Materiality and Risk

Chapter 9

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

9-1

Learning Objective 1
Apply the concept of materiality
to the audit.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Materiality
It is a major consideration in determining
the appropriate audit report to issue.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

9-3

Materiality
The auditors responsibility is to determine
whether financial statements are
materially misstated.
If there is a material misstatement,
the auditor will bring it to the clients
attention so that a correction can be made.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

9-4

Steps in Applying Materiality

Step Set preliminary judgment
1 about materiality

Allocate preliminary
Step judgment about
2 materiality to
segments
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

Planning
extent
of tests

9-5

Steps in Applying Materiality

Step Estimate total
3 misstatement in segment
Step Estimate the
4 combined misstatement

Evaluating
results

Compare combined
Step
estimate with judgment
5
about materiality
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

9-6

Learning Objective 2
Make a preliminary judgment
about what amounts to
consider material.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

9-7

Set Preliminary Judgment About

Materiality
Auditors decide early in the audit
the combined amount of misstatements
of the financial statements that would
be considered material.
This preliminary judgment is the maximum
amount by which the auditor believes the
statements could be misstated and still not
affect the decisions of reasonable users.
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

9-8

Factors Affecting Judgment

Materiality is a relative rather
than an absolute concept.
Bases are needed for
evaluating materiality.
Qualitative factors also
affect materiality.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

9-9

Guidelines
Accounting and auditing standards
do not provide specific materiality
guidelines to practitioners.
Professional judgment is to be used
at all times in setting and applying
materiality guidelines.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Learning Objective 3
Allocate preliminary materiality
to segments of the audit
during planning.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Allocate Preliminary Judgment

About Materiality to Segments
This is necessary because 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)

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Learning Objective 4
Use materiality to evaluate
audit findings.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Estimated Total Misstatement

and Preliminary Judgment
Estimated Misstatement Amount

Account

Cash
Accounts receivable
Inventory
Total estimated
misstatement amount
Preliminary judgment
about materiality

Known
Misstatement
Tolerable
and Direct
Misstatement Projection

$ 4,000
20,000
36,000

Sampling
Error

Total

$ 2,000
12,000
31,500

N/A
6,000
15,750

$ 2,000
18,000
47,250

$45,500

$16,800

$62,300

$50,000

N/A = Not applicable

Cash audited 100 percent
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Estimated Total Misstatement

and Preliminary Judgment
Net misstatements in the sample ($3,500)
Total sampled ($50,000)
Total recorded population value ($450,000)
= Direct projection estimate of misstatement ($31,500)

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Learning Objective 5
Define risk in auditing.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Risk
Auditors accept some level of risk
in performing the audit.
An effective auditor recognizes that
risks exist, are difficult to measure,
and require careful thought to respond.
Responding to risks properly is critical
to achieving a high-quality audit.
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Risk and Evidence

Auditors gain an understanding of the
clients business and industry and
assess client business risk.
Auditors use the audit risk model to further
identify the potential for misstatements
and where they are most likely to occur.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Illustration of Differing Evidence

Among Cycles
Sales and
collection
cycle

Acquisition Payroll and

and payment personnel
cycle
cycle

Inherent
risk

Medium

High

Low

Control
risk

Medium

Low

Low

Acceptable
audit risk

Low

Low

Low

Planned
Medium
detection risk

Medium

High

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Illustration of Differing Evidence

Among Cycles
Inventory and
warehousing
cycle

Capital acquisition
and repayment
cycle

Inherent
risk

High

Low

Control
risk

High

Medium

Acceptable
audit risk

Low

Low

Planned
detection risk

Low

Medium

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Learning Objective 6
Describe the audit risk model
and its components.

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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

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Learning Objective 7
Consider the impact of
engagement risk on
acceptable audit 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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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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
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Methods Practitioners Use to

Assess Acceptable Audit Risk
Factors
External users
reliance on
financial
statements

Methods Used to Assess

Acceptable Audit Risk

Examine financial statements

Read minutes of the board
Examine form 10K
Discuss financing plans
with management

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Methods Practitioners Use to

Assess Acceptable Audit Risk
Factors

Methods Used to Assess

Acceptable Audit Risk

Likelihood
of financial
difficulties

Analyze financial statements

for difficulties using ratios
Examine inflows and outflows
of cash flow statements

Management
integrity

See Chapter 8 for client

acceptance and continuance

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Learning Objective 8
Consider the impact of several
factors on the assessment
of inherent risk.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Factors Affecting Inherent Risk

Nature of the clients business

Results of previous audits
Initial versus repeat engagement
Related parties
Nonroutine transactions
Judgment required to correctly record
account balances and transactions
Makeup of the population
Factors related to fraudulent financial reporting
Factors related to misappropriation of assets

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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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

Factors
influencing
risks

Inherent
risk

Planned
detection
risk
I

Planned
audit
evidence
D

Control risk
D = Direct relationship; I = Inverse relationship
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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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

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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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

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Relationships of Risk to
Evidence
Acceptable Inherent
audit risk risk

Control
risk

Planned
detection
risk

High

Low

Low

High

Low

Low

Low

Low

Medium

Medium

Low

High

High

Low

High

Medium

Medium

Medium

Medium

Medium

High

Low

Medium

Medium

Medium

Situation

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

Amount of
evidence
required

9 - 36

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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Learning Objective 10
Discuss how materiality and risk
are related and integrated into
the audit process.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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Relationship of Tolerable
Misstatement and Risks to
Planned Evidence
Acceptable
audit risk
Inherent
risk

D
I

Planned
detection risk
I

D
I

Planned
audit evidence
D

Control
risk
Tolerable
misstatement
D = Direct relationship; I = Inverse relationship
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr

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End of Chapter 9

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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