AUDITING
CHAPTER 2
Standards, Materiality, & Risk
By
David N. Ricchiute
TOPICS
Audit & Attestation standards
Auditing concepts
Audit risk
Materiality in financial statement
audit
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GBW Ch. 2 8th ed
EARLY DEVELOPMENT OF
STANDARDS
1941 Accounting Series Release
(ASR)#21
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SEC requires audit report
Audit conducted in accordance with
generally accepted standards
1948 AICPA approves generally accepted
auditing standards (GAAS)
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RECENT DEVELOPMENT OF
STANDARDS
1970s practitioners criticized GAAS as not
sufficiently specific
1986 Attestation standards developed
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Umbrella for engagement standards
GAAS applies exclusively to financial statement
audits
GBW Ch. 2 8th ed
COMPARING GAAS &
ATTESTATION
Attestation
GAAS
Broad range of
engagements
including audit
Financial statement
audit
Umbrella for all attest
services
Audit one of many
attest engagements
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GENERAL STANDARDS
Attestation
GAAS
Adequate technical training
Adequate technical
training
Adequate knowledge
Assertion can be evaluated by
reasonable criteria &
consistently measured or
estimated
Independence in mental
attitude
Independence in mental
attitude
Due professional care
Due professional care
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FIELDWORK STANDARDS
Attestation
GAAS
Adequately planned &
supervised
Adequately planned &
supervised
Understanding internal
control
Sufficient evidence
Sufficient competent
evidential matter
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REPORTING STANDARDS
Attestation
GAAS
Assertion identified
Conclusion about conformity
with established criteria
State significant reservations
Limited use to parties
agreeing on procedures
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Conclusion about
conformity with GAAP
Consistent use of GAAP
Adequate informative
disclosures
Opinion on statements as a
whole
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STANDARDS FOR PUBLIC
COMPANY ENGAGEMENTS
Sarbanes-Oxley Act of 2002

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Creates Public Company Accounting Oversight
Board (PCAOB)
Delegates authority to PCAOB to
 Oversee, regulate accounting and auditing
professions
 Develop accounting, auditing standards or
 Accept accounting standards from FASB
 Accept auditing standards from AICPA
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AUDITING CONCEPTS
Independence
Due care
Evidence
Reporting
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INDEPENDENCE
EXPLAINED
In fact
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State of mind
Attitude of impartiality
In appearance
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Free of overt interest in client
GBW Ch. 2 8th ed
CONSULTING & PUBLIC
COMPANY ENGAGEMENTS 2000
… consulting & other services may shorten the
distance between the auditor & management.
Independence—if not in fact, then certainly in
appearance—becomes a more elusive
proposition. … In this dual role, the auditor,
who guards the integrity of the numbers, now
both oversees & answers to management.
Arthur Levitt, Jr., “Renewing the Covenant with Investors”
Speech at NYU Center for Law & Business, 5/10/00.
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SEC PUBLIC COMPANIES
INDEPENDENCE REFORMS 2000
Engagement team model of
independence

Team & immediate family prohibited from
investments in clients
Increased restrictions for IT and internal audit
consulting
Required disclosure audit/nonaudit fees in
proxy statement
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GBW Ch. 2 8th ed
SARBANES-OXLEY, &
INDEPENDENCE 2002
Establishes PCAOB
Addresses accountability for corporate
& criminal fraud
Limits audit firm’s consulting services
to public company clients
Client board of directors to approve
consulting services provided by
auditor
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SERVICES PROHIBITED BY
SARBANES-OXLEY
For public companies:
Bookkeeping, other accounting services
Information systems design,
implementation
Valuation or appraisal services
Actuarial services
Internal audit outsourcing services
Management functions, human resources
Broker, dealer, investment advisor
Legal, expert services
Other services to be determined
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SEC, INDEPENDENCE, &
PUBLIC COMPANIES 2003
Further independence regulations

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Rotate engagement partner 5-7 years
Restrict firm’s independence for 1 year
when client hires member of audit team
Violates independence if auditor’s
compensation based on selling service
other than attest
Require auditor report certain matters to
client’s audit committee
 Critical accounting policies
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DUE CARE EXPLAINED
Care when providing
professional services
Adequate training for
professional services
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DUE CARE IN LAW
Every man who offers his service to another & is
employed assumes the duty to exercise such skill
as he possesses with reasonable care &
diligence. …if one offers his service, he is
understood as holding himself out to the public
as possessing the degree of skill commonly
possessed by others in the same employment &
if his pretensions are unfounded, he commits a
species of fraud upon every man who employs
him . . .
Cooley on Torts
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DUE CARE & WORLDCOM
2002
2nd largest long-distance carrier restated
financial statements for 5 quarters
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Network access fees capitalized instead of
expensed
Overstated net income by $11 billion
Overstated balance sheet by $75 billion
Not GAAP
Auditor knew but did not challenge
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DUE CARE &PRUDENT
PRACTITIONER
Foresee unreasonable risk to others
Attend to extra risks
Consider unusual circumstances or
relationships
Identify unfamiliar situation & take
precautions
Resolve doubt
Keep current
Review work of assistants
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DUE CARE
OPERATIONALIZED
Auditor obtains knowledge of
business to understand events,
transactions, practices with significant
effect on financial statements
Plan audit to limit audit risk to low
level
Assess possible errors on balance
sheet
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EVIDENCE EXPLAINED
Underlying accounting data

Journals, ledgers, reconciliations,
accounting manuals
Corroborating information
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Receiving reports, invoices,
contracts, representations from
3rd parties
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EVIDENCE
Basis for all decisions
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Evidential matter
Planning & supervision
Internal control
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EVIDENCE: SUFFICIENCY
& COMPETENCE
Sufficiency

Quantity useful evidence collected at
reasonable cost
Competence

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Validity: varies with source
Relevance: related to assertion
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EVIDENCE HIERARCHY
Independent sources more reliable than
management

Banks, debtors
Evidence obtained directly more persuasive
than indirect evidence from management

Physical examination, observation, computation,
inspection
Effective internal control systems produce
more reliable evidence
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PLANNING &
SUPERVISION EXPLAINED
Planning

Developing objectives & strategy
Supervision
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Directing assistants toward
objectives
Determining when objectives
are met
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INTERNAL CONTROL
Policies & procedures of management &
board of directors
Provides reasonable assurance their
objectives will be achieved
Auditor must understand client’s internal
controls
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To plan audit
To design audit tests
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REPORTING EXPLAINED
Report states conclusion

Attestation report
 Whether management’s assertion conforms
with stated criteria

Audit report
 Whether financial statements conform to
GAAP
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AUDIT REPORT
CONCLUSION
In our opinion, the financial statements
referred to above present fairly, in all
material respects, the financial position
of the company . . ., & the results of its
operations and its cash flows . . ., in
conformity with generally accepted
accounting principles.
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STRATEGY FOR RISK
Risk of omissions or misstatements
Design engagement to control material
omissions or misstatements
Provide reasonable not absolute assurance
of detecting omissions or misstatements
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ATTESTATION RISK
Probability that attester may unknowingly
fail to modify a written conclusion about
an assertion that is materially misstated
D. N. Ricchiute, Auditing, 8th ed.
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AUDIT RISK
Probability that auditor may unknowingly
fail to modify opinion on financial
statements that are materially misstated
D. N. Ricchiute, Auditing, 8th ed.
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COMPONENTS OF AUDIT
RISK
Client sources of risk
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Inherent risk
Control risk
Auditor source of risk
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Detection risk
GBW Ch. 2 8th ed
COMPONENTS OF AUDIT
RISK DEFINED
Inherent risk

Risk that errors will occur
Control risk

Risk that internal controls won’t prevent, detect,
correct errors
Detection risk
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Risk that audit procedures won’t find errors
GBW Ch. 2 8th ed
INHERENT RISK SOURCES
Risk that errors will occur
Business
Industry
Management’s predisposition to
manage earnings
Aggressive use of GAAP
Specific accounts
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Liquid assets vs. nonliquid assets
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CONTROL RISK SOURCES
Risk that internal controls won’t prevent,
detect, correct errors
Outdated technology
Outdated software
Lack of respect for controls by top
management
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DETECTION RISK
SOURCES
Likelihood that errors could occur and not
be detected by audit procedures
Nature of audit procedures
Extent of audit procedures
Timing of audit procedures
Auditor’s judgment
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AUDIT RISK MODEL:
SAS No. 47
AR = IR x CR x DR
DR =
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AR
IR x CR
GBW Ch. 2 8th ed
AUDITOR’S BUSINESS
RISK
The probability that a practitioner might
incur damages despite issuing an
appropriate report

Ex.: litigation
Factors affecting auditor’s business
risk
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Aggressive financial reporting
Management integrity or reputation
Conflicts of interest & regulatory problems
Industry characteristics
GBW Ch. 2 8th ed
AUDITOR’S RESPONSE TO
BUSINESS RISK
If business risk is higher, adjust audit risk
assessment
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Set audit risk lower
Decrease acceptable level of detection risk
Increase evidence
Drop client
If assurance levels all same, do not adjust
audit risk
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AUDIT FAILURE DEFINED
Failing to perform procedures that
would reduce audit risk to a relatively
low level
Ex.: Sunbeam
Sunbeam’s auditor a) identified reserves not
in compliance with GAAP; b) proposed
adjustments which management rejected;
c) accepted reserves as stated after
incorrectly applying materiality analysis
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MATERIALITY
The magnitude or an omission or
misstatement of accounting information
that, in the judgment of a reasonable
person relying on the information,
would have been changed or influenced
by the omission or misstatement.1
Statement of Financial Accounting Standards No. 2, “Qualitative
Characteristics of Accounting Information,” Stamford: FASB, 1980,
par 132.
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MATERIALITY IN
PRACTICE
Preliminary estimate of materiality for
planning guides audit effort, evidence
collection
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SAS No. 22, “Planning & Supervision”
GBW Ch. 2 8th ed
AUDIT RISK, MATERIALITY,
AUDIT EFFORT
Inverse relationship between audit risk
and materiality

Low audit risk suggests it would take larger
amounts to be material
Inverse relationship between materiality
and audit effort (hours worked)
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Higher materiality threshold suggests less
audit effort
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QUANTITATIVE
MATERIALITY CRITERIA
Effect on

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Net income
Total assets
Total revenue
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SAS 99 ON MATERIALITY
Auditors should
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Not rely solely on quantitative materiality
criteria
Judge materiality of misstatements both
individually & in aggregate
Recognize that intentional but immaterial
misstatements are inappropriate & may
be unlawful
GBW Ch. 2 8th ed
QUALITATIVE MATERIALITY
CONSIDERATIONS
Misstatement may not be immaterial if:
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Affects debt compliance requirements
Masks change in earnings
Conceals unlawful transaction
Prompts undue expectations
Hides failure to meet analysts’ expectations
Associated with an estimate
Affects management’s compensation
GBW Ch. 2 8th ed
ALLOCATING PRELIMINARY
MATERIALITY ESTIMATES
On the basis of
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Relative magnitude of financial statement
accounts
Relative variability of financial statement
accounts
Professional judgment
GBW Ch. 2 8th ed