CHAPTER 5
Audit Risk
& Materiality
1
The phrase “reasonable
assurance” in the audit report
indicates that there is some
audit risk.
Scope paragraph:
We conducted our audits in accordance with
generally accepted auditing standards. Those
standards require that we plan and perform
the audit to obtain reasonable assurance
about whether the financial statements are
free of material misstatement...
2
Note the mention
of materiality in
the audit report.
Scope paragraph:
We conducted our audits in accordance with
generally accepted auditing standards. Those
standards require that we plan and perform
the audit to obtain reasonable assurance
about whether the financial statements are
free of material misstatement...
3
Note the mention
of materiality in
the audit report.
What is
materiality?
4
What is
materiality?
Materiality is the magnitude of omitted
or misstated information that probably
would have made a difference in the
judgment of someone relying on that
information (FASB 2).
5
For each engagement, auditors
typically establish a preliminary
judgment about materiality.
The preliminary judgment
about materiality is the maximum
amount by which the auditor believes the statements could be
misstated and still not affect the
decisions of reasonable users.
6
For each engagement, auditors
typically establish a preliminary
judgment about materiality.
- may be based on a firm-wide formula
considering profitability and/or total
assets, e.g., 6% of net income
adjusted according
to auditor judgment
7
How does the preliminary judgment
about materiality affect the volume
of audit evidence?
A small materiality
estimate will result
in more evidence.
“Investigate misstatements over $100.”
A large materiality
estimate will result
in less evidence.
“Investigate misstatements over $10,000.”
8
factors affecting the preliminary
judgment about materiality
- materiality is strongly influenced by
client size
$1000...
peanuts
$1000 - WOW!
9
factors affecting the preliminary
judgment about materiality
- materiality is strongly influenced by
client size
- multiple bases of materiality may be
appropriate
FOR EXAMPLE:
The auditor may be concerned that:
net income is not misstated by $100,000,
and total assets is not misstated by
$300,000.
10
factors affecting the preliminary
judgment about materiality
- materiality is strongly influenced by
client size
- multiple bases of materiality may be
appropriate
- an irregularity is considered more material than an error of the same dollar
amount.
WHY?
11
factors affecting the preliminary
judgment about materiality
- materiality is strongly influenced by
client size
- multiple bases of materiality may be
appropriate
- an irregularity is considered more material than an error of the same dollar
amount.
- small differences from contractual
requirements may be material (e.g.,
ratios related to debt agreements)
12
factors affecting the preliminary
judgment about materiality
- multiple bases of materiality may be
appropriate
- an irregularity is considered more material than an error of the same dollar
amount.
- small differences from contractual
requirements may be material (e.g.,
ratios related to debt agreements)
- immaterial amounts may accumulate
into a material amount
13
What is acceptable
audit risk?
set
materiality, and
assess acceptable
audit risk and
inherent risk
Acceptable audit risk is the
risk that the auditor is willing
to accept that an unqualified
opinion will be issued for
statements that are materially
misstated.
14
the
lower
the
acceptable
audit
risk
2%
15
the
lower
the
acceptable
audit
risk
2%
98%
the
greater
the
certainty
the
auditor
wants to
achieve
16
the
lower
the
98%
acceptable
audit
the
risk
greater
2%
the
certainty
the
auditor
wants to
achieve
the
greater
the amount
of audit
evidence
and
costs 17
What is achieved
audit risk?
Achieved audit risk is the
actual risk that the statements are materially misstated after an unqualified
opinion has been issued.
18
How do acceptable and achieved
audit risk affect the audit report?
if
achieved
audit
risk
5%
<
acceptable
audit
risk
10%
audit report is
supported by
the evidence 19
How do acceptable and achieved
audit risk affect the audit report?
if
achieved
audit
risk
15%
>
acceptable
audit
risk
5%
audit report is
not supported
by the evidence
20
Risk is very difficult
to quantify.
subjective
based on
judgment
21
How can an auditor reduce
audit risk?
audit
risk
achieved
risk
gather
more
evidence
acceptable
risk
sufficient,
competent
evidence
and cost
22
Auditors may face additional audit
risk because of business risk; i.e.,
the risk that the client will have
financial problems.
Auditors should consider:
- degree to which users rely on the client’s financial statements
- likelihood that the client will have financial difficulties after the report has
been issued
- management integrity
23
Audit Risk has 3 components
which combine to make the
audit risk model (AU 312):
audit
inherent
=
x
risk
risk
?
control
detection
x
risk
risk
24
Inherent Risk
- defined as the risk that material misstatements exist before considering
the client internal controls
- some accounts, components, cycles
are inherently riskier than others
auditors must:
- identify inherently risky areas
- gather appropriate evidence
regarding those areas
25
inherent risk considerations
- nature of client’s business
EXAMPLE: Sally’s Clothing Boutique
rents store space in a house.
What are the inherently risky
accounts? cash
inventory
accounts payable
Sally’s
26
inherent risk considerations
- nature of client’s business
EXAMPLE: Sally’s Clothing Boutique
rents store space in a house.
What are the inherently less
risky accounts?
fixed assets
equity
Sally’s
27
inherent risk considerations
- nature of client’s business
- integrity of management
poor
integrity
more
evidence
28
inherent risk considerations
- nature of client’s business
- integrity of management
- client motivation to misstate the financial statements
Are management
bonuses based
on net income?
29
inherent risk considerations
- nature of client’s business
- integrity of management
- client motivation to misstate the financial statements
- results of previous audits - accounts,
components which had material misstatements in prior years should be
tested extensively in the current year
30
inherent risk considerations
- nature of client’s business
- integrity of management
- client motivation to misstate the financial statements
- results of previous audits
- initial vs. repeat engagements
Why are initial audit
engagements inherently
riskier than repeats?
31
Why are initial audit
engagements inherently
riskier than repeats?
- during the initial engagement, the
auditor is not familiar with client
systems, internal controls, and
personnel
- during the initial engagement, beginning balances must be extensively examined
32
inherent risk considerations
- nature of client’s business
- integrity of management
- client motivation to misstate the financial statements
- results of previous audits
- initial vs. repeat engagements
Has
- related parties
- nonroutine transactions GAAP been
correctly
applied?
33
inherent risk considerations
- related parties
- nonroutine transactions
- judgment required to correctly record
transactions
- susceptibility to defalcation
Example: CASH
34
inherent risk considerations
- judgment required to correctly record
transactions
- susceptibility to defalcation
- makeup of the population
Which is riskier?
average
average
age of a/p, age of a/p,
15 days
45 days
35
Audit Risk has 3 components
which combine to make the
audit risk model: (AU 312)
audit
inherent
=
x
risk
risk
control
detection
x
risk
risk
?
36
Audit Risk has 3 components
which combine to make the
audit risk model: (AU 312)
audit
inherent
=
x
risk
risk
control
detection
x
risk
risk
the
risk that material
misstatements will not be
prevented or
detected by
internal controls
37
Audit Risk has 3 components
which combine to make the
audit risk model: (AU 312)
audit
inherent
=
x
risk
risk
control
detection
x
risk
risk
?
38
Audit Risk has 3 components
which combine to make the
audit risk model: (AU 312)
audit
inherent
=
x
risk
risk
control
detection
x
risk
risk
Detection risk is the risk
that material misstatements will not be detected
by the auditor.
39
Why does detection risk exist?
- the auditor samples (sampling risk)
- the auditor may select ineffective audit
procedures
- the auditor may apply procedures
ineffectively
- the auditor may incorrectly evaluate
the results of procedures
The last 3 reasons are nonsampling errors. The risk of their occurrence is nonsampling risk.
40
Audit Risk has 3 components
which combine to make the
audit risk model: (AU 312)
audit
inherent
=
x
risk
risk
control
detection
x
risk
risk
Which of these
components can the
auditor influence?
41
Audit Risk has 3 components
which combine to make the
audit risk model: (AU 312)
audit
inherent
control
=
x
x
risk
risk
risk
Which of these
components can
the auditor
influence?
indirectly:
influence
management
detection
risk
directly
- larger
sample
size
- enhanced
training 42
audit risk as a double-hoop basketball game
internal
controls
auditing
procedures
43
audit risk as a double-hoop basketball game
internal
controls
misstatements
(inherently
risky accounts
auditing
are better shots)
procedures
44
audit risk as a double-hoop basketball game
internal
controls
misstatements
detected by
internal controls
auditing
procedures
45
audit risk as a double-hoop basketball game
internal
controls
misstatements
not detected by
internal controls
(control risk)
auditing
procedures
46
audit risk as a double-hoop basketball game
internal
controls
misstatements
detected by
auditors
auditing
procedures
47
audit risk as a double-hoop basketball game
internal
controls
misstatements
undetected by
auditors
(detection risk)
auditing
procedures
48