Addthis Arens Chapter09

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Materiality and Risk

Chapter 9

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Learning Objective 1

Apply the concept of materiality

to the audit.

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Materiality

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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

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Steps in Applying Materiality

Planning extent of tests Step

1

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Steps in Applying Materiality

Evaluating results

Step 3

Estimate total

misstatement in segment

Step 4

Estimate the

combined misstatement

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Learning Objective 2

Make a preliminary judgment

about what amounts to

consider material.

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Set Preliminary Judgment About

Materiality

This preliminary judgment is the maximum amount by which the auditor believes the statements could be misstated and still not

Auditors decide early in the audit

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Factors Affecting Judgment

Materiality is a relative rather than an absolute concept.

Bases are needed for evaluating materiality.

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Guidelines

Accounting and auditing standards do not provide specific materiality guidelines to practitioners.

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Learning Objective 3

Allocate preliminary materiality

to segments of the audit

during planning.

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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.

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Learning Objective 4

Use materiality to evaluate

audit findings.

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Estimated Total Misstatement

and Preliminary Judgment

Cash

Accounts receivable Inventory

Total estimated

misstatement amount Preliminary judgment

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Estimated Total Misstatement

and Preliminary Judgment

Net misstatements in the sample ($3,500)

× Total recorded population value ($450,000) ÷ Total sampled ($50,000)

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Learning Objective 5

Define risk in auditing.

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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.

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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

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Illustration of Differing Evidence

Among Cycles

A Medium High Low

Control risk

B Medium Low Low

Acceptable audit risk

C Low Low Low

Planned

detection risk

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Illustration of Differing Evidence

Among Cycles

B High Medium

Acceptable audit risk

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Learning Objective 6

Describe the audit risk model

and its components.

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Audit Risk Model for Planning

PDR = AAR ÷ (IR × CR)

PDR = Planned detection risk

AAR = Acceptable audit risk

IR = Inherent risk

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Learning Objective 7

Consider the impact of

engagement risk on

acceptable audit risk.

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Impact of Engagement Risk on

Acceptable Audit Risk

Auditors decide engagement risk and use that risk to modify acceptable audit risk.

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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}

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Methods Practitioners Use to

Assess Acceptable Audit Risk

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

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Methods Practitioners Use 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 Methods Used to Assess

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Learning Objective 8

Consider the impact of several

factors on the assessment

of inherent risk.

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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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Learning Objective 9

Discuss the relationship of

risks to audit evidence.

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Relationship of Factors Influencing

Risks to Risks and Risks to Planned

Evidence

D = Direct relationship; I = Inverse relationship

Factors influencing

risks

Acceptable audit risk

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Relationship of Factors Influencing

Risks to Risks and Risks to Planned

Evidence

_{The engagement may require}

more experienced staff

_{The engagement will be reviewed}

more carefully than usual

_{Auditors can change the audit}

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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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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}

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Measurement Limitations

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Relationships of Risk to

Evidence

Acceptable

audit risk Inherentrisk Controlrisk

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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