Materiality and Risk
Chapter 9
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
9-1
Learning Objective 1
Apply the concept of materiality
to the audit.
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9-2
Materiality
It is a major consideration in determining
the appropriate audit report to issue.
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9-3
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.
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
9-4
Steps in Applying Materiality
Step Set preliminary judgment
1 about materiality
Allocate preliminary
Step judgment about
2 materiality to
segments
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Planning
extent
of tests
9-5
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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9-6
Learning Objective 2
Make a preliminary judgment
about what amounts to
consider material.
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9-7
Set Preliminary Judgment
About Materiality
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.
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
9-8
Factors Affecting Judgment
Materiality is a relative rather
than an absolute concept.
Bases are needed for
evaluating materiality.
Qualitative factors also
affect materiality.
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
9-9
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.
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9 - 10
Learning Objective 3
Allocate preliminary materiality
to segments of the audit
during planning.
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9 - 11
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 107 (AU 312)
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
9 - 12
Learning Objective 4
Use materiality to evaluate
audit findings.
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9 - 13
Estimated Total Misstatement
and Preliminary Judgment
Estimated Misstatement Amount
Account
Cash
Accounts receivable
Inventory
Total estimated
misstatement amount
Preliminary judgment
about materiality
Known
Misstatement
Tolerable
and Direct
Misstatement Projection
$ 4,000
20,000
36,000
Sampling
Error
Total
$ 2,000
12,000
31,500
$
N/A
6,000
15,750
$ 2,000
18,000
47,250
$45,500
$16,800
$62,300
$50,000
N/A = Not applicable
Cash audited 100 percent
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9 - 14
Estimated Total Misstatement
and Preliminary Judgment
Net misstatements in the sample ($3,500)
÷ Total sampled ($50,000)
× Total recorded population value ($450,000)
= Direct projection estimate of misstatement ($31,500)
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9 - 15
Learning Objective 5
Define risk in auditing.
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9 - 16
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.
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
9 - 17
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 - 18
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
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9 - 19
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
detection risk
Low
Medium
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9 - 20
Learning Objective 6
Describe the audit risk model
and its components.
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9 - 21
Audit Risk Model for Planning
PDR = AAR ÷ (IR × CR)
where:
PDR = Planned detection risk
AAR = Acceptable audit risk
IR = Inherent risk
CR = Control risk
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9 - 22
Learning Objective 7
Consider the impact of
engagement risk on
acceptable audit risk.
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9 - 23
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 - 24
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 - 25
Methods Practitioners Use to
Assess Acceptable Audit Risk
Factors
External users’
reliance on
financial
statements
Methods Used to Assess
Acceptable Audit Risk




Examine financial statements
Read minutes of the board
Examine form 10K
Discuss financing plans
with management
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9 - 26
Methods Practitioners Use to
Assess Acceptable Audit Risk
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 - 27
Learning Objective 8
Consider the impact of several
factors on the assessment
of inherent risk.
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9 - 28
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
Factors related to fraudulent financial reporting
Factors related to misappropriation of assets
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9 - 29
Learning Objective 9
Discuss the relationship of
risks to audit evidence.
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9 - 30
Relationship of Factors Influencing
Risks to Risks and Risks to
Planned 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 - 31
Relationship of Factors Influencing
Risks to Risks and Risks to
Planned 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 - 32
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 - 33
Tolerable Misstatement, Risks,
and Balance-related Audit
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.
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9 - 35
Relationships of Risk to
Evidence
Acceptable Inherent
audit risk risk
Control
risk
Planned
detection
risk
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
Situation
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Amount of
evidence
required
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
Relationship of Tolerable
Misstatement and Risks to
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
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9 - 39
Audit Risk Model for Planning
AcAR = IR × CR × AcDR
where:
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
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
D
Inherent
risk
D
Control
risk
D
Achieved
detection
risk
I
9 - 41
Revising Risks and Evidence
The auditor must revise the original
assessment of the appropriate risk.
The auditor should consider the effect
of the revision on evidence requirements,
without the use of the audit risk model.
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9 - 42
End of Chapter 9
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
9 - 43