1. Advanced Auditing Materiality and the Audit Risk Model
Dr. Mohamed A. Hamada
Lecturer of Accounting Information Systems

2. Audit Risk Auditors accept some level of risk in performing the audit.
risks are difficult to measure,
and require careful thought to respond.

3. 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.

4. Audit Risk Model for Planning
PDR = AAR ÷ (IR × CR)
where:
PDR = Planned detection risk
AAR = Acceptable audit risk
IR = Inherent risk
CR = Control risk

5. Planned detection risk PDR, is a measure of the risk that audit evidence for an account will fail to detect misstatements exceeding a tolerable amount.
Acceptable audit risk AAR, is a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued.

6. Inherent risk is a measure of the auditor’s assessment of the likelihood that there are material misstatements in an account before considering the effectiveness of internal control.
Control risk is a measure of the auditor’s assessment of the likelihood that misstatements exceeding a tolerable amount in an account will not be prevented or detected by the client’s internal controls.

7. Example : there are four situations that involve the audit risk model as it is used for planning audit evidence requirements in the audit of inventory. For each situation, calculate planned detection risk.
Answer: 1. 1%; %; %; %

8. 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

9. Factors Affecting Inherent Risk
Nature of the client’s business
Results of previous audits
Initial versus repeat engagement
Related parties
Non-routine 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

10. Relationships of Risk to Evidence
Situation
Acceptable
audit risk
Inherent
risk
Control
risk
Planned
detection
risk
Amount of
evidence
required 1 2 3 4 5
High
Low
Medium
Low
High
Medium
Low
High
Medium
High
Medium
Low
Low
Medium
High

11. Materiality It is a major consideration in determining
the appropriate audit report to issue.

12. 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.

13. Steps in Applying Materiality1
Set preliminary judgment
about materiality
Planning
extent
of tests
Step 2
Allocate preliminary
judgment about
materiality to
segments

14. Steps in Applying Materiality3
Estimate total
misstatement in segment
Step 4
Estimate the
combined misstatement
Evaluating
results
Step 5
Compare combined
estimate with judgment
about materiality

15. Estimated Total Misstatement and Preliminary Judgment
Estimated Misstatement Amount
Account
Tolerable
Misstatement
Known
Misstatement
and Direct
Projection
Sampling
Error
Total
Cash
Accounts receivable
Inventory
Total estimated
misstatement amount
Preliminary judgment
about materiality
$ 4,000
20,000
36,000
$50,000
$ 2,000
12,000
31,500
$45,500
$ N/A
6,000
15,750
$16,800
$ 2,000
18,000
47,250
$62,300
N/A = Not applicable
Cash audited 100 percent

16. 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)

17. End of Chapter 9