©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley Materiality and Risk Chapter 9

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Learning Objective 1 Apply the concept of materiality to the audit.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Materiality It is a major consideration in determining the appropriate audit report to issue.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Materiality The auditor’s responsibility is to determine whether financial statements are materially misstated. If there is a material misstatement, the auditor will bring it to the client’s attention so that a correction can be made.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Steps in Applying Materiality Planning extent of tests Step 1 Set preliminary judgment about materiality Step 2 Allocate preliminary judgment about materiality to segments

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Steps in Applying Materiality Evaluating results Step 3 Estimate total misstatement in segment Step 4 Estimate the combined misstatement Compare combined estimate with judgment about materiality Step 5

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Learning Objective 2 Make a preliminary judgment about what amounts to consider material.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Set Preliminary Judgment About Materiality This preliminary judgment is the maximum amount by which the auditor believes the statements could be misstated and still not affect the decisions of reasonable users. Auditors decide early in the audit the combined amount of misstatements of the financial statements that would be considered material.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Factors Affecting Judgment Materiality is a relative rather than an absolute concept. Bases are needed for evaluating materiality. Qualitative factors also affect materiality.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Guidelines Guidelines Accounting and auditing standards do not provide specific materiality guidelines to practitioners. Professional judgment is to be used at all times in setting and applying materiality guidelines.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Learning Objective 3 Allocate preliminary materiality to segments of the audit during planning.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Allocate Preliminary Judgment About Materiality to Segments This is necessary because 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)

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Learning Objective 4 Use materiality to evaluate audit findings.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Estimated Total Misstatement and Preliminary Judgment Cash Accounts receivable Inventory Total estimated misstatement amount Preliminary judgment about materiality $ 4,000 20,000 36,000 $50,000 $ 2,000 12,000 31,500 $45,500 $ N/A 6,000 15,750 $16,800 $ 2,000 18,000 47,250 $62,300 Tolerable Misstatement Known Misstatement and Direct Projection Sampling ErrorTotalAccount Estimated Misstatement Amount N/A = Not applicable Cash audited 100 percent

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Estimated Total Misstatement and Preliminary Judgment Net misstatements in the sample ($3,500) × Total recorded population value ($450,000) ÷ Total sampled ($50,000) = Direct projection estimate of misstatement ($31,500)

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Learning Objective 5 Define risk in auditing.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Risk Auditors accept some level of risk in performing the audit. An effective auditor recognizes that risks exist, are difficult to measure, and require careful thought to respond. Responding to risks properly is critical to achieving a high-quality audit.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Risk and Evidence Auditors gain an understanding of the client’s business and industry and assess client business risk. Auditors use the audit risk model to further identify the potential for misstatements and where they are most likely to occur.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Illustration of Differing Evidence Among Cycles Sales and collection cycle Acquisition and payment cycle Payroll and personnel cycle Inherent risk AMediumHighLow Control risk BMediumLow Acceptable audit risk CLow Planned detection risk DMedium High

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Illustration of Differing Evidence Among Cycles Inventory and warehousing cycle Capital acquisition and repayment cycle Inherent risk AHighLow Control risk BHighMedium Acceptable audit risk CLow Planned detection risk DLowMedium

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Learning Objective 6 Describe the audit risk model and its components.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Audit Risk Model for Planning PDR = AAR ÷ (IR × CR) PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk where:

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Learning Objective 7 Consider the impact of engagement risk on acceptable audit risk.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 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.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 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

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Methods Practitioners Use to Assess Acceptable Audit Risk Methods Used to Assess Acceptable Audit Risk External users’ reliance on financial statements  Examine financial statements  Read minutes of the board  Examine form 10K  Discuss financing plans with management Factors

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Methods Practitioners Use to Assess Acceptable Audit Risk Likelihood of financial difficulties  Analyze financial statements for difficulties using ratios  Examine inflows and outflows of cash flow statements Management integrity  See Chapter 8 for client acceptance and continuance Methods Used to Assess Acceptable Audit Risk Factors

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Learning Objective 8 Consider the impact of several factors on the assessment of inherent risk.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Factors Affecting Inherent Risk  Nature of the client’s business  Results of previous audits  Initial versus repeat engagement  Related parties  Nonroutine transactions  Judgment required to correctly record account balances and transactions  Makeup of the population  Factors related to fraudulent financial reporting  Factors related to misappropriation of assets

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Learning Objective 9 Discuss the relationship of risks to audit evidence.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 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

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence  The engagement may require more experienced staff  The engagement will be reviewed more carefully than usual  Auditors can change the audit torespond to risks

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 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.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 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

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Measurement Limitations One major limitation in the application of the audit risk model is the difficulty of measuring the components of the model.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Relationships of Risk to Evidence Acceptable audit risk Inherent risk Control risk Planned detection risk Amount of evidence requiredSituation High Low Medium High Low High Medium Low High Medium High Medium Low Medium Low Medium High Medium

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 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.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr Learning Objective 10 Discuss how materiality and risk are related and integrated into the audit process.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 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

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasleyr 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.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley End of Chapter 9