materiality and risk - knowledge & experience sharing · materiality and risk chapter 9 ©2012...
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©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5 - 5
Materiality and Risk
Chapter 9
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 2
Learning Objective 1
Apply the concept of materiality to the audit.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 3
Materiality
Major consideration in determining
the appropriate audit report
Referenced in audit report’s scope
paragraph
What is meant by the term “material”?
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 4
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.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 5
Steps in Applying Materiality
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Learning Objective 2
Make a preliminary judgment about what
amounts to consider material.
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Set Preliminary Judgment About Materiality
Thresholds represent the maximum statements that could be misstated and still not affect users decisions.
Auditors set materiality thresholds early in the engagement.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 8
Factors Affecting Judgment
Materiality is a relative rather
than an absolute concept.
Bases are needed for
evaluating materiality.
Qualitative factors also
affect materiality.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 9
Qualitative Factors
Considerations that may render material a
quantitatively small misstatement include:
Changing trend
Financial statements users Conceals an illegal act
Loan covenants
Management compensation
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 10
Guidelines
Accounting and auditing standards do not
provide specific materiality guidelines.
Professional judgment is used to set and
apply materiality guidelines.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 11
Learning Objective 3
Allocate preliminary materiality to segments
of the audit during planning.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 12
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.
SAS 107 (AU 312)
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 13
Learning Objective 4
Use materiality to evaluate audit findings.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 14
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
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 15
Estimated Total Misstatement and Preliminary Judgment
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 16
Estimated Total Misstatement and Preliminary Judgment
Estimated Misstatement
($31,500)
= Net misstatements in Sample ($3,500) Total sampled ($50,000)
× Total recorded
population value ($450,000)
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 17
Learning Objective 5
Define risk in auditing.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 18
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.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 19
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.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 20
Audit Risk Model for Planning
PDR = AAR ÷ (IR × CR)
where: PDR = Planned detection risk
AAR = Acceptable audit risk
IR = Inherent risk
CR = Control risk
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 21
Audit Risk Model for Planning
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 22
Illustration of Differing Evidence Among Cycles
Sales and collection cycle
Acquisition and payment cycle
Payroll and personnel cycle
Inherent risk
A Medium High Low
Control risk
B Medium Low Low
Acceptable audit risk
C Low Low Low
Planned detection risk
D Medium Medium High
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 23
Illustration of Differing Evidence Among Cycles
Inventory and warehousing cycle
Capital acquisition and repayment cycle
Inherent risk
A High Low
Control risk
B High Medium
Acceptable audit risk
C Low Low
Planned detection risk
D Low Medium
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 24
Learning Objective 6
Describe the audit risk model and its components.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 25
Audit Risk Model Components
Planned Detection
Risk
Acceptable Audit Risk
Control Risk
Inherent Risk
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 26
Learning Objective 7
Consider the impact of engagement risk on acceptable audit risk.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 27
Engagement Risk
What is Engagement Risk?
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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.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 29
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
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 30
Methods Practitioners Use to Assess Acceptable Audit Risk
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 31
Learning Objective 8
Consider the impact of several factors on the assessment of inherent risk.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 32
Factors Affecting Inherent Risk
Nature of Client’s
Business
Industry practices
Non-routine transactions
Makeup of the population
Culture Related parties
Factors related to fraudulent
financial reporting
Factors related to
misappropriation of assets
Audit Experience
Prior audit results
Initial vs. repeat engagement
Audit judgment required to
correctly record balances and
transactions
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 33
Learning Objective 9
Discuss the relationship of risks to audit evidence.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 34
Relationship of Factors Influencing Risks to Risks and Risks to Planned
Evidence
D = Direct relationship; I = Inverse relationship
Factors influencing
risks
Acceptable audit risk
Planned detection
risk
Planned audit
evidence
Inherent risk
Control risk
I
D
I
I D
I D
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 35
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
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 36
Audit Risk for Segments
Both control risk and inherent risk are
typically set for each cycle, each
account, and often even each audit
objective, not for the overall audit.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 37
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
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 38
Risk and Evidence
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 39
Measurement Limitations
One major limitation in the audit risk model is
the difficulty of measuring the components
of the model.
Preliminary Assessed Level
of Risk
Actual level of risk achieved on the audit
+/-
Known Unknown
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 40
Relationships of Risk to Evidence
Acceptable audit risk
Inherent risk
Control risk
Planned detection risk
Amount of evidence required Situation
High
Low
Low
Medium
High
Low
Low
High
Medium
Low
Low
Low
High
Medium
Medium
High
Medium
Low
Medium
Medium
Low
Medium
High
Medium
Medium
1
2
3
4
5
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 41
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.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 42
Learning Objective 10
Discuss how materiality and risk are related and integrated into the audit process.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 43
Relationship of Tolerable Misstatement and Risks to
Planned Evidence
D = Direct relationship; I = Inverse relationship
Acceptable audit risk
Inherent risk
Control risk
Tolerable misstatement
Planned detection risk
Planned audit evidence
I
D
I
I I
I
D
D
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 44
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.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 9 - 45
End of Chapter 9