1. Copyright © 2007 Pearson Education Canada 1 Chapter 8: Materiality and Risk

2. Copyright © 2007 Pearson Education Canada 8-2 Chapter 8 objectives  Consider how materiality is used to decide on the amount of fieldwork to be collected  List the different types of risks considered during the audit process  Identify the components of the audit risk model  Explain how inherent risk is assessed  Discuss how the audit risk model is used during the conduct of the audit

3. Copyright © 2007 Pearson Education Canada 8-3 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?

4. Copyright © 2007 Pearson Education Canada 8-4 Steps in applying materiality during the audit

5. Copyright © 2007 Pearson Education Canada 8-5 When you find a material misstatement  What would you do?  If you ask the client to correct the material misstatement and they refuse, what are your options?

6. Copyright © 2007 Pearson Education Canada 8-6 Levels of misstatements (pp. 211-12)  1. Identified misstatements  2. Likely misstatements  3. Likely aggregate misstatements  4. Further possible misstatements

7. Copyright © 2007 Pearson Education Canada 8-7 Materiality is set early  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

8. Copyright © 2007 Pearson Education Canada 8-8 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

9. Copyright © 2007 Pearson Education Canada 8-9 Potential bases for materiality  Revenue  Net income before taxes (NIBT) – also exclude EI  Total Assets  Shareholders’ Equity

10. Copyright © 2007 Pearson Education Canada 8-10 Practice problem 8-16 (p. 238)  Let’s take a look at a realistic set of financial statements  How would you calculate the materiality figure?  What base would you choose?

11. Copyright © 2007 Pearson Education Canada 8-11 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

12. Copyright © 2007 Pearson Education Canada 8-12 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

13. Copyright © 2007 Pearson Education Canada 8-13 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

14. Copyright © 2007 Pearson Education Canada 8-14 Audit risk model

15. Copyright © 2007 Pearson Education Canada 8-15 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

16. Copyright © 2007 Pearson Education Canada 8-16 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

17. Copyright © 2007 Pearson Education Canada 8-17 Assessing Audit Risk  Factors: – Nature of users – Likelihood of financial difficulties – Management integrity  Also consider business risk

18. Copyright © 2007 Pearson Education Canada 8-18 When audit risk goes down  What happens to the evidence to be collected?  What does this say about the nature of the users?  About potential lawsuits?

19. Copyright © 2007 Pearson Education Canada 8-19 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)  Internal controls are ignored in this assessment

20. Copyright © 2007 Pearson Education Canada 8-20 Inherent risk is assessed at the account balance assertion level  Let’s look at a company like a big bank  What are it’s inherent risks for mortgages receivable?  For loan loss provisions ?

21. Copyright © 2007 Pearson Education Canada 8-21 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

22. Copyright © 2007 Pearson Education Canada 8-22 Reliance on internal controls is a choice  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

23. Copyright © 2007 Pearson Education Canada 8-23 Control risk  What would we consider when assessing the control risk with respect to money deposited at an ATM?

24. Copyright © 2007 Pearson Education Canada 8-24 Where reliance on internal controls occurs the auditor must  1. Obtain an understanding of internal controls  2. Evaluate control risk (the capacity for the internal control to prevent or detect errors)  3. Design tests of controls and test the internal controls (Certain controls may not need to be tested every year, such as programmed controls that have not changed since the prior year. They can be tested as infrequently as every three years.)

25. Copyright © 2007 Pearson Education Canada 8-25 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

26. Copyright © 2007 Pearson Education Canada 8-26 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

27. Copyright © 2007 Pearson Education Canada 8-27 Detection risk  This is the only part of the audit risk model that can be affected by the actions of the auditor

28. Copyright © 2007 Pearson Education Canada 8-28 Practice problem 8-17 (p. 238)  Three different scenarios  How would you set audit risk, inherent risk, control risk and detection risk?

29. Copyright © 2007 Pearson Education Canada 8-29 Materiality, risk and evidence  Evidence collection needs to increase when: – Risk of errors increases – Materiality goes down

30. Copyright © 2007 Pearson Education Canada 8-30 Practice problem 8-22 (p. 241)  How would you defend your selection of a materiality level in court?