1. Materiality and Risk
Chapter 8

2. materiality to the audit.
Learning Objective 1
Apply the concept of
materiality to the audit.

3. 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.

4. Steps in Applying Materiality1
Set preliminary
judgment about
materiality.
Planning
extent
of tests
Step 2
Allocate preliminary
judgment about
materiality
to segments.

5. Steps in Applying Materiality3
Estimate total
misstatement in segment.
Evaluating
results
Step 4
Estimate the
combined misstatement.
Compare combined
estimate with judgment
about materiality.
Step 5

6. Make a preliminary judgment
Learning Objective 2
Make a preliminary judgment
about what amounts to
consider material.

7. Set Preliminary Judgment
Ideally, auditors decide early in the audit
the combined amount of misstatements
of the financial statements that would
be considered material.
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.

8. Factors Affecting Judgment
Materiality is a relative rather
than an absolute concept.
Bases are needed for
evaluating materiality.
Qualitative factors also
affect materiality.

9. Allocate preliminary materiality to segments of the audit
Learning Objective 3
Allocate preliminary materiality
to segments of the audit
during planning.

10. 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)

11. Use materiality to evaluate
Learning Objective 4
Use materiality to evaluate
audit findings.

12. Estimated Total Misstatement Example
Net misstatement of the sample
Total sampled ÷
Total recorded population value ×
Direct projection estimate of misstatement =
$3,500 ÷ $50,000 × $450,000 = $31,500

13. Example of Estimate for Sampling Error
Tolerable Direct Sampling
Account Misstatement Projection Error Total
Cash $ 4,000 $ $ N/A $
Accounts receivable 20, , ,000* 18,000
Inventory , , ,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%

14. Define risk in auditing.
Learning Objective 5
Define risk in auditing.

15. 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.

16. 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.

17. Example of Differing Evidence Among Cycles
Sales and
Collection
Cycle
Acquisition
and Payment
Payroll and
Personnel
Inherent
risk A
medium
high
low
Control
risk B
medium
low
Acceptable
audit risk C
low
Planned
detection risk D
medium
high

18. Example of Differing Evidence Among Cycles
Inventory and
Warehousing
Cycle
Capital Acquisition
and Repayment
Cycle A
Inherent
risk
high
low
Control
risk B
high
medium
Acceptable
audit risk C
low
Planned
detection risk D
low
medium

19. Describe the audit risk model and its components.
Learning Objective 6
Describe the audit risk
model and its components.

20. Audit Risk Model for Planning
PDR = AAR ÷ (IR × CR)
Where
PDR = Planned detection risk
AAR = Acceptable audit risk
IR = Inherent risk
CR = Control risk

21. Learning Objective 7
Consider the impact of
engagement risk on
acceptable audit risk.

22. 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.

23. Factors Affecting Acceptable Audit Risk
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

24. Factors Affecting Acceptable Audit Risk
The auditor’s evaluation of
management’s integrity

25. Making the Acceptable Audit Risk Decision
Methods to Assess Risk
Factors
External users
reliance on
financial
statements
Examine financial statements.
Read minutes of the board.
Examine form 10K.
Discuss financing plans
with management.

26. Making the Acceptable Audit Risk Decision
Factors
Methods to Assess Risk
Likelihood
of financial
difficulties
Analyze financial statements for difficulties using ratios.
Examine inflows and outflows of cash flow statements.
Management
integrity
See Chapter 7 for client acceptance and continuance.

27. Consider the impact of several factors on the assessment
Learning Objective 8
Consider the impact of several
factors on the assessment
of inherent risk.

28. 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

29. Learning Objective 9
Consider information
gathered to assess the
likelihood of fraud.

30. Assessing Risks of Fraud
Three conditions are generally present.
1. Incentives/Pressures
2. Opportunities
3. Attitudes/Rationalization

31. 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.

32. 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.

33. 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.

34. 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.

35. Discuss the relationship of risks to audit evidence.
Learning Objective 10
Discuss the relationship
of risks to audit evidence.

36. Relationship of Risk Factors, Risk, and Evidence
Acceptable audit risk
Control risk
Inherent
risk
Planned
audit
evidence D I
Planned
detection
risk I D
Factors
Influencing
Risks
D = Direct relationship; I = Inverse relationship

37. Changing the Audit in Response to Risk
The engagement may require
more experienced staff.
The engagement will be reviewed
more carefully than usual.

38. 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.

39. 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.

40. 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.

41. Measurement Limitations
One major limitation in the application
of the audit risk model is the difficulty
of measuring the components of the model.

42. Relationships of Risk to Evidence
Acceptable Planned Amount of
Audit Inherent Control Detection Evidence
Situation Risk Risk Risk Risk Required
1 High Low Low High Low
2 Low Low Low Medium Medium
3 Low High High Low High
4 Medium Medium Medium Medium Medium
5 High Low Medium Medium Medium

43. 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.

44. Discuss how materiality and risk are related and integrated
Learning Objective 11
Discuss how materiality and risk
are related and integrated
into the audit process.

45. Tolerable Misstatements, Risk, and Planned Evidence
Acceptable
audit risk
Inherent
risk
Control
Tolerable
misstatement
Planned
detection risk
audit evidence
D = Direct relationship; I = Inverse relationship I D

46. Audit Risk Model for Evaluating Results
AcAR = IR × CR × AcDR
Where
AcAR = Achieved audit risk
AcDR = Achieved detection risk
IR = Inherent risk
CR = Control risk

47. 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.

48. End of Chapter 8