©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley Materiality and Risk Chapter 9

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley Learning Objective 1 Apply the concept of materiality to the audit.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 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 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 Steps in Applying Materiality

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley Learning Objective 2 Make a preliminary judgment about what amounts to consider material.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 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 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 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 Guidelines 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 Learning Objective 3 Allocate preliminary materiality to segments of the audit during planning.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 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 Learning Objective 4 Use materiality to evaluate audit findings.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 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 Estimated Total Misstatement and Preliminary Judgment

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 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 Learning Objective 5 Define risk in auditing.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 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 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 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 Audit Risk Model for Planning

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley Illustration of Differing Evidence Among Cycles Sales and collection cycle Acquisition and payment cycle Payroll and personnel cycle Inherent risk AMediumHighLow Control risk BMediumLowLow Acceptable audit risk CLowLowLow Planned detection risk DMediumMediumHigh

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley Illustration of Differing Evidence Among Cycles Inventory and warehousing cycle Capital acquisition and repayment cycle Inherent risk AHighLow Control risk BHighMedium Acceptable audit risk CLowLow Planned detection risk DLowMedium

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley Learning Objective 6 Describe the audit risk model and its components. its components.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 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 Learning Objective 7 Consider the impact of engagement risk on acceptable audit risk. on acceptable audit risk.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley Engagement Risk What is Engagement Risk?

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 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 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 Methods Practitioners Use to Assess Acceptable Audit Risk

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley Learning Objective 8 Consider the impact of several factors on the assessment of inherent risk. the assessment of inherent risk.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 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 Learning Objective 9 Discuss the relationship of risks to audit evidence. to audit evidence.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 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 ID I D

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 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 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 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 Risk and Evidence

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 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 Relationships of Risk to Evidence Acceptable audit risk Inherent risk Control risk Planned detection risk Amount of evidence requiredSituation HighLowLowMediumHighLowLowHighMediumLowLowLowHighMediumMediumHighMediumLowMediumMediumLowMediumHighMediumMedium

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 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 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 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 II I D D

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 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 End of Chapter 9