8 - 1Copyright 2003 Pearson Education Canada Inc.

CHAPTER 8Materiality

and Risk

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 - 3Copyright 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...

The phrase “reasonableassurance” in the audit reportindicates that there is some

audit 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 - 5Copyright 2003 Pearson Education Canada Inc.

What ismateriality?

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 - 7Copyright 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..

?

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.

8 - 9Copyright 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..

- may be based on a firm-wide formula considering net income, gross profit, total assets, revenue, shareholders’ equity, e.g., 5% of net income

adjusted accordingto auditor judgment

8 - 10Copyright 2003 Pearson Education Canada Inc.

How does the preliminary judgment How does the preliminary judgment about materiality affect the about materiality affect the volumevolume

of audit evidence?of audit evidence?

8 - 11Copyright 2003 Pearson Education Canada Inc.

A small materialityestimate will resultin more evidence.

“Investigate misstate- ments over $100.”

How does the preliminary judgment How does the preliminary judgment about materiality affect the about materiality affect the volumevolume

of audit evidence?of audit evidence?

8 - 12Copyright 2003 Pearson Education Canada Inc.

A small materialityestimate will resultin more evidence.

A large materialityestimate will resultin less evidence.

How does the preliminary judgment How does the preliminary judgment about materiality affect the about materiality affect the volumevolume

of audit evidence?of audit evidence?

“Investigate mis- statements over $100.”

“Investigate misstate- ments over $10,000.”

8 - 13Copyright 2003 Pearson Education Canada Inc.

- materiality is strongly influenced by client size

$1,000 - WOW!

$1,000...peanuts

Factors affecting the preliminary Factors affecting the preliminary judgment about materiality judgment about materiality

8 - 14Copyright 2003 Pearson Education Canada Inc.

- materiality is strongly influenced by client size- multiple bases of materiality may be appropriateFOR 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 - 15Copyright 2003 Pearson Education Canada Inc.

- materiality is strongly influenced by client size- multiple bases of materiality may be appropriate- a fraud, illegal act or other irregularity is considered more ma terial than an error of the same dollar amount.

WHY?WHY?

Factors affecting the preliminary Factors affecting the preliminary judgment about materiality judgment about materiality

8 - 16Copyright 2003 Pearson Education Canada Inc.

- materiality is strongly influenced by client size- multiple bases of materiality may be appropriate- a fraud, illegal act or other rregularity is considered more material than an error of the same dollar amount.- small differences from contractual requirements may be material (e.g., ratios related to debt agreements)

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 be appropriate- a fraud, illegal act or other irregularity is considered more material than an error of the same dollar amount.- small differences from contractual requirements may be material (e.g., ratios related to debt agreements)- immaterial amounts may accumulate into 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 acceptable audit 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 - 20Copyright 2003 Pearson Education Canada Inc.

thelowerthe

acceptableaudit risk

2%

8 - 21Copyright 2003 Pearson Education Canada Inc.

the greater the certainty the auditor wants to achieve

98%

thelowerthe

acceptableaudit risk

2%

8 - 22Copyright 2003 Pearson Education Canada Inc.

the greater the certainty the auditor wants to achieve

98%

thegreater

the amountof audit

evidenceand

costs

thelowerthe

acceptableaudit risk

2%

8 - 23Copyright 2003 Pearson Education Canada Inc.

What is achieved audit risk?

8 - 24Copyright 2003 Pearson Education Canada Inc.

Achieved audit risk is theactual risk that the state-ments are materially mis-stated after an unqualifiedopinion has been issued.

What is achieved audit risk?

8 - 25Copyright 2003 Pearson Education Canada Inc.

How do How do acceptableacceptable and and achievedachieved audit risk affect the audit risk affect the audit reportaudit report??

8 - 26Copyright 2003 Pearson Education Canada Inc.

How do How do acceptableacceptable and and achievedachieved audit risk affect the audit risk affect the audit reportaudit report??

ifachieved audit risk

acceptable audit risk<audit report issupported bythe evidence

5%

10%

8 - 27Copyright 2003 Pearson Education Canada Inc.

How do How do acceptableacceptable and and achievedachieved audit risk affect the audit risk affect the audit reportaudit report??

audit report isnot supported

by the evidence

ifachieved audit risk

acceptable audit risk>

15%

5%

8 - 28Copyright 2003 Pearson Education Canada Inc.

Risk is very difficult Risk is very difficult to to quantifyquantify..

subjective

based onjudgment

8 - 29Copyright 2003 Pearson Education Canada Inc.

How canHow canan auditor an auditor

reducereduce audit audit risk?risk?

8 - 30Copyright 2003 Pearson Education Canada Inc.

How can an auditor How can an auditor reducereduce achieved audit risk?achieved audit risk?

audit risk

evidenceand cost

achieved risk

acceptable risk

sufficient,appropriate

gathergather moremore evidenceevidence

8 - 31Copyright 2003 Pearson Education Canada Inc.

Auditors may face additional auditAuditors may face additional auditrisk because of risk because of business riskbusiness risk; i.e.,; i.e.,

the risk of loss or injury to thethe risk of loss or injury to theauditor’s practice because of aauditor’s practice because of a

client relationship (e.g., litigation,client relationship (e.g., litigation,adverse publicity, etc.).adverse publicity, etc.).

8 - 32Copyright 2003 Pearson Education Canada Inc.

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.).

- degree to which users rely on the client’s financial statements

Auditors should consider:

FinancialStatements

Ace Company

8 - 33Copyright 2003 Pearson Education Canada Inc.

- degree to which users rely on the client’s financial statements- likelihood that the client will have financial difficulties after the report has been issued

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 - 34Copyright 2003 Pearson Education Canada Inc.

- degree to which users rely on the client’s financial statements- likelihood that the client will have financial difficulties 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 xaudit risk

inherent risk

control risk

detection risk

8 - 36Copyright 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 x

audit risk

inherent risk

control risk

detection risk

8 - 37Copyright 2003 Pearson Education Canada Inc.

Inherent RiskInherent Risk- defined as the risk that material mis- statements exist before considering the client’s internal controls

8 - 38Copyright 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, cycles are inherently riskier than others

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, cycles are inherently riskier than others

auditors must:- identify inherently risky areas- gather appropriate evidence regarding those areas

8 - 40Copyright 2003 Pearson Education Canada Inc.

Inherent risk considerationsInherent risk considerations

- nature of client’s business

EXAMPLE: Sally’s Clothing Boutique rents store space in a house.

What are the inherently riskyaccounts? Sally’s

8 - 41Copyright 2003 Pearson Education Canada Inc.

Inherent risk considerationsInherent risk considerations- nature of client’s business

EXAMPLE: Sally’s Clothing Boutique rents store space in a house.

What are the inherently riskyaccounts? cash inventory accounts payable

Sally’s

8 - 42Copyright 2003 Pearson Education Canada Inc.

Inherent risk considerationsInherent risk considerations- nature of client’s business

EXAMPLE: Sally’s Clothing Boutique rents store space in a house.

What are the inherently lessrisky accounts?

Sally’s

8 - 43Copyright 2003 Pearson Education Canada Inc.

Inherent risk considerationsInherent risk considerations- nature of client’s business

EXAMPLE: Sally’s Clothing Boutique rents store space in a house.

What are the inherently lessrisky accounts? capital assets equity

Sally’s

8 - 44Copyright 2003 Pearson Education Canada Inc.

Inherent risk considerationsInherent risk considerations- nature of client’s business- integrity of management

poorintegrity

moreevidence

8 - 45Copyright 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

Are managementbonuses based on net income?

8 - 46Copyright 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 - accounts, components which had material mis- statements in prior years should be tested extensively in the current year

8 - 47Copyright 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

Why are Why are initialinitial audit audit engagements inherentlyengagements inherently

riskier than riskier than repeatsrepeats??

8 - 48Copyright 2003 Pearson Education Canada Inc.

Why are Why are initialinitial audit audit engagements inherentlyengagements inherently

riskier than riskier than repeatsrepeats??- during the initial engagement, the auditor is not familiar with client systems, internal controls, and personnel

8 - 49Copyright 2003 Pearson Education Canada Inc.

Why are Why are initialinitial audit audit engagements inherentlyengagements inherently

riskier than riskier than repeatsrepeats??- during the initial engagement, the auditor is not familiar with client systems, internal controls, and personnel- during the initial engagement, be- ginning balances must be exten- sively examined

8 - 50Copyright 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

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 - 52Copyright 2003 Pearson Education Canada Inc.

Inherent risk considerationsInherent risk considerations- related parties- nonroutine transactions- judgment required to correctly record transactions

What do you mean by“obsolete” inventory?

8 - 53Copyright 2003 Pearson Education Canada Inc.

Inherent risk considerationsInherent risk considerations- related parties- nonroutine transactions- judgment required to correctly record transactions- susceptibility to defalcation

Example: CASH

8 - 54Copyright 2003 Pearson Education Canada Inc.

average age of a/p, 45 days

Which is riskierWhich is riskier?? average age of a/p, 15 days

Inherent risk considerationsInherent risk considerations- judgment required to correctly record transactions- susceptibility to defalcation- makeup of the population

8 - 55Copyright 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 x

audit risk

inherent risk

control risk

detection risk

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 xaudit risk

inherent risk

control risk

detection risk

8 - 57Copyright 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 xaudit risk

inherent risk

control risk

detection risk

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 xaudit risk

inherent risk

control risk

detection risk

8 - 59Copyright 2003 Pearson Education Canada Inc.

Why does Why does detection riskdetection risk exist? exist?

8 - 60Copyright 2003 Pearson Education Canada Inc.

$$

$$

$$ $

$$

$

$$

$$

$$

$

$ $ $

Why does Why does detection riskdetection risk exist? exist?

- the auditor samples (sampling risk)

8 - 61Copyright 2003 Pearson Education Canada Inc.

Why does Why does detection riskdetection risk exist? exist?

- the auditor samples (sampling risk)- the auditor may select ineffective audit procedures

8 - 62Copyright 2003 Pearson Education Canada Inc.

Why does Why does detection riskdetection risk exist? exist?

- the auditor samples (sampling risk)- the auditor may select ineffective audit procedures- the auditor may apply procedures ineffectively

8 - 63Copyright 2003 Pearson Education Canada Inc.

Why does Why does detection riskdetection risk exist? exist?

- 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 - 64Copyright 2003 Pearson Education Canada Inc.

Why does Why does detection riskdetection risk exist? exist?

The last 3 reasons are The last 3 reasons are nonsam-nonsam-pling errorspling errors. The risk of their oc-. The risk of their oc-currence is currence is non-sampling risknon-sampling 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 - 65Copyright 2003 Pearson Education Canada Inc.

Which of these Which of these components can the components can the

auditor influence?auditor 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::

= x xaudit risk

inherent risk

control risk

detection risk

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- enhanced training

= x xaudit risk

inherent risk

control risk

detection risk

8 - 67Copyright 2003 Pearson Education Canada Inc.

auditingprocedures

internalcontrols

Audit risk as a double-hoop basketball gameAudit risk as a double-hoop basketball game

8 - 68Copyright 2003 Pearson Education Canada Inc.

auditingprocedures

misstatements(inherently

risky accountsare better shots)

internalcontrols

Audit risk as a double-hoop basketball gameAudit risk as a double-hoop basketball game

8 - 69Copyright 2003 Pearson Education Canada Inc.

auditingprocedures

misstatementsdetected by

internal controls

internalcontrols

Audit risk as a double-hoop basketball gameAudit risk as a double-hoop basketball game

8 - 70Copyright 2003 Pearson Education Canada Inc.

auditingprocedures

misstatementsnot detected by internal controls

(control risk)

internalcontrols

Audit risk as a double-hoop basketball gameAudit risk as a double-hoop basketball game

8 - 71Copyright 2003 Pearson Education Canada Inc.

auditingprocedures

misstatements detected by auditors

internalcontrols

Audit risk as a double-hoop basketball gameAudit risk as a double-hoop basketball game

8 - 72Copyright 2003 Pearson Education Canada Inc.

auditingprocedures

internalcontrols

Audit risk as a double-hoop basketball gameAudit risk as a double-hoop basketball game

misstatements undetected by

auditors(detection risk)