Materiality Audits provide reasonable assurance that the financial statements are free of material misstatements.

User Focus Materiality is defined in terms of financial statement users Therefore no hard and fast rulesTherefore no hard and fast rules Need to consider multiple users and multiple basesNeed to consider multiple users and multiple bases

FIGURE Steps in Applying Materiality Estimate total misstatement in segment Step 3 Estimate the combined misstatement Step 4 Compare combined estimate with preliminary or revised judgment about materiality Step 5 Set preliminary judgment about materiality Step 1 Allocate preliminary judgment about materiality to segments Step 2 Planning extent of tests Evaluating results

Set Preliminary Judgment About Materiality Base X(function of client) Percentage(function of audit risk) = Preliminary estimate of materiality

Materiality Percentage Typically 3-6% for net income, lower percentages for larger bases such as assets or revenues High risk Low % Low risk High % (less evidence; less assurance)

Increase in Less materiality evidence required Materiality/Evidence Relation

As lower acceptable levels of audit risk and materiality are established, the auditor should plan more work on individual accounts to: 1. Find smaller errors. 2. Find larger errors. 3. Increase tolerable error in accounts. 4. Increase materiality in the accounts.

Figure 9-3 Balance (000) TM Cash AR 18, Inventory 29, Current Assets 1, P,P&E 10, AP 4, Notes 28,300 0 Accruals 5, Equity 22,463 0 Total (materiality = 442) 884 Total (materiality = 442) 884

Factors affecting tolerable misstatement Larger allocationSmaller allocation Large balanceSmall balance Errors expectedFew errors expected Costly to test orLess costly to test Testable with AP

Steps in Applying Materiality Planning phase Set preliminary judgment Allocate materiality to segments Evaluating Estimate total results misstatement in segment results misstatement in segment Estimate combined misstatement Compare combined misstatement to materiality estimate

Projecting Errors Balance in accts. receivable: 1,000,000 Accts. receivable tested: 250,000 Overstatement errors: 10,000 Projected error = (10,000/250,000) x 1,000,000 = 40,000 + allowance for sampling error

Tolerable Est. of Total Misstatement Misstmt. Tolerable Est. of Total Misstatement Misstmt. Over- Under- Over- Under- Over- Under- Over- Under- Account stmt. stmt. stmt. stmt. Cash 2,000 3,000 2, A/R12,00018,000 4,000 19,000 Inventory 8,00014,000 3,000 10,000 Prepaids 3,000 5,000 2,000 1,000 Total25,00040,000 11,000 30,000 Preliminary estimate of materiality: Overstatements = 12,500 Understatements = 20,000

Options When Projected Errors Exceed Materiality Record an adjustmentRecord an adjustment –Usually limited to actual errors Perform more testingPerform more testing –Better error estimate –Lower sampling risk Qualify OpinionQualify Opinion

Options Applied to Prob Projected understmt. errors $30,000 Materiality 20,000 Min. necessary error reduction 10,000 Auditor could record adjustment for at least $10,000 and/or perform additional testing (focusing on AR and inventory because largest projected errors)

Audit Risk Model PDR = AAR IR x CR IR x CRwhere: PDR= Planned detection risk AAR= Acceptable audit risk IR= Inherent risk CR= Control risk or: AAR = IR x CR x PDR

Planned Detection Risk Risk that the auditor fails to detect a material error Determines amount of evidenceDetermines amount of evidence Dependent variable because it is determined by other risk model factorsDependent variable because it is determined by other risk model factors Decrease More evidence PDR required

Acceptable Audit Risk Risk that the auditor fails to modify opinion when f/s are misstated Depends upon use of financial statementsDepends upon use of financial statements Client’s financial positionClient’s financial position

Inherent Risk Likelihood of error in a segment (without considering effectiveness of controls) Varies by account (errors are more likely in some accounts than others)Varies by account (errors are more likely in some accounts than others) Varies by objective within accountsVaries by objective within accounts

Inherent Risk Factors Nonroutine transactionsNonroutine transactions Management estimatesManagement estimates Net realizable value issuesNet realizable value issues Subject to theft or manipulationSubject to theft or manipulation

Control Risk Risk that client’s internal controls fail to detect an error To assess control risk below maximum: Must study and document controlsMust study and document controls Must test their effectivenessMust test their effectiveness

9-24 (b) Inherent risk and control risk differ from planned detection risk in that they: 1. Arise from the misapplication of audit procedures. procedures. 2. May be assessed in either quantitative or nonquantitative terms. nonquantitative terms. 3. Exist independently of the financial statement audit. statement audit. 4. Can be changed at the auditor’s discretion.

Assessing Fraud Risk In addition to risk model assessment, auditors must assess risk of fraud on every engagement related to: –Fraudulent financial reporting –Misappropriation of assets These risk assessments may be incorporated in the risk model assessments or considered separately.

The “Fraud Triangle” Opportunities Weak Board of Directors Weak Internal Controls Attitudes/Rationalizations Lack of a Code of Conduct Disregard for Financial Reporting Incentives/Pressures Tight Debt Covenants Unrealistic Analyst Expectations

AAR = IRxCR x PDR Audit Risk an Risk internal Risk the Risk error will controls won’t auditor occurdetect it won’t occurdetect it won’t detect it detect it IR x CR = Risk of Material Misstatement

Factor Assessment LevelComment AAR Entire audit Based on use of f/s IR Objective level Assessed based IR Objective level Assessed based each cycle/account on likelihood of error each cycle/account on likelihood of error CR Objective level Depends on each cycle/ existence and account effectiveness of controls CR Objective level Depends on each cycle/ existence and account effectiveness of controls PDR Objective level Determined by each cycle/ other risk model account factors PDR Objective level Determined by each cycle/ other risk model account factors

PDR = AAR IR x CR IR x CR PDR decreases Evidence increases Everything else can be expressed as a function of DR 1.AAR decreases - PDR decreases (evid. inc.) 2.IR decreases -PDR increases (evid. dec.) 3.CR decreases -PDR increases (evid. dec.)

Materiality Percentage High AAR High % (low risk audit) Low AAR Low % (high risk audit)

Problem #1 = min. evidence Situation Risk AARHHLLHM IRLHHLMM CRLLHHMM PDR HMLLMM Planned EvidenceLMHHMM

Problem #3 = max. evidence Situation Risk AARHHLLHM IRLHHLMM CRLLHHMM PDR HMLLMM Planned EvidenceLMHHMM

Effect onEffect on Effect onEffect on Change in factor PDREvidence 1. Increase in AAR IncreaseDecrease 2. Increase in CR DecreaseIncrease 3. Increase in PDR NADecrease 4. Increase in IR DecreaseIncrease 5. Increase in IR, No effect*No effect Decrease in CR in same amount

CR IR AAR PE CR IR AAR PE a. Increase LTD N N D I (First answer to collected homework given as an example)