Materiality and Risk

Chapter 9

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 9-1

 Learning Objective 1
Apply the concept of materiality
to the audit.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9-2

 Materiality

It is a major consideration in determining

the appropriate audit report to issue.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9-3

 Materiality

The auditors responsibility is to determine

whether financial statements are
materially misstated.

If there is a material misstatement,

the auditor will bring it to the clients
attention so that a correction can be made.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9-4

 Steps in Applying Materiality

Step Set preliminary judgment

1 about materiality
Planning
extent
Allocate preliminary of tests
Step judgment about
2 materiality to
segments

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9-5

 Steps in Applying Materiality

Step Estimate total

3 misstatement in segment

Step Estimate the

Evaluating
4 combined misstatement
results

Compare combined
Step
estimate with judgment
5
about materiality
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9-6
 Learning Objective 2
Make a preliminary judgment
about what amounts to
consider material.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9-7

 Set Preliminary Judgment About
Materiality
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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9-8

 Factors Affecting Judgment

Materiality is a relative rather

than an absolute concept.

Bases are needed for

evaluating materiality.

Qualitative factors also

affect materiality.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9-9

 Guidelines

Accounting and auditing standards

do not provide specific materiality
guidelines to practitioners.

Professional judgment is to be used

at all times in setting and applying
materiality guidelines.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 10

 Learning Objective 3
Allocate preliminary materiality
to segments of the audit
during planning.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 11

 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.

SAS 107 (AU 312)

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 12

 Learning Objective 4
Use materiality to evaluate
audit findings.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 13

 Estimated Total Misstatement
and Preliminary Judgment
Estimated Misstatement Amount
Known
Misstatement
Tolerable and Direct Sampling
Account Misstatement Projection Error Total

Cash $ 4,000 $ 2,000 $ N/A $ 2,000

Accounts receivable 20,000 12,000 6,000 18,000
Inventory 36,000 31,500 15,750 47,250
Total estimated
misstatement amount $45,500 $16,800 $62,300
Preliminary judgment
about materiality $50,000

N/A = Not applicable

Cash audited 100 percent
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 14
 Estimated Total Misstatement
and Preliminary Judgment
Net misstatements in the sample ($3,500)

Total sampled ($50,000)

Total recorded population value ($450,000)

= Direct projection estimate of misstatement ($31,500)

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 15

 Learning Objective 5
Define risk in auditing.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 16

 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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 17

 Risk and Evidence

Auditors gain an understanding of the

clients business and industry and
assess client business risk.

Auditors use the audit risk model to further

identify the potential for misstatements
and where they are most likely to occur.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 18

 Illustration of Differing Evidence
Among Cycles
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
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 19
 Illustration of Differing Evidence
Among Cycles
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
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 20
 Learning Objective 6
Describe the audit risk model
and its components.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 21

 Audit Risk Model for Planning

PDR = AAR (IR CR)

where: PDR = Planned detection risk

AAR = Acceptable audit risk

IR = Inherent risk

CR = Control risk

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 Learning Objective 7
Consider the impact of
engagement risk on
acceptable audit risk.

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 Impact of Engagement Risk on
Acceptable Audit Risk
Auditors decide engagement risk and use
that risk to modify acceptable audit risk.

Engagement risk closely relates to client

business risk.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 24

 Factors Affecting Acceptable
Audit Risk
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 auditors evaluation of

managements integrity

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 25

 Methods Practitioners Use to
Assess Acceptable Audit Risk
Methods Used to Assess
Factors Acceptable Audit Risk
External users Examine financial statements
reliance on Read minutes of the board
financial Examine form 10K
statements Discuss financing plans
with management

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 26

 Methods Practitioners Use to
Assess Acceptable Audit Risk
Methods Used to Assess
Factors Acceptable Audit Risk
Likelihood Analyze financial statements
of financial for difficulties using ratios
difficulties Examine inflows and outflows
of cash flow statements
Management See Chapter 8 for client
integrity acceptance and continuance

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 Learning Objective 8
Consider the impact of several
factors on the assessment
of inherent risk.

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 Factors Affecting Inherent Risk
Nature of the clients business
Results of previous audits
Initial versus repeat engagement
Related parties
Nonroutine transactions
Judgment required to correctly record
account balances and transactions
Makeup of the population
Factors related to fraudulent financial reporting
Factors related to misappropriation of assets
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 Learning Objective 9
Discuss the relationship of
risks to audit evidence.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 30

 Relationship of Factors Influencing
Risks to Risks and Risks to Planned
Evidence
Acceptable audit risk

D D I

Factors I Planned I Planned

Inherent
influencing detection audit
risk
risks risk evidence
I D

Control risk
D = Direct relationship; I = Inverse relationship
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 31
 Relationship of Factors Influencing
Risks to Risks and Risks to Planned
Evidence
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

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 32

 Audit Risk for Segments

Both control risk and inherent risk are

typically set for each cycle, each
account, and often even each audit
objective, not for the overall audit.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 33

 Tolerable Misstatement, Risks,
and Balance-related Audit Objectives
It is common to assess inherent and control
risk for each balance-related audit objective

It is not common to allocate materiality

to objectives

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 Measurement Limitations

One major limitation in the application of the

audit risk model is the difficulty of measuring
the components of the model.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 35

 Relationships of Risk to
Evidence
Planned Amount of
Acceptable Inherent Control detection evidence
Situation audit risk risk risk risk required
1 High Low Low High Low
2 Low Low Low Medium Medium
3 Low High High Low High
4 Medium Medium Medium Medium Medium
5 High Low Medium Medium Medium

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 36

 Tests of Details of Balances
Evidence Planning Worksheet
Auditors develop various types of worksheets
to aid in relating the considerations affecting
audit evidence to the appropriate
evidence to accumulate.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 37

 Learning Objective 10
Discuss how materiality and risk
are related and integrated into
the audit process.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 38

 Relationship of Tolerable
Misstatement and Risks to
Planned Evidence
Acceptable
audit risk D D I
Planned I Planned
Inherent detection risk audit evidence
risk I
I D I
Control
risk

Tolerable
misstatement
D = Direct relationship; I = Inverse relationship
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 39
 Revising Risks and Evidence

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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 9 - 40

 End of Chapter 9

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