Chapter 1 Materiality and Audit Risk

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CHAPTER
1
Considering Materiality and Audit Risk
Introduction
-The auditor`s responsibility section in an audit
report includes two important phrases that
are directly related to materiality and risk. We
conducted our audits in accordance with
auditing standards generally accepted in the
United States of America. Those standards
require that we plan and perform the audit to
obtain reasonable assurance about whether
the financial statements are free of material
misstatements.
Introduction
- The phrase obtain reasonable assurance is
intended to inform users that auditors do not
guarantee or ensure the fair presentation of the
financial statements.
- The phrase free of material misstatements is
intended to inform users that auditor's
responsibility is limited to material financial
information. Materiality is important because it is
impractical for auditors to provide assurances on
immaterial amounts.
Materiality
• Materiality is a major consideration in determining
the appropriate audit report to issue.
FASB Concept Statement 2 defines Materiality as:
• The magnitude of an omission or misstatement of
accounting information that,
in the light of surrounding
circumstances, makes it probable that the judgment of a
reasonable person relying on the information would have
been
changed
misstatement.
or
influenced
by
the
omission
or
Materiality
Auditor Responsibility:
Because auditors are responsible for determining whether
financial statements are materially misstated, they must, upon
discovering a material misstatement, bring it to the client’s
attention so that a correction can be made. If the client refuses to
correct the statements, the auditor must issue a qualified or an
adverse opinion,
depending on the materiality of the
misstatement. To make such determinations, auditors depend on
a thorough knowledge of the application of materiality.
Materiality
The difficulty that auditors have in applying materiality
in practice:
1. While the definition emphasizes reasonable users who
rely on the statements to make decisions, auditors must
have knowledge of the likely users of the client’s
statements and the decisions that are being made. In
practice, auditors may not know who all the users are or
what decisions they may make based on the financial
statements.
Materiality
Applying Materiality
Auditors follow five closely related steps in applying materiality
Step 1
Set preliminary judgment about materiality
judgment
Planning extent
about of tests
Step 2
Allocate preliminary
materiality to segments
Step 3
Estimate total misstatement in segment
Step 4
Estimate the combined misstatement
Step 5
Compare
combined
estimate
with
preliminary or revised judgment about
materiality .
Evaluating
results
Materiality
Step (1) : Set Preliminary Judgment :
- Is the maximum amount by which the auditor
believes the statements could be misstated and
still not affects the decisions of reasonable users.
- The reason for setting a preliminary judgment
about materiality is to help the auditor plan the
appropriate evidence to accumulate .
- The auditor will frequently change the
preliminary judgment about materiality during
the audit. When that is done, the new judgment
is called a revised judgment about materiality.
Materiality
Step (2): Allocate preliminary judgment about materiality to
segments (tolerable misstatements)
- If auditors have a preliminary judgment about
materiality for each segment, it helps them decide
the appropriate audit evidence to accumulate
segmentation means lower amounts and more
evidence.
- Most auditors allocate materiality to balance sheet
rather than income statement accounts. Because
most income statement misstatements have an
equal effect on the balance sheet because of the
double-entry book-keeping system.
Materiality
Step (2): Allocate preliminary judgment about materiality to segments
(tolerable misstatements)
Auditors face three major difficulties in allocating materiality
to balance sheet
accounts:
1. Auditors expect certain accounts to have more
misstatements than others.
2. Both overstatements and understatements must be
considered.
3. Relative audit costs affect the allocation.
Materiality
Step (3): Estimated total misstatement ad preliminary
judgment
When auditors perform audit procedures for each segment of the
audit, they document all misstatements found. Misstatements in
an account can be of two types: known misstatements and likely
misstatements.
1. Known misstatements are those where the auditor can
determine the amount of the misstatement in the account. For
example, when auditing property, plant, and equipment, the
auditor may identify capitalized leased equipment that should be
expensed because it is an operating lease.
Step (3): Estimated total misstatement ad
preliminary judgment
There are two types of likely misstatements.
1. The first are misstatements that arise from differences between management’s and
the auditor’s judgment about estimates of account balances. Examples are
differences in the estimate for the allowance for uncollectible accounts or for
warranty liabilities.
2. The second are projections of misstatements based on the auditor’s tests of a
sample from a population.
For example, assume the auditor finds six client misstatements in a
sample of 200 in testing inventory costs. The auditor uses these
misstatements to estimate the total likely misstatements in inventory
(step 3). The total is called an estimate or a “projection” or
“extrapolation” because only a sample, rather than the entire
population, was audited. The projected misstatement amounts for each
account are combined on the worksheet (step 4), and then the
combined likely misstatement is compared with materiality (step 5).
Step (3): Estimated total misstatement ad
preliminary judgment
The calculation of the direct projection estimate of misstatement is:
Direct projection estimate of misstatement=
(Net misstatements in the sample /Total sampled)× Total recorded
population value
The calculation of Total estimated misstatement amount is:
Total estimated misstatement =
Direct projection estimate of misstatement+ Sampling Error
Notes :
Sampling Error= 50%of direct projection (for
simplification)
Note: sampling error= $0 if segment is audited 100%
-Sampling Error: represents the maximum misstatement
in account details not audited.
Comparison Between Total Estimated Misstatement
Amount of a Segment and Tolerable Misstatement
• If total estimated misstatement amount of a segment <
tolerable misstatement
the segment is
accepted.
• If total estimated > tolerable misstatements
the
segment is rejected and adjustments by management
are needed.
Examples
• 1) If an auditor decides to allocate $ 36,000 of
a total preliminary judgment about materiality
of $ 500,000 to inventory, in auditing
inventory, the auditor found $ 3,500 of net
overstated amounts in a sample of $ 50,000 of
the total population of $ 450,000
Required: Explain the auditor decision towards
the acceptance of inventory balance.
Solution
• Total estimated misstatement amount of the inventory:
Direct Projection
Direct Projection
($3,5000 ÷ 50,000) × 450,000
+
Sampling Error
($31,500 × 50%)
$31,500
15,750
$47,250
Where
•Tolerable misstatement = $36,000
•*Total estimated misstatement exceeds tolerable misstatement
The auditor reject the inventory balance as it appears in the balance •
sheet, and requires adjustments made by management.
Example (2) :
- If an auditor decides to allocate $35,000 of a total
preliminary judgment about materiality of
$80,000 to accounts receivable, in auditing
accounts receivable, the auditor found $4,000 of
overstated amounts and $6,000 of understated
amounts in a sample of $100,000 of the total
population of $1000,000.
Required: Explain the auditor decision towards the
acceptance of accounts receivable balance.
Solution
- Net misstatement in accounts receivable = $2,000 understand.
-Total estimated misstatement amount of the accounts receivable:
Direct projection
($2,000÷100,000)×1,000,000
+
Sampling Error
($20,000×50%)
$20,000
10,000
Where
Tolerable misstatement = $35,000
Total estimated misstatement lesser than tolerable misstatement
The auditor accepts the accounts receivable balance as it appears
in the balance sheet.
Problem:
You are evaluating audit results for assets in the audit of El Marwa Manufacturing.
You set the preliminary judgment about materiality at $50000. The account
balances, tolerable misstatement, and estimated overstatements in the
accounts are shown next.
Account
Account
Balance
Tolerable
Misstatement
Estimate of
Total Overstatement
Cash
$ 50000
1200000
2500000
250000
$ 4000000
$ 5000
30000
50000
15000
$ 100000
$ 1000
20000
25000
12000
$58000
Acc. Receivable
Inventory
Other assets
Total
Required:
•Assume you tested inventory amounts totaling $1000000 and found $10000 in
overstatements. Ignoring sampling risk, what is your estimate of the total misstatement in
inventory.
•Based on the audit of the assets accounts and ignoring other accounts, are the overall
financial statements acceptable? Explain.
•What do you believe the auditor should do in the circumstances?
Solution:
• The Direct projection of the total misstatement in inventory =
(Net Misstatement in the Sample/Total Sampled)x Total Recorded
Population Value
($ 10000/$1000000) x $ 2500000 = $25000
• No. the overall financial statements are not acceptable. Including
the projected error for inventory, the total overstatement errors are
$58000 which exceeds materiality of $50000.
• The auditor should either propose an audit adjustment so that the
unadjusted statement amount is less than materiality, and/or
perform more testing to obtain a better estimate of the population
misstatements. The additional testing will likely focus on receivables
and inventory because they have the largest estimated
misstatement.
Case:
• In allocating tolerable misstatement, the auditor of El Marwa company
uses judgment in the allocation, subject to the following two arbitrary
requirements:
1. Tolerable misstatements for any account cannot exceed 75% of the
preliminary judgment.
2. The sum of all tolerable misstatements cannot exceed twice the preliminary
judgment about materiality.
After the auditor completed the audit, he prepared the following table
which includes a comparison of estimated total misstatement for
preliminary judgment about materiality:
Comparison of Estimated Total Misstatement to Preliminary Judgment about Materiality
Estimated Misstatement Amount
Account
Tolerable
Known Misstatement Sampling
Misstatement And Direct
Error
Projection
Cash
$4000
$2000
$ NA
Acc. Receivable
20000
12000
6000
Inventory
36000
31500
15750
Total estimated misstatement amount
Preliminary judgment about materiality $50000
NA=NOT applicable.
Cash audited 100 %
$45500
$16800
Total
$2000
18000
47250
$62300
• Required:
1. What is the auditor's decision regarding the acceptability of the
financial statements?
2. What are the alternative actions that the auditor will take before he
issues the audit report?
• Solution:
1. The total estimate misstatement of $62300 exceeds the preliminary
judgment about materiality of $50000. Because the estimated
combined misstatement exceeds the preliminary judgment, the
financial statements are not acceptable.
2. The auditor can either:
Determine whether the estimated likely misstatement actually exceeds
$50000 by performing additional audit procedures. If the auditor
decides to perform additional audit procedures, they will
concentrated in the inventory area, because it is the major are of
difficulty, where estimated misstatement of $47250 is significantly
greater than tolerable misstatement of $36000.
Require the client to make an adjustment for estimated misstatement.
Audit Risk
• It is level of uncertainty in performing the audit process.
• 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 for achieving a high-quality audit.
Example of Audit Risks
• Uncertainty about the competence of evidence.
• Uncertainty about the effectiveness of a client ICs.
• Uncertainty about the fairness of F.S when the audit is completed.
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 identify the potential for
misstatements and where they are most likely to occur.
Audit Risk Model For Planning
• A formal model reflecting the relationship between
acceptable audit risk (AAR) , inherent risk (IR), control
risk (CR) and planned detection risk (PDR).
• The audit risk model is used for planning in deciding
how much evidence to accumulate in each cycle. It is
usually stated as follows.
• PDR=AAR/IR×CR
OR
AAR=IR× CR × PDR
Ex:
IR= 100%
CR=100%
AAR=5%
PDR= 0.05/1×1=0.05 or 5%
1- planned detection risk (PDR)
Is a measure of the risk that audit evidence for a segment
will fail to detect misstatements exceeding a tolerable
amount.
This type of risk Is dependent on other three factors in
the model.
Determines the amount of substantive elements that the
auditor plans to accumulate.
• If PDR is reduced, the auditor needs to accumulate
more evidence to achieve the reduced planned risk.
• PDR= 0.05, the auditor plans to accumulate evidence
until the risk misstatement exceeding tolerable
misstatement reduced to 5%
2- Inherent Risk
• Is a measure of the auditor assessment of the likelihood
that there are material misstatements (errors or frauds) in a
segment before considering the effectiveness of internal
controls?
• The assumption depends on discussion with management,
knowledge of the company, and results of past years.
• IR is the sensitivity to material misstatement assuming no
material control.
• Inherent Risk related inversely to PDR but directly relates
to evidence.
High inherent risk
low PDR
more evidence
Example
Study the effect of IR in PDR and according to the amount of evidence
that should be accumulated.
AAR = 5%
IR = 20%, 60%, 80%, 95%
CR = 100%
PDR = ??
PDR = AAR / (IR X CR)
INHERENT RISK
Low
HIGH
IR 20%
IR 60%
IR 80%
IR 95%
PDR =
PDR =
PDR =
PDR =
0.05/(0.2X1) = 0.05/(0.6X1) = 0.05/(0.8X1) = 0.05/(0.95X1)
0.25
0.08
0.06
= 0.05
PDR = 25%
PDR = 8%
PDR = 6%
PDR = 5%
Less planned
More planned
evidence
evidence
Less planned
More
staff
experiences
staff
Assessing IR:
The auditor should consider several major factors
when assessing inherent risk:
• Nature of the client's business.
• Results of previous audits.
• Initial versus repeat engagement.
• Related parties.
• Non-routine transactions.
• Judgment required to correctly record account
balances and transactions
• Makeup of the population.
3- Control Risk ( CR ):
• Control risk is a measure of the auditor's assessment of
the likelihood that misstatements exceeding a tolerable
amount in a segment will not be prevented or detected
by the client's ICs.
• The more effective the ICs the lower the risk factor that
could be assigned to control risk.
• Relationship between PDR and CR is inverse.
• Relationship between evidence and CR is direct.
• Effective ICs
Increase PDR
decrease
evidence
• Ineffective ICs
decrease PDR
increase
evidence
4 – Acceptable Audit Risk ( AAR ):
• Is a measure of how will the auditor is to accept that the F.S may be
materiality misstated after the audit is completed and an
unqualified opinion has been issued.
• Zero risk
the auditor is certain that no misstatement is F.S, or
willing to have complete assurance.
• 100% risk
would be complete uncertainty.
• Audit assurance, over all assurance, level of assurance = 1-AAR.
• AAR
have direct relationship with PDR.
• AAR
have inverse relationship with evidence.
• LOW AAR
low PDR, high evidence.
• HIFH AAR
high PDR, low evidence.
Assessing AAR ( changing AAR for business ) Business risk
(engagement risk):
• Auditors must decide the appropriate acceptable audit
risk for an audit, preferred during audit planning. First,
auditors decide engagement risk and then use
engagement risk to modify acceptable audit risk.
• Engagement risk is the risk that the auditor will suffer
harm because of a client relationship, even though the
audit report rendered for the client was correct.
• Ex. If a client declares bankruptcy after an audit
completed, the likelihood of lawsuit against CPA firm is
reasonably high even if the quality the audit was good.
• Engagement risk closely relates to client business risk.
Factors affecting Acceptable Audit Risk:
• The first category of factors that determine acceptable audit risk is the
degree to which users rely on the financial statements.
• The following factors are indicators of this:
– Client's sized
– Distribution of ownership
– Nature and amount of liabilities
• The second category of factors is the likelihood that a client will have
financial difficulties after the audit report is issued.
• Factors affecting this are:
–
–
–
–
–
Liquidity position
Profits (losses) in previous years
Method of financing growth
Nature of the client's operations
Competence of management
• The third category of factors is the auditor's evaluation of management's
integrity.
• Factors that may affect this are:
– Relationship with current or previous auditors
– Frequency of turnover of key financial or internal audit personnel
– Relationship with employees and labor unions.
Table:
Methods Practitioners Use to Asses Acceptable Audit Risk
Factors
External users'
reliance on
financial
statements
Methods used to Assess Acceptable Audit Risk
1. Examine the financial statements, including footnote.
2. Read minutes of board of directors meetings to determine
future plans
3. Discuss financing plans with management.
Likelihood of
1. Analyze the financial statements for financial difficulties
financial difficulties
using ratios and other analytical procedures.
2. Examine historical and projected as flow statements for
the growth of cash inflows and outflows.
Management
integrity
1. Relationship with current or previous auditors
2. Frequency of turnover of key financial or internal
audit personnel
3. Relationship with employees and labor unions.
Evaluating Results:
• After the auditor plans the engagement and accumulates audit evidence,
results can also be stated in terms of the evaluation version of the audit
risk model.
• The audit risk model for evaluation is:
ACAR = IR X CR X ACDR
Where:
• ACAR = achieved audit risk. A measure of the risk the auditor has taken
that an account in the financial statements is materiality misstated after
the auditor has accumulated audit evidence.
• IR = inherent risk. It is the same inherent risk factor discussed in planning
unless it has been revised as a result of new information.
• Cr = control risk. It is also the same control risk discussed previously unless
it has been revised during the audit.
• ACDR = achieved detection risk. A measure of the risk that audit evidence
for a segment did not detect misstatements exceeding a tolerable amount,
if such misstatement existed. The auditor can reduce achieved detection
risk only by accumulating substantive evidence.
Ex:
•
•
•
•
•
IR= 100%
CR= 100%
ACDR= 4%
AAR= 5%
ACAR= IR×CR ×ACDR
= 1 ×1 ×0.04=4%
Comment
• The auditor compares ACAR (4%) with AAR (5%) and
concludes that sufficient evidence has been
accumulated the auditor is satisfied that achieved risk
is less than or equal to AAR.
• If AAR is 3% more evidence accumulated.
Risk and Evidence:
Table : Relationships of risk evidence
Situation
Acceptable
audit risk
Inherent risk
1
High
Low
2
low
Low
3
Low
4
5
Control risk
Planned
detection
risk
Amount of
evidence
required
High
Low
Low
Medium
Medium
High
High
Low
High
Medium
Medium
Medium
Medium
Medium
High
Low
Medium
Medium
Medium
Low
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