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Chapter 9
2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9-1
Auditing Definition
Auditing reduces information risk to a socially
acceptable level.
To accomplish this,
Set materiality (yardstick)
Manage risks.
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Materiality
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Materiality
Information is material when it is likely to
influence the economic decisions of financial
statement users.
Planning materiality (preliminary judgment) is
the largest amount of uncorrected dollar
misstatement that could exist in published
financial statements and still fairly present
financial statements in conformity with GAAP.
Tolerable misstatement is the amount an account
can be off and still be considered fairly stated.
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Steps in Applying
Materiality
Set preliminary
Step
judgment about
1
materiality.
Planning
extent
Allocate preliminary of tests
Step judgment about
2 materiality
to segments.
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Steps in Applying
Materiality
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Determining Whats Material
Not required to define materiality as a
specific dollar amount.
Rule of thumb for materiality is under
5% is not material where over 10%
would be material.
Auditors judgment determines
materiality
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Factors that affect auditors
judgement on materiality
Absolute size - half a million
Relative size - in relation to F/S such as 5% of net
income.
Qualitative aspects (nature) - management fraud v.s.
employee fraud
Circumstances - what will F/S be used for, how widely
published
Uncertainty - lower materiality level because of risk of
being wrong.
Cumulative error - errors may accumulate into a
material error
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Preliminary Assessment of
Materiality
Helps the auditor avoid surprises such as:
Not auditing enough - litigation
Auditing too much - costly
Fine tunes the audit for effectiveness and
efficiency.
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Assigning Materiality to
Accounts
Top Down, define total materiality and divide
amongst the accounts
Bottoms-up, assign materiality to each account
and add the amounts to get total materiality for
the F/S.
The amount assigned to the account is the
tolerable misstatement.
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Allocate Preliminary Judgment
About Materiality to Segments
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Estimated Total
Misstatement Example
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Example of Estimate
for Sampling Error
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Analytical Procedures can help
determine materiality
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Risk
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Managing Risk using the
Model
Audit Risk = Inherent Risk x Control Risk x
Detection Risk
AR = IR x CR x DR
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Inherent Risk
The risk that material misstatements have
entered the accounting system.
Based on type of business, environment, type
of management, etc.
What errors could occur?
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Control Risk
Control risk is the probability that the clients
internal control activities will fail to detect
material misstatements.
What has client done to mitigate inherent
risks?
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Detection Risk
The probability that audit procedures will fail
to produce evidence of material misstatements.
This is the only part of the risk model the
auditor controls by planning the nature, timing
and extent of audit procedures.
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Audit Risk
The risk that an auditor will issue an
inappropriate opinion.
Manage audit risk by
Evaluating the clients inherent and control risk
Adjusting audit procedures (detection risk)
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Who Controls the Risks
The auditor controls the audit risk by
controlling detection risk.
Inherent and control risk are controlled by the
client and the business the client is in.
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Anchoring
Anchoring is the auditor using a carryover
view of the client's internal control structure
from previous audits.
How does this affect the audit?
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Inherent Risk is affected by
Economic conditions such as asset valuations,
offsetting assets and liabilities, changes in
deferral policies, compliance with covenants.
Complexity of transactions.
Type of business, type of ownership, size of
business
Relative risk, some accounts are riskier than
others.
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Major Factors When
Assessing Inherent Risk
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Audit Risk Overall
The probability of giving an incorrect opinion
on financial statements as a whole.
On an individual item like accounts receivable,
it is the risk that a material misstatement
occurs beyond an acceptable level.
Acceptable level is defined by materiality
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Risk and Evidence
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Example of Differing
Evidence Among Cycles
Sales and Acquisition Payroll and
Collection and Payment Personnel
Cycle Cycle Cycle
Inherent
A risk
medium high low
Control
B risk
medium low low
Acceptable
C audit risk
low low low
Planned
D detection risk
medium medium high
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Example of Differing
Evidence Among Cycles
Inventory and Capital Acquisition
Warehousing and Repayment
Cycle Cycle
Inherent
A risk
high low
Control
B risk
high medium
Acceptable
C audit risk
low low
Planned
D detection risk
low medium
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Audit Risk Model
for Planning
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Factors Affecting
Acceptable Audit Risk
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Factors Affecting
Acceptable Audit Risk
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Making the Acceptable
Audit Risk Decision
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Making the Acceptable
Audit Risk Decision
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Overall Requirement
An audit should be planned and performed to obtain
reasonable assurance about whether the financial
statements are free of material misstatements,
whether caused by error or fraud.
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Causes of Misstatements
Causes
Errors Fraud
Fraudulent Misappropriation
Financial of Assets
Reporting
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Two Types of Fraud Considered in
an Audit
Misappropriation of assets--examples:
Theft of assets
Fraudulent expenditures
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Professional Skepticism
An attitude that includes a questioning mind and a
critical assessment of audit evidence
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Terminology Simplification
To simplify the display, we will abbreviate the
term used in the standard risk of material
misstatement due to fraud as follows:
Risk of material
misstatement = Risk of fraud
due to fraud
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Fraud Conditions (Fraud
Triangle)
Incentive
(Pressure)
Opportunity Rationalization
(Attitude)
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Examples of Risks Factors
for Fraudulent Reporting
1. Incentives/Pressures
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Examples of Risks Factors
for Fraudulent Reporting
2. Opportunities
3. Attitudes/Rationalization
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Steps involved in Considering the
Risk of Fraud
1. Staff discussion
2. Obtain information needed to identify risks
3. Identify risks
4. Assess identified risks
5. Respond to results of assessment
6. Evaluate audit evidence
7. Communicate about fraud
8. Document consideration of fraud
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Step 1Staff Discussion of the
Risk of Fraud
Brainstorm
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Step 2Obtain information
needed to identify risk of fraud
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Step 3Identify Risks that may
Result in Fraud and Consider
Type of risk
Likelihood of Risk
Pervasiveness of risk
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Step 4Assess the identified risks after
considering programs and controls
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Step 5Respond to Results of the
Assessment
As risk increases
Overall responses
More experienced staff
More attention to accounting policies
Less predictable procedures
Specific responses
Consider need to increase evidence by altering the
nature, timing and extent of audit procedures
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Step 5Respond to Results of the
Assessment (concluded)
Accounting estimates
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Step 6Evaluate Audit Evidence
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Step 7Communicate about
Fraud
Communicate
All fraud to an appropriate level of management
All management fraud to audit committee
All material fraud to management and audit
committee
Determine if reportable conditions related to
internal control have been identified;
communicate them to the audit committee
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Document Consideration of Fraud
Document steps 1 -7
Staff discussion
Information used to identify risk of fraud
Fraud risks identified
Assessed risks after considering programs and controls
Results of assessment of fraud risk
Evaluation of audit evidence
Communications requirements
If improper revenue recognition was not considered a
risk, why it wasnt
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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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Changing the Audit in
Response to Risk
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Audit Risk for Segments
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Relating Risk of Fraud to
Risk Model Components
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Tolerable Misstatement, Risks,
and Balance-related Objectives
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Measurement Limitations
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Relationships of Risk
to Evidence
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Tests of Details of Balances
Evidence Planning Worksheet
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Revising Risks
and Evidence
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End of Chapter 9
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