Chapter 9 Materiality and Risk Audit Risk CPA

Presentation Outline Steps in Applying Materiality Risk in Auditing Planning Model Relationships Evaluating Results

I. Steps in Applying Materiality

Step 1 in Applying Materiality Set preliminary judgment about materiality. Permissible misstatements are often less for smaller clients. Although the FASB and AICPA are unwilling to provide specific materiality guidelines to practitioners, bases are needed for evaluating materiality. See Figure 9-2 on page 235. Qualitative factors can affect materiality. See factors on pages 234-235. The preliminary judgment about materiality is the maximum amount the auditor believes the statements could be misstated and still not affect the decisions of reasonable users. Decided early in audit.

Step 2 in Applying Materiality Allocate preliminary judgment about materiality to segments. Most practitioners allocate materiality to balance sheet rather than income statement accounts. This is because most income statement misstatements have an equal effect on the balance sheet because of the double-entry bookkeeping system. The sum of the tolerable misstatement is allowed to exceed overall materiality because (1) it is unlikely that all accounts will be misstated by the full amount of tolerable misstatement, and (2) some accounts are overstated while others are understated, resulting in a net amount that is likely to be less than overall materiality. An allocation is necessary because evidence is accumulated by segments rather than the financial statements taken as a whole. The allocation to account balances is known as the tolerable misstatement.

Illustration of Tolerable Misstatement Allocation for Current Assets Account Misstatement Cash $ 4,000 Accounts receivable 20,000 Inventory 36,000 Preliminary judgment about materiality $50,000

Step 3 in Applying Materiality Estimate total misstatement in segment. $3,500 net misstatement of the inventory sample $3,500 ÷ $50,000 × $450,000 = $31,500 $50,000 total inventory sampled $450,000 total recorded population value for inventory $31,500 direct projection estimate of misstatement × ÷ = One way to calculate the estimate of misstatement is to make a direct projection from the sample to the population.

Illustration of Estimating Total Misstatement in Segment Tolerable Direct Sampling Account Misstatement Projection Error Total Cash $ 4,000 $ 0 $ N/A $ 0 Accounts receivable 20,000 12,000 6,000* 18,000 Inventory 36,000 31,500 15,750* 47,250 Preliminary judgment about materiality $50,000 *estimate for sampling error is 50%

Step 4 in Applying Materiality Estimate the combined misstatement. Tolerable Direct Sampling Account Misstatement Projection Error Total Cash $ 4,000 $ 0 $ N/A $ 0 Accounts receivable 20,000 12,000 6,000* 18,000 Inventory 36,000 31,500 15,750* 47,250 Total estimated misstatement amount $43,500 $16,800 $60,300 Preliminary judgment about materiality $50,000 *estimate for sampling error is 50%

Step 5 in Applying Materiality Compare combined estimate with preliminary or revised judgment about materiality. Tolerable Direct Sampling Account Misstatement Projection Error Total Cash $ 4,000 $ 0 $ N/A $ 0 Accounts receivable 20,000 12,000 6,000* 18,000 Inventory 36,000 31,500 15,750* 47,250 Total estimated misstatement amount $43,500 $16,800 $60,300 Preliminary judgment about materiality $50,000 *estimate for sampling error is 50% Because the estimated combined misstatement exceeds the preliminary judgment, the financial statements are not acceptable. The auditor may perform additional audit procedures to reevaluate the estimate, or require adjustment for the estimated misstatements.

II. Risk in Auditing Components of Audit Risk Acceptable Audit Risk Inherent Risk Control Risk Planned Detection Risk

A. Components of Audit Risk Susceptibility of an assertion to material misstatement assuming no related internal controls. Inherent Risk (IR) Total misstatement - Caught by internal controls Risk of misstatements not being detected by system of internal control. Control Risk (CR) - Caught by auditor Detection Risk (DR) Risk of misstatements not being detected by the auditor. = Undetected misstatement Audit Risk (AR) Misstatement that remains undetected by the auditor.

B. Acceptable Audit Risk The following factors mean that audit risk should be kept lower: Reliance by External Users Likelihood of Financial Failure Integrity of Management

1. Reliance by External Users When external users place heavy emphasis on the financial statements, acceptable audit risk should be kept low. The following generally results in more users of the financial statements: Larger clients Publicly held corporations Extensive use of liabilities XYZ Co. Financial Statements

2. Likelihood of Financial Failure There is a greater chance of having to defend the quality of the audit when there is a financial failure. Failure indicators include: Shortage of funds Declining net income or continued losses Risky industries such as technology Management lacking competency to deal with financial difficulties

3. Integrity of Management If a client has questionable integrity, the auditor is likely to assess acceptable audit risk lower. Indications of integrity problems include: Frequent disagreements with prior auditors, the IRS, and/or SEC Frequent turnover of key financial and internal audit personnel Ongoing conflicts with labor unions and employees

C. Inherent Risk Nature of the Client’s Business Results of Previous Audits Initial vs. Repeat Engagement Related Parties Nonroutine Transactions Judgment Required Make-up of the Population

1. Nature of the Client’s Business Ricky’s Electronics Inherent risk is likely to vary from business to business for accounts such as inventory, accounts and loans receivable, and property, plant, and equipment. The nature of the business should have little effect on cash, notes payable, and mortgages payable.

2. Results of Previous Audits Misstatements found in the previous year’s audit have a high likelihood of occurring again. Many types of misstatements are systematic in nature, and organizations are slow in making changes to eliminate them.

3. Initial vs. Repeat Engagement Most auditors use a larger inherent risk for initial audits than for repeat engagements in which no material misstatements had been found.

4. Related Parties Examples of related party transactions are those between parent and subsidiary companies, and management or owners and the company. Increases inherent risk because there is a greater likelihood of misstatement.

5. Nonroutine Transactions Transactions that are unusual for the client are more likely to be recorded incorrectly. Examples include fire losses, major property acquisitions, etc.

Uncollectible accounts receivable 6. Judgment Needed Many account balances require estimates and a great deal of management judgment including: Uncollectible accounts receivable Obsolete inventory Warranty liabilities

7. Make-up of the Population Accounts receivable where most accounts are significantly overdue Transactions with related parties Disbursements made payable to cash Inventory with a slow turnover

There are two basic phases to an auditor’s evaluation of control risk: D. Control Risk There are two basic phases to an auditor’s evaluation of control risk: Obtain an understanding of internal control. This phase applies to all audits. Test the internal controls for effectiveness. This phase only applies when the auditor chooses to assess control risk at below the maximum.

E. Planned Detection Risk The auditor can reduce planned detection risk by performing more substantive testing. Lowering Acceptable Audit Risk Increased audit evidence Lower Detection Risk

III. Planning Model Relationships Acceptable Audit Risk Relationships Inherent Risk Relationships Control Risk Relationships The Overall Relationship of Components in Planning the Audit Process The Audit Risk Model for Planning

A. Acceptable Audit Risk Relationships Planned detection risk audit evidence Inverse Direct Acceptable audit risk is the risk that the auditor is willing to take of giving an unqualified opinion when the financial statements are materially misstated. As acceptable audit risk increases, the auditor is willing to collect less evidence (inverse) and therefore accept a higher detection risk (direct).

B. Inherent Risk Relationships Planned detection risk audit evidence I D Inherent risk is the susceptibility of an assertion to material misstatement assuming no related internal controls. As inherent risk increases, the auditor must reduce detection risk (inverse) by collecting more audit evidence (direct).

C. Control Risk Relationships Planned detection risk Planned audit evidence I D Control risk Control risk is the risk of misstatements not being detected by the client’s system of internal control. As control risk increases, the auditor must reduce detection risk (inverse) by collecting more audit evidence (direct).

D = Direct relationship; I = Inverse relationship D. The Overall Relationship of Components in Planning the Audit Process Acceptable audit risk D D I Inherent risk Planned detection risk I Planned audit evidence I I D I Control risk Tolerable misstatement D = Direct relationship; I = Inverse relationship

E. The Audit Risk Model for Planning PDR = AAR ÷ (IR × CR) Where PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk

IV. Evaluating Results Audit Risk Model for Evaluating Results Reducing Achieved Audit Risk Revising Risks and Evidence

A. Audit Risk Model for Evaluating Results AcAR = IR × CR × AcDR Where AcAR = Achieved audit risk AcDR = Achieved detection risk IR = Inherent risk CR = Control risk

B. Reducing Achieved Audit Risk The audit risk model for evaluating results is stated in SAS 47. Research subsequent to the issuance of SAS 47 has shown that it is not appropriate to uses this evaluation formula as originally intended. However, the model does show three possible ways to reduce achieved audit risk to an acceptable level. Reduce inherent risk – not feasible unless new facts are uncovered during the audit process. Reduce control risk – may be possible to reevaluate control risk to a lower level by conducting more tests of internal controls. Reduce achieved detection risk – can be achieved by larger sample sizes and/or additional audit procedures.

C. Revising Risks and Evidence Great care must be used when revising the risk factors when the actual results are not as favorable as planned. When the auditor concludes that the original assessment of control risk or inherent risk was understated or acceptable audit risk was overstated, a two step approach should be used: 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. Research shows that using the model in the evaluation stage often results in an insufficient increase of evidence.

Risk and Audit Planning Summary Audit Process Applying Materiality Risk and Audit Planning Evaluating Results Risk Internal Control