8 - 1 Copyright 2003 Pearson Education Canada Inc. CHAPTER 8 Materiality and Risk
8 - 2 Copyright 2003 Pearson Education Canada Inc. Steps in audit planning obtain information about client’s legal obligations obtain background informat ion perform preliminary analytical procedures preplan set materiality, and assess acceptable audit risk and inherent risk
8 - 3 Copyright 2003 Pearson Education Canada Inc. Scope paragraph: We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement... The phrase “reasonable assurance” in the audit report indicates that there is some audit risk.
8 - 4 Copyright 2003 Pearson Education Canada Inc. Scope paragraph: We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement... Note the reference to materiality in the audit report.
8 - 5 Copyright 2003 Pearson Education Canada Inc. What is materiality? Note the reference to materiality in the audit report.
8 - 6 Copyright 2003 Pearson Education Canada Inc. Materiality is the magnitude of omitted or misstated information that,in the light of surrounding circumstances, would change or influence the decision of someone relying on the financial statements who has a reasonable knowledge of business and economic activities. What is materiality?
8 - 7 Copyright 2003 Pearson Education Canada Inc. For each engagement, auditors typically establish a preliminary judgment about materiality. ?
8 - 8 Copyright 2003 Pearson Education Canada Inc. For each engagement, auditors typically establish a preliminary judgment about materiality. The preliminary judgment about materiality is the maximum amount by which the auditor be- lieves the statements could be misstated and still not affect the decisions of reasonable users.
8 - 9 Copyright 2003 Pearson Education Canada Inc. For each engagement, auditors typically establish a preliminary judgment about materiality. - may be based on a firm-wide formula considering net income, gross profit, total assets, revenue, shareholders’ equity, e.g., 5% of net income adjusted according to auditor judgment
Copyright 2003 Pearson Education Canada Inc. How does the preliminary judgment about materiality affect the volume of audit evidence?
Copyright 2003 Pearson Education Canada Inc. A small materiality estimate will result in more evidence. “Investigate misstate- ments over $100.” How does the preliminary judgment about materiality affect the volume of audit evidence?
Copyright 2003 Pearson Education Canada Inc. A small materiality estimate will result in more evidence. A large materiality estimate will result in less evidence. How does the preliminary judgment about materiality affect the volume of audit evidence? “Investigate mis- statements over $100.” “Investigate misstate- ments over $10,000.”
Copyright 2003 Pearson Education Canada Inc. - materiality is strongly influenced by client size $1,000 - WOW! $1, peanuts Factors affecting the preliminary judgment about materiality
Copyright 2003 Pearson Education Canada Inc. - materiality is strongly influenced by client size - multiple bases of materiality may be appropriate FOR EXAMPLE: The auditor may be concerned that: net income is not misstated by $100,000, and total assets is not misstated by $300,000. Factors affecting the preliminary judgment about materiality
Copyright 2003 Pearson Education Canada Inc. - materiality is strongly influenced by client size - multiple bases of materiality may be appropriate - a fraud, illegal act or other irregularity is considered more ma terial than an error of the same dollar amount. WHY? WHY? Factors affecting the preliminary judgment about materiality
Copyright 2003 Pearson Education Canada Inc. - materiality is strongly influenced by client size - multiple bases of materiality may be appropriate - a fraud, illegal act or other rregularity is considered more material than an error of the same dollar amount. - small differences from contractual requirements may be material (e.g., ratios related to debt agreements) Factors affecting the preliminary judgment about materiality
Copyright 2003 Pearson Education Canada Inc. - multiple bases of materiality may be appropriate - a fraud, illegal act or other irregularity is considered more material than an error of the same dollar amount. - small differences from contractual requirements may be material (e.g., ratios related to debt agreements) - immaterial amounts may accumulate into a material amount Factors affecting the preliminary judgment about materiality
Copyright 2003 Pearson Education Canada Inc. Steps in audit planning obtain information about client’s legal obligations obtain background information perform preliminary analytical procedures preplan What is acceptable audit risk? set materiality, and assess acceptable audit risk and inherent risk
Copyright 2003 Pearson Education Canada Inc. What is acceptable audit risk? Acceptable audit risk is the risk that the auditor is willing to accept that an unqualified opinion will be issued for statements that are materially misstated. set materiality, and assess acceptable audit risk and inherent risk
Copyright 2003 Pearson Education Canada Inc. the lower the acceptable audit risk 2%
Copyright 2003 Pearson Education Canada Inc. the greater the certainty the auditor wants to achieve 98% the lower the acceptable audit risk 2%
Copyright 2003 Pearson Education Canada Inc. the greater the certainty the auditor wants to achieve 98% the greater the amount of audit evidence and costs the lower the acceptable audit risk 2%
Copyright 2003 Pearson Education Canada Inc. What is achieved audit risk?
Copyright 2003 Pearson Education Canada Inc. Achieved audit risk is the actual risk that the state- ments are materially mis- stated after an unqualified opinion has been issued. What is achieved audit risk?
Copyright 2003 Pearson Education Canada Inc. How do acceptable and achieved audit risk affect the audit report?
Copyright 2003 Pearson Education Canada Inc. How do acceptable and achieved audit risk affect the audit report? if achieved audit risk acceptable audit risk < audit report is supported by the evidence 5% 10%
Copyright 2003 Pearson Education Canada Inc. How do acceptable and achieved audit risk affect the audit report? audit report is not supported by the evidence if achieved audit risk acceptable audit risk > 15% 5%
Copyright 2003 Pearson Education Canada Inc. Risk is very difficult to quantify. subjective based on judgment
Copyright 2003 Pearson Education Canada Inc. How can an auditor reduce audit risk?
Copyright 2003 Pearson Education Canada Inc. How can an auditor reduce achieved audit risk? audit risk evidence and cost achieved risk acceptable risk sufficient, appropriate gather gather more more evidence evidence
Copyright 2003 Pearson Education Canada Inc. Auditors may face additional audit risk because of business risk; i.e., the risk of loss or injury to the auditor’s practice because of a client relationship (e.g., litigation, adverse publicity, etc.).
Copyright 2003 Pearson Education Canada Inc. Auditors may face additional audit risk because of business risk; i.e., the risk of loss or injury to the auditor’s practice because of a client relationship (e.g., litigation, adverse publicity, etc.). - degree to which users rely on the client’s financial statements Auditors should consider: Financial Statements Ace Company
Copyright 2003 Pearson Education Canada Inc. - degree to which users rely on the client’s financial statements - likelihood that the client will have financial difficulties after the report has been issued Auditors should consider: Auditors may face additional audit risk because of business risk; i.e., the risk of loss or injury to the auditor’s practice because of a client relationship (e.g., litigation, adverse publicity, etc.).
Copyright 2003 Pearson Education Canada Inc. - degree to which users rely on the client’s financial statements - likelihood that the client will have financial difficulties after the report has been issued - management integrity Auditors should consider: Auditors may face additional audit risk because of business risk; i.e., the risk of loss or injury to the auditor’s practice because of a client relationship (e.g., litigation, adverse publicity, etc.).
Copyright 2003 Pearson Education Canada Inc. Audit Risk has 3 components which combine to make the audit risk model: = xx audit risk inherent risk control risk detection risk
Copyright 2003 Pearson Education Canada Inc. Audit Risk has 3 components which combine to make the audit risk model: ? = xx audit risk inherent risk control risk detection risk
Copyright 2003 Pearson Education Canada Inc. Inherent Risk - defined as the risk that material mis- statements exist before considering the client’s internal controls
Copyright 2003 Pearson Education Canada Inc. Inherent Risk - defined as the risk that material mis- statements exist before considering the client’s internal controls - some accounts, components, cycles are inherently riskier than others
Copyright 2003 Pearson Education Canada Inc. Inherent Risk - defined as the risk that material mis- statements exist before considering the client’s internal controls - some accounts, components, cycles are inherently riskier than others auditors must: - identify inherently risky areas - gather appropriate evidence regarding those areas
Copyright 2003 Pearson Education Canada Inc. Inherent risk considerations - nature of client’s business EXAMPLE: Sally’s Clothing Boutique rents store space in a house. What are the inherently risky accounts? Sally’s
Copyright 2003 Pearson Education Canada Inc. Inherent risk considerations - nature of client’s business EXAMPLE: Sally’s Clothing Boutique rents store space in a house. What are the inherently risky accounts? cash inventory accounts payable Sally’s
Copyright 2003 Pearson Education Canada Inc. Inherent risk considerations - nature of client’s business EXAMPLE: Sally’s Clothing Boutique rents store space in a house. What are the inherently less risky accounts? Sally’s
Copyright 2003 Pearson Education Canada Inc. Inherent risk considerations - nature of client’s business EXAMPLE: Sally’s Clothing Boutique rents store space in a house. What are the inherently less risky accounts? capital assets equity Sally’s
Copyright 2003 Pearson Education Canada Inc. Inherent risk considerations - nature of client’s business - integrity of management poor integrity more evidence
Copyright 2003 Pearson Education Canada Inc. Inherent risk considerations - nature of client’s business - integrity of management - client motivation to misstate the finan- cial statements Are management bonuses based on net income?
Copyright 2003 Pearson Education Canada Inc. Inherent risk considerations - nature of client’s business - integrity of management - client motivation to misstate the finan- cial statements - results of previous audits - accounts, components which had material mis- statements in prior years should be tested extensively in the current year
Copyright 2003 Pearson Education Canada Inc. Inherent risk considerations - nature of client’s business - integrity of management - client motivation to misstate the finan- cial statements - results of previous audits - initial vs. repeat engagements Why are initial audit engagements inherently riskier than repeats?
Copyright 2003 Pearson Education Canada Inc. Why are initial audit engagements inherently riskier than repeats? - during the initial engagement, the auditor is not familiar with client systems, internal controls, and personnel
Copyright 2003 Pearson Education Canada Inc. Why are initial audit engagements inherently riskier than repeats? - during the initial engagement, the auditor is not familiar with client systems, internal controls, and personnel - during the initial engagement, be- ginning balances must be exten- sively examined
Copyright 2003 Pearson Education Canada Inc. Inherent risk considerations - nature of client’s business - integrity of management - client motivation to misstate the finan- cial statements - results of previous audits - initial vs. repeat engagements - related parties
Copyright 2003 Pearson Education Canada Inc. Inherent risk considerations - nature of client’s business - integrity of management - client motivation to misstate the finan- cial statements - results of previous audits - initial vs. repeat engagements - related parties - non-routine transactions Has GAAP been correctly applied?
Copyright 2003 Pearson Education Canada Inc. Inherent risk considerations - related parties - nonroutine transactions - judgment required to correctly record transactions What do you mean by “obsolete” inventory?
Copyright 2003 Pearson Education Canada Inc. Inherent risk considerations - related parties - nonroutine transactions - judgment required to correctly record transactions - susceptibility to defalcation Example: CASH
Copyright 2003 Pearson Education Canada Inc. average age of a/p, 45 days Which is riskier? average age of a/p, 15 days Inherent risk considerations - judgment required to correctly record transactions - susceptibility to defalcation - makeup of the population
Copyright 2003 Pearson Education Canada Inc. Audit Risk has 3 components which combine to make the audit risk model: ? = xx audit risk inherent risk control risk detection risk
Copyright 2003 Pearson Education Canada Inc. Audit Risk has 3 components which combine to make the audit risk model: the risk that material misstatements will not be prevented or detected by internal controls = xx audit risk inherent risk control risk detection risk
Copyright 2003 Pearson Education Canada Inc. Audit Risk has 3 components which combine to make the audit risk model: ? = xx audit risk inherent risk control risk detection risk
Copyright 2003 Pearson Education Canada Inc. Audit Risk has 3 components which combine to make the audit risk model: Detection risk is the risk that material misstate- ments will not be detected by the auditor. = xx audit risk inherent risk control risk detection risk
Copyright 2003 Pearson Education Canada Inc. Why does detection risk exist?
Copyright 2003 Pearson Education Canada Inc. $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $$ Why does detection risk exist? - the auditor samples (sampling risk)
Copyright 2003 Pearson Education Canada Inc. Why does detection risk exist? - the auditor samples (sampling risk) - the auditor may select ineffective audit procedures
Copyright 2003 Pearson Education Canada Inc. Why does detection risk exist? - the auditor samples (sampling risk) - the auditor may select ineffective audit procedures - the auditor may apply procedures ineffectively
Copyright 2003 Pearson Education Canada Inc. Why does detection risk exist? - the auditor samples (sampling risk) - the auditor may select ineffective audit procedures - the auditor may apply procedures ineffectively - the auditor may incorrectly evaluate the results of procedures
Copyright 2003 Pearson Education Canada Inc. Why does detection risk exist? The last 3 reasons are nonsam- pling errors. The risk of their oc- currence is non-sampling risk. - the auditor samples (sampling risk) - the auditor may select ineffective audit procedures - the auditor may apply procedures ineffectively - the auditor may incorrectly evaluate the results of procedures
Copyright 2003 Pearson Education Canada Inc. Which of these components can the auditor influence? Audit Risk has 3 components which combine to make the audit risk model: = xx audit risk inherent risk control risk detection risk
Copyright 2003 Pearson Education Canada Inc. Which of these Which of these components can the auditor the auditor influence? influence? Audit Risk has 3 components which combine to make the audit risk model: indirectly: influence manage- ment directly - larger sample size - enhanced training = xx audit risk inherent risk control risk detection risk
Copyright 2003 Pearson Education Canada Inc. auditing procedures internal controls Audit risk as a double-hoop basketball game
Copyright 2003 Pearson Education Canada Inc. auditing procedures misstatements (inherently risky accounts are better shots) internal controls Audit risk as a double-hoop basketball game
Copyright 2003 Pearson Education Canada Inc. auditing procedures misstatements detected by internal controls internal controls Audit risk as a double-hoop basketball game
Copyright 2003 Pearson Education Canada Inc. auditing procedures misstatements not detected by internal controls (control risk) internal controls Audit risk as a double-hoop basketball game
Copyright 2003 Pearson Education Canada Inc. auditing procedures misstatements detected by auditors internal controls Audit risk as a double-hoop basketball game
Copyright 2003 Pearson Education Canada Inc. auditing procedures internal controls Audit risk as a double-hoop basketball game misstatements undetected by auditors (detection risk)