auditing 81.3550 materiality & risk chapter 8 materiality & risk chapter 8
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Auditing 81.3550Auditing 81.3550
Materiality & Risk
Chapter 8
Materiality & Risk
Chapter 8
HighlightsHighlights
• Materiality and professional judgment• Define the types of risks involved in an audit• Examine the risk model and it components
relationships• Discuss the impact of different risk levels on an
audit• Examine how risk and materiality are related
• Materiality and professional judgment• Define the types of risks involved in an audit• Examine the risk model and it components
relationships• Discuss the impact of different risk levels on an
audit• Examine how risk and materiality are related
8 - 2Copyright 2003 Pearson Education Canada Inc.
Steps in audit planningSteps in audit planningobtain
informationabout
client’s legalobligations
obtainbackgroundinformat ion
performpreliminaryanalytical
procedures
preplan
setmateriality, and
assess acceptableaudit risk andinherent risk
8 - 4Copyright 2003 Pearson Education Canada Inc.
Scope paragraph:We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement...
Note the referenceto materiality inthe audit report.
8 - 6Copyright 2003 Pearson Education Canada Inc.
Materiality is the magnitude of omitted or misstated information that,in the light of surrounding circumstances, would change or influence the decision of someone relying on the financial statements who has a reasonable knowledge of business and economic activities.
What ismateriality?
8 - 8Copyright 2003 Pearson Education Canada Inc.
For each engagement, auditors For each engagement, auditors typically establish a typically establish a preliminary preliminary
judgment about materialityjudgment about materiality..
The preliminary judgmentabout materiality is the maximumamount by which the auditor be-lieves the statements could be
misstated and still not affect thedecisions of reasonable users.
MaterialityMateriality• Relative concept need to consider and compare to
something• Auditor once sets preliminary level may later
adjust it based on the evidence• Involves the use of professional judgment to set
initial and subsequent levels of materiality• Guidelines provided by the CICA and may be also
provided by the Firm• End decision is the auditors do not have to use
these guidelines
• Relative concept need to consider and compare to something
• Auditor once sets preliminary level may later adjust it based on the evidence
• Involves the use of professional judgment to set initial and subsequent levels of materiality
• Guidelines provided by the CICA and may be also provided by the Firm
• End decision is the auditors do not have to use these guidelines
CCA Research Study Guidelines: Materiality
CCA Research Study Guidelines: Materiality
• 5-10% of Net Income B4 taxes
• .5-5 % of Gross Profit
• .5-1% of Total Assets
• .5-5% of Shareholders Equity
• .5-1% of Revenue
• Weighted average of those items listed above
• .5-2% of expenses – suggested guidelines for Non-profits
• 5-10% of Net Income B4 taxes
• .5-5 % of Gross Profit
• .5-1% of Total Assets
• .5-5% of Shareholders Equity
• .5-1% of Revenue
• Weighted average of those items listed above
• .5-2% of expenses – suggested guidelines for Non-profits
8 - 12Copyright 2003 P earson Education Canada Inc.
A sm all m aterialityestim ate w ill resultin m ore evidence.
A large m aterialityestim ate w ill resultin less evidence.
How does the prelim inary judgm ent How does the prelim inary judgm ent about m ateriality affect the about m ateriality affect the volum evolum e
of audit evidence?of audit evidence?
“Investigate m is-statem ents over $100.”
“Investigate m isstate-m ents over $10,000.”
8 - 14Copyright 2003 Pearson Education Canada Inc.
- materiality is strongly influenced byclient size
- multiple bases of materiality may beappropriate
FOR EXAMPLE: The auditor may be concerned that:net income is not misstated by $100,000,and total assets is not misstated by$300,000.
Factors affecting the preliminary Factors affecting the preliminary judgment about materiality judgment about materiality
8 - 17Copyright 2003 Pearson Education Canada Inc.
- multiple bases of materiality may beappropriate
- a fraud, illegal act or other irregularityis considered more material than anerror of the same dollar amount.
- small differences from contractualrequirements may be material (e.g.,ratios related to debt agreements)
- immaterial amounts may accumulateinto a material amount
Factors affecting the preliminary Factors affecting the preliminary judgment about materiality judgment about materiality
8 - 18Copyright 2003 Pearson Education Canada Inc.
Steps in audit planningSteps in audit planningobtain
informationabout
client’s legalobligations
obtainbackgroundinformation
performpreliminaryanalytical
procedures
preplan
What isacceptableaudit risk?
setmateriality, and
assess acceptableaudit risk andinherent risk
8 - 19Copyright 2003 Pearson Education Canada Inc.
What is acceptableaudit risk?
Acceptable audit risk is therisk that the auditor is willingto accept that an unqualified
opinion will be issued for statements that are materially
misstated.
setmateriality, and
assess acceptableaudit risk andinherent risk
8 - 2 2C o p y r i g h t 2 0 0 3 P e a r s o n E d u c a t i o n C a n a d a I n c .
t h eg r e a t e r
t h ec e r t a i n t y
t h ea u d i t o r
w a n t s t oa c h i e v e
9 8 %
t h eg r e a t e r
t h e a m o u n to f a u d i t
e v i d e n c ea n d
c o s t s
t h el o w e r
t h e a c c e p t a b l e
a u d i t r i s k
2 %
8 - 28Copyright 2003 Pearson Education Canada Inc.
Risk is very difficult Risk is very difficult to to quantifyquantify..
subjective
based onjudgment
8 - 30Copyright 2003 Pearson Education Canada Inc.
How can an auditor How can an auditor reducereduceachieved audit risk?achieved audit risk?
auditrisk
evidenceand cost
achievedrisk
acceptablerisk
sufficient,appropriate
gathergathermoremore
evidenceevidence
8 - 34Copyright 2003 Pearson Education Canada Inc.
- degree to which users rely on the client’s financial statements
- likelihood that the client will have financialdifficulties after the report has been issued
- management integrity
Auditors should consider:
Auditors may face additional audit risk Auditors may face additional audit risk because of because of business riskbusiness risk; i.e., the risk of ; i.e., the risk of
loss or injury to the auditor’s practice loss or injury to the auditor’s practice because of a client relationship (e.g., because of a client relationship (e.g.,
litigation, adverse publicity, etc.).litigation, adverse publicity, etc.).
8 - 35Copyright 2003 Pearson Education Canada Inc.
Audit Risk has 3 components Audit Risk has 3 components which combine to make the which combine to make the
audit risk modelaudit risk model::
= x xauditrisk
inherentrisk
controlrisk
detectionrisk
8 - 39Copyright 2003 Pearson Education Canada Inc.
Inherent RiskInherent Risk- defined as the risk that material mis-
statements exist before considering the client’s internal controls
- some accounts, components, cyclesare inherently riskier than others
auditors must:- identify inherently risky areas- gather appropriate evidence
regarding those areas
8 - 51Copyright 2003 Pearson Education Canada Inc.
Inherent risk considerationsInherent risk considerations- nature of client’s business- integrity of management- client motivation to misstate the finan-
cial statements- results of previous audits- initial vs. repeat engagements- related parties- non-routine transactions
HasGAAP been
correctlyapplied?
8 - 54Copyright 2003 Pearson Education Canada Inc.
averageage of a/p, 45 days
Which is riskierWhich is riskier??averageage of a/p, 15 days
Inherent risk considerationsInherent risk considerations- judgment required to correctly record
transactions- susceptibility to defalcation- makeup of the population
8 - 56Copyright 2003 Pearson Education Canada Inc.
Audit Risk has 3 components Audit Risk has 3 components which combine to make the which combine to make the
audit risk modelaudit risk model::
therisk that material
misstatements will not be prevented ordetected by
internal controls
= x xauditrisk
inherentrisk
controlrisk
detectionrisk
8 - 58Copyright 2003 Pearson Education Canada Inc.
Audit Risk has 3 components Audit Risk has 3 components which combine to make the which combine to make the
audit risk modelaudit risk model::
Detection risk is the riskthat material misstate-
ments will not be detectedby the auditor.
= x xauditrisk
inherentrisk
controlrisk
detectionrisk
8 - 64Copyright 2003 Pearson Education Canada Inc.
Why does Why does detection riskdetection risk exist?exist?
The last 3 reasons areThe last 3 reasons are nonsamnonsam--plingpling errorserrors. The risk of their. The risk of their ococ--currencecurrence is is nonnon--sampling risksampling risk..
- the auditor samples (sampling risk)- the auditor may select ineffective audit
procedures- the auditor may apply procedures
ineffectively- the auditor may incorrectly evaluate
the results of procedures
8 - 66Copyright 2003 Pearson Education Canada Inc.
Which of these Which of these components can components can
the auditor the auditor influence?influence?
Audit Risk has 3 components Audit Risk has 3 components which combine to make the which combine to make the
audit risk modelaudit risk model::
indirectly:influencemanage-
ment
directly- larger
sample size
- enhancedtraining
= x xauditrisk
inherentrisk
controlrisk
detectionrisk
Relationship Between Components of Risk Model
Relationship Between Components of Risk Model
• Audit risk decreases = increased level of assurance req’d = increased amount of evidence req’d
• Inherent Risk and Detection Risk have inverse relationship example: IR deemed high (holding CR constant) required decreased level of detection risk to hold Audit Risk Level constant = more evidence req’ d to lower DR
• Inverse relationship between CR and DR = CR increases then DR must decrease holding IR constant = more evidence require to reduce DR
• See diagram p.222
• Audit risk decreases = increased level of assurance req’d = increased amount of evidence req’d
• Inherent Risk and Detection Risk have inverse relationship example: IR deemed high (holding CR constant) required decreased level of detection risk to hold Audit Risk Level constant = more evidence req’ d to lower DR
• Inverse relationship between CR and DR = CR increases then DR must decrease holding IR constant = more evidence require to reduce DR
• See diagram p.222