1. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 1 Materiality and Risk Chapter 9

2. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 2 Learning Objective 1 Apply the concept of materiality to the audit.

3. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 4 Steps in Applying Materiality Step 1 Set preliminary judgment about materiality. Step 2 Allocate preliminary judgment about materiality to segments. Planning extent of tests

5. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 5 Steps in Applying Materiality Step 3 Estimate total misstatement in segment. Step 4 Estimate the combined misstatement. Evaluating results Compare combined estimate with judgment about materiality. Step 5

6. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 6 Learning Objective 2 Make a preliminary judgment about what amounts to consider material.

7. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 7 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 9 Learning Objective 3 Allocate preliminary materiality to segments of the audit during planning.

10. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 11 Learning Objective 4 Use materiality to evaluate audit findings.

12. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 12 Estimated Total Misstatement Example Net misstatement of the sample $3,500 ÷ $50,000 × $450,000 = $31,500 Total sampled Total recorded population value Direct projection estimate of misstatement × ÷ =

13. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 13 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%

14. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 14 Learning Objective 5 Define risk in auditing.

15. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 17 Example of Differing Evidence Among Cycles Sales and Collection Cycle Acquisition and Payment Cycle Payroll and Personnel Cycle Inherent risk Control risk Acceptable audit risk Planned detection risk A B C D mediumhighlow mediumlow medium high

18. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 18 Example of Differing Evidence Among Cycles Inventory and Warehousing Cycle Capital Acquisition and Repayment Cycle Inherent risk Control risk Acceptable audit risk Planned detection risk A B C D highlow highmedium low medium

19. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 19 Learning Objective 6 Describe the audit risk model and its components.

20. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 20 Audit Risk Model for Planning PDR = AAR ÷ (IR × CR) PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk

21. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 21 Learning Objective 7 Consider the impact of risk on acceptable audit risk.

22. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 23 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

24. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 24 Factors Affecting Acceptable Audit Risk The auditor’s evaluation of management’s integrity

25. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 25 Making the Acceptable Audit Risk Decision Methods to Assess Risk External users reliance on financial statements Examine financial statements. Read minutes of the board. Examine form 10K. Discuss financing plans with management. Factors

26. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 26 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 8 for client acceptance and continuance.

27. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 27 Learning Objective 8 Consider the impact of several factors on the assessment of inherent risk.

28. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 29 Learning Objective 9 Consider information gathered to assess the likelihood of fraud.

30. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 30 Assessing Risks of Fraud Three conditions are generally present. 1. Incentives/Pressures 2. Opportunities 3. Attitudes/Rationalization

31. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 35 Learning Objective 10 Discuss the relationship of risks to audit evidence.

36. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 36 Relationship of Risk Factors, Risk, and Evidence Factors Influencing Risks Acceptable audit risk Planned detection risk Planned audit evidence Inherent risk Control risk I D I ID I D D = Direct relationship; I = Inverse relationship

37. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 42 Relationships of Risk to Evidence AcceptablePlannedAmount of AuditInherentControlDetectionEvidence SituationRiskRiskRiskRiskRequired 1HighLowLowHighLow 2LowLowLowMediumMedium 3LowHighHighLowHigh 4MediumMediumMediumMediumMedium 5HighLowMediumMediumMedium

43. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 44 Learning Objective 11 Discuss how materiality and risk are related and integrated into the audit process.

45. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 45 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

46. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 46 Audit Risk Model for Evaluating Results AcAR = IR × CR × AcDR AcAR = Achieved audit risk AcDR = Achieved detection risk IR = Inherent risk CR = Control risk

47. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 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. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 9 - 48 End of Chapter 9