8 - 1 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Materiality and Risk Chapter 8

8 - 2 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 1 Apply the concept of materiality to the audit.

8 - 3 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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.

8 - 4 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Steps in Applying Materiality Step 1 Set preliminary judgment about materiality. Planning extent of tests Step 2 Allocate preliminary judgment about materiality to segments.

8 - 5 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Steps in Applying Materiality Step 3 Estimate total misstatement in segment. Evaluating results Step 4 Estimate the combined misstatement. Compare combined estimate with judgment about materiality. Step 5

8 - 6 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 2 Make a preliminary judgment about what amounts to consider material.

8 - 7 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Set Preliminary Judgment 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. Ideally, auditors decide early in the audit the combined amount of misstatements of the financial statements that would be considered material.

8 - 8 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/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.

8 - 9 ©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 3 Allocate preliminary materiality to segments of the audit during planning.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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 39 (AU 350)

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 4 Use materiality to evaluate audit findings.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Estimated Total Misstatement Example Net misstatement of the sample $3,500 ÷ $50,000 × $450,000 = $31,500 Total recorded population value × Total sampled ÷ Direct projection estimate of misstatement =

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Example of Estimate for Sampling Error Tolerable Direct Sampling Account Misstatement Projection Error Total Cash$ 4,000$ 0$ N/A$ 0 Accounts receivable 20,000 12,000 6,000* 18,000 Inventory 36,000 31,500 15,750* 47,250 Total estimated misstatement amount$43,500$16,800$60,300 Preliminary judgment about materiality$50,000 *estimate for sampling error is 50%

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 5 Define risk in auditing.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley 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.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Example of Differing Evidence Among Cycles Sales and Collection Cycle Acquisition and Payment Cycle Payroll and Personnel Cycle Inherent risk A mediumhighlow Control risk B mediumlow Acceptable audit risk C low Planned detection risk D medium high

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Example of Differing Evidence Among Cycles Inventory and Warehousing Cycle Capital Acquisition and Repayment Cycle Inherent risk A highlow Control risk B highmedium Acceptable audit risk C low Planned detection risk D lowmedium

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 6 Describe the audit risk model and its components.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Audit Risk Model for Planning PDR = AAR ÷ (IR × CR) PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 7 Consider the impact of engagement risk on acceptable audit risk.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/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.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Factors Affecting Acceptable Audit Risk The degree of which external users rely on the statements The degree of which external users rely on the statements The likelihood that a client will have financial difficulties after the audit report is issued

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Factors Affecting Acceptable Audit Risk The auditor’s evaluation of management’s integrity

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Making the Acceptable Audit Risk Decision External users reliance on financial statements Examine financial statements. Read minutes of the board. Examine form 10K. Discuss financing plans with management. Methods to Assess Risk Factors

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Making the Acceptable Audit Risk Decision Methods to Assess Risk Likelihood of financial difficulties Analyze financial statements for difficulties using ratios. Examine inflows and outflows of cash flow statements. Factors Management integrity See Chapter 7 for client acceptance and continuance.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 8 Consider the impact of several factors on the assessment of inherent risk.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Major Factors When Assessing Inherent Risk Nature of the client’s business Results of previous audits Initial versus repeat engagement Related parties Nonroutine transactions Judgment – correctly record account balances and transactions Makeup of the population

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 9 Consider information gathered to assess the likelihood of fraud.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Assessing Risks of Fraud Three conditions are generally present. 1. Incentives/Pressures 2. Opportunities 3. Attitudes/Rationalization

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Examples of Risks Factors for Fraudulent Reporting 1. Incentives/Pressures Financial stability or profitability is threatened by economic, industry, or entity operating conditions. Excessive pressure exists for management to meet debt requirements. Personal net worth is materially threatened.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Examples of Risks Factors for Fraudulent Reporting 2. Opportunities There are significant accounting estimates that are difficult to verify. There is ineffective oversight over financial reporting. High turnover or ineffective accounting internal audit, or information technology staff exists.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Examples of Risks Factors for Fraudulent Reporting 3. Attitudes/Rationalization Inappropriate or inefficient communication and support of the entity’s values is evident. A history of violations of laws is known. Management has a practice of making overly aggressive or unrealistic forecasts.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Responding to the Risk of Fraud Design and perform audit procedures to address identified fraud risk. Change the overall conduct of the audit to respond to identified fraud risk. Perform procedures to address the risk of management override of controls.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 10 Discuss the relationship of risks to audit evidence.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Relationship of Risk Factors, Risk, and Evidence Factors Influencing Risks Acceptable audit risk Control risk Inherent risk Planned detection risk I D I Planned audit evidence D I I D D = Direct relationship; I = Inverse relationship

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Changing the Audit in Response to Risk The engagement may require more experienced staff. The engagement will be reviewed more carefully than usual.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/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.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Relating Risk of Fraud to Risk Model Components The risk of fraud can be assessed for the entire audit or by cycle, account, and objective. Specific response could include revising assessments of acceptable audit risk, inherent risk, and control risk.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Tolerable Misstatement, Risks, and Balance-related 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.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Measurement Limitations One major limitation in the application of the audit risk model is the difficulty of measuring the components of the model.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Relationships of Risk to Evidence AcceptablePlannedAmount of AuditInherentControlDetectionEvidence SituationRiskRiskRiskRiskRequired 1HighLowLowHighLow 2LowLowLowMediumMedium 3LowHighHighLowHigh 4MediumMediumMediumMediumMedium 5HighLowMediumMediumMedium

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/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.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Learning Objective 11 Discuss how materiality and risk are related and integrated into the audit process.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Tolerable Misstatements, Risk, and Planned Evidence Acceptable audit risk Inherent risk Control risk Tolerable misstatement Planned detection risk Planned audit evidence D = Direct relationship; I = Inverse relationship I D I II I D D

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Audit Risk Model for Evaluating Results AcAR = IR × CR × AcDR AcAR = Achieved audit risk AcDR = Achieved detection risk IR = Inherent risk CR = Control risk

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley Revising Risks and Evidence The audit risk model is primarily a planning model and is therefore of limited use in evaluating results. Great care must be used in revising the risk factors when the actual results are not as favorable as planned.

©2003 Prentice Hall Business Publishing, Essentials of Auditing 1/e, Arens/Elder/Beasley End of Chapter 8