Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. Chapter 9 9-1

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. 9-2 Apply the concept of materiality to the audit. Make a preliminary judgment about what amounts to consider material. Determine performance materiality during planning. Use materiality to evaluate audit findings. Define risk in auditing.

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. 9-3 Describe the audit risk model and its components. Consider the impact of engagement risk on acceptable audit risk. Consider the impact of several factors on the assessment of inherent risk. Discuss the relationship of risks to audit evidence. Discuss how materiality and risk are related and integrated into the audit process.

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. Apply the concept of materiality to the audit. 9-4

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. 9-5  Major consideration in determining the appropriate audit report  Referenced in auditor’s responsibility section of the audit report  What is meant by the term “material”?

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. 9-6 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.

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. 9-7

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. Make a preliminary judgment about what amounts to consider material

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. 9-9 Auditors set materiality thresholds early in the engagement. Thresholds represent the maximum amount that statements could be misstated and still not affect users’ decisions.

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall Materiality is a relative rather than an absolute concept. Benchmarks are needed for evaluating materiality. Qualitative factors also affect materiality.

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall Considerations that may render material a quantitatively small misstatement include: Loan covenantsChanging trend Management compensation Financial statement users Conceals an illegal act

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall Accounting and auditing standards do not provide specific materiality guidelines. Professional judgment is used to set and apply materiality guidelines.

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. Determine performance materiality during planning

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall Evidence is accumulated by segments rather than for the financial statements as a whole. Most practitioners allocate materiality to balance sheet accounts.

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. Use materiality to evaluate audit findings

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall Auditor can determine the misstated amount in an account (“Known”) Two types of “Likely” misstatements:  Judgmental differences  Projections of misstatements from audit samples

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. 9-17

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall Estimated Misstatement ($31,500) = Net misstatements in Sample ($3,500) Total sampled ($50,000) × Total recorded population value ($450,000)

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. Define risk in auditing

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall  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.

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall Auditors need to understand the client’s business and assess business risk. The audit risk model helps identify the potential and likelihood of misstatements.

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall PDR = AAR ÷ (IR × CR) where:PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. 9-23

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall Sales and collection cycle Acquisition and payment cycle Payroll and personnel cycle Inherent risk A B Control risk C D Acceptable audit risk Medium Medium HighLow LowLow Low Planned detection riskMedium LowLow MediumHigh

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall A B C D Inventory and warehousing cycle Capital acquisition and repayment cycle Inherent risk Control risk Acceptable audit risk Planned detection risk HighLow High Low Low Medium Low Medium

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. Describe the audit risk model and its components. its components

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall Planned Detection Risk Inherent Risk Control Risk Acceptable Audit Risk

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. Consider the impact of engagement risk on acceptable audit risk. on acceptable audit risk

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall What is Engagement Risk?

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall Auditors decide engagement risk and use that risk to modify acceptable audit risk. Engagement risk closely relates to client business risk.

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall  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

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. 9-32

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. Consider the impact of several factors on the assessment of inherent risk. the assessment of inherent risk

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall Nature of Client’s Business  Industry practices  Non-routine transactions  Makeup of the population Audit Experience  Prior audit results  Initial vs. repeat engagement  Audit judgment required to correctly record balances and transactions Culture  Related parties  Factors related to fraudulent financial reporting  Factors related to misappropriation of assets

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. Discuss the relationship of risks to audit evidence. to audit evidence

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall Acceptable audit risk Inherent risk Planned detection risk Planned audit evidence Control risk I D I D D Factors influencing risks

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall  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

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall Both control risk and inherent risk are typically set for each cycle, each account, and often each audit objective, not for the overall audit.

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall  It is common to assess inherent and control risk for each balance-related audit objective  It is not common to allocate materiality to objectives

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. 9-40

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall 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

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall Auditors develop various types of worksheets to aid in relating the considerations affecting audit evidence to the appropriate evidence to accumulate.

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. Discuss how materiality and risk are related and integrated into the audit process

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall Acceptable audit risk Inherent risk Control risk Performance materiality D = Direct relationship; I = Inverse relationship Planned detection risk Planned audit evidence I I IDI IDD

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall 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.

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. 9-46

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall. Copyright All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. 9-47