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Chapter 9
Materiality and Risk
AuditRisk
CPA
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Presentation Outline
I. Steps in Applying Materiality
II. Risk in Auditing
III. Planning Model Relationships
IV. !aluating Results
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Step 1 in Applying Materiality
Set preli$inary %udg$ent a&out $ateriality.
The preliminary judgment about materiality is the maximum amount
the auditor believes the statements could be misstated and still not
affect the decisions of reasonable users. Decided early in audit.
Permissible misstatements are often less for smaller clients.
Although the FASB and A!PA are un"illing to provide specific
materiality guidelines to practitioners# bases are needed for
evaluating materiality. See Figure $%& on page &'(.
)ualitative factors can affect materiality. See factors on pages
&'*%&'(.
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Step 2 in Applying MaterialityAllo(ate preli$inary %udg$ent a&out $ateriality to
seg$ents.
An allocation is necessary because evidence is accumulated by
segments rather than the financial statements ta+en as a "hole. The
allocation to account balances is +no"n as the tolerable misstatement.
,ost practitioners allocate materiality to balance sheet rather
than income statement accounts. This is because most income
statement misstatements have an e-ual effect on the balance sheet
because of the double%entry boo++eeping system.
The sum of the tolerable misstatement is allo"ed to exceed overall
materiality because /0 it is unli+ely that all accounts "ill be
misstated by the full amount of tolerable misstatement# and &0 some
accounts are overstated "hile others are understated# resulting in a
net amount that is li+ely to be less than overall materiality.
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Illustration o* +olera&le Misstate$ent
Allo(ation *or Current Assets
Tolerable
Account ,isstatement
!ash 1 *#222
Accounts receivable &2#222
nventory '3#222
Preliminary judgment
about materiality 1(2#222
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Step " in Applying Materiality
sti$ate total $isstate$ent in seg$ent.
4ne "ay to calculate the estimate of misstatement is to ma+e a direct
projection from the sample to the population.
1'#(22 net misstatement of the inventory sample
"'// 0 '//// 5#'//// "1'//
1(2#222 total inventory sampled
1*(2#222 total recorded population value for inventory
1'/#(22 direct projection estimate of misstatement
5
6
7
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Illustration o* sti$ating +otal
Misstate$ent in Seg$ent
Tolerable Direct Sampling
Account ,isstatement Projection 8rror Total
!ash 1 *#222 1 2 1 9:A 1 2Accounts receivable &2#222 / 3#222; /
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Tolerable Direct Sampling
Account ,isstatement Projection 8rror Total
!ash 1 *#222 1 2 1 9:A 1 2Accounts receivable &2#222 / 3#222; /
Step # in Applying Materiality
sti$ate the (o$&ined $isstate$ent.
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Tolerable Direct Sampling
Account ,isstatement Projection 8rror Total
!ash 1 *#222 1 2 1 9:A 1 2
Accounts receivable &2#222 / 3#222; /
Step ' in Applying MaterialityCo$pare (o$&ined esti$ate 3ith preli$inary or
re!ised %udg$ent a&out $ateriality.
Because the estimated combined misstatement exceeds the
preliminary judgment# the financial statements are not acceptable.
The auditor may perform additional audit procedures to reevaluatethe estimate# or re-uire adjustment for the estimated misstatements.
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II. Risk in Auditing
A. Co$ponents o* Audit Risk
4. A((epta&le Audit RiskC. Inherent Risk
5. Control Risk
. Planned 5ete(tion Risk
Audit
Risk
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A. Co$ponents o* Audit Risk
Inherent Risk
6IR7
Control Risk6CR7
5ete(tion Risk65R7
Audit Risk
6AR7
Sus(epti&ility o* an assertion to$aterial $isstate$ent assu$ing no
related internal (ontrols.
Risk o* $isstate$ents not &eing
dete(ted &y syste$ o* internal
(ontrol.
Risk o* $isstate$ents not &eingdete(ted &y the auditor.
Misstate$ent that re$ains
undete(ted &y the auditor.
Caught &y
internal
(ontrols
Caught &y
auditor
8ndete(ted
$isstate$ent
+otal
$isstate$ent
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4. A((epta&le Audit Risk
1. Relian(e &y ternal 8sers
2. :ikelihood o* ;inan(ial ;ailure
". Integrityo* Manage$ent
Audit
?is+
+he *ollo3ing *a(tors $ean that audit risk should &e
kept lo3er