Materiality and Risk
Chapter 9
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley
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Learning Objective 1
Apply the concept of materiality to the audit.
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Materiality
Major consideration in determining
the appropriate audit report
Referenced in audit report’s scope
paragraph
What is meant by the term “material”?
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Materiality
Auditor’s responsibility = determine whether
financial statements are materially misstated.
Auditor will bring material misstatements to the
client’s attention so corrections can be made.
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Steps in Applying Materiality
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Learning Objective 2
Make a preliminary judgment about what
amounts to consider material.
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Set Preliminary Judgment About
Materiality
Auditors set materiality thresholds early in the
engagement.
Thresholds represent the maximum statements
that could be misstated and still not affect
users decisions.
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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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Qualitative Factors
Considerations that may render material a
quantitatively small misstatement include:
Loan covenants
Changing trend
Management compensation
Financial statements users
Conceals an illegal act
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Guidelines
Accounting and auditing standards do not
provide specific materiality guidelines.
Professional judgment is used to set and
apply materiality guidelines.
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Learning Objective 3
Allocate preliminary materiality to segments
of the audit during planning.
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Allocate Preliminary Judgment
About Materiality to Segments
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)
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Learning Objective 4
Use materiality to evaluate audit findings.
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Known and Likely Misstatements
Auditor can determine the misstated
amount in an account (“Known”)
Two types of “Likely” misstatements:

Judgmental differences

Projections of misstatements from
audit samples
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Estimated Total Misstatement
and Preliminary Judgment
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Estimated Total Misstatement
and Preliminary Judgment
Estimated
Net misstatements in Sample ($3,500)
× Total recorded
=
Misstatement
Total sampled ($50,000)
population value
($31,500)
($450,000)
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Learning Objective 5
Define risk in auditing.
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Risk
Auditors accept some level of
risk in performing the audit.
Risks exist, are difficult to
measure, and require careful
thought in response.
Proper risk response is critical
to achieving a high-quality audit.
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Risk and Evidence
Auditors need to understand the client’s
business and assess business risk.
The audit risk model helps identify the
potential and likelihood of misstatements.
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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
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Audit Risk Model for Planning
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Illustration of Differing Evidence
Among Cycles
Sales and
collection
cycle
Acquisition Payroll and
and payment personnel
cycle
cycle
A
Inherent
risk
Medium
High
Low
B
Control
risk
Medium
Low
Low
C
Acceptable
audit risk
Low
Low
Low
D
Planned
Medium
detection risk
Medium
High
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Illustration of Differing Evidence
Among Cycles
Inventory and
warehousing
cycle
Capital acquisition
and repayment
cycle
A
Inherent
risk
High
Low
B
Control
risk
High
Medium
C
Acceptable
audit risk
Low
Low
D
Planned
Low
detection risk
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Medium
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Learning Objective 6
Describe the audit risk model and
its components.
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Audit Risk Model Components
Planned
Detection
Risk
Inherent
Risk
Control
Risk
Acceptable
Audit
Risk
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Learning Objective 7
Consider the impact of engagement risk
on acceptable audit risk.
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Engagement Risk
What is Engagement 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 to which external users
rely on the statements
The likelihood that a client will have
financial difficulties after the
audit report is issued
The auditor’s evaluation of
management’s integrity
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Methods Practitioners Use to
Assess Acceptable Audit Risk
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Learning Objective 8
Consider the impact of several factors on
the assessment of inherent risk.
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Factors Affecting Inherent Risk
Nature of Client’s
Business
 Industry practices
 Non-routine transactions
 Makeup of the population
Audit Experience
 Prior audit results
 Initial vs. repeat engagement
 Audit judgment required to
correctly record balances and
transactions
Culture
 Related parties
 Factors related to fraudulent
financial reporting
 Factors related to
misappropriation of assets
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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
D
Factors
influencing
risks
Inherent
risk
I
Planned
detection
risk
I
I
I
Planned
audit
evidence
D
Control risk
D = Direct relationship; I = Inverse relationship
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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
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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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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
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Risk and Evidence
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Measurement Limitations
One major limitation in the audit risk model is
the difficulty of measuring the components
of the model.
Known
Unknown
Preliminary
Assessed Level
of Risk
Actual level of
risk achieved
on the audit
+/-
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Relationships of Risk to
Evidence
Acceptable Inherent
audit risk risk
Control
risk
Planned
detection
risk
1
High
Low
Low
High
Low
2
Low
Low
Low
Medium
Medium
3
Low
High
High
Low
High
4
Medium
Medium
Medium
Medium
Medium
5
High
Low
Medium
Medium
Medium
Situation
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Amount of
evidence
required
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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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Learning Objective 10
Discuss how materiality and risk are related
and integrated into the audit process.
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Relationship of Tolerable
Misstatement and Risks to
Planned Evidence
Acceptable
audit risk
Inherent
risk
I
D
Planned
detection risk
I
D
I
I
Planned
audit evidence
D
I
Control
risk
Tolerable
misstatement
D = Direct relationship; I = Inverse relationship
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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.
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End of Chapter 9
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