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

2. 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.

3. 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.

4. Apply the concept of materiality to the audit.

5. 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.

6. 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

7. Steps in Applying Materiality

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

9. 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.

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

11. 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

12. 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.

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

14. 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.

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

16. 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

17. Estimated Total Misstatement and Preliminary Judgment

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

19. Define risk in auditing.5
Define risk in auditing.

20. 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.

21. 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.

22. 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

23. Audit Risk Model for Planning

24. 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

25. 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

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

27. 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.

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

29. 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.

30. 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.

31. 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.

32. Methods Practitioners Use to Assess Acceptable Audit Risk

33. 8 Consider the impact of several factors on
the assessment of inherent risk.

34. 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

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

36. 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

37. 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

38. 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.

39. 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.

40. Risk and Evidence

41. 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
+/-

42. 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.

43. 10 Discuss how materiality and risk are related
and integrated into the audit process.

44. 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

45. 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.

46. Do you have any questions?

47. Copyright
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