arens audit c10e ch08

8/13/2019 Arens Audit C10e Ch08

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Copyright 2007 Pearson Education Canada

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Chapter 8: Materiality and

Risk


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8-2

Chapter 8 objectives

Consider how materiality is used to decideon the amount of fieldwork to be collected

List the different types of risks considered

during the audit process Identify the components of the audit risk

model

Explain how inherent risk is assessed Discuss how the audit risk model is used

during the conduct of the audit


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8-3

Materiality is in the eye of the

beholder An audit is expected to obtain reasonable

assurance that there is an absence of

material misstatement

A material error is defined in the context of

what a reasonable business user would

thinkwould it affect his/her decision?


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8-4

Steps in applying materiality during

the audit


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8-5

When you find a material

misstatement What would you do?

If you ask the client to correct the material

misstatement and they refuse, what are

your options?


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Copyright 2007 Pearson Education Canada8-7

Materiality is set early

The preliminary judgment aboutmateriality is set prior to the conduct of

detailed audit testing, during planning Helps in deciding the amount of evidence

to collect

If there are substantial changes to thefinancial statements, then materiality mayneed to be revised


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Copyright 2007 Pearson Education Canada8-8

What affects the materiality

decision? Materiality is relative rather than absolute

A base needs to be chosen

Qualitative factors are used (emphasizing

the importance of knowledge of business)

Firm guidelines or past practice


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Copyright 2007 Pearson Education Canada 8-9

Potential bases for materiality

Revenue

Net income before

taxes (NIBT)

also exclude EI

Total Assets

Shareholders

Equity


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Practice problem 8-16 (p. 238)

Lets take a look at a realistic set of

financial statements

How would you calculate the materiality

figure?

What base would you choose?


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What is risk?

Risks arise when a situation involvesuncertainty

Assessing risks includes assessingprobabilitieswhat is the risk of raintoday? What is the risk of a flood today?

Assessing risks is part of our daily liveswe constantly assess the likelihood ofevents when making decisions


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Risk in auditing

The auditor accepts some level of

uncertainty when performing an audit

There is always a small likelihood

remaining that the financial statements

may be in error

The audit risk model is used as part of astrategic auditing approach


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Strategic auditing

An audit engagement is a tactical plan of

action

Audit procedures are designed to satisfy

audit objectives and to reduce the

probability of errors or other misstatements

in the financial statements


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Audit risk model


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Audit risk model formula

Audit risk = inherent risk x control risk x

detection risk

AR = IR x CR x DR

The audit risk model is a planning model


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Audit risk

A measure of the auditors willingness (i.e.the auditor chooses this number) to acceptthat the financial statements may be

materially misstated even though a properaudit has been conducted

Audit ASSURANCE is the complement ofaudit risk

Complete assurance is impossible toachieve


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Assessing Audit Risk

Factors:

Nature of users

Likelihood offinancialdifficulties

Management

integrity Also consider

business risk


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When audit risk goes down

What happens tothe evidence to be

collected? What does this say

about the nature ofthe users?

About potentiallawsuits?


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Inherent risk

A measure of the likelihood that there are

material misstatements in a segment

simply due to the nature of the segment(e.g. cash is more likely to be stolen than

sheets of steel)

Internal controls are ignored in thisassessment


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Inherent risk is assessed at the

account balance assertion level Lets look at a

company like a big

bank What are its inherent

risks for mortgages

receivable?

For loan loss

provisions?


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Control risk

A measure of the likelihood that

misstatements will NOT be detected or

prevented by the internal control systems This assessment is conducted because it is

required by generally accepted auditing

standards and also because it is needed todesign the nature and extent of audit tests


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Control risk

What would we

consider when

assessing thecontrol risk with

respect to money

deposited at anATM?


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Where reliance on internal controls

occurs the auditor must 1. Obtain an understanding of internal controls

2. Evaluate control risk (the capacity for the

internal control to prevent or detect errors) 3. Design tests of controls and test the internal

controls (Certain controls may not need to be

tested every year, such as programmed controls

that have not changed since the prior year. They

can be tested as infrequently as every three

years.)


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Setting control risk at 100%

This means that there is no reliance on

internal controls, because control risk is at

maximum (which means that the assurancefrom tests of controls will be zero)

This can occur either because of

inadequate control systems or it may be tooexpensive to use tests of controls rather

than tests of details


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Planned detection risk

This represents the audit testing that is

required on the part of the auditor (or team)

to adequately assess the financialstatements

Once audit risk is set, and control risk and

inherent risk assessed, then detection riskcan be calculated


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Detection risk

This is the only

part of the audit

risk model that canbe affected by the

actions of the

auditor


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Three different

scenarios

How would you setaudit risk, inherent

risk, control risk and

detection risk?


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Materiality, risk and evidence

Evidence collection needs to increase

when:

Risk of errors increases

Materiality goes down


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How would you

defend your selection

of a materiality levelin court?

arens audit c10e ch08

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