1. Auditing: The Art and Science of Assurance Engagements Chapter 7: Materiality and Risk Copyright © 2011 Pearson Canada Inc.

2. Auditing, Canadian Eleventh Edition Chapter 7 Learning Objectives 1.Identify the components of the audit risk model. 2.Explain how inherent risk is assessed. 3.Examine how materiality is used to assess the amount of work conducted during an audit engagement. 4.Relate the components of the audit risk model to the amount of evidence that should be collected during an audit. 7-2 Copyright © 2011 Pearson Canada Inc.

3. Auditing, Canadian Eleventh Edition What is Risk? Risks arise when a situation involves uncertainty. Assessing risks includes assessing probabilities – what is the “risk” of rain today? What is the “risk” of a flood today? Assessing risks is part of our daily lives – we constantly assess the likelihood of events when making decisions. 7-3 Copyright © 2011 Pearson Canada Inc.

4. Auditing, Canadian Eleventh Edition Risk in Auditing The auditor accepts some level of uncertainty when performing an audit. There is always a small likelihood remaining that the financial statements may be in error. The audit risk model is used as part of a strategic auditing approach. 7-4 Copyright © 2011 Pearson Canada Inc.

5. Auditing, Canadian Eleventh Edition Strategic Auditing An audit engagement is a tactical plan of action. Audit procedures are designed to satisfy audit objectives and to reduce the probability of errors or other misstatements in the financial statements. 7-5 Copyright © 2011 Pearson Canada Inc.

6. Auditing, Canadian Eleventh Edition Audit Risk Model 7-6 Copyright © 2011 Pearson Canada Inc.

7. Auditing, Canadian Eleventh Edition Audit Risk Model Formula Audit risk = inherent risk x control risk x detection risk AR = IR x CR x DR The audit risk model is a planning model. 7-7 Copyright © 2011 Pearson Canada Inc.

8. Auditing, Canadian Eleventh Edition Audit Risk A measure of the auditor’s willingness (i.e. the auditor chooses this number) to accept that the financial statements may be materially misstated even though a proper audit has been conducted. Audit ASSURANCE is the complement of audit risk. Complete assurance is impossible to achieve. 7-8 Copyright © 2011 Pearson Canada Inc.

9. Auditing, Canadian Eleventh Edition Assessing Audit Risk Factors: –Nature of users –Likelihood of financial difficulties –Management integrity Also consider business risk 7-9 Copyright © 2011 Pearson Canada Inc.

10. Auditing, Canadian Eleventh Edition Inherent Risk A measure of the likelihood that there are material misstatements in a segment simply due to the nature of the segment (e.g. cash is more likely to be stolen than sheets of steel). Inherent Risk is assessed at the account balance assertion level Internal controls are ignored in this assessment. 7-10 Copyright © 2011 Pearson Canada Inc.

11. Auditing, Canadian Eleventh Edition Assessing Inherent Risk The auditor should consider several major factors when assessing inherent risk: Nature of the client’s business Nature of data processing systems/data communications. Integrity of management. Client motivation. Results of previous audits. Initial versus repeat engagement. (Continued) 7-11 Copyright © 2011 Pearson Canada Inc.

12. Auditing, Canadian Eleventh Edition Assessing Inherent Risk (Continued) Related parties. Nonroutine transactions. Judgment required to record account balances and transactions correctly. Assets that are susceptible to misappropriation. Makeup of the population. 7-12 Copyright © 2011 Pearson Canada Inc.

13. Auditing, Canadian Eleventh Edition Control Risk A measure of the likelihood that misstatements will NOT be detected or prevented by the internal control systems. This assessment is conducted because it is required by generally accepted auditing standards and also because it is needed to design the nature and extent of audit tests. 7-13 Copyright © 2011 Pearson Canada Inc.

14. Auditing, Canadian Eleventh Edition Internal Controls The auditor is required to evaluate internal controls, not to rely upon them. Reliance may be necessary for certain types of systems (e.g. complex automated systems or paperless systems). In other situations, the auditor may choose between internal control testing and tests of details. 7-14 Copyright © 2011 Pearson Canada Inc.

15. Auditing, Canadian Eleventh Edition Reliance on Internal Controls Auditors must: 1.Obtain an understanding of the design of the client’s internal control. 2.Evaluate the design effectiveness of those controls based on the understanding. 3.Test internal control for operational effectiveness. 7-15 Copyright © 2011 Pearson Canada Inc.

16. Auditing, Canadian Eleventh Edition Setting Control Risk at 100% This means that there is no reliance on internal controls, because control risk is at maximum (which means that the assurance from tests of controls will be zero). This can occur either because of inadequate control systems or it may be too expensive to use tests of controls rather than tests of details. 7-16 Copyright © 2011 Pearson Canada Inc.

17. Auditing, Canadian Eleventh Edition Planned Detection Risk This represents the audit testing that is required on the part of the auditor (or team) to adequately assess the financial statements. Once audit risk is set, and control risk and inherent risk assessed, then detection risk can be calculated. This is the only part of the audit risk model that can be affected by the actions of the auditor 7-17 Copyright © 2011 Pearson Canada Inc.

18. Auditing, Canadian Eleventh Edition Discussion Problem 7-18, p. 234 Working with the audit risk model. 7-18 Copyright © 2011 Pearson Canada Inc.

19. Auditing, Canadian Eleventh Edition Discussion Problem 7-19, p. 234 Assessing audit risk factors. 7-19 Copyright © 2011 Pearson Canada Inc.

20. Auditing, Canadian Eleventh Edition Discussion Problem 7-20, p. 235 Three different scenarios How would you set audit risk, inherent risk, control risk and detection risk? 7-20 Copyright © 2011 Pearson Canada Inc.

21. Auditing, Canadian Eleventh Edition Materiality Previously, paragraph 5142.04 of the CICA Handbook (replaced by material in CAS 320 and CAS 450) defines materiality as follows: A misstatement... in financial statements is considered to be material if, in the light of surrounding circumstances, it is probable that the decision of a person who is relying on the financial statements, and who has a reasonable knowledge of business and economic activities (the user), would be changed or influenced by such misstatement... 7-21 Copyright © 2011 Pearson Canada Inc.

22. Auditing, Canadian Eleventh Edition Materiality is in the “Eye of the Beholder” An audit is expected to obtain reasonable assurance that there is an absence of “material misstatement”. A material error is defined in the context of what a reasonable business user would think – would it affect his/her decision? 7-22 Copyright © 2011 Pearson Canada Inc.

23. Auditing, Canadian Eleventh Edition Steps in Applying Materiality During the Audit 7-23 Copyright © 2011 Pearson Canada Inc.

24. Auditing, Canadian Eleventh Edition Material Misstatement What would you do if you found a material misstatement? If you ask the client to correct the material misstatement and they refuse, what are your options? 7-24 Copyright © 2011 Pearson Canada Inc.

25. Auditing, Canadian Eleventh Edition Levels of Misstatements CAS 450 suggests that an auditor be concerned with several levels of misstatement in assessing whether or not there is a material misstatement: 1.Identified misstatements 2. Likely or projected misstatements 3. Likely aggregate misstatement 4. Further possible misstatements 5. Maximum possible misstatement 7-25 Copyright © 2011 Pearson Canada Inc.

26. Auditing, Canadian Eleventh Edition Discussion Problem 7-21, p. 235 Dealing with different types of misstatements. 7-26 Copyright © 2011 Pearson Canada Inc.

27. Auditing, Canadian Eleventh Edition Materiality The preliminary judgment about materiality is set prior to the conduct of detailed audit testing, during planning. Helps in deciding the amount of evidence to collect. If there are substantial changes to the financial statements, then materiality may need to be revised. 7-27 Copyright © 2011 Pearson Canada Inc.

28. Auditing, Canadian Eleventh Edition What Affects the Materiality Decision? Materiality is relative rather than absolute. A base needs to be chosen. Qualitative factors are used (emphasizing the importance of knowledge of business). Firm guidelines or past practice. 7-28 Copyright © 2011 Pearson Canada Inc.

29. Auditing, Canadian Eleventh Edition Potential Bases for Materiality Common bases include the following: 5 to 10 percent of net income before taxes. 1/2 percent to 5 percent of gross profit. 1/2 percent to 1 percent of total assets. 1/2 percent to 5 percent of shareholders’ equity. 1/2 percent to 2 percent of revenue. 1/2 percent to 2 percent of expenses or revenue as suggested by the guideline for non-profit entities. 7-29 Copyright © 2011 Pearson Canada Inc.

30. Auditing, Canadian Eleventh Edition Discussion Problem 7-22, p. 235 Let’s take a look at a realistic set of financial statements. How would you calculate the materiality figure? What base would you choose? 7-30 Copyright © 2011 Pearson Canada Inc.