2. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 1 Materiality and Risk Chapter 9

3. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 2 Learning Objective 1 Apply the concept of materiality to the audit.

4. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 3 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.

5. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 4 Steps in Applying Materiality Step1 Set preliminary judgment about materiality. Planningextent of tests Step2 Allocate preliminary judgment about materiality to segments.

6. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 5 Steps in Applying Materiality Evaluatingresults Step3 Estimate total misstatement in segment. Step4 Estimate the combined misstatement. Compare combined estimate with judgment about materiality. Step5

7. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 6 Learning Objective 2 Make a preliminary judgment about what amounts to consider material.

8. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 7 Set Preliminary Judgment This preliminary judgment is the maximum amount by which the auditor believes the statements could be misstated and still not affect the decisions of reasonable users. Ideally, auditors decide early in the audit the combined amount of misstatements of the financial statements that would be considered material.

9. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 8 Factors Affecting Judgment Materiality is a relative rather than an absolute concept. Bases are needed for evaluating materiality. Qualitative factors also affect materiality.

10. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 9 Learning Objective 3 Allocate preliminary materiality to segments of the audit during planning.

11. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 10 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. Most practitioners allocate materiality to balance sheet accounts. SAS 39 (AU 350)

12. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 11 Learning Objective 4 Use materiality to evaluate audit findings.

13. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 12 Estimated Total Misstatement and Preliminary Judgment Cash Accounts receivable Inventory Total estimated misstatement amount misstatement amount Preliminary judgment about materiality about materiality $ 4,000 20,000 20,000 36,000 36,000$50,000 $ 0 12,000 12,000 31,500 31,500$43,500 $ N/A 6,000 6,000 15,750 15,750$16,800 $ 0 18,000 18,000 47,250 47,250$60,300 TolerablemisstatementDirectprojectionSampling error* TotalAccount Estimated misstatement amount *estimate for sampling error is 50%

14. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 13 Estimated Total Misstatement and Preliminary Judgment Net misstatements in the sample $3,500 ÷ $50,000 × $450,000 = $31,500 Total recorded population value × Total sampled ÷ Direct projection estimate of misstatement =

15. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 14 Learning Objective 5 Define risk in auditing.

16. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 15 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. Responding to risks properly is critical to achieving a high-quality audit.

17. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 16 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.

18. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 17 Example of Differing Evidence Among Cycles Sales and collectioncycleAcquisition and payment cycle Payroll and personnelcycleInherentriskAmediumhighlow ControlriskBmediumlowlow Acceptable audit risk Clowlowlow Planned detection risk Dmediummediumhigh

19. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 18 Example of Differing Evidence Among Cycles Inventory and warehousingcycle Capital acquisition and repayment cycle InherentriskAhighlow ControlriskBhighmedium Acceptable audit risk Clowlow Planned detection risk Dlowmedium

20. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 19 Learning Objective 6 Describe the audit risk model and its components.

21. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 20 Audit Risk Model for Planning PDR = AAR ÷ (IR × CR) PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk

22. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 21 Learning Objective 7 Consider the impact of engagement risk on acceptable audit risk.

23. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 22 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.

24. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 23 Factors Affecting Acceptable Audit Risk The degree to which external users rely on the statements 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

25. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 24 Factors Affecting Acceptable Audit Risk The auditor’s evaluation of management’s integrity

26. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 25 Making the Acceptable Audit Risk Decision Methods used to assess acceptable audit risk External users reliance on financialstatements Examine financial statements. Examine financial statements. Read minutes of the board. Read minutes of the board. Examine form 10K. Examine form 10K. Discuss financing plans Discuss financing plans with management. with management.Factors

27. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 26 Making the Acceptable Audit Risk Decision Likelihood of financial difficulties Analyze financial statements for difficulties using ratios. Analyze financial statements for difficulties using ratios. Examine inflows and outflows of cash flow statements. Examine inflows and outflows of cash flow statements. Managementintegrity See Chapter 8 for client acceptance and continuance. See Chapter 8 for client acceptance and continuance. Methods used to assess acceptable audit risk Factors

28. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 27 Learning Objective 8 Consider the impact of several factors on the assessment of inherent risk.

29. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 28 Major Factors When Assessing Inherent Risk Nature of the client’s business Nature of the client’s business Results of previous audits Results of previous audits Initial versus repeat engagement Initial versus repeat engagement Related parties Related parties Nonroutine transactions Nonroutine transactions Judgment – correctly record account Judgment – correctly record account balances and transactions Makeup of the population Makeup of the population

30. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 29 Learning Objective 9 Discuss the relationship of risks to audit evidence.

31. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 30 Relationship of Risk Factors, Risk, and Evidence Factorsinfluencingrisks Acceptable audit risk PlanneddetectionriskPlannedauditevidenceInherentrisk Control risk I D I ID I D D = Direct relationship; I = Inverse relationship

32. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 31 Changing the Audit in Response to Risk The engagement may require more experienced staff. The engagement will be reviewed more carefully than usual.

33. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 32 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.

34. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 33 Relating Risk of Fraud to Risk Model Components The risk of fraud can be assessed for the entire audit or by cycle, account, and objective. Specific response could include revising assessments of acceptable audit risk, inherent risk, and control risk.

35. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 34 Tolerable Misstatement, Risks, and Balance-related 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.

36. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 35 Measurement Limitations One major limitation in the application of the audit risk model is the difficulty of measuring the components of the model.

37. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 36 Relationships of Risk to Evidence Acceptable audit risk InherentriskControlriskPlanneddetectionrisk Amount of evidencerequiredSituationHighLowLowMediumHighLowLowHighMediumLowLowLowHighMediumMediumHighMediumLowMediumMediumLowMediumHighMediumMedium12345

38. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 37 Tests of Details of Balances Evidence Planning Worksheet 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.

39. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 38 Learning Objective 10 Discuss how materiality and risk are related and integrated into the audit process.

40. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 39 Tolerable Misstatements, Risk, and Planned Evidence Acceptable audit risk Inherentrisk Controlrisk Tolerablemisstatement Planned detection risk Planned audit evidence D = Direct relationship; I = Inverse relationship I D I II I D D

41. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 40 Audit Risk Model for Evaluating Results AcAR = IR × CR × AcDR AcAR = Achieved audit risk AcAR = Achieved audit risk IR = Inherent risk CR = Control risk AcDR = Achieved detection risk

42. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 41 Revising Risks and Evidence The audit risk model is primarily a planning model and is therefore of limited use in evaluating results. Great care must be used in revising the risk factors when the actual results are not as favorable as planned.

43. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 9 - 42 End of Chapter 9