Materiality and Risk

Chapter 9

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9-1

 Learning Objective 1

Apply the concept of materiality

to the audit.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9-2

 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.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9-3

 Steps in Applying Materiality

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

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9-4

 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.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9-5

 Learning Objective 2

Make a preliminary judgment

about what amounts to
consider material.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9-6

 Set Preliminary Judgment about
Materiality
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.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9-7

 Factors Affecting Judgment

Materiality is a relative rather

than an absolute concept.

Bases are needed for

evaluating materiality.

Qualitative factors also

affect materiality.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9-8

 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.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9-9

 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.

SAS 39 (AU 350)

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 11

 Learning Objective 4

Use materiality to evaluate

audit findings.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 12

 Estimated Total Misstatement and
Preliminary Judgment
Estimated misstatement amount
Tolerable Direct Sampling
Account misstatement projection error* Total
Cash $ 4,000 $ 0 $ N/A $ 0
Accounts receivable 20,000 12,000 6,000 18,000
Inventory 36,000 31,500 15,750 47,250
Total estimated
misstatement amount $43,500 $16,800 $60,300
Preliminary judgment
about materiality $50,000

*estimate for sampling error is 50%

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 13

 Estimated Total Misstatement and
Preliminary Judgment
Net misstatements in the sample

Total sampled

Total recorded population value

= Direct projection estimate of misstatement

$3,500 $50,000 $450,000 = $31,500

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 14

 Learning Objective 5

Define risk in auditing.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 15

 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.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 16

 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.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 17

 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

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 18

 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

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 Learning Objective 6

Describe the audit risk model

and its components.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 20

 Audit Risk Model for Planning
PDR = AAR (IR CR)

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.

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 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

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 24

 Making the Acceptable Audit Risk
Decision
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.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 25

 Making the Acceptable Audit Risk
Decision
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 inherit 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

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 Learning Objective 9

Discuss the relationship of

risks to audit evidence.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 29

 Relationship of Risk Factors,
Risk, and 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
2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 30
 Relationship of Risk Factors,
Risk, and 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.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 31

 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.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 32

 Relating Risk of Fraud to Risk
Model Components

The risk of fraud can be assessed for the

entire audit or by cycle, account, and objective.

Specific response could include

revising assessments of acceptable
audit risk, inherent risk, and control risk.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 33

 Tolerable Misstatement, Risks,
and Balance-related 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.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 37

 Learning Objective 10

Discuss how materiality and risk

are related and integrated into
the audit process.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 38

 Tolerable Misstatements, Risk,
and 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

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 39

 Evaluating Results
AcAR = IR CR AcDR

AcAR = Achieved audit risk

IR = Inherent risk

CR = Control risk

AcDR = Achieved detection risk

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 40

 Audit Risk Models for Planning
Evidence and Evaluating Results
D Inherent
Acceptable Achieved risk
Compare
audit audit
risk risk
D Control
risk

Substantive Achieved
D
audit detection
evidence risk
D = Direct relationship
I = Inverse relationship I
2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 41
 Revising Risks and Evidence

The audit risk model is primarily a

planning model and is therefore of
limited use in evaluating results.

Great care must be used in revising

the risk factors when the actual results
are not as favorable as planned.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 9 - 42

 End of Chapter 9

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