4. 9 - 4
Presentation Outline
Concept of materiality
Preliminary judgment about materiality
Allocate preliminary materiality to segment
Materiality to evaluate audit findings
Risk in auditing
Audit risk model
5. 9 - 5
Presentation Outline
Impact of business risk on acceptable audit
risk
Impact of several factors on the assessment of
inherent risk
Risk for segment
Relationship between materiality and risk
6. 9 - 6
Materiality
The auditor’s
responsibility is to
determine whether
financial
statements are
materially
misstated.
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According to SA 320, Characteristics of
Materiality :
Misstatement including omissions
Individually or in aggregate
Influence the economic decision of users of
financial statement.
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The level of audit Materiality
Amounts
are
immaterial
Amounts
are
material
Amounts
are so
material
9. 9 - 9
Steps in Applying Materiality
Step
1
Set preliminary
judgment about
materiality.
Planning
extent
of tests
Step
2
Allocate preliminary
judgment about
materiality
to segments.
10. 9 - 10
Steps in Applying Materiality
Evaluating
results
Step
3
Estimate total
misstatement in segment.
Step
4
Estimate the
combined misstatement.
Compare combined
estimate with judgment
about materiality.
Step
5
11. 9 - 11
Set Preliminary Judgment
about Materiality
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.
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Factors Affecting Judgment
Materiality is a relative rather
than an absolute concept.
Benchmarks are needed for
evaluating materiality.
Qualitative factors also
affect materiality.
13. 9 - 13
Illustration of Tolerable Misstatement
Allocation for Current Assets
Tolerable
Account Misstatement
Cash $ 4,000
Accounts receivable 20,000
Inventory 36,000
Preliminary judgment
about materiality $50,000
14. 9 - 14
Allocate Preliminary
Judgement About Matriality
Misstatement:
Difference between the reported amount and the expected
amount
Types of misstatements:
1.Likely misstatement: Based on certain evidence
2.Known misstatements: Sure about the errors.
Example: If the auditor sends out 40 Account Receivable
confirmation letters, and 4 of them come back saying the
customer owes a different amount than the company has
recorded, the auditor knows there is a misstatements for
those 4 customer accounts and believes a larger error is
likely based on the sample
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Tolerabe Misstatement:
A monetary amount set by the auditor in respect of which the
auditor seeks to obtain an appropriate level of assurance that the
monetary amount set by the auditor is not exceeded by the actual
misstatement in the population. Or the amount that can not impact
the fair presentation of the entire financial statements
Example:If an auditor decides to allocate Tk 100,000 of a total
preliminary judgement about materiality of Tk 200,000 to Account
receivable ,tolerable misstatement for Account Receivable is Tk
100,000
Allocate Preliminary Judgement
About Matriality
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Estimate Misstatement and Compare with
Preliminary Judgement
Estimated Misstatement:Calculated based on
the actual audit tests.
For example:In auditing inventory the auditor
found Tk.3500 of net overstament amounts in a
sample of Tk.50000 of the total population
Tk 450000.
Estimated misstatement =( 3500 / 50000) * 450000
=31500
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Tolerable Direct Sampling
Account Misstatement Projection Error Total
Cash $ 4,000 $ 0 $ N/A $ 0
Accounts receivable 20,000 12,000 6,000* 18,000
Inventory 36,000 31,500 15,750* 47,250
Total estimated
misstatement amount $43,500 $16,800 $60,300
Preliminary judgment
about materiality $50,000
*estimate for sampling error is 50%
Estimate Misstatement and Compare
with Preliminary Judgement
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II. Risk in Auditing
A. Components of Audit Risk
B. Acceptable Audit Risk
C. Inherent Risk
D. Control Risk
E. Planned Detection Risk
Audit
Risk
19. A. Components of Audit Risk
Inherent Risk
(IR)
Control Risk
(CR)
Detection Risk
(DR)
Audit Risk
(AR)
Susceptibility of an assertion to
material misstatement assuming no
related internal controls.
Risk of misstatements not being
detected by system of internal
control.
Risk of misstatements not being
detected by the auditor.
Misstatement that remains
undetected by the auditor.
Caught by
internal
controls
Caught by
auditor
Undetected
misstatement
Total
misstatement
-
-
=
20. 9 - 20
Factors Affecting Acceptable
Audit Risk
1. Reliance by External Users
2. Likelihood of Financial Failure
3. Integrity of Management
Audit
Risk
The following factors mean that audit risk should be
kept lower:
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1. Reliance by External Users
When external users place
heavy emphasis on the
financial statements,
acceptable audit risk should
be kept low. The following
generally results in more
users of the financial
statements:
Larger clients
Publicly held corporations
Extensive use of liabilities
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2. Likelihood of Financial Failure
There is a greater chance of
having to defend the quality
of the audit when there is a
financial failure. Failure
indicators include:
Shortage of funds
Declining net income or
continued losses
Risky industries such as
technology
Management lacking
competency to deal with
financial difficulties
23. 9 - 23
3. Integrity of Management
If a client has questionable
integrity, the auditor is likely
to assess acceptable audit risk
lower. Indications of integrity
problems include:
Frequent disagreements with
prior auditors, the IRS,
and/or SEC
Frequent turnover of key
financial and internal audit
personnel
Ongoing conflicts with labor
unions and employees
24. 9 - 24
Factors Affecting Inherent Risk
Nature of the client’s business
Results of previous audits
Initial versus repeat engagement
Related parties
Nonroutine transactions
Judgment required to correctly record
account balances and transactions
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1. Nature of the Client’s
Business
Inherent risk is likely to vary
from business to business for
accounts such as inventory,
accounts and loans receivable,
and property, plant, and
equipment.
The nature of the business
should have little effect on cash,
notes payable, and mortgages
payable.
Ricky’s Electronics
26. 9 - 26
2. Results of Previous Audits
Misstatements found in
the previous year’s audit
have a high likelihood
of occurring again.
Many types of
misstatements are
systematic in nature,
and organizations are
slow in making changes
to eliminate them.
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3. Initial vs. Repeat Engagement
Most auditors use a larger
inherent risk for initial
audits than for repeat
engagements in which
no material
misstatements had been
found.
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4. Related Parties
Examples of related
party transactions are
those between parent
and subsidiary
companies, and
management or owners
and the company.
Increases inherent risk
because there is a
greater likelihood of
misstatement.
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5. Nonroutine Transactions
Transactions that are
unusual for the client
are more likely to be
recorded incorrectly.
Examples include fire
losses, major property
acquisitions, etc.
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6. Judgment Needed
Many account balances
require estimates and a
great deal of
management judgment
including:
Uncollectible accounts
receivable
Obsolete inventory
Warranty liabilities
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D. Control Risk
There are two basic phases to an auditor’s evaluation of
control risk:
1. Obtain an understanding of internal control. This
phase applies to all audits.
2. Test the internal controls for effectiveness. This
phase only applies when the auditor chooses to
assess control risk at below the maximum.
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E. Planned Detection Risk
The auditor can reduce planned detection risk by
performing more substantive testing.
Increased audit
evidence
Lower
Detection
Risk
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A. Acceptable Audit Risk Relationships
Acceptable audit risk is the risk that the auditor is
willing to take of giving an unqualified opinion when
the financial statements are materially misstated.
As acceptable audit risk increases, the auditor is
willing to collect less evidence (inverse) and
therefore accept a higher detection risk (direct).
Acceptable
audit risk
Planned
detection risk
Planned
audit evidence
InverseDirect
34. 9 - 34
B. Inherent Risk Relationships
Inherent risk is the susceptibility of an assertion to
material misstatement assuming no related internal
controls.
As inherent risk increases, the auditor must reduce
detection risk (inverse) by collecting more audit
evidence (direct).
Inherent
risk
Planned
detection risk
Planned
audit evidenceI
D
35. 9 - 35
C. Control Risk Relationships
Control risk is the risk of misstatements not being
detected by the client’s system of internal control.
As control risk increases, the auditor must reduce
detection risk (inverse) by collecting more audit
evidence (direct).
Control
risk
Planned
detection risk
Planned
audit evidence
I D
36. 9 - 36
E. The Audit Risk Model
for Planning
PDR = AAR ÷ (IR × CR)
PDR = Planned detection risk
AAR = Acceptable audit risk
IR = Inherent risk
CR = Control risk
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IV. Evaluating Results
A. Audit Risk Model for Evaluating Results
B. Reducing Achieved Audit Risk
C. Revising Risks and Evidence
38. 9 - 38
A. Audit Risk Model for
Evaluating Results
AcAR = IR × CR × AcDR
AcAR = Achieved audit risk
AcDR = Achieved detection risk
IR = Inherent risk
CR = Control risk
39. 9 - 39
B. Reducing Achieved Audit Risk
The audit risk model for evaluating results is stated in SAS 47.
Research subsequent to the issuance of SAS 47 has shown
that it is not appropriate to uses this evaluation formula as
originally intended. However, the model does show three
possible ways to reduce achieved audit risk to an acceptable
level.
Reduce inherent risk – not feasible unless new facts are uncovered
during the audit process.
Reduce control risk – may be possible to reevaluate control risk to
a lower level by conducting more tests of internal controls.
Reduce achieved detection risk – can be achieved by larger sample
sizes and/or additional audit procedures.
40. 9 - 40
Summary
Applying
Materiality
Risk and Audit
Planning
Evaluating
Results
Audit Process
Internal Control
Risk
