Materiality and Risk
Chapter 8
©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
8-1
Learning Objective 1
Apply the concept of
materiality to the audit.
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8-2
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.
©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
8-3
Steps in Applying
Materiality
Step
1
Set preliminary
judgment about
materiality.
Allocate preliminary
Step
judgment about
2
materiality
to segments.
Planning
extent
of tests
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8-4
Steps in Applying
Materiality
Step
Estimate total
3 misstatement in segment.
Step
Estimate the
4 combined misstatement.
Evaluating
results
Compare combined
Step
estimate with judgment
5
about materiality.
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8-5
Learning Objective 2
Make a preliminary judgment
about what amounts to
consider material.
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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.
©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
8-7
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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8-8
Learning Objective 3
Allocate preliminary materiality
to segments of the audit
during planning.
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8-9
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)
©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
8 - 10
Learning Objective 4
Use materiality to evaluate
audit findings.
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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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8 - 12
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%
$43,500
$16,800
©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley
$60,300
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Learning Objective 5
Define risk in auditing.
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8 - 14
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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8 - 15
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.
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8 - 16
Example of Differing
Evidence Among Cycles
A
B
C
D
Inherent
risk
Control
risk
Acceptable
audit risk
Planned
detection risk
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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8 - 17
Example of Differing
Evidence Among Cycles
A
B
C
D
Inherent
risk
Control
risk
Acceptable
audit risk
Planned
detection risk
Inventory and
Warehousing
Cycle
Capital Acquisition
and Repayment
Cycle
high
low
high
medium
low
low
low
medium
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8 - 18
Learning Objective 6
Describe the audit risk
model and its components.
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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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8 - 20
Learning Objective 7
Consider the impact of
engagement risk on
acceptable audit risk.
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8 - 21
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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8 - 22
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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8 - 23
Factors Affecting
Acceptable Audit Risk
The auditor’s evaluation of
management’s integrity
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8 - 24
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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8 - 25
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 7 for client
acceptance and continuance.
integrity
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8 - 26
Learning Objective 8
Consider the impact of several
factors on the assessment
of inherent risk.
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Major Factors When
Assessing Inherent Risk
• Nature of the client’s 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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8 - 28
Learning Objective 9
Consider information
gathered to assess the
likelihood of fraud.
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8 - 29
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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8 - 31
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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8 - 32
Examples of Risks Factors
for Fraudulent Reporting
3. Attitudes/Rationalization
Inappropriate or inefficient communication
and support of the entity’s 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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8 - 33
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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8 - 34
Learning Objective 10
Discuss the relationship
of risks to audit evidence.
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Relationship of Risk Factors,
Risk, and 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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8 - 36
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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8 - 37
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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8 - 38
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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8 - 39
Tolerable Misstatement, Risks,
and Balance-related 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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8 - 40
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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8 - 41
Relationships of Risk
to Evidence
Acceptable
Audit
Situation Risk
1
High
2
Low
3
Low
4
Medium
5
High
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
8 - 42
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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8 - 43
Learning Objective 11
Discuss how materiality and risk
are related and integrated
into the audit process.
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8 - 44
Tolerable Misstatements,
Risk, and Planned Evidence
Acceptable
audit risk
Inherent
risk
Control
risk
D
I
Planned
detection risk
I
D
I
I
Planned
audit evidence
D
I
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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8 - 46
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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8 - 47
End of Chapter 8
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