1. Chapter 9 Materiality and Risk
Audit Risk
CPA

2. Presentation Outline Steps in Applying Materiality Risk in Auditing
Planning Model Relationships
Evaluating Results

3. I. Steps in
Applying
Materiality

4. Step 1 in Applying Materiality
Set preliminary judgment about materiality.
Permissible misstatements are often less for smaller clients.
Although the FASB and AICPA are unwilling to provide specific materiality guidelines to practitioners, bases are needed for evaluating materiality. See Figure 9-2 on page 235.
Qualitative factors can affect materiality. See factors on pages
The preliminary judgment about materiality is the maximum amount
the auditor believes the statements could be misstated and still not
affect the decisions of reasonable users. Decided early in audit.

5. Step 2 in Applying Materiality
Allocate preliminary judgment about materiality to segments.
Most practitioners allocate materiality to balance sheet rather than income statement accounts. This is because most income statement misstatements have an equal effect on the balance sheet because of the double-entry bookkeeping system.
The sum of the tolerable misstatement is allowed to exceed overall materiality because (1) it is unlikely that all accounts will be misstated by the full amount of tolerable misstatement, and (2) some accounts are overstated while others are understated, resulting in a net amount that is likely to be less than overall materiality.
An allocation is necessary because evidence is accumulated by
segments rather than the financial statements taken as a whole. The
allocation to account balances is known as the tolerable misstatement.

6. Illustration of Tolerable Misstatement Allocation for Current Assets
Account Misstatement
Cash $ 4,000
Accounts receivable 20,000
Inventory ,000
Preliminary judgment
about materiality $50,000

7. Step 3 in Applying Materiality
Estimate total misstatement in segment.
$3,500 net misstatement of the inventory sample
$3,500 ÷ $50,000 × $450,000 = $31,500
$50,000 total inventory sampled
$450,000 total recorded population value for inventory
$31,500 direct projection estimate of misstatement × ÷ =
One way to calculate the estimate of misstatement is to make a direct
projection from the sample to the population.

8. Illustration of Estimating Total Misstatement in Segment
Tolerable Direct Sampling
Account Misstatement Projection Error Total
Cash $ 4,000 $ $ N/A $
Accounts receivable 20, , ,000* 18,000
Inventory , , ,750* 47,250
Preliminary judgment
about materiality $50,000
*estimate for sampling error is 50%

9. Step 4 in Applying Materiality
Estimate the combined misstatement.
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%

10. Step 5 in Applying Materiality
Compare combined estimate with preliminary or revised judgment about materiality.
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%
Because the estimated combined misstatement exceeds the
preliminary judgment, the financial statements are not acceptable.
The auditor may perform additional audit procedures to reevaluate
the estimate, or require adjustment for the estimated misstatements.

11. II. Risk in Auditing Components of Audit Risk Acceptable Audit Risk
Inherent Risk
Control Risk
Planned Detection Risk

12. A. Components of Audit Risk
Susceptibility of an assertion to material misstatement assuming no related internal controls.
Inherent Risk
(IR)
Total misstatement -
Caught by internal controls
Risk of misstatements not being detected by system of internal control.
Control Risk
(CR) -
Caught by auditor
Detection Risk
(DR)
Risk of misstatements not being detected by the auditor. =
Undetected misstatement
Audit Risk
(AR)
Misstatement that remains undetected by the auditor.

13. B. Acceptable Audit Risk
The following factors mean that audit risk should be kept lower:
Reliance by External Users
Likelihood of Financial Failure
Integrity of Management

14. 1. Reliance by External Users
When external users place heavy emphasis on the financial statements, acceptable audit risk should be kept low. The following generally results in more users of the financial statements:
Larger clients
Publicly held corporations
Extensive use of liabilities
XYZ Co.
Financial Statements

15. 2. Likelihood of Financial Failure
There is a greater chance of having to defend the quality of the audit when there is a financial failure. Failure indicators include:
Shortage of funds
Declining net income or continued losses
Risky industries such as technology
Management lacking competency to deal with financial difficulties

16. 3. Integrity of Management
If a client has questionable integrity, the auditor is likely to assess acceptable audit risk lower. Indications of integrity problems include:
Frequent disagreements with prior auditors, the IRS, and/or SEC
Frequent turnover of key financial and internal audit personnel
Ongoing conflicts with labor unions and employees

17. C. Inherent Risk Nature of the Client’s Business
Results of Previous Audits
Initial vs. Repeat Engagement
Related Parties
Nonroutine Transactions
Judgment Required
Make-up of the Population

18. 1. Nature of the Client’s Business
Ricky’s Electronics
Inherent risk is likely to vary from business to business for accounts such as inventory, accounts and loans receivable, and property, plant, and equipment.
The nature of the business should have little effect on cash, notes payable, and mortgages payable.

19. 2. Results of Previous Audits
Misstatements found in the previous year’s audit have a high likelihood of occurring again.
Many types of misstatements are systematic in nature, and organizations are slow in making changes to eliminate them.

20. 3. Initial vs. Repeat Engagement
Most auditors use a larger inherent risk for initial audits than for repeat engagements in which no material misstatements had been found.

21. 4. Related Parties
Examples of related party transactions are those between parent and subsidiary companies, and management or owners and the company.
Increases inherent risk because there is a greater likelihood of misstatement.

22. 5. Nonroutine Transactions
Transactions that are unusual for the client are more likely to be recorded incorrectly.
Examples include fire losses, major property acquisitions, etc.

23. Uncollectible accounts receivable
6. Judgment Needed
Many account balances require estimates and a great deal of management judgment including:
Uncollectible accounts receivable
Obsolete inventory
Warranty liabilities

24. 7. Make-up of the Population
Accounts receivable where most accounts are significantly overdue
Transactions with related parties
Disbursements made payable to cash
Inventory with a slow turnover

25. There are two basic phases to an auditor’s evaluation of control risk:
D. Control Risk
There are two basic phases to an auditor’s evaluation of control risk:
Obtain an understanding of internal control. This phase applies to all audits.
Test the internal controls for effectiveness. This phase only applies when the auditor chooses to assess control risk at below the maximum.

26. E. Planned Detection Risk
The auditor can reduce planned detection risk by performing more substantive testing.
Lowering Acceptable Audit Risk
Increased audit evidence
Lower Detection Risk

27. III. Planning Model Relationships
Acceptable Audit Risk Relationships
Inherent Risk Relationships
Control Risk Relationships
The Overall Relationship of Components in Planning the Audit Process
The Audit Risk Model for Planning

28. A. Acceptable Audit Risk Relationships
Planned
detection risk
audit evidence
Inverse
Direct
Acceptable audit risk is the risk that the auditor is willing to take of giving an unqualified opinion when the financial statements are materially misstated.
As acceptable audit risk increases, the auditor is willing to collect less evidence (inverse) and therefore accept a higher detection risk (direct).

29. B. Inherent Risk Relationships
Planned
detection risk
audit evidence I D
Inherent risk is the susceptibility of an assertion to material misstatement assuming no related internal controls.
As inherent risk increases, the auditor must reduce detection risk (inverse) by collecting more audit evidence (direct).

30. C. Control Risk Relationships
Planned
detection risk
Planned
audit evidence I D
Control
risk
Control risk is the risk of misstatements not being detected by the client’s system of internal control.
As control risk increases, the auditor must reduce detection risk (inverse) by collecting more audit evidence (direct).

31. D = Direct relationship; I = Inverse relationship
D. The Overall Relationship of Components in Planning the Audit Process
Acceptable
audit risk D D I
Inherent
risk
Planned
detection risk I
Planned
audit evidence I I D I
Control
risk
Tolerable
misstatement
D = Direct relationship; I = Inverse relationship

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

33. IV. Evaluating Results Audit Risk Model for Evaluating Results
Reducing Achieved Audit Risk
Revising Risks and Evidence

34. A. 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

35. B. Reducing Achieved Audit Risk
The audit risk model for evaluating results is stated in SAS 47. Research subsequent to the issuance of SAS 47 has shown that it is not appropriate to uses this evaluation formula as originally intended. However, the model does show three possible ways to reduce achieved audit risk to an acceptable level.
Reduce inherent risk – not feasible unless new facts are uncovered during the audit process.
Reduce control risk – may be possible to reevaluate control risk to a lower level by conducting more tests of internal controls.
Reduce achieved detection risk – can be achieved by larger sample sizes and/or additional audit procedures.

36. C. Revising Risks and Evidence
Great care must be used when revising the risk factors when the actual results are not as favorable as planned.
When the auditor concludes that the original assessment of control risk or inherent risk was understated or acceptable audit risk was overstated, a two step approach should be used:
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. Research shows that using the model in the evaluation stage often results in an insufficient increase of evidence.

37. Risk and Audit Planning
Summary
Audit Process
Applying Materiality
Risk and Audit Planning
Evaluating Results
Risk
Internal Control