1 Chapter 9 Materiality and Audit Risk 2 3 Under which auditing approach(es) are auditors required to obtain an understanding of the internal controls?

1

Chapter 9

Materiality and Audit Risk

2

3

Under which auditing approach(es) are auditors required to obtain an understanding of the internal controls?

Giselle

4

Which section of the Auditing Standards requires auditors to obtain an understanding of the internal controls?

Elizabeth W

5

Why are auditors always required to obtain and understanding of the internal controls?

Eric

6

.03 The objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels through understanding the entity and its environment, including the entity's internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement.

AU-C 315 Understanding the Entity & Its Environment & Assessing RoMM

7

we are always required to obtain an understanding of the Internal Control

to identify & assess the RoMM risks of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels

through understanding the entity and its environment, including the entity's internal control, thereby to provide a basis for designing and implementing responses to the assessed RoMM.

planning phase

8

Analytical Procedures

during the planning phase

• understand the client’s industry and business

• to identify potential misstatements

• attention directing

• design audit procedures that reduce the risk we might fail to detect a material misstatement

page 94

9

AICPA

December 2006

109Statementon AuditingStandards

Understanding the Entity and its Environment andAssessing the Risks of MaterialMisstatement

10

Under what audit approach(es) are auditors required to obtain sufficient appropriate audit evidence?

Ellen

11

Which section of the Auditing Standards requires auditors to obtain sufficient appropriate evidence?

Dev

12

.04 The objective of the auditor is to design and perform audit procedures that enable the auditor to obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the auditor's opinion.

AU-C 500Audit Evidence

13

How do we obtain audit evidence?

Jennifer

14

What is the definition of audit risk?

Brenda

15

Audit risk. The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated.

Audit risk is a function of the risks of material misstatement and detection risk.

16

What is the definition of Materiality?

Ryan M

17

AU Section 312 Audit Risk and Materiality in Conducting an Audit Source: SAS No. 107. Effective for audits of financial statements for periods beginning on or after Dec. 15, 2006. Earlier application is permitted.

.04 The auditor's consideration of materiality is a matter of professional judgment and is influenced by his perception of the needs of a reasonable person who will rely on the financial statements. The perceived needs of a reasonable person are recognized in the discussion of materiality in Financial Accounting Standards Board Statement of Financial Accounting Concepts No. 2, Qualitative

Characteristics of Accounting Information, which defines materiality as "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."

18

Performance Materiality

Performance Materiality

tolerable error

tolerable misstatement

The allocation of the preliminary judgment about materiality to segments (account balances or classes of transactions)

19

Michael

Describe a Significant Class of Transactions ?

Describe a Transaction Cycle?

20

Class of Transactions

Accounts receivable xxx.xx

Sales xxx.xx

Revenue & Collection Cycle

Accounts receivable xxx.xx

Sales xxx.xx

Cash xxx.xx

Accounts receivable xxx.xx

21

cash accounts receivable sales250 800

300450 200 550 450 550350 275 200 350 200550 100 100 550 100200 450 375 200 375100 300 190 100 190375 190 480 375 480190 320 365 190 365

330 845 2,260

22

Audit Risk Model

23

What are the elements of the “Audit Risk Model”?

Steffan

24

the Audit Risk Model

AAR = IR * CR * PDRpage 128

Materiality and Risk

25

the Audit Risk Model

AAR = IR * CR * PDR

Risk of Material Misstatement

RoMM = combines IR * CR

Materiality and RiskPage 1

28

26

Audit Risk Model

.

.

CR of assessmentour offunction a is PDR of level planned the

iprelationsh inversehen constant t a is ARA assume

* rearrange

RoMM

cf(CR)PDR

IR*CRc

PDR

CRIRAAR

PDRPDRCRIRAAR

27

Which Component(s) of Audit Risk do you think the auditor might be able to reduce?

Which Component(s) of Audit Risk do you think the auditor would be unable to reduce?

Elizabeth

28

RoMMAAR = IR CR PDR

transactions balances

analytical procedures (planning)

substantive tests of transactions

substantive analytical procedures

tests of details of balances

tests of controls

environmental client auditor

29

Obtain engagementUnderstand the client AU-C

315Analytical procedures

Understand the internal controls Risk assessment Testing AU-C 500

Tests of controls (transactions) Substantive tests of transactions Substantive Analytical proceduresSubstantive tests of details of balances

Reporting AU-C 700

30

Describe the relationship between Control Risk and the planned level of Detection Risk?

The mathematical relationship

Suiting

31

Audit Risk Model

high CR if

effective are controls the

showing evidence need we low CR if )(

CR

cCRfDR

What type of audit procedures will we perform to obtain appropriate evidence that controls are effective?

32

Audit Risk Model

level Low a toreduced bemust PDR high CR if

Highremain toPDRfor OK isit low CR if )(

CR

cCRfDR

What type of audit procedures will we perform to obtain appropriate evidence to reduce Detection Risk to a low level?

33

Audit Risk Model

Tests eSubstantiv extensive need we low PDR if

Tests eSubstantivour limit can wehigh PDR if )(

CR

cCRfDR

What type of audit procedures will we perform to obtain appropriate evidence if Planned Detection Risk is high?

34

What is the definition of Control Risk

Steve

35

Control risk. The risk that a misstatement that could occur in an assertion about a class of transaction, account balance, or disclosure and that could be material, either

individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity's internal control.

36

What is the definition of

Planned Detection Risk

Catherine

37

Planned Detection risk.

The risk that the audit evidence for a segment will fail to detect misstatements exceeding tolerable misstatement.

38

Detection risk. The risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements.

39

Brian

If we assess CR = Low, what does that tell us about the level of PDR …. ?

If we assess CR = High, what does that tell us about the level of PDR …. ?

40

If we assess CR = Max, what does that imply about the effectiveness of the Internal Controls?

Alejandro

41

If we assess CR = Low, what does that imply about the effectiveness of the Internal Controls?

Sandra

42

Polina

If we assess Control Risk as Low, what type of evidence would be appropriate for our audit procedures need to generate?

43

Chesley

If PDR = High, what does that imply about Control Risk …. ?

If PDR = Low, what does that imply about Control Risk …. ?

44

preliminary Control Risk assessmentsignificant classes of Transactions

occur complete accuracy classify cutoff

Credit sales Low Low Low Low MaxCash receipts Low Low Low Low LowPayroll Low Low Max Low MaxCash Disburse Low Low Low Low LowPurchasing Low Low Low Low Low

45

when we assess Control Risk less than Max

Control

activity

Test of

Control Proc

Results

Of ToC

Occur Low

Complete Low

Accuracy Low

Classification Low

Cutoff Max Max Max Max

Credit Sales Transactions

46

High Risk Areas and Transactions

47

1. Related Party Transactions

2. Non Routine Transactions

3. Judgement -Actg Estimates

4. Complex Transactions

48

1. Related Party Transactions

high risk

49

Related Party Transactions

high risk - page 86 & 135

One of the parties is in a position to exert significant influence over another party

Related parties can structure transactions to conceal problems in the financial statements

50

2. Non Routine Transactions

high risk

51

3. Judgement -Actg Estimates

52

53

Auditing accounting estimates

high risk

p. 135 (judgment required)

Keep track of differences (page 360)

54

Auditing accounting estimates

With estimates, there often is no right answer

• Keep track of differences between the estimate and what auditor finds reasonable

• Evaluate differences taken together

55

56

4. Complex Transactions

high risk

page 77 - ENRON

57

Katherine

In your statistics class, why does a larger sample increase your level of confidence?

How does evidence reduce risk?

58

59

Accounts Receivable Project

Sample Results Tolerable Misstatement

1. Known misstatement

2. Projection of sample results to the population

3. Allowance for sampling risk

• Estimates– Difference between auditor’s estimate– Book Value (management’s estimate

Page 125-126

$3,500$3,500*(450,000/50,000) = $31,500

$15,750$47,250

60

61

62

63

Please describe Professional Skepticism ?

Tracy

64

An attitude that includes a questioning mind, being alert to conditions that may indicate possible misstatement due to fraud or error, and a critical assessment of audit evidence.

65

66

67

68

69

70

Given the definition of Audit Risk

what is the relationship between

Materiality and Audit Risk?

???

71

Evaluation of Sample Results

Critical Value = μ + Zβ* Sx/√n 2,295.47 + 1.04 *1,390.09 / √ 44 = 2,513.42

We are unable to conclude that Accounts Receivable is not materially overstated because the sample mean of $2,425.56 is less than the $2,513.42 critical value.

72

Sample Projected Allowance for Sampling Risk Projected

Book Results to = Zβ*sx/√n Error

Population RIAA 15.0% plusAllowance

balance 2,371,983.60 2,371,983.60 Zβ 1.04

size 930 44 930 std dev 1,390.09sum 106,724.85 std error 209.56

average 2,425.56 2,255,775.24 allow 217.95 202,690.25

projected overstatement 116,208.36 projected allowance 202,690.25 318,898.62

averageBV 2,550.52

sample 2,425.56

error 124.96 217.95 342.90x930 318,898.62