Materiality and
Risk
Chapter 9
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9-1
Learning Objective 1
Apply the concept of
materiality to the audit.
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Materiality
The auditor’s responsibility is to determine whether
financial statements are materially misstated.
Also, if public, material weaknesses in I/Cs.
If there is a material misstatement,
the auditor will bring it to the client’s
attention so that a correction can be made.
SAS 89: Audit committee = backbone
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Steps in Applying
Materiality
Set preliminary
Step
judgment about
1
materiality (total).
Allocate preliminary
Step judgment about
2 Materiality to
segments (accounts) = tolerable misstatement
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Steps in Applying
Materiality
Step Estimate total
3 misstatement in segment.
Step Estimate the
4 combined misstatement.
Compare segment and combined
Step
estimate with judgments
5
about materiality.
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Learning Objective 2
Make a preliminary judgment
about what amounts to
consider material.
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Set Preliminary Judgment
Ideally, auditors decide early in the audit
the combined amount of misstatements
of the financial statements that would
be considered material.
This preliminary judgment is the maximum
amount by which the auditor believes the
statements could be misstated and still not
affect the decisions of reasonable users.
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Factors Affecting Judgment
Materiality is a relative rather
than an absolute concept.
Bases are needed for
evaluating materiality. What is the
key accounting variable? Sliding scale?
Qualitative factors also
affect materiality: IPO, Debt Covenant ratios.
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Learning Objective 3
Allocate preliminary materiality
to segments of the audit
during planning.
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Allocate Preliminary Judgment
About Materiality to
Segments
This is necessary because evidence is
accumulated by segments rather than
for the financial statements as a whole.
Most practitioners allocate materiality
to balance sheet accounts.
I/S and B/S accounts
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Learning Objective 4
Use materiality to evaluate
audit findings.
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Estimated Total
Misstatement Example
Net misstatement of the sample
÷ Total sampled
× Total recorded population value
= Direct projection estimate of misstatement
$3,500 ÷ $50,000 × $450,000 = $31,500
$3,500 = Known, $28,000 = Estimated
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Example of Estimate
for Sampling Error
Tolerable
Account Misstatement Projection Error/
Cash $ 4,000 $
Accounts receivable 20,000 12,000 6,00
Inventory 36,000 31,50
Total estimated
misstatement amount $43,500
Preliminary judgment
about materiality $60,000
*estimate for sampling error is 50%
So…..Adjustment: dr. Cost of Goods Sold 11,250
cr. Inventory
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Learning Objective 5
Define risk in auditing.
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Risk
Auditors accept some level of risk
in performing the audit.
An effective auditor recognizes that
risks exist, are difficult to measure,
and require careful thought to respond.
Responding to risks properly is critical
to achieving a high-quality audit.
Research – auditors better at risk
assessment, than risk response (testing)
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Risk and Evidence
Auditors use the audit risk model to further
identify the potential for misstatements
and where they are most likely to occur.
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Audit Risk Model
for Planning
PDR = AAR ÷ (IR × CR)
PDR = Planned detection risk (calculated)
AAR = Acceptable audit risk (set)
IR = Inherent risk (assessed)
CR = Control risk (determined)
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Learning Objective 6
Describe the audit risk
model and its components.
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Audit Risk Model
for Planning
PDR = AAR ÷ (IR × CR)
PDR = Planned detection risk (calculated) – by account
AAR = Acceptable audit risk (set) - engagement
IR = Inherent risk (assessed) – by account
CR = Control risk (determined) – by account
©2003Where
Prentice Hall are
BusinessBR andAuditing
Publishing, FR and
(engagement
Assurance Services 9/e,level)?????
Arens/Elder/Beasley 9 - 19
Learning Objective 7
Consider the impact of
engagement risk
on acceptable audit risk.
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Factors Affecting
Acceptable Audit Risk (set)
The degree of which external users
rely on the statements: legal, reputation, regulators
The likelihood that a client will have
financial difficulties after the
audit report is issued
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Factors Affecting
Acceptable Audit Risk
The auditor’s evaluation of
management’s integrity
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Making the Acceptable
Audit Risk Decision
Factors Methods to Assess Risk
• Examine financial statements.
External users •
Read minutes of the board.
reliance on •
Examine form 10K.
financial • Discuss financing plans
statements
with management.
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Making the Acceptable
Audit Risk Decision
Factors Methods to Assess Risk
• Analyze financial statements
Likelihood for difficulties using
of financial ratios.
difficulties • Examine inflows and
outflows of cash flow
• statements.
Anonymous Caller, Waste
Management Management • Non-Financial factors!!!!
cases. SEC letters
integrity and past audit disagreements. FR
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Learning Objective 8
Consider the impact of several
factors on the assessment
of inherent risk.
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Major Factors When
Assessing Inherent Risk
• Nature of the client’s business
• Results of previous audits
• Initial versus repeat engagement
• Related parties
• Fraud Risk
• Non-routine transactions
• Judgment
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Learning Objective 9
Discuss the relationship
of risks to audit evidence.
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Relationship of Risk Factors,
Risk, and Evidence
Acceptable audit risk
D D I
Factors Planned Planned
Inherent I I
Influencing detection audit
risk
Risks risk evidence
I D
Control risk
D = Direct relationship; I = Inverse relationship
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End of Chapter 9
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