CHAPTER 9

MATERIALITY & RISK

MATERIALITY: the magnitude of an omission or misstatement of accounting information that, in the

light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying
on the information would have been changed or influenced by the omission or misstatement.

In planning, the auditor needs to determine a materiality threshold.

AU-C 320: MATERIALITY IN PLANIING AND PERFORMING AN AUDIT

Materiality and audit risk are to beginning considered throughout the audit.
AUDIT RISK: [defined in AU 200] Risk that we are going to express an inappropriate opinion when the
financial statements are materially misstated.
 Influenced by the elements in the audit risk model
 Stipulate overall audit risk at the financial statement level- risk im willing to accept.
 Competence Level : 1 – audit assurance [being provided to the public] = Audit risk
o 95% confident this audit with detect material misstatement
o Non – quantified = HIGH, MED, LOW
o Quantified= 5%
o Professional judgment
o ENGAGEMENT RISK(p262): risk that the auditor or audit firm will suffer harm after the
audit is finished, even though the audit report was correct. [INFLUENCES PROFESSIONAL
JUDGMENT]
 May be called business risk by CPA firm
 Risk you will sued if you blow the audit
 The less audit risk I am willing to accept for this client the less rigorous this audit has to be

Planning materiality threshold to the financial statements

1) Planning; help develop our audit programs
2) Fieldwork; determining whether elements of the financial statements are fairly presented
3) End; identify the affect on our audit report of unidentified misstatements

FACTORS AFFECTING PRELIMINARY MATERIALITY JUDGMENT

PRELIMINARY JUDGMENT ABOUT MATERIALITY: the maximum amount by which the audit believes
that the statements could be misstated and still not affect the decisions of reasonable users; used in
audit planning.
 Materiality is a relative rather than an absolute concept. Materiality threshold is dependent
specifically on the client situation
 Uses of benchmarks are common
 Qualitative factors affect materiality decisions

Provide reasonable assurance that you will detect misstatements if they exist.
After setting the preliminary judgment about materiality using a primary benchmark we consider the
level of misstatement that are material of important sections.

PERFORMANCE MATERIALITY: amount set by the auditor at less than the materiality of the financial
statements as a whole, to reduce to an appropriately low level the probability that the aggregate of an
undetected misstatement exceeds our materiality threshold of the financial statements as a whole. If
applicable, performance materiality also refers to the amount set by the auditor at less than the
materiality level of transactions, account balances, or disclosers when building the audit programs.
 CHAPTER 9
MATERIALITY & RISK

 Conservative measure to protect us, set its slightly below what we truly think is our materiality
threshold
o As materiality threshold goes down the rigor our audit must go up
 “Looking for a needle in the hay stack”
 Sample sizing are going to grow, stronger sources of evidence
o More likely we will detect items over the true threshold
o After implementations, a whole lot more misstatements are going to have to be
corrected by the client
 Establish performance materiality at financial statement level
 AICPA Standards; materiality allocated down to the elements is performance materiality
 PCAOB Standards; allocated materiality to the elements is tolerable misstatements
o TOLERBLE MISSTATMENTS: the application of performance materiality to a sampling
procedure
 SASs state you allocate down to the assertion level while our book states you allocate down to
the audit objective level
𝐴𝑅 = 𝐼𝑅 × 𝐶𝑅 × 𝐷𝑅
𝐴𝑅
𝐷𝑅 =
𝐼𝑅 × 𝐶𝑅
AR: Audit Risk
IR: Inherent Risk
CR: Control Risk
DR: Detection Risk [PLUG]
o Audit Risk Model: tool that the auditors use to plan their substantive testing
(misstatements)
 AUDIT RISK: how willing the auditor is to accept that the financial statements
may be material misstated after the audit is completed and an unqualified
opinion has been issued
o Product of the equation
o Detecting misstatements
o Determined by allocating it down from the financial statement level
 INHERENT RISK: measures the auditors’ assessment of the susceptibility of an
assertion to material misstatement, before considering the effectiveness f
related internal controls
o Risk of material misstatement in the assertion assuming no internal
control, centers auditor thinking
o Determined by auditor’s judgment
 CONTROL RISK: measures the auditor’s assessment of the risk that a material
misstatement could occur in the assertion and not be prevent or detected on a
timely basis by the client’s internal controls
o Client’s system of internal control (in the area we building our audit
program for) will fail to prevent or detect material misstatements
o Determined by auditors evaluating of internal controls including testing
 DETECTION RISK: auditors and audit evidence gathered will fail to detect
material misstatements
o PLUG!
o Achieved with auditor substantive testing
o Whole purpose of using this model
o Cannot = 100%
 CHAPTER 9
MATERIALITY & RISK

 RISK OF MATERIAL MISSTATEMENT: Inherent Risk and Control Risk

Auditor should design and perform substantive tests for all relevant assertions
 Can’t rely on the client’s system of internal controls

We will mechanically allocate down these misstatements down to balance sheet accounts
It is highly unlikely that the whole amount of the account will be the performance materially. We can
also take advantage of netting.

AU-C 530: “ AUDIT SAMPLING”

Auditors are required to project uncorrected misstatements
 KNOWN MISSTATEMENTS: auditor can determine the amount of the misstatement in the
account
o Sample from a population with misstatements, what you do with information is blow it
up to the population size and now a lot of unknown misstatements
 LIKELY MISSTATEMENTS:
o Misstatements that arise from a difference between managements’ and the auditor’s
judgment of estimates of account balances
 Uncertain in nature
o Projections of misstatements based on the auditor’s tests of sample from a population
 Need to total up the uncorrected misstatements; total estimates misstatements

𝑁𝑒𝑡 𝑀𝑖𝑠𝑠𝑡𝑎𝑡𝑒𝑚𝑒𝑛𝑡𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑠𝑎𝑚𝑝𝑙𝑒

× 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑐𝑜𝑟𝑑𝑒𝑑 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑣𝑎𝑙𝑢𝑒
𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑚𝑝𝑙𝑒
= 𝐷𝑖𝑟𝑒𝑐𝑡 𝑝𝑟𝑜𝑗𝑒𝑐𝑡𝑖𝑜𝑛 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒 𝑜𝑓 𝑚𝑖𝑠𝑠𝑡𝑎𝑡𝑒𝑚𝑒𝑛𝑡

 Direct project assumes your population is the exactly like your sample
o We can ONLY make an interval estimate on the population
 AUDITORs (judgmentally): direct projection + allowance for sampling error
o SAMPLING ERROR: auditor has sampled only a portion of the population and there is a
risk that the sample does not accurately represent the population
 Judgment number: 50% of direct projection
o Total uncorrected misstatement is calculated by adding up the direct projections from
the individual accounts + and allowance for sampling error for the whole financial
statements
o Compare to threshold of materiality that awe established during planning
o Client does not have to fix every misstatement
 Just enough to get the uncorrected misstatements under the threshold
 It takes lots of time and expense to fix these misstatements

AU-C 450: “EVALUATION OF MISSTATEMENT IDENTIFIED DURING THE AUDIT”

Auditor should communicate on a timely basis with an appropriate level of management all the
misstatements accumulated in the audit and ask management to correct the misstatements.
 Reaction / Actions are based on the clients reactions on our request to fix the problems
 Document the amount below in which misstatements are regarded descriptive
o All misstatement collected during the audit
o Overall conclusion if the uncorrected misstatements are material
 CHAPTER 9
MATERIALITY & RISK

MATERIAL MISSTATMENTS

1. CLIENTS INTERNAL CONTROLS

2. AUDITORS SUBSTANTIVE TESTING

3. FINANCIAL STATEMENTS

Not giving a opinion on the financial statements are bone dry, giving an opinion not materially
wet