR x CR x DR

 The audit risk model is a planning model

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Audit risk
 A measure of the auditor’s willingness (i.e.
the auditor chooses this number) to accept
that the financial statements may be
materially misstated even though a proper
audit has been conducted
 Audit ASSURANCE is the complement of
audit risk
 Complete assurance is impossible to
achieve
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Assessing Audit Risk
 Factors:
– Nature of users
– Likelihood of
financial
difficulties
– Management
integrity
 Also consider
business risk
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When audit risk goes down
 What happens to
the evidence to be
collected?
 What does this say
about the nature of
the users?
 About potential
lawsuits?

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Inherent risk
 A measure of the likelihood that there are
material misstatements in a segment
simply due to the nature of the segment
(e.g. cash is more likely to be stolen than
sheets of steel)
 Internal controls are ignored in this
assessment

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Inherent risk is assessed at the
account balance assertion level
 Let’s look at a
company like a big
bank
 What are it’s inherent
risks for mortgages
receivable?
 For loan loss
provisions?

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Control risk
 A measure of the likelihood that
misstatements will NOT be detected or
prevented by the internal control systems
 This assessment is conducted because it is
required by generally accepted auditing
standards and also because it is needed to
design the nature and extent of audit tests

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Reliance on internal controls is a
choice
 The auditor is required to evaluate internal
controls, not to rely upon them
 Reliance may be necessary for certain
types of systems (e.g. complex automated
systems or paperless systems)
 In other situations, the auditor may choose
between internal control testing and tests
of details

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Control risk
 What would we
consider when
assessing the
control risk with
respect to money
deposited at an
ATM?

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Where reliance on internal controls
occurs the auditor must
 1. Obtain an understanding of internal controls
 2. Evaluate control risk (the capacity for the
internal control to prevent or detect errors)
 3. Design tests of controls and test the internal
controls (Certain controls may not need to be
tested every year, such as programmed controls
that have not changed since the prior year. They
can be tested as infrequently as every three
years.)
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Setting control risk at 100%
 This means that there is no reliance on
internal controls, because control risk is at
maximum (which means that the assurance
from tests of controls will be zero)
 This can occur either because of
inadequate control systems or it may be
too expensive to use tests of controls rather
than tests of details
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Planned detection risk
 This represents the audit testing that is
required on the part of the auditor (or
team) to adequately assess the financial
statements
 Once audit risk is set, and control risk and
inherent risk assessed, then detection risk
can be calculated

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Detection risk
 This is the only
part of the audit
risk model that can
be affected by the
actions of the
auditor

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Practice problem 8-17 (p. 238)
 Three different
scenarios
 How would you set
audit risk, inherent
risk, control risk and
detection risk?

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Materiality, risk and evidence
 Evidence collection needs to increase
when:
– Risk of errors increases
– Materiality goes down

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Practice problem 8-22 (p. 241)
 How would you
defend your selection
of a materiality level
in court?

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