1. 4-1 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4 Materiality and Risk

2. 4-2 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Audit Planning Tools Preliminary materiality decisions Preliminary risk assessment Audit programs

3. 4-3 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Materiality Materiality refers to an amount (or transaction) that would influence the decisions of users with respect to the client's financial statements, i.e., an amount (or event) that would make a difference.

4. 4-4 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Materiality Judgment Criteria Absolute size Relative size Nature of the item or issue Circumstances Uncertainty Cumulative Effects

5. 4-5 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. AUDIT RISK MODEL (ARM) The AUDIT RISK MODEL decomposes overall audit risk (AR) into three components: inherent risk (IR), control risk (CR), and detection risk (DR). AR = IR x CR x DR

6. 4-6 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Audit Risk Model AR = risk that the auditor may unknowingly fail to modify the opinion on financial statements that are materially misstated. IR = likelihood that, in the absence of internal controls, a material misstatement could occur. CR = likelihood that a material misstatement would not be caught by internal controls. DR = risk that a material misstatement would not be caught by audit procedures.

7. 4-7 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Inherent Risk: General Categories and Examples of Errors and Frauds (Exhibit 4-2) Invalid transactions are recorded: Fictitious sales are recorded and charged to nonexistent customers. Valid transactions are omitted from the accounts: Shipments to customers never get recorded. Unauthorized transactions are executed and recorded: A customer’s order is not approved for credit, yet the goods are shipped, billed, and charged to the customer without requiring payment in advance. Transaction amounts are inaccurate: A customer is billed and the sale is recorded in the wrong amount because the quantity shipped and the quantity billed is not the same and the unit price is for a different product. Transactions are classified in the wrong accounts: Sales to a subsidiary company are recorded as sales to outsiders instead of intercompany sales, or the amount is charged to the wrong customer account receivable record. Transaction accounting and posting is incorrect: Sales are posted in total to the accounts receivable control account, but some are not posted to individual customer account records. Transactions are recorded in the wrong period: Shipments made in January (next year) are backdated and recorded as sales and charges to customers in December. Shipments in December are recorded as sales and charges to customers in January.

8. 4-8 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Factors Affecting Inherent Risk Dollar size of the account Liquidity Volume of transactions Complexity of the transactions Subjectivity of estimates

9. 4-9 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Factors Affecting Control Risk Control environment Existence and effectiveness of control activities Monitoring

10. 4-10 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Factors Affecting Detection Risk Nature, timing, and extent of audit procedures Sampling risk –Risk of choosing an unrepresentative sample Nonsampling risk –Risk that the auditor may reach inappropriate conclusions based upon available evidence.

11. 4-11 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Audit Program List of audit procedures to be performed Based upon output of Audit Risk Model

12. 4-12 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. GENERAL APPROACHES TO GATHERING EVIDENCE Test of Transactions –Few number of transactions –High dollar value Test of Balances –Large number of transactions –Relatively smaller dollar value –Auditor must be able to rely on internal controls.

13. 4-13 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. General Audit Procedures Recalculation Physical observation Confirmation Verbal Inquiry Examination of documents –Vouching –Tracing Scanning Analytical Procedures

14. 4-14 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Auditing with Computers Automated Workpaper Software Spreadsheet Software Text Retrieval Software Public Databases Word Processing Software Computer Assisted Audit Tools and Techniques (CAATTs)

15. 4-15 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Automated Workpaper Software: Uses Budget/time and expense analysis Trial balance generation Lead schedule generation Supporting detail schedules Adjusting entries Sampling calculations Confirmation control Consolidation Financial statement preparation Tax return preparation

16. 4-16 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Automated Workpaper Software: Benefits Ease of use Enhanced engagement planning, administration, and review Improved workpaper consistency Improved staff productivity

17. 4-17 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Spreadsheet Applications: Uses Analytic procedures Mathematical procedures Macros Templates Linked spreadsheets Data import/export Graphs Database capabilities Workpaper automation Financial statement automation Engagement administration

18. 4-18 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Spreadsheet Software Advantages Ease of use Inexpensive Flexible Standard templates can be developed Disadvantages Training Development takes time Computer memory limitations

19. 4-19 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Text Retrieval Software Advantages Easy to search large volumes of information Large volume of information is available Minimal training necessary Disadvantages Prohibitive start-up costs Not all information is available in electronic format Some text files may require modification for ease of use

20. 4-20 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Public Databases Public databases are sources of information available to the auditor via telephone link to the auditor’s computer. Examples: –LEXUS/NEXUS –EDGAREDGAR –Firm bulletin boards (Intranets)

21. 4-21 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Word Processing Software: Uses Consideration of the client’s internal controls –Documenting understanding –Internal control questionnaires Developing audit programsDeveloping audit programs Reporting

22. 4-22 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Word Processing Applications Advantages Error correction Reusable manuscripts Mail merge Flexibility to import graphs and spreadsheets Disadvantages Training costs

23. 4-23 McGraw-Hill/Irwin ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. Computer Assisted Audit Tools and Techniques (CAATTs) CAATTs - the use of software to perform audit procedures With CAATTS, the auditor is able to access and extract client information without disrupting data processing Some CAATTs Procedures –Calculate field statistics (totals, high, low and average value) –Performing complex recalculations –Join, concantenate and compare different files –Perform detailed analysis Stratification Gap and duplicate key detection Sample selection