MODERN AUDITING 7th Edition William C. Boynton California Polytechnic State University at San Luis Obispo Raymond N. Johnson Portland State University Walter G. Kell University of Michigan Developed by: Dr. Raymond N. Johnson, CPA Gregory K. Lowry, MBA, CPA John Wiley & Sons, Inc.

CHAPTER 8 MATERIALITY, RISK AND PRELIMINARY AUDIT STRATEGIES Audit Risk Preliminary Audit Strategies

The Concept of Materiality The FASB defines materiality as The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying in the information would have been changed or influenced by the omission or misstatement.

Preliminary Judgments About Materiality The auditor makes preliminary judgments about materiality levels in planning the audit. This assessment is referred to as planning materiality, and may ultimately differ from the materiality levels used at the conclusion of the audit in evaluating the audit findings because: 1. the surrounding circumstances may change and 2. additional information about the client will have been obtained during the course of the audit.

Preliminary Judgments About Materiality In planning an audit, the auditor should assess materiality at the following 2 levels: 1. The financial statement level because the auditor’s opinion on fairness extends to the financial statements taken as a whole. 2. The account balance level because the auditor verifies account balances in reaching an overall conclusion on the fairness of the financial statements.

Materiality Levels Based on a Variable Percentage of Total Assets or Revenue Figure 8-1

Materiality at the Financial Statement Level Quantitative Guidelines Currently, neither accounting nor auditing standards contain official guidelines on quantitative measures of materiality. The following are illustrative of some guidelines used in practice:  5% to 10% of net income before taxes (10% for smaller incomes, 5% for larger ones)  1/2% to 1% of total assets  1% of equity  1/2% to 1% of gross revenue  A variable percentage based on the greater of total assets or revenue

Materiality at the Financial Statement Level Qualitative Considerations Qualitative considerations relate to the causes of misstatements. A misstatement that is quantitatively immaterial may be qualitatively material.

Materiality at the Account Balance Level 1. Account balance materiality is the minimum misstatement that can exist in an account balance for it to be considered materially misstated. 2. Misstatement up to that level is known as tolerable misstatement. 3. The concept of materiality at the account balance level should not be confused with the term material account balance.

Allocating Financial Statement Materiality to Accounts 1. When the auditor’s preliminary judgments about financial statement materiality are quantified, a preliminary estimate of materiality for each account may be obtained by allocating financial statement materiality to the individual accounts. 2. The allocation may be made to both balance sheet and income statement accounts. 3. In making the allocation, the auditor should consider: a. the likelihood of misstatements in the accounts and b. the probable cost of verifying the account.

Relationship between Materiality and Audit Evidence 1. It is generally correct to say that the lower the materiality level, the greater the amount of evidence needed. 2. It is also generally correct to say that the larger or more significant an account balance is, the greater the amount of evidence needed.

The Audit Risk Model Audit risk is the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated. The audit risk model expresses the relationship among the audit risk components as follows: AR = IR x CR x DR

The Audit Risk Model SAS Nos. 39, 43, and 45 contain an expanded audit risk model that subdivides detection risk into 2 components. AP for analytical procedures risk and TD for tests of details risk. Hence, the relationship among audit risk components can be expressed as: AR = IR x CR x AP x TD

Risk Components Matrix Figure 8-2

Assessing the Components of Audit Risk 1. Inherent risk is the susceptibility of an assertion to a material misstatement, assuming that there are no controls. 2. Control risk is the risk that a material misstatement that could occur in an assertion will not be prevented or detected on a timely basis by the entity’s internal controls. 3. Detection risk is the risk that the auditor will not detect a mater misstatement that exists in an assertion.

Example Inherent Risk Factors Pervasive effect on the financial statements Profitability relative to the industry Sensitivity of operating results to economic factors Going concern problems such as lack of working capital Cause of known misstatements in prior audits Management turnover, reputation, and accounting skills

Example Inherent Risk Factors Specific account factors Difficult to audit accounts or transactions Contentious or difficult accounting issues Susceptibility to misappropriation Complexity of calculations Extent of judgment related to assertions Cause of known misstatements in prior audits Sensitivity of valuations to economic factors

Example Factors: Risk of Fraud due to Fraudulent Financial Reporting Management’s characteristics and influence over the control environment A failure of management to display and communicate an appropriate attitude regarding internal control and the financial reporting process Senior management turnover Nonfinancial management’s excessive preoccupation with accounting results Strained relationship with prior auditors Industry conditions Operating characteristics and financial stability

Example Factors: Risk of Fraud due to Misappropriation of Assets Susceptibility of assets to misappropriation of assets Internal controls

Interrelationships Among Materiality, Audit Risk, and Audit Evidence Figure 8-3

Alternative Preliminary Audit Strategies Figure 8-4

4 Common Preliminary Audit Strategies Figure 8-5

Relationship Between Strategies and Transaction Cycles The previously described strategies are intended to characterize the audit approaches for different assertions, not for the entire audit. Frequently, however, a common strategy is applied to groups of assertions affected by a transaction class within a transaction cycle.

Relationship Between Strategies and Transaction Cycles The following framework is representative of practice:

CHAPTER 8 MATERIALITY, RISK AND PRELIMINARY AUDIT STRATEGIES

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