Materiality and Risk
Chapter 9
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9-1
Learning Objective 1
Apply the concept of materiality
to the audit.
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9-2
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.
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9-3
Steps in Applying Materiality
Set preliminary
Step
judgment about
1
materiality.
Allocate preliminary
Step judgment about
2 materiality
to segments.
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
Planning
extent
of tests
9-4
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.
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9-5
Learning Objective 2
Make a preliminary judgment
about what amounts to
consider material.
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9-6
Set Preliminary Judgment about
Materiality
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.
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9-7
Factors Affecting Judgment
Materiality is a relative rather
than an absolute concept.
Bases are needed for
evaluating materiality.
Qualitative factors also
affect materiality.
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9-8
Guidelines
Accounting and auditing standards
do not provide specific materiality
guidelines to practitioners.
Professional judgment is to be used
at all times in setting and applying
materiality guidelines.
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9-9
Learning Objective 3
Allocate preliminary materiality
to segments of the audit
during planning.
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9 - 10
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)
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9 - 11
Learning Objective 4
Use materiality to evaluate
audit findings.
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9 - 12
Estimated Total Misstatement and
Preliminary Judgment
Estimated misstatement amount
Account
Cash
Accounts receivable
Inventory
Total estimated
misstatement amount
Preliminary judgment
about materiality
Tolerable
Direct Sampling
misstatement projection error*
$ 4,000
20,000
36,000
Total
$
0
12,000
31,500
$
N/A
6,000
15,750
$
0
18,000
47,250
$43,500
$16,800
$60,300
$50,000
*estimate for sampling error is 50%
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9 - 13
Estimated Total Misstatement and
Preliminary Judgment
Net misstatements in the sample
÷ Total sampled
× Total recorded population value
= Direct projection estimate of misstatement
$3,500 ÷ $50,000 × $450,000 = $31,500
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9 - 14
Learning Objective 5
Define risk in auditing.
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9 - 15
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.
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9 - 16
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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9 - 17
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
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9 - 18
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
9 - 19
Learning Objective 6
Describe the audit risk model
and its components.
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9 - 20
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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9 - 21
Learning Objective 7
Consider the impact of
engagement risk on
acceptable audit risk.
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9 - 22
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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9 - 23
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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9 - 24
Making the Acceptable Audit Risk
Decision
Factors
Methods used to assess
acceptable audit risk
External users’
reliance on
financial
statements
•
•
•
•
Examine financial statements.
Read minutes of the board.
Examine form 10K.
Discuss financing plans
with management.
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9 - 25
Making the Acceptable Audit Risk
Decision
Factors
Methods used to assess
acceptable audit risk
Likelihood
of financial
difficulties
• Analyze financial statements
for difficulties using ratios.
• Examine inflows and outflows
of cash flow statements.
Management
integrity
• See Chapter 8 for client
acceptance and continuance.
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9 - 26
Learning Objective 8
Consider the impact of several
factors on the assessment
of inherit risk.
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9 - 27
Factors Affecting Inherent Risk







Nature of the client’s business
Results of previous audits
Initial versus repeat engagement
Related parties
Nonroutine transactions
Judgment required to correctly record
account balances and transactions
Makeup of the population
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9 - 28
Learning Objective 9
Discuss the relationship of
risks to audit evidence.
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9 - 29
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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9 - 30
Relationship of Risk Factors,
Risk, and 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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9 - 31
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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9 - 32
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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9 - 33
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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9 - 34
Measurement Limitations
One major limitation in the application of the
audit risk model is the difficulty of measuring
the components of the model.
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9 - 35
Relationships of Risk to Evidence
Acceptable
Situation audit risk
Inherent
risk
Control
risk
Planned
detection
risk
Amount of
evidence
required
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
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9 - 36
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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9 - 37
Learning Objective 10
Discuss how materiality and risk
are related and integrated into
the audit process.
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9 - 38
Tolerable Misstatements, Risk,
and 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
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9 - 39
Evaluating Results
AcAR = IR × CR × AcDR
AcAR = Achieved audit risk
IR = Inherent risk
CR = Control risk
AcDR = Achieved detection risk
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9 - 40
Audit Risk Models for Planning
Evidence and Evaluating Results
Acceptable
audit
risk
Compare
Achieved
audit
risk
Substantive
audit
evidence
D = Direct relationship
I = Inverse relationship
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
D
Inherent
risk
D
Control
risk
D
Achieved
detection
risk
I
9 - 41
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.
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9 - 42
End of Chapter 9
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
9 - 43