MATERIALITY
AND
RISK
SECTION 8
Importance of Materiality and Risk
•
Materiality and risk underlie the application of all
generally accepted auditing standards
•
Must consider materiality and risk in:
1. Planning
2. Evaluation of F/S
Materiality
•
Presented fairly in accordance with GAAP implies?
•
From an accounting perspective, materiality involves the
determination of what information should be reported
•
From an auditing perspective?
•
CICA Handbook definition:
•
A matter of judgment
•
Thus handbook requires the auditor to consider
•
Circumstances of the company
•
The users of the F/S
•
The auditor makes a preliminary judgment about
materiality levels in planning the audit
•
May ultimately differ from materiality levels used in
evaluating audit findings
•
Materiality involves both qualitative and
quantitative considerations
•
In assessing the quantitative amount it is necessary
to relate the nature and dollar amount to the F/S
•
In planning, the auditor is usually concerned with
just the quantitative
•
Qualitative?
Financial Statement Materiality
•
It is necessary for the auditor to assess materiality on the F/S
because the auditor's opinion on fairness extends to the F/S
taken as a whole
•
Thus what does it mean when F/S are materially misstated?
•
Error or fraud
•
In planning there can be more than one level of materiality
relating to the F/S
•
Income statement materiality is often related to net income
•
Any other choices?
•
Balance sheet materiality is often related to total assets
•
Other choices?
•
The smallest aggregate level of errors considered material to
any one of the F/S should be used for planning
•
Why is this rule appropriate?
1. The nature of the financial statements
2. Auditing procedures
•
As an example consider the auditing procedure to
determine that year-end sales are recorded in the
proper period
Account Balance Materiality
•
The maximum error that can exist in an account before it is
considered materially misstated
•
Inverse relationship between materiality and audit evidence
•
In making a preliminary judgment about materiality
consider:
1.
The likelihood of errors in the account
2.
Expected audit costs
Calculating Materiality
•
Any quantitative assessment of materiality must give full
consideration to the surrounding circumstances as they exist
at that time
•
Ratios and percentages
•
Guidelines:
1.
2.
3.
4.
5.
5% to 10% of net income before taxes
1% to 2% of total assets
1% of equity
½ % of gross revenue
A variable percentage of gross revenue
If total revenue is
over
but not over
Materiality is
$0
$30 thousand
$ 0 + .05
30 thousand
100 thousand
1,450 + .025
100 thousand
300 thousand
3,200 + .018
300 thousand
1 million
6,800 + .012
1 million
3 million
15,200 + .008
3 million
10 million
31,200 + .0054
10 million
30 million
69,000 + .0038
30 million
100 million
145,000 + .0025
100 million
300 million
320,000 + .00175
300 million
1 billion
670,000 + .0012
1 billion
3 billion
1,510,000 + .0008
3 billion
10 billion
3,110,000 + .00055
10 billion
30 billion
6,960,000 + .00038
30 billion
………….
14,560,000 + .00025
Source: Donald A. Leslie, “Materiality, the Concept and Its Application to Auditing.” (CICA,
1985 – p. 21)
Qualitative Factors
Should answer the following questions
1.
Nature of the item?
2.
Unusual or extraordinary?
3.
Contingency?
4.
Based on existing facts?
5.
Relevant to F/S taken as a whole?
6.
Relevant to the total of the accounts of which it forms a part?
7.
Relevant to other related items?
Materiality in Tests of Controls
•
The significance of an internal control deviation
•
Deviations in internal controls may increase the risk
of errors occurring in the accounting records
•
Such deviations do not necessarily give rise to
errors
•
But the auditor must consider the possible relation
of the deviation errors to materiality
•
The relationship between the value of the
transaction containing the deviations and some
multiple of materiality is of primary significance
1. The acceptable upper limit can be fixed at 5%
2. The acceptable upper limit can be given a frequency range
of 3% to 8%
3. No criteria for the upper limit
Materiality in Tests of Transactions
and Details of Balances
•
Should be directly related to the established level of
materiality
•
Statistical sampling
•
Remember the inverse relationship
•
Primary objective of allocating materiality to accounts is to
minimize audit costs without increasing audit risk
Allocating F/S Materiality to Accounts
•
When the auditor’s preliminary judgment about F/S
materiality is quantified, a preliminary estimate of materiality
for each account may be obtained
•
Allocations can be made to both the balance sheet and
income statement accounts
•
An illustrative example:
Cash
Accounts Receivable
Inventories
Fixed Assets
$ 200,000
300,000
1,000,000
2,700,000
•
In this example, the auditor anticipates few errors in cash and
plant assets and some errors in accounts receivables and
inventories
•
Assume that the preliminary estimate of F/S materiality is
$100,000
Cash
Accounts Receivable
Inventories
Fixed Assets
•
$ 200,000
300,000
1,000,000
2,700,000
This allocation may be revised
Materiality
$ 1,000
29,000
60,000
10,000
$100,000
•
What if $19,000 of errors were found in verifying accounts
receivable?
Cash
Accounts Receivable
Inventories
Fixed Assets
•
$ 200,000
300,000
1,000,000
2,700,000
Materiality
$ 1,000
19,000
70,000
10,000
$100,000
What has a great impact on allocating materiality?
The Concept of Audit Risk
•
Audit risk is the risk that the auditor may unknowingly fail
to appropriately modify an opinion on the F/S that are
materially misstated
•
If the auditor desires a probability or certainty of rendering
the correct opinion of 97%, what is the audit risk?
•
The audit opinion is based upon the verification of account
balances, thus audit risk must be related to account balances
Components of Audit Risk
•
Three components:
1. Inherent risk
2. Control risk
3. Detection risk
Inherent Risk
•
Some accounts may be susceptible to loss through
fraud or theft
•
Complex calculations for leases or pensions are
more likely to contain errors
•
Inherent risk also extends to factors that affect the
financial statements as a whole
Control Risk
•
A function of the effectiveness of the client’s system
of internal control
•
Effective controls over an account
•
Control risk can never be zero
Detection Risk
•
A function of the effectiveness of the auditor’s
verification of account balances
•
What influences detection risk?
•
In estimating detection risk, the auditor should also
consider the likelihood that errors will be made in
judgment
•
•
Inverse relation between the inherent risk and
control risk for an account and the detection risk for
that account
•
DR a 1/IR
•
DR a 1/CR
Inherent risk and control risk relate to the
circumstances of the client, but detection risk is
controlled by the auditor
The Audit Risk Model
•
The three components can expressed in quantitative
terms
•
They can also be expressed in non-quantitative
terms
•
AR = IR x CR x DR
•
Assume that the auditor made the following risk assessments
in examining inventories
•
•
•
•
•
Desired audit risk
Inherent risk
Control risk
DR
5%
50%
50%
= AR / (IR x CR)
= 0.05/(0.5 x 0.5)
= 0.2
The auditor may decide that the inherent risk cannot be
quantified and use a conservative approach
Inherent Risk
Control Risk
Detection Risk
HIGH
•Small
•Few
.70
Audit risk
.6 x .8 x.7 = .34
Samples
substantive
tests
•Extensive
reliance
on IC
HIGH
.80
•System
poorly designed
•System
poorly executed
•Not
tested (CR = 1.00)
LOW
.30
•Large
samples
•Many
substantive
.6 x .8 x .3 = .14
tests
HIGH
•Assets
•New
.60
reliance on IC
susceptible to theft
client
•Integrity
•Non
•No
HIGH
doubtful
•As
.70
.6 x .2 x .7 = .08
.30
.6 x .2 x .3 = .04
above
profitable and
needs financing
LOW
.20
•System
well designed and
well executed
•Audit
tests show system
effective
LOW
•As
above
Inherent Risk
Control Risk
Detection Risk
HIGH
•Small
•Few
.70
Audit risk
.4 x .8 x.7 = .22
Samples
substantive
tests
•Extensive
reliance
on IC
HIGH
.80
•System
poorly designed
•System
poorly executed
•Not
tested (CR= 1.00)
LOW
.30
•Large
samples
•Many
substantive
.4 x .8 x .3 = .10
tests
LOW
.40
•Assets
not susceptible to
•No
theft
•Old
reliance on IC
HIGH
client
•Integrity
.4 x .2 x .7 = .06
.30
.4 x .2 x .3 = .02
above
believed high
•Profitable
financed
•As
.70
and easily
LOW
.20
•System
well designed and
well executed
•Audit
tests show system
effective
LOW
•As
above
Problem 1: Shown on the following three pages are the statements of earnings and
financial position for Prairie Stores Corporation.
Required:
a.
Use professional judgment in reaching a preliminary judgment about materiality
based on revenue, net income before taxes, total assets, and shareholders equity.
Your conclusions should be stated I terms of percentages and dollars.
b.
Assume you complete the audit and conclude that your preliminary judgment about
materiality has been exceeded. What should you do?
c.
As discussed in part (b), likely net earnings from continuing operations before
income taxes were used as a base for materiality when completing the audit. Discuss
why most auditors use before tax net earnings instead of after tax net earnings when
calculating materiality based on the income statement.
Statement of Earnings
Prairie Stores Corporation
For the 53 Weeks
For the 52 weeks ended:
Ended May 3, 2002
$
Revenue
Net sales
8,351,149
28-Apr-01
29-Apr-00
$
$
6,601,255
5,959,587
59,675
43,186
52,418
8,410,824
6,644,441
6,012,005
Cost of sales
5,197,375
4,005,548
3,675,369
Marketing, general, and administrative expenses
2,590,080
2,119,590
1,828,169
Other income
Costs and expenses
Provision for loss on restructured operations
64,100
Interest expense
141,662
46,737
38,546
7,993,217
6,171,875
5,542,084
417,607
472,566
469,921
196,700
217,200
214,100
220,907
255,366
255,821
-
-
Earnings from continuing operations before income taxes
Income taxes
Earnings from continuing operations
Provision for loss on discontinued operations, net of income taxes
$
20,700
Net earnings
$
200,207
$
255,366
$
255,821
Statement of Financial Position
Prairie Stores Corporation
May 3, 2002
April 28, 2001
Assets
Current assets
Cash
$
39,683
$
37,566
Temporary investments (at cost, which approximates market)
123,421
271,639
Receivables, less allowances of $16,808 in 2002 and $17,616 in 2001
899,752
759,001
Inventories
Finished product
680,974
Raw materials and supplies
443,175
550,407
1,124,149
Deferred income tax benefits
Prepaid expenses
Current assets
$
Land, buildings, equipment, at cost, less accumulated amortization
Investments in affiliated companies and sundry assets
Goodwill and other intangible assets
Total assets
$
353,795
904,202
9,633
10,468
57,468
35,911
2,254,106
$
2,018,787
1,393,902
1,004,455
112,938
83,455
99,791
23,145
3,860,737
$3,129,842
Liabilities and Shareholders’ Equity
Current liabilities
Notes payable
$280,238
$113,411
64,594
12,336
359,511
380,395
112,200
63,557
76,479
89,151
321,871
269,672
1,214,893
928,522
Long-term debt
730,987
390,687
Other noncurrent liabilities
146,687
80,586
Accrued income tax liability
142,344
119,715
2,234,911
1,519,510
200,195
199,576
Retained earnings
1,425,631
1,410,756
Shareholders’ equity
1,625,826
1,610,332
Current portion of long-term debt
Accounts and drafts payable
Accrued salaries, wages, and
vacations
Accrued income taxes
Other accrued liabilities including goods and services tax
Current liabilities
Total liabilities
Shareholders’ equity
Common stock issued, 51,017 shares in 2002 and 50,992 in 2001
Total liabilities and shareholders’ equity
$
3,860,737
$
3,129,842
Problem 2: The following questions deal with the use of the audit risk model.
a.
b.
Assume that the auditor is doing a first-year municipal audit of Sackville, New
Brunswick, and concludes that the internal control is not likely to be effective.
1)
Explain why the auditor is likely to set both inherent and control risks at 100
percent for most segments.
2)
Assuming (1), explain the relationship of audit risk to planned detection risk.
3)
Assuming (1), explain the effect of planned detection risk on evidence
accumulation compared with its effect if planned detection risk were larger.
Assume that the auditor is doing the third-year municipal audit of Sackville, New
Brunswick, and concludes that internal controls are effective and in inherent risk is
low.
1)
Explain why the auditor is likely to set inherent risk and control risks for
material segments at a higher level than, say, 40 percent, even when the two
risks are low.
2)
For the audit of fixed asset accounts, assume inherent and control risks of 50
percent each and an audit risk or 5 percent. Calculated planned detection risk.
3)
For (2), explain the effect of planned detection risk on evidence accumulation
compared with its effect if planned detection risk were smaller.
c.
Assume that the auditor is doing the fifth-year municipal audit of Sackville, New
Brunswick, and concludes that audit risk can be set high, and inherent and control
risk should be set low.
1)
What circumstances would result in these conclusions.
2)
For the audit of repairs and maintenance, inherent and control risk are set at 20
percent each. Audit risk is 5 percent. Calculate planned detection risk.
3)
How much evidence should be accumulated in this situation?
Problem 3: Using the audit risk model, state the effect on control risk, inherent risk, audit
risk, and planned evidence for each of the following independent events. In each of
the events (a) to (j), circle one letter for each of the three independent variables and
planned evidence: I = increase, D = decrease, N = no effect, and C = cannot
determine from the information provided. Explain your reasoning.
a.
The client's management martially increased long-term contractual debt:
Control risk
IDNC
Inherent risk IDNC
b.
IDNC
Planned evidence IDNC
The company changed from a privately held company to a publicly held company:
Control risk
IDNC
Inherent risk IDNC
c.
Audit risk
Audit risk
IDNC
Planned evidence IDNC
The auditor decided to assess control risk at a level below maximum; it was
previously assessed at maximum:
Control risk IDNC
Inherent risk IDNC
Audit risk
IDNC
Planned evidence IDNC
d.
The account balance increased materially from the preceding year without apparent
reason:
Control risk
IDNC
Inherent risk IDNC
e.
IDNC
Planned evidence IDNC
You determined through the planning phase that working capital, debt to equity ratio,
and other indications of financial condition had improved during the past year:
Control risk
IDNC
Inherent risk IDNC
f.
Audit risk
Audit risk
IDNC
Planned evidence IDNC
This is the second year of the engagement and there were few misstatements in the
previous year. The auditor also decided to increase reliance on internal control:
Control risk IDNC
Inherent risk IDNC
Audit risk
IDNC
Planned evidence IDNC
g.
About halfway through the audit, you discover that the client is constructing its own
building during idle periods, using factory personnel. This is the first time the client
has done this and it is being done at your recommendation:
Control risk
IDNC
Inherent risk IDNC
h.
IDNC
Planned evidence IDNC
In discussions with management, you conclude that management is planning to sell
the business in the next few months. Because of the planned changes, several key
accounting personnel quit several months ago for alternative employment. You also
observe that the gross margin percent has significantly increased compared with that
of the preceding year:
Control risk
IDNC
Inherent risk IDNC
i.
Audit risk
Audit risk
IDNC
Planned evidence IDNC
There has been a change in several key management personnel. You believe that
management is somewhat lacking in personal integrity, compared with the previous
management. You believe it is still appropriate to do the audit:
Control risk IDNC
Inherent risk IDNC
Audit risk
IDNC
Planned evidence IDNC
j.
In auditing inventory, you obtain an understanding of internal control and perform
tests of controls. You find it significantly improved compared with that of the
preceding year. You also observe that due to technology changes in the industry, the
client’s inventory may be somewhat obsolete:
Control risk
IDNC
Inherent risk IDNC
Audit risk
IDNC
Planned evidence IDNC
Problem 4: Some accountants have suggested that the auditor’s report should include a
statement of materiality level and audit risk that the auditor used in conducting the
audit.
Required:
a.
The proponents of such disclosure believe that the information would be useful to
users of the financial statements being reported on. Explain fully why you think they
have this view.
b.
Some accountants oppose such disclosure. Explain why you think they are not in
favour of it.
c.
What is you position on the issue?