Chapter 9
Materiality and Audit Risk
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Gordon
Under which auditing approach(es) are
auditors required to obtain an
understanding of the internal controls?
3
Katina
Which section of the Auditing Standards
requires auditors to obtain an
understanding of the internal controls?
4
Lauren
Why are auditors always required to obtain
and understanding of the internal controls?
5
planning phase
we are always required to obtain an
understanding of the Internal Control
to identify & assess the RoMM risks of material
misstatement,
to provide a
basis for designing and implementing
responses to the assessed RoMM.
whether due to fraud or error, at the financial statement and relevant assertion levels through
understanding the entity and its environment, including the entity's internal control, thereby
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Huyen
Under what audit approach(es) are auditors
required to obtain sufficient appropriate audit
evidence?
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Julissa
Which section of the Auditing Standards
requires auditors to obtain sufficient
appropriate evidence?
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AU-C 500
Audit Evidence
.04 The objective of the auditor is to design and
perform audit procedures that enable the
auditor to obtain sufficient appropriate audit
evidence to be able to draw reasonable
conclusions on which to base the auditor's
opinion.
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Marc
How do we obtain audit evidence?
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Somer
What is the definition of audit risk?
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Audit risk. The risk that the auditor
expresses an inappropriate audit opinion
when the financial statements are
materially misstated.
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Jena
What is the definition of Materiality?
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AU Section 312
Audit Risk and Materiality in Conducting an Audit
Source: SAS No. 107.
Effective for audits of financial statements for periods beginning on
or after Dec. 15, 2006. Earlier application is permitted.
.04 The auditor's consideration of materiality is a matter of professional
judgment and is influenced by his perception of the needs of a reasonable person
who will rely on the financial statements. The perceived needs of a reasonable
person are recognized in the discussion of materiality in Financial Accounting
Standards Board Statement of Financial Accounting Concepts No. 2, Qualitative
Characteristics of Accounting Information, which 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 or influenced
by the omission or misstatement."
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Performance Materiality
Performance Materiality
tolerable error
tolerable misstatement
The allocation of the preliminary judgment
about materiality to segments (account
balances or classes of transactions)
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Xiaodan
Describe a Significant Class of Transactions ?
Describe a Transaction Cycle?
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Class of Transactions
Accounts receivable
Sales
xxx.xx
xxx.xx
Revenue & Collection Cycle
Accounts receivable
xxx.xx
Sales
xxx.xx
Cash
xxx.xx
Accounts receivable
xxx.xx
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cash
250
450
350
550
200
100
375
190
330
accounts receivable
800
300
200
275
100
450
300
190
320
550
200
100
375
190
480
365
845
450
350
550
200
100
375
190
sales
550
200
100
375
190
480
365
2,260
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Audit Risk Model
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Nicole
What are the elements of the “Audit Risk Model”?
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Materiality and Risk
the Audit Risk Model
AAR = IR * CR * PDR
page 128
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Materiality and Risk
the Audit Risk Model
AAR = IR * CR * PDR
Risk of Material Misstatement
RoMM = combines IR * CR
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Audit Risk Model
AAR IR CR PDR
rearrange
PDR 
assume AAR is a constant t hen PDR 
AAR
IR *CR
c
inverse relationsh ip
IR*CR
the planned level of PDR is a function of our assessment of CR
.
PDR  f(CR) 
c.
RoMM
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Ricardo
Which Component(s) of Audit Risk do you
think the auditor might be able to reduce?
Which Component(s) of Audit Risk do you
think the auditor would be unable to
reduce?
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AAR =
RoMM
CR
DR
client
auditor
environmental
IR
balances
transactions
tests of details of balances
substantive analytical procedures
substantive tests of transactions
tests of controls
analytical procedures (planning)
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Obtain engagement
Understand the client
AU-C 315
Analytical procedures
Understand the internal controls
Risk assessment
Testing
AU-C 500
Tests of controls (transactions)
Substantive tests of transactions
Substantive Analytical procedures
Substantive tests of details of balances
Reporting
AU-C 700
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Ian
Describe the relationship between Control Risk
and the planned level of Detection Risk?
The mathematical relationship
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Audit Risk Model
c
DR  f (CR) 
CR
we need evidence showing
if CR  low 
the controls are effective
if CR  high 
What type of audit procedures will we perform to
obtain appropriate evidence that controls are
effective?
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Audit Risk Model
c
DR  f (CR) 
if CR  low  it is OK for PDR to remain High
CR
if CR  high  PDR must be reduced to a Low level
What type of audit procedures will we perform to
obtain appropriate evidence to reduce Detection
Risk to a low level?
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Audit Risk Model
DR  f (CR) 
c
CR
if PDR  high  we can limit our Substantiv e Tests
if PDR  low  we need extensive Substantiv e Tests
What type of audit procedures will we perform to
obtain appropriate evidence if Planned Detection
Risk is high?
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Chen
What is the definition of Control Risk
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Control risk. The risk that a misstatement that
could occur in an assertion about a class of
transaction, account balance, or
disclosure and that could be material, either
individually or when aggregated with other misstatements,
will
not be prevented, or detected and
corrected, on a timely basis by the entity's
internal control.
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Jonathan de
What is the definition of
Planned Detection Risk
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Planned Detection risk.
The risk that the audit evidence for a
segment will fail to detect misstatements
exceeding tolerable misstatement.
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Detection risk. The risk that the
procedures performed by the auditor to
reduce audit risk to an acceptably low
level will not detect a misstatement that
exists and that could be material, either
individually or when aggregated with other
misstatements.
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Alyssa
If we assess CR = Low, what does that
tell us about the level of PDR …. ?
If we assess CR = High, what does that
tell us about the level of PDR …. ?
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Iris
If we assess CR = Max, what does that
imply about the effectiveness of the
Internal Controls?
38
Ciara
If we assess CR = Low, what does that
imply about the effectiveness of the
Internal Controls?
39
Katie
If we assess Control Risk as Low, what
type of evidence would our audit
procedures need to generate?
40
Dillon
If PDR = High, what does that imply
about Control Risk …. ?
If PDR = Low, what does that imply
about Control Risk …. ?
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preliminary Control Risk assessment
significant classes of Transactions
occur
complete
accuracy
classify
cutoff
Credit sales
Low
Cash receipts
Low
Low
Low
Low
Low
Low
Low
Low
Max
Low
Low
Low
Low
Low
Low
Low
Max
Low
Max
Low
Low42
Payroll
Low
Cash Disburse Low
Purchasing
Low
when we assess Control Risk less than Max
Credit Sales Transactions
Occur
Low
Complete
Low
Accuracy
Low
Classification
Low
Cutoff
Max
Control
activity
Test of
Control Proc
Results
Of ToC
Max
Max
Max
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High Risk Areas and
Transactions
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1. Related Party Transactions
2. Non Routine Transactions
3. Judgement -Actg Estimates
4. Complex Transactions
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1. Related Party Transactions
high risk
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Related Party Transactions
high risk - page 86 & 135
One of the parties is in a position to exert
significant influence over another party
Related parties can structure transactions to
conceal problems in the financial statements
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2. Non Routine Transactions
high risk
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3. Judgement -Actg Estimates
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Auditing accounting estimates
high risk
p. 135 (judgment required)
Keep track of differences
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Auditing accounting estimates
With estimates, there often is no right answer
• Keep track of differences between the
estimate and what auditor finds reasonable
• Evaluate differences taken together
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4. Complex Transactions
high risk
page 77 - ENRON
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Stephanie
In your statistics class, why does a
larger sample increase your level of
confidence?
How does evidence reduce risk?
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Accounts Receivable Project
Sample Results Tolerable Misstatement
Page 125-126
1. Known misstatement
$3,500
2. Projection
of sample results to the population
$3,500*(450,000/50,000)
= $31,500
3. Allowance for sampling risk
$15,750
• Estimates
$47,250
– Difference between auditor’s estimate
– Book Value (management’s estimate
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Jon
Please describe Professional Skepticism ?
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An attitude that includes a questioning
mind, being alert to conditions that may
indicate possible misstatement due to
fraud or error, and a critical assessment
of audit evidence.
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???
Given the definition of Audit Risk
what is the relationship between
Materiality and Audit Risk?
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Evaluation of Sample Results
Critical Value = μ + Zβ* Sx/√n
2,295.47 + 1.04 *1,390.09 / √ 44 = 2,513.42
We are unable to conclude that Accounts
Receivable is not materially overstated because the
sample mean of $2,425.56 is less than the
$2,513.42 critical value.
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Sample
Results
Book
balance
size
sum
average
2,371,983.60
930
2,371,983.60
44
930
106,724.85
2,425.56 2,255,775.24
projected overstatement
average
BV
sample
error
Projected
to
Population
116,208.36
2,550.52
2,425.56
124.96
Allowance for Sampling Risk
= Zβ*sx/√n
RIAA
15.0%
Zβ
std dev
std error
allow
Projected
Error
plus
Allowance
1.04
1,390.09
209.56
217.95 202,690.25
projected allowance 202,690.25
217.95
x930
318,898.62
342.90
318,898.62
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