Materiality

and Risk

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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.

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Steps in Applying
Materiality
Step
1

Set preliminary
judgment about
materiality.

Allocate preliminary
Step
judgment about
2
materiality
to segments.
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Planning
extent
of tests

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

Set Preliminary
Judgment
Ideally, 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.
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Factors Affecting
Judgment
Materiality is a relative rather
than an absolute concept.
Bases are needed for
evaluating materiality.
Qualitative factors also
affect materiality.
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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 39 (AU 350)
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Estimated Total
Misstatement Example
Net misstatement of the sample

Total sampled
Total recorded population value
Direct projection estimate of misstatement
$3,500 $50,000 $450,000 = $31,500

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Example of Estimate
for Sampling Error
Tolerable
Direct Sampling
Misstatement Projection Error
Total
$ 4,000
$
0 $ N/A
$
0
20,000
12,000
6,000* 18,000
36,000
31,500
15,750* 47,250

Account
Cash
Accounts receivable
Inventory
Total estimated
misstatement amount
Preliminary judgment
about materiality
$50,000
*estimate for sampling error is 50%
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$43,500

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$16,800

$60,300

Learning Objective 5

Define risk in auditing.

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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.
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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.

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Example of Differing
Evidence Among Cycles

A
B
C
D

Inherent
risk
Control
risk
Acceptable
audit risk
Planned
detection risk
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Sales and
Collection
Cycle

Acquisition
and Payment
Cycle

Payroll and
Personnel
Cycle

medium

high

low

medium

low

low

low

low

low

medium

medium

high

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Example of Differing
Evidence Among Cycles

A
B
C
D

Inherent
risk
Control
risk
Acceptable
audit risk
Planned
detection risk
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Inventory and
Warehousing
Cycle

Capital Acquisition
and Repayment
Cycle

high

low

high

medium

low

low

low

medium

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Audit Risk Model

for Planning
PDR = AAR (IR CR)

PDR = Planned detection risk

AAR = Acceptable audit risk
IR = Inherent risk
CR = Control 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.

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Factors Affecting
Acceptable Audit Risk
The degree of which external users
rely on the statements
The likelihood that a client will have
financial difficulties after the
audit report is issued

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Factors Affecting
Acceptable Audit Risk
The auditors evaluation of
managements integrity

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Making the Acceptable

Audit Risk Decision
Factors

Methods to Assess Risk

Examine financial statements.

External users
Read minutes of the board.
reliance on
Examine form 10K.
financial
Discuss financing plans
statements
with management.
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Making the Acceptable

Audit Risk Decision
Factors

Methods to Assess Risk

Likelihood
of financial
difficulties

Analyze financial statements

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

Management See Chapter 8 for client

acceptance and continuance.
integrity
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Major Factors When

Assessing Inherent Risk
Nature of the clients business
Results of previous audits
Initial versus repeat engagement
Related parties
Nonroutine transactions
Judgment correctly record account
balances and transactions
Makeup of the population
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Assessing Risks of Fraud

Three conditions are generally present.
1. Incentives/Pressures
2. Opportunities
3. Attitudes/Rationalization
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Examples of Risks
Factors
for Fraudulent Reporting
1. Incentives/Pressures

Financial stability or profitability is threatened by

economic, industry, or entity operating conditions.
Excessive pressure exists for management
to meet debt requirements.
Personal net worth is materially threatened.
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Examples of Risks
Factors
for Fraudulent Reporting
2. Opportunities

There are significant accounting estimates

that are difficult to verify.
There is ineffective oversight over
financial reporting.
High turnover or ineffective accounting internal
audit, or information technology staff exists.
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Examples of Risks
Factors
for Fraudulent Reporting
3. Attitudes/Rationalization

Inappropriate or inefficient communication

and support of the entitys values is evident.
A history of violations of laws is known.
Management has a practice of making overly
aggressive or unrealistic forecasts.
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Responding to the
Risk of Fraud
Design and perform audit procedures
to address identified fraud risk.
Change the overall conduct of the audit
to respond to identified fraud risk.
Perform procedures to address the risk
of management override of controls.
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Relationship of Risk
Factors,
Risk, and
Evidence
Acceptable
audit risk
D

Factors
Influencing
Risks

Inherent
risk

Planned
detection
risk
I

Planned
audit
evidence
D

Control risk
D = DirectAuditing
relationship;
I = Inverse
relationship
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Changing the Audit in

Response to Risk
The engagement may require
more experienced staff.
The engagement will be reviewed
more carefully than usual.

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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.

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Relating Risk of Fraud to

Risk Model Components
The risk of fraud can be assessed
for the entire audit or by cycle,
account, and objective.
Specific response could include
revising assessments of acceptable
audit risk, inherent risk, and control risk.
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Tolerable Misstatement,
Risks,
and Balance-related
It is common to assess inherent and control
Objectives
risk for each balance-related audit objective.
It is not common to allocate
materiality to objectives.

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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.

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Relationships of Risk
to Evidence
Acceptable
Audit
Situation Risk
1
High
2
Low
3
Low
4
Medium
5
High

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Planned
Inherent Control Detection
Risk
Risk
Risk
Low
Low
High
Low
Low
Medium
High
High
Low
Medium Medium Medium
Low
Medium Medium

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Amount of
Evidence
Required
Low
Medium
High
Medium
Medium

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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.

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Tolerable Misstatements,
Risk, and Planned
Acceptable Evidence
audit risk
Inherent
risk
Control
risk

D
I

Planned
detection risk
I

D
I

Planned
audit evidence
D

Tolerable
misstatement
D = Direct
relationship;
I = Inverse
relationship
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Audit Risk Model for

Evaluating Results
AcAR = IR CR AcDR

AcAR = Achieved audit risk

AcDR = Achieved detection risk
IR = Inherent risk
CR = Control risk
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Revising Risks
and Evidence
The audit risk model is primarily a
planning model and is therefore of
limited use in evaluating results.
Great care must be used in revising
the risk factors when the actual results
are not as favorable as planned.

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