Auditing 81.3550 Materiality & Risk Chapter 8 Materiality & Risk Chapter 8.

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


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.


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?


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.”


- 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


- 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


Steps in audit planningSteps in audit planningobtain

informationabout

client’s legalobligations

obtainbackgroundinformation

performpreliminaryanalytical

procedures

preplan

What isacceptableaudit risk?

setmateriality, and



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


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 %


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

subjective

based onjudgment


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

auditrisk

evidenceand cost

achievedrisk

acceptablerisk

sufficient,appropriate

gathergathermoremore

evidenceevidence


- 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.).


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


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


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?


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




therisk that material

misstatements will not be prevented ordetected by

internal controls

= x xauditrisk

inherentrisk

controlrisk

detectionrisk




Detection risk is the riskthat material misstate-

ments will not be detectedby the auditor.

= x xauditrisk

inherentrisk

controlrisk

detectionrisk


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


Which of these Which of these components can components can

the auditor the auditor influence?influence?



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

Auditing 81.3550 Materiality & Risk Chapter 8 Materiality & Risk Chapter 8.

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