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Materiality and Risk

Chapter 9

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Learning Objective 1

Apply the concept of materiality to the audit.

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Materiality

Major consideration in determining


the appropriate audit report

Referenced in audit reports scope


paragraph

What is meant by the term material?

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Materiality

Auditors responsibility = determine whether


financial statements are materially misstated.

Auditor will bring material misstatements to the


clients attention so corrections can be made.

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Steps in Applying 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 About
Materiality

Auditors set materiality thresholds early in the


engagement.

Thresholds represent the maximum statements


that could be misstated and still not affect
users decisions.

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Factors Affecting Judgment

Materiality is a relative rather


than an absolute concept.

Bases are needed for


evaluating materiality.

Qualitative factors also


affect materiality.

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Qualitative Factors

Considerations that may render material a


quantitatively small misstatement include:

Loan covenants Changing trend

Management compensation

Financial statements users Conceals an illegal act

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Guidelines

Accounting and auditing standards do not


provide specific materiality guidelines.

Professional judgment is used to set and


apply materiality guidelines.

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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

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)


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Learning Objective 4

Use materiality to evaluate audit findings.

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Known and Likely Misstatements

Auditor can determine the misstated


amount in an account (Known)

Two types of Likely misstatements:


Judgmental differences
Projections of misstatements from
audit samples

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Estimated Total Misstatement
and Preliminary Judgment

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Estimated Total Misstatement
and Preliminary Judgment

Estimated Net misstatements in Sample ($3,500)


Misstatement = Total recorded
Total sampled ($50,000) population value
($31,500)
($450,000)

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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.

Risks exist, are difficult to


measure, and require careful
thought in response.

Proper risk response is critical


to achieving a high-quality audit.

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Risk and Evidence

Auditors need to understand the clients


business and assess business risk.

The audit risk model helps identify the


potential and likelihood of misstatements.

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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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Audit Risk Model for Planning

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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
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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.

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Audit Risk Model Components

Planned
Inherent
Detection
Risk
Risk

Acceptable
Control Audit
Risk Risk

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Learning Objective 7

Consider the impact of engagement risk


on acceptable audit risk.

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Engagement Risk

What is Engagement 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

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Methods Practitioners Use to
Assess Acceptable Audit Risk

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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 Clients Audit Experience
Business
Prior audit results
Initial vs. repeat engagement
Industry practices
Audit judgment required to
Non-routine transactions
correctly record balances and
Makeup of the population
transactions

Culture
Related parties
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.

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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
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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

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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.

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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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Risk and Evidence

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Measurement Limitations

One major limitation in the audit risk model is


the difficulty of measuring the components
of the model.

Known Unknown
Preliminary Actual level of
Assessed Level +/- risk achieved
of Risk on the audit

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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

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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.

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Learning Objective 10

Discuss how materiality and risk are related


and integrated into the audit process.

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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
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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.

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End of Chapter 9

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