Chapter 9 Materiality and Risk

Chapter 9 Materiality and Risk Audit Risk CPA 9-1 Presentation Outline I. III. Steps in Applying Materiality II. Risk in Auditing Planning Model Relationships IV. Evaluating Results

9-2 9-3 Step 1 in Applying Materiality Set preliminary judgment about materiality. Permissible misstatements are often less for smaller clients. Although the FASB and AICPA are unwilling to provide specific materiality guidelines to practitioners, bases are needed for evaluating materiality. See Figure 9-2 on page 235. Qualitative factors can affect materiality. See factors on pages 234-235. The preliminary judgment about materiality is the maximum amount the auditor believes the statements could be misstated and still not affect the decisions of reasonable users. Decided early in audit. 9 - 4

Step 2 in Applying Materiality Allocate preliminary judgment about materiality to segments. Most practitioners allocate materiality to balance sheet rather than income statement accounts. This is because most income statement misstatements have an equal effect on the balance sheet because of the double-entry bookkeeping system. The sum of the tolerable misstatement is allowed to exceed overall materiality because (1) it is unlikely that all accounts will be misstated by the full amount of tolerable misstatement, and (2) some accounts are overstated while others are understated, resulting in a net amount that is likely to be less than overall materiality. An allocation is necessary because evidence is accumulated by segments rather than the financial statements taken as a whole. The allocation to account balances is known as the tolerable misstatement. 9-5 Illustration of Tolerable Misstatement Allocation for Current Assets

Account Cash Accounts receivable Inventory Preliminary judgment about materiality Tolerable Misstatement $ 4,000 20,000 36,000 $50,000 9-6 Step 3 in Applying Materiality Estimate total misstatement in segment. $3,500 net misstatement of the inventory sample

= $50,000 total inventory sampled $450,000 total recorded population value for inventory $31,500 direct projection estimate of misstatement $3,500 $50,000 $450,000 = $31,500 One way to calculate the estimate of misstatement is to make a direct projection from the sample to the population. 9-7 Illustration of Estimating Total Misstatement in Segment

Account Cash Accounts receivable Inventory Tolerable Direct Sampling Misstatement Projection Error Total $ 4,000 $ 0 $ N/A $ 0 20,000 12,000 6,000* 18,000 36,000 31,500

15,750* 47,250 Preliminary judgment about materiality $50,000 *estimate for sampling error is 50% 9-8 Step 4 in Applying Materiality Estimate the combined misstatement. Tolerable Direct Sampling Misstatement Projection Error Total $ 4,000 $ 0 $ N/A

$ 0 20,000 12,000 6,000* 18,000 36,000 31,500 15,750* 47,250 Account Cash Accounts receivable Inventory Total estimated misstatement amount Preliminary judgment about materiality $50,000 *estimate for sampling error is 50%

$43,500 $16,800 $60,300 9-9 Step 5 in Applying Materiality Compare combined estimate with preliminary or revised judgment about materiality. Tolerable Direct Sampling Misstatement Projection Error Total $ 4,000 $ 0 $ N/A

$ 0 20,000 12,000 6,000* 18,000 36,000 31,500 15,750* 47,250 Account Cash Accounts receivable Inventory Total estimated misstatement amount $43,500 $16,800 $60,300 Preliminary judgment about materiality $50,000

*estimate for sampling error is 50% Because the estimated combined misstatement exceeds the preliminary judgment, the financial statements are not acceptable. The auditor may perform additional audit procedures to reevaluate the estimate, or require adjustment for the estimated misstatements. 9 - 10 II. Risk in Auditing Components of Audit Risk B. Acceptable Audit Risk C. Inherent Risk D. Control Risk E. Planned Detection Risk A. Audit Risk

9 - 11 A. Components of Audit Risk Total misstatement Inherent Risk (IR) Susceptibility of an assertion to material misstatement assuming no related internal controls. Control Risk (CR) Risk of misstatements not being detected by system of internal control.

Detection Risk (DR) Risk of misstatements not being detected by the auditor. Audit Risk (AR) Misstatement that remains undetected by the auditor. Caught by internal controls Caught by auditor

= Undetected misstatement B. Acceptable Audit Risk Audit Risk The following factors mean that audit risk should be kept lower: 1. Reliance by External Users 2. Likelihood of Financial Failure 3. Integrity of Management 9 - 13 1. Reliance by External Users

XYZ Co. Financial Statements When external users place heavy emphasis on the financial statements, acceptable audit risk should be kept low. The following generally results in more users of the financial statements: Larger clients Publicly held corporations Extensive use of liabilities 9 - 14 2. Likelihood of Financial Failure There is a greater chance of

having to defend the quality of the audit when there is a financial failure. Failure indicators include: Shortage of funds Declining net income or continued losses Risky industries such as technology Management lacking competency to deal with financial difficulties 9 - 15 3. Integrity of Management If a client has questionable integrity, the auditor is likely to assess acceptable audit risk

lower. Indications of integrity problems include: Frequent disagreements with prior auditors, the IRS, and/or SEC Frequent turnover of key financial and internal audit personnel Ongoing conflicts with labor unions and employees 9 - 16 C. Inherent Risk Nature of the Clients Business 2. Results of Previous Audits 3. Initial vs. Repeat Engagement 4.

Related Parties 5. Nonroutine Transactions 6. Judgment Required 7. Make-up of the Population 1. 9 - 17 1. Nature of the Clients Business Rickys Electronics Inherent risk is likely to vary from business to business for accounts such as inventory,

accounts and loans receivable, and property, plant, and equipment. The nature of the business should have little effect on cash, notes payable, and mortgages payable. 9 - 18 2. Results of Previous Audits Misstatements found in the previous years audit have a high likelihood of occurring again.

Many types of misstatements are systematic in nature, and organizations are slow in making changes to eliminate them. 9 - 19 3. Initial vs. Repeat Engagement Most auditors use a larger inherent risk for initial audits than for repeat engagements in which no material misstatements had been found. 9 - 20

4. Related Parties Examples of related party transactions are those between parent and subsidiary companies, and management or owners and the company. Increases inherent risk because there is a greater likelihood of misstatement. 9 - 21 5. Nonroutine Transactions

Transactions that are unusual for the client are more likely to be recorded incorrectly. Examples include fire losses, major property acquisitions, etc. 9 - 22 6. Judgment Needed Many account balances require estimates and a great deal of management judgment including: Uncollectible accounts

receivable Obsolete inventory Warranty liabilities 9 - 23 7. Make-up of the Population Accounts receivable where most accounts are significantly overdue Transactions with related parties Disbursements made payable to cash Inventory with a slow turnover 9 - 24

D. Control Risk There are two basic phases to an auditors evaluation of control risk: 1. Obtain an understanding of internal control. This phase applies to all audits. 2. Test the internal controls for effectiveness. This phase only applies when the auditor chooses to assess control risk at below the maximum. 9 - 25 E. Planned Detection Risk The auditor can reduce planned detection risk by performing more substantive testing. Increased audit evidence Low

erin g Acc ept able Aud it Risk Lower Detection Risk 9 - 26 III. Planning Model Relationships

Acceptable Audit Risk Relationships B. Inherent Risk Relationships C. Control Risk Relationships The Overall Relationship of Components in Planning the Audit Process E. The Audit Risk Model for Planning A. D. 9 - 27 A. Acceptable Audit Risk Relationships Acceptable audit risk Direct

Planned detection risk Inverse Planned audit evidence Acceptable audit risk is the risk that the auditor is willing to take of giving an unqualified opinion when the financial statements are materially misstated. As acceptable audit risk increases, the auditor is willing to collect less evidence (inverse) and therefore accept a higher detection risk (direct). 9 - 28 B. Inherent Risk Relationships D

Inherent risk I Planned detection risk Planned audit evidence Inherent risk is the susceptibility of an assertion to material misstatement assuming no related internal controls. As inherent risk increases, the auditor must reduce

detection risk (inverse) by collecting more audit evidence (direct). 9 - 29 C. Control Risk Relationships Planned detection risk Control risk I Planned audit evidence D Control risk is the risk of misstatements not being detected by the clients system of internal control.

As control risk increases, the auditor must reduce detection risk (inverse) by collecting more audit evidence (direct). 9 - 30 D. The Overall Relationship of Components in Planning the Audit Process Acceptable audit risk Inherent risk Control risk D I

Planned detection risk I D I I Planned audit evidence D I Tolerable misstatement D = Direct relationship; I = Inverse relationship

9 - 31 E. The Audit Risk Model for Planning PDR = AAR (IR CR) PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk 9 - 32 IV. Evaluating Results A. Audit Risk Model for Evaluating Results B. Reducing Achieved Audit Risk

C. Revising Risks and Evidence 9 - 33 A. Audit Risk Model for Evaluating Results AcAR = IR CR AcDR AcAR = Achieved audit risk AcDR = Achieved detection risk IR = Inherent risk CR = Control risk 9 - 34 B. Reducing Achieved Audit Risk The audit risk model for evaluating results is stated in SAS 47. Research subsequent to the issuance of SAS 47 has shown that it is not appropriate to uses this evaluation formula as originally intended. However, the model does show three possible ways to reduce achieved audit risk to an acceptable

level. Reduce inherent risk not feasible unless new facts are uncovered during the audit process. Reduce control risk may be possible to reevaluate control risk to a lower level by conducting more tests of internal controls. Reduce achieved detection risk can be achieved by larger sample sizes and/or additional audit procedures. 9 - 35 C. Revising Risks and Evidence

Great care must be used when revising the risk factors when the actual results are not as favorable as planned. When the auditor concludes that the original assessment of control risk or inherent risk was understated or acceptable audit risk was overstated, a two step approach should be used: The auditor must revise the original assessment of the appropriate risk. 2. The auditor should consider the effect of the revision on evidence requirements , without the use of the audit risk model. Research shows that using the model in the evaluation stage often results in an insufficient increase of evidence. 9 - 36 1. Summary Audit Process Applying

Materiality Risk and Audit Planning Evaluating Results Risk Internal Control 9 - 37

Recently Viewed Presentations

  • Rehearsal Techniques

    Rehearsal Techniques

    Rehearsal Techniques Question. The first part (i) you just need to name two and in the second part (ii) explain how it would help an actor to prepare for the scene.. If you are asked to discuss rehearsal techniques, the...
  • Impressionism In art, what can that possibly mean?

    Impressionism In art, what can that possibly mean?

    Dancers in Pink by Edgar Degas Boating by Edouard Manet Impressionism Girl with a Watering Can By Pierre- Auguste Renoir Claude Monet One of the central artists associated with Impressionism was Claude Monet. Monet's painting, Impression, Sunrise, inspired the name...
  • Health and Safety Awareness

    Health and Safety Awareness

    Depends on context but for Barry, 6-8 weeks. Objectives: Specific, Measurable, Achievable, Realistic, Time bound. Have a go at writing a SMART objective for Barry to prepare the packs for the next open day which is due on 22 March....
  • 3.3- Hooliganism in sport What is Hooliganism? Where

    3.3- Hooliganism in sport What is Hooliganism? Where

    Any violence brings the sport into disrepute and damages its ability to gain extra numbers at the grass root level with parents not wanting their children in contact with violence. Legitimate fans will be kept behind while others are herding....
  • Boreatton Park Shropshire 18th-22nd June 2018 LEARNING OUTSIDE

    Boreatton Park Shropshire 18th-22nd June 2018 LEARNING OUTSIDE

    Boreatton Park Shropshire ... doors and gates are locked at night but can be opened from the inside in an emergency without the need for unlocking A PGL staff member is available on duty throughout the night (contactable by phone)...
  • Examples of Sports Marketing - Sports Career Consulting, LLC

    Examples of Sports Marketing - Sports Career Consulting, LLC

    Lesson 2.5 Understanding the Sports & Entertainment Product Copyright © 2017 by Sports Career Consulting, LLC ...
  • Estate planning, superannuation and taxation

    Estate planning, superannuation and taxation

    An individual is liable for excess non-concessional contributions tax if they do not release an amount for the excess non-concessional contributions (section 292-80 ITAA 1997). For 2016/17 these excess non-concessional contributions are taxed at 49% (47% from 1 July 2017).
  • Kein Folientitel

    Kein Folientitel

    ) C-10 (1967) (revocation 1997) Annex B Gruyère -- C-9 (1967) Annex B Emmental -- C-33 / C-34 (1973) Annex B Camembert/Brie PDO -- Annex B Fontina PDO -- Annex B Fiore Sardo PDO -- Annex B Asiago PDO --...