1. Materiality and Risk Chapter 9

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

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

5. Steps in Applying Materiality Planning extent of tests Step 1 Set preliminary judgment about materiality Step 2 Allocate preliminary judgment about materiality to segments

6. Steps in Applying Materiality Evaluating results Step 3 Estimate total misstatement in segment Step 4 Estimate the combined misstatement Compare combined estimate with judgment about materiality Step 5

8. Set Preliminary Judgment About Materiality 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. Auditors decide early in the audit the combined amount of misstatements of the financial statements that would be considered material.

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

10. 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.

14. Estimated Total Misstatement and Preliminary Judgment Cash Accounts receivable Inventory Total estimated misstatement amount Preliminary judgment about materiality $ 4,000 20,000 36,000 $50,000 $ 2,000 12,000 31,500 $45,500 $ N/A 6,000 15,750 $16,800 $ 2,000 18,000 47,250 $62,300 Tolerable Misstatement Known Misstatement and Direct Projection Sampling Error Total Account Estimated Misstatement Amount N/A = Not applicable Cash audited 100 percent

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

17. 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.

18. Risk and Evidence Auditors gain an understanding of the client’s 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.

19. Illustration of Differing Evidence Among Cycles Sales and collection cycle Acquisition and payment cycle Payroll and personnel cycle Inherent risk A Medium High Low Control risk B Medium Low Low Acceptable audit risk C Low Low Low Planned detection risk D Medium Medium High

20. Illustration of Differing Evidence Among Cycles Inventory and warehousing cycle Capital acquisition and repayment cycle Inherent risk A High Low Control risk B High Medium Acceptable audit risk C Low Low Planned detection risk D Low Medium

22. Audit Risk Model for Planning PDR = AAR ÷ (IR × CR) PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk where:

24. 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.

31. Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence D = Direct relationship; I = Inverse relationship Factors influencing risks Acceptable audit risk Planned detection risk Planned audit evidence Inherent risk Control risk I D I I D I D

33. 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.

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

36. Relationships of Risk to Evidence Acceptable audit risk Inherent risk Control risk Planned detection risk Amount of evidence required Situation High Low Low Medium High Low Low High Medium Low Low Low High Medium Medium High Medium Low Medium Medium Low Medium High Medium Medium 1 2 3 4 5

37. 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.

39. Relationship of Tolerable Misstatement and Risks to Planned Evidence D = Direct relationship; I = Inverse relationship Acceptable audit risk Inherent risk Control risk Tolerable misstatement Planned detection risk Planned audit evidence I D I I I I D D

40. Audit Risk Model for Planning AcAR = IR × CR × AcDR AcAR = Achieved audit risk IR = Inherent risk CR = Control risk AcDR = Achieved detection risk where:

41. Audit Risk Models for Planning Evidence and Evaluating Results Acceptable audit risk Inherent risk Control risk Achieved detection risk Substantive audit evidence Achieved audit risk Compare D I D D D = Direct relationship I = Inverse relationship

42. 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.

43. End of Chapter 9