Considering Materiality and Audit Risk Chapter 9 Considering Materiality and Audit Risk 1

Learning Objectives Apply the concept of materiality to the audit. Make a preliminary judgment about what amounts to consider material. Determine performance materiality during planning. Use materiality to evaluate audit findings. Define risk in auditing.

Learning Objectives Describe the audit risk model and its components. Consider the impact of engagement risk on acceptable audit risk. Consider the impact of several factors on the assessment of inherent risk. Discuss the relationship of risks to audit evidence. Discuss how materiality and risk are related and integrated into the audit process.

Apply the concept of materiality to the audit.

Materiality Major consideration in determining the appropriate audit report Referenced in auditor’s responsibility section of the audit report What is meant by the term “material”? Audit report reference is “free of material misstatement” FASB Concept Statement 2 defines Materiality as: The magnitude of an omission or misstatement of accounting information that in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.

Materiality Auditor’s responsibility = determine whether financial statements are materially misstated. Auditor will bring material misstatements to the client’s attention so corrections can be made. Absent a client remedy of the material misstatement, the auditor will most likely issue a qualified or adverse report

Steps in Applying Materiality

Make a preliminary judgment about what amounts to consider material. 2 Make a preliminary judgment about what amounts to consider material.

Set Preliminary Judgment About Materiality Auditors set materiality thresholds early in the engagement. Thresholds represent the maximum amount that statements could be misstated and still not affect users’ decisions. This step is normally performed during the planning phase of the audit. The auditor must make a determination based on individual misstatements as well as the aggregate misstatement amount.

Factors Affecting Judgment Materiality is a relative rather than an absolute concept. Benchmarks are needed for evaluating materiality. Qualitative factors also affect materiality.

Qualitative Factors Considerations that may render material a quantitatively small misstatement include: Loan covenants Changing trend Management compensation The SEC Staff Accounting Bulletin #108 requires the auditor to consider both qualitative and quantitative factors in assessing materiality. Financial statement users Conceals an illegal act

Guidelines Accounting and auditing standards do not provide specific materiality guidelines. Professional judgment is used to set and apply materiality guidelines. Other factors that may influence the auditor’s materiality threshold include the control environment, entity level controls, the quality of information systems and the existence of an internal audit function.

Determine performance materiality during planning. 3 Determine performance materiality during planning.

Allocate Preliminary Judgment About Materiality to Segments Evidence is accumulated by segments rather than for the financial statements as a whole. Most practitioners allocate materiality to balance sheet accounts. While materiality may be allocated to balance sheet accounts, the auditor must be mindful of the impact on the income statement since most balance sheet account adjustments will also impact the income statement. In addition, the investment community is often more sensitive to a company’s earnings than the balance sheet.

Use materiality to evaluate audit findings. 4 Use materiality to evaluate audit findings.

Known and Likely Misstatements Auditor can determine the misstated amount in an account (“Known”) Two types of “Likely” misstatements: Judgmental differences Projections of misstatements from audit samples

Estimated Total Misstatement and Preliminary Judgment

Estimated Total Misstatement and Preliminary Judgment ($31,500) Net misstatements in Sample ($3,500) Total sampled ($50,000) = × Total recorded population value ($450,000)

Define risk in auditing. 5 Define risk in auditing.

Risk Auditors accept some level of risk in performing the audit. Risks exist, are difficult to measure, and require careful thought in response. Proper risk response is critical to achieving a high-quality audit.

Risk and Evidence Auditors need to understand the client’s business and assess business risk. The audit risk model helps identify the potential and likelihood of misstatements. The second standard of fieldwork requires auditors to gain an understanding of the client’s business and assess client business risk.

Audit Risk Model for Planning PDR = AAR ÷ (IR × CR) where: PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk PDR = Auditor fails to detect misstatements > the tolerable amount AAR = Auditor will incorrectly issue a “clean” opinion IR = Risk of material misstatements before considering internal controls CR = Internal controls fail to prevent or detect material misstatements

Audit Risk Model for Planning

Illustration of Differing Evidence Among Cycles Sales and collection cycle Acquisition and payment cycle Payroll and personnel cycle A Inherent risk High Low Medium B Control risk Medium Low Low C Acceptable audit risk Low Low Low D Planned detection risk Medium Medium High

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

Describe the audit risk model and its components. 6 Describe the audit risk model and its components.

Audit Risk Model Components Planned Detection Risk Inherent Risk Acceptable Audit Risk Control Risk Planned detection risk is the risk that audit evidence for a segment will fail to detect misstatements exceeding tolerable misstatement. Planned detection risk is dependent on the other three factors in the model. Inherent risk measures the auditor’s assessment of the likelihood that there are material misstatements due to error or fraud in a segment before considering the effectiveness of internal control. Control risk measures the auditor’s assessment of whether misstatements exceeding a tolerable amount in a segment will be prevented or detected on a timely basis by the client's internal controls. Acceptable audit risk 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.

Consider the impact of engagement risk on acceptable audit risk. 7 Consider the impact of engagement risk on acceptable audit risk.

Engagement Risk What is Engagement Risk? Often, a firm defines their image by their client base. Engagement Risk is the risk that the auditor or audit firm will suffer harm after the audit is finished. In other words, it is the risk of lawsuit or unfavorable publicity resulting from being associated with this client.

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.

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 This is where the auditor will place reliance on prior experience with this client and management’s attitude toward controls and governance, accounting standards and the audit relationship.

Methods Practitioners Use to Assess Acceptable Audit Risk

8 Consider the impact of several factors on the assessment of inherent risk.

Factors Affecting Inherent Risk Nature of Client’s Business Industry practices Non-routine transactions Makeup of the population Audit Experience Prior audit results Initial vs. repeat engagement Audit judgment required to correctly record balances and transactions Culture Related parties Factors related to fraudulent financial reporting Factors related to misappropriation of assets

Discuss the relationship of risks to audit evidence. 9 Discuss the relationship of risks to audit evidence.

Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence Acceptable audit risk I D D Inherent risk Factors influencing risks Planned detection risk Planned audit evidence I As control risks increase, the auditor will want to gather additional evidence to minimize the risk of failing to find a material misstatement. D Control risk

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

Audit Risk for Segments Both control risk and inherent risk are typically set for each cycle, each account, and often each audit objective, not for the overall audit.

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 Inherent risk factors will have varying degrees of impact on balance sheet accounts. For example, inventory has greater risks than fixed assets in a wholesale distribution company, yet the materiality threshold for both accounts will most likely be the same since a correction to either account will impact the income statement.

Risk and Evidence

Measurement Limitations One major limitation in the audit risk model is the difficulty of measuring the components of the model. Known Unknown Due to the judgmental nature of evaluating and assessing risk at the beginning of the engagement, the actual level of risk achieved at the end of the audit is never really known. Preliminary Assessed Level of Risk Actual level of risk achieved on the audit +/-

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.

10 Discuss how materiality and risk are related and integrated into the audit process.

Relationship of Tolerable Misstatement and Risks to Planned Evidence Acceptable audit risk D D I Planned detection risk I Planned audit evidence Inherent risk I I D I Control risk As the auditor perceives a greater risk that controls will not detect a material misstatement, the auditor’s risk tolerance for detecting material misstatements will decrease (tighten) to minimize the risk of error. Similarly if detection risk decreases, the auditor will need to gather more evidence to minimize the risk of failing to find a material misstatement. Performance materiality D = Direct relationship; I = Inverse relationship

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. Although the risk assessment is performed during the planning phase of the audit, the auditor needs to recognize changes in the client’s business that could impact (change) the preliminary risk rating.

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