157_33205_EY426_2013_1__2_1_Arens14e_ch09_ppt_ge

©2012 Pearson Education, ©2012 Pearson Education, Auditing 14/e,Auditing 14/e, Arens/Elder/Beasley Arens/Elder/Beasley 5 - 5

Considering Materiality Considering Materiality and Audit Riskand Audit Risk

Chapter 9Chapter 9

©2012 Pearson Education, ©2012 Pearson Education, Auditing 14/e,Auditing 14/e, Arens/Elder/Beasley Arens/Elder/Beasley 9 - 9 - 22

Learning Objective 1Learning Objective 1

Apply the concept of materiality to the audit.Apply the concept of materiality to the audit.


MaterialityMateriality

Major consideration in determiningthe appropriate audit report

Referenced in audit report’s scope paragraph

What is meant by the term “material”?


MaterialityMateriality

Auditor’s responsibility = determine whether financial statements are materially misstated.

Auditor will bring material misstatements to the client’s attention so corrections can be made.


Steps in Applying MaterialitySteps in Applying Materiality



Make a preliminary judgment about what Make a preliminary judgment about what amounts to consider material.amounts to consider material.


Set Preliminary Judgment Set Preliminary Judgment About MaterialityAbout Materiality

Thresholds represent the maximum statements that could be misstated and still not affect users decisions.

Auditors set materiality thresholds early in theengagement.


Factors Affecting JudgmentFactors Affecting Judgment

Materiality is a relative ratherthan an absolute concept.

Bases are needed forevaluating materiality.

Qualitative factors alsoaffect materiality.


Qualitative FactorsQualitative Factors

Considerations that may render material a quantitatively small misstatement include:

Changing trend

Financial statements users Conceals an illegal act

Loan covenants

Management compensation


GuidelinesGuidelines

Accounting and auditing standards do not provide specific materiality guidelines.

Professional judgment is used to set and apply materiality guidelines.



Allocate preliminary materiality to segments Allocate preliminary materiality to segments of the audit during planning.of the audit during planning.


Allocate Preliminary Allocate Preliminary Judgment About Judgment About

Materiality to SegmentsMateriality to Segments

Evidence is accumulated by segments rather than for the financial statements as a whole.

Most practitioners allocate materialityto balance sheet accounts.

SAS 107 (AU 312)



Use materiality to evaluate audit findings.Use materiality to evaluate audit findings.


Known and Likely Known and Likely MisstatementsMisstatements

Auditor can determine the misstated amount in an account (“Known”)

Two types of “Likely” misstatements: Judgmental differences Projections of misstatements from

audit samples


Estimated Total Estimated Total Misstatement and Misstatement and

Preliminary JudgmentPreliminary Judgment


Estimated Total Estimated Total Misstatement and Misstatement and

Preliminary JudgmentPreliminary Judgment

Estimated Misstateme

nt($31,500)

=Net misstatements in Sample ($3,500)Total sampled ($50,000)

× Total recorded population value ($450,000)



Define risk in auditing.Define risk in auditing.


RiskRisk

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.


Risk and EvidenceRisk and Evidence

Auditors need to understand the client’s business and assess business risk.

The audit risk model helps identify the potential and likelihood of misstatements.


Audit Risk Model for Audit Risk Model for PlanningPlanning

PDR = AAR ÷ (IR × CR)

where: PDR = Planned detection risk

AAR = Acceptable audit risk

IR = Inherent risk

CR = Control risk


Audit Risk Model for Audit Risk Model for PlanningPlanning


Illustration of Differing Illustration of Differing Evidence Among CyclesEvidence Among Cycles

Sales andcollectioncycle

Acquisitionand paymentcycle

Payroll andpersonnelcycle

InherentriskA MediumMedium HighHigh LowLow

ControlriskB MediumMedium LowLow LowLow

Acceptableaudit riskC LowLow LowLow LowLow

Planneddetection riskD MediumMedium MediumMedium HighHigh


Illustration of Differing Illustration of Differing Evidence Among CyclesEvidence Among Cycles

Inventory andwarehousingcycle

Capital acquisitionand repaymentcycle

InherentriskA HighHigh LowLow

ControlriskB HighHigh MediumMedium

Acceptableaudit riskC LowLow LowLow

Planneddetection riskD LowLow MediumMedium



Describe the audit risk model and Describe the audit risk model and its components.its components.


Audit Risk Model Audit Risk Model ComponentsComponents

Planned Detection

Risk

Acceptable Audit Risk

Control Risk

InherentRisk



Consider the impact of engagement risk Consider the impact of engagement risk on acceptable audit risk.on acceptable audit risk.


Engagement Risk Engagement Risk

What is Engagement Risk?


Impact of Engagement Risk Impact of Engagement Risk on Acceptable Audit Riskon Acceptable Audit Risk

Auditors decide engagement risk and use that risk to modify acceptable audit risk.

Engagement risk closely relates to client business risk.


Factors Affecting Acceptable Factors Affecting Acceptable Audit RiskAudit Risk

The degree to which external usersrely on the statements

The likelihood that a client will havefinancial difficulties after theaudit report is issued

The auditor’s evaluation of management’s integrity


Methods Practitioners Use Methods Practitioners Use to Assess Acceptable Audit to Assess Acceptable Audit

RiskRisk



Consider the impact of several factors on Consider the impact of several factors on the assessment of inherent risk.the assessment of inherent risk.


Factors Affecting Inherent Factors Affecting Inherent RiskRisk

Nature of Client’s Business

Industry practices Non-routine transactions Makeup of the population

Culture Related parties Factors related to fraudulent financial reporting Factors related to misappropriation of assets

Audit Experience

Prior audit results Initial vs. repeat engagement Audit judgment required to

correctly record balances and transactions



Discuss the relationship of risks Discuss the relationship of risks to audit evidence.to audit evidence.


Relationship of Factors Relationship of Factors Influencing Risks to Risks and Influencing Risks to Risks and

Risks to Planned EvidenceRisks to Planned Evidence

D = Direct relationship; I = Inverse relationship

Factorsinfluencing

risks

Acceptable audit risk

Planneddetection

risk

Plannedaudit

evidence

Inherentrisk

Control risk

I

D

I

ID

I D


Relationship of Factors Relationship of Factors Influencing Risks to Risks and Influencing Risks to Risks and

Risks to Planned EvidenceRisks 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


Audit Risk for SegmentsAudit Risk for Segments

Both control risk and inherent risk aretypically set for each cycle, eachaccount, and often even each auditobjective, not for the overall audit.


Tolerable Misstatement, Tolerable Misstatement, Risks,Risks,

and Balance-related Audit and Balance-related Audit ObjectivesObjectives

It is common to assess inherent and control risk for each balance-related audit objective

It is not common to allocate materiality to objectives


Risk and EvidenceRisk and Evidence


Measurement LimitationsMeasurement Limitations

One major limitation in the audit risk model is the difficulty of measuring the components of the model.

Preliminary Assessed Level

of Risk

Actual level of risk achieved on the audit

+/-

Known Unknown


Relationships of Risk to Relationships of Risk to EvidenceEvidence

Acceptableaudit risk

Inherentrisk

Controlrisk

Planneddetectionrisk

Amount ofevidencerequiredSituation

HighHigh

LowLow

LowLow

MediumMedium

HighHigh

LowLow

LowLow

HighHigh

MediumMedium

LowLow

LowLow

LowLow

HighHigh

MediumMedium

MediumMedium

HighHigh

MediumMedium

LowLow

MediumMedium

MediumMedium

LowLow

MediumMedium

HighHigh

MediumMedium

MediumMedium

1

2

3

4

5


Tests of Details of Balances Tests of Details of Balances Evidence Planning Evidence Planning

WorksheetWorksheet

Auditors develop various types of worksheets to aid in relating the considerations affectingaudit evidence to the appropriate evidence to accumulate.



Discuss how materiality and risk are related Discuss how materiality and risk are related and integrated into the audit process.and integrated into the audit process.


Relationship of Tolerable Relationship of Tolerable Misstatement and Risks toMisstatement and Risks to

Planned EvidencePlanned Evidence

D = Direct relationship; I = Inverse relationship

Acceptableaudit risk

Inherentrisk

Controlrisk

Tolerablemisstatement

Planneddetection risk

Plannedaudit evidence

I

DI

I I

I

D

D


Revising Risks and EvidenceRevising Risks and Evidence

The auditor must revise the originalassessment of the appropriate risk.

The auditor should consider the effectof the revision on evidence requirements,without the use of the audit risk model.


End of Chapter 9

157_33205_EY426_2013_1__2_1_Arens14e_ch09_ppt_ge

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