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1. 3-1
Chapter 3
Risk Assessment
and Materiality
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin

2. 3-2
Audit Risk
The risk that an auditor will issue an
unqualified opinion on materially
misstated financial statements.
Financial statement
level
Individual account
balance or class
of transactions level
LO# 1

3. 3-3
Engagement Risk
An auditor’s exposure
to financial loss and
damage to
professional reputation.
Client and third
party lawsuits
Negative
publicity
LO# 1
Local audit
failure …

4. 3-4
The Audit Risk Model
Audit Risk = IR × CR × DR
Inherent risk and control risk:
Risk that material misstatements exist
Nonsampling
risk
Sampling
risk
Detection risk:
Risk that auditor will not detect misstatements
• Inappropriate audit procedure
• Fail to detect when using
appropriate audit procedure
• Misinterpreting audit results
LO# 2

5. 3-5
Using the Audit Risk Model
 Set a planned level of audit risk such that an opinion
can be issued on the financial statements.
 Assess inherent risk and control risk.
 Use the audit risk equation to solve for the appropriate
level of detection risk:
AR = IR × CR × DR
DR =
AR
IR × CR
Auditors use this level of detection risk to design audit
procedures that will reduce audit risk to an acceptable level.
LO# 3

6. 3-6
Limitations of the
Audit Risk Model
Preliminary
Assessment
Level of Risk
Actual
or Achieved
Level of Risk
LO# 4
+ / –
The audit risk model is a planning tool, but it has some limitations
that must be considered when the model is used to revise an audit
plan or to evaluate audit results.
• The desired level of audit risk may not actually be achieved.
• It does not consider potential auditor error.
• There is not way of knowing what the preliminary level of risk
actually was.

7. 3-7
The Auditor’s Risk Assessment Process
Figure 3-2 An Overview of the Auditor’s Assessment of Business Risks and Risk of Material
Misstatements
LO# 5

8. 3-8
Errors are unintentional misstatements:
 Mistakes in gathering or processing financial data used
to prepare financial statements.
 Unreasonable accounting estimates arising from
oversight or misinterpretation of facts.
 Mistakes in the application of accounting principles
relating to amount, classification, manner of
presentation, or disclosure.
LO# 6
Assessing the Risk of Material
Misstatement Due to Error or Fraud

9. 3-9
Fraud involves intentional
misstatements. The fraud risk
identification process includes:
 Sources of information about possible
fraud
 Communications among the audit team
 Inquires of management and others
 Fraud risk factors
 Analytical procedures
 Other information
LO# 6
Assessing the Risk of Material
Misstatement Due to Error or Fraud

10. 3-10
Three conditions usually
exist when fraud occurs.
Incentive or
pressure to
perpetrate fraud
Opportunity
to carry out
the fraud
Attitude or
rationalization
to justify fraud
LO# 6
Assessing the Risk of Material Misstatement
Due to Error or Fraud
(Fraud Triangle)

11. 3-11
Auditor’s Response to
the Risk Assessment (See Figure 3-3)
Financial statement level risks
Develop an overall
response.
Determine what can go wrong
at the account or assertion level.
LO# 7
Assess the risk of material misstatement at the financial statement and assertion levels.
Do
these
risks relate
pervasively
to the
financial
statements?
Design audit
procedures for
assertion level risks.
Assertion level risks
Yes
No

12. 3-12
Evaluation of Audit
Test Results
At the completion of the audit, the auditor should consider:
 1. whether the accumulated results of audit procedures affect the
assessments of the entity’s business risk and the risk of material
misstatement, and
 2. whether the total misstatements cause the financial statements to be
materially misstated.
THEN…
 If the financial statements are materially misstated, the auditor should
 1. request management to eliminate the material misstatement, or
 2. if management does not make needed adjustments, the auditor should
issue a qualified or adverse opinion.
LO# 8

13. 3-13
Documentation of the
Auditor’s Risk Assessment
The auditor should document:
 Discussions among engagement personnel.
 Procedures performed to identify and assess the risks
of material misstatement due to fraud.
 Risks of identified material misstatement due to fraud
and a description of the auditor’s response to the risks.
 Fraud risks or other conditions that result in additional
audit procedures.
 The nature of the communications about fraud made to
management, the audit committee, and others.
LO# 9

14. 3-14
Communications about Fraud
Whenever the auditor has found evidence that a fraud may exist,
that matter should be brought to the attention of an appropriate
level of management. Fraud involving senior management and
fraud that causes a material misstatement of the financial
statement should be reported directly to the audit committee of the
board of directors.
The auditor should reach an understanding with the audit
committee regarding the expected nature and extent of
communications about misappropriations perpetrated by lower-
level employees.
LO# 10

15. 3-15
Materiality
The magnitude of an omission or misstatement of
accounting information that makes it probable that
the judgment of a reasonable person relying on
the information would be changed or influenced
by the omission or misstatement.
Materiality is not an absolute and
it is not a black or white issue!
The determination of materiality
requires professional judgment.
LO# 11

16. 3-16
Steps in Applying Materiality
on an Audit
Step 1:
Determine a materiality level for the overall financial statements
(planning materiality)
Step 2:
Determine tolerable misstatement
(allocation of materiality at individual account/class of transactions level)
Step 3:
Evaluate auditing findings
(near the end of the audit)
LO# 12

17. 3-17
End of Chapter 3
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin