© 2002 Mcgraw-Hill Ryerson Limited. All Rights Reserved

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All rights reserved.
2002 McGraw-Hill Ryerson Limited.
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Part Two
BASIC AUDITING CONCEPTS: MATERIALITY, AUDIT RISK, AND EVIDENCE
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Chapter 3
CHAPTER 3 MATERIALITY AND RISK
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MATERIALITY AND AUDIT RISK
AuG-7, Applying materiality and audit risk concepts in conducting and audit, provides the auditor with professional guidance in considering materiality and audit risk when planning and performing an audit in accordance with GAAS. The wording of the auditor's report recognizes both of these concepts by including the following terms: reasonable assurance in all material respects.
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MATERIALITY
A misstatement or the aggregate of all misstatements in financial statements is considered to be material if, in light of surrounding circumstances, it is probable that the decision of a person who is relying on the financial statements, and who has a reasonable knowledge of business and economic activities ( the user), would be changed or influenced by such misstatement or the aggregate of all misstatements.
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STEPS IN APPLYING MATERIALITY
Step 1: Establish a preliminary judgment about materiality. Step 2: Document misstatements identified during the audit examination. Step 3: Estimate the likely misstatement and compare to materiality.
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THE STRATEGIC SYSTEMS APPROACH

Use knowledge of business. Assess internal and external environments.
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FACTORS

The clients strategic objectives. The clients strategic advantages over its competitors. Risks that threaten achievement of the clients objectives. Critical issues facing the industry.
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AUDIT RISK
Audit risk is the risk that the auditor will fail to express a reservation in his or her opinion on financial statements that are materiality misstated. Auditor business risk is the exposure to loss or injury to professional practice from litigation, adverse publicity, or other events arising in connection with financial statements audited and reported on.
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THE AUDIT RISK MODEL
AR = IR x CR x DR
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INHERENT RISK (IR)
Inherent risk is the susceptibility of an assertion to material misstatement in the financial statements in the absence of internal controls. At the beginning of an engagement, the auditor must assess specific factors related to the client that may increase or decrease the likelihood of material misstatement occurring.
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CONTROL RISK (CR)
Control risk is the risk that material misstatements will not be prevented or detected on a timely basis by the entitys internal control. Chapter 6 contains a detailed discussion of this topic.
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DETECTION RISK (DR)
Detection risk is the risk that the substantive audit procedures will not detect a material misstatement that exists in an account balance or class of transactions. Detection risk is composed of two risks or uncertainties: Sampling risk Nonsampling risk
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USE OF THE AUDIT RISK MODEL

1. Setting a planned level of audit risk. 2. Assessing inherent risk and control risk. 3. Solving the audit risk equation for the appropriate level of detection risk.
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AN EXAMPLE
Set planned audit risk for accounts receivable at .05. Assume further that the auditor assesses inherent risk to be .80 and control risk is 60. To determine the level of detection risk for auditing accounts receivable, the audit risk model is solved: AR = IR x CR x DR DR = AR / (IR x CR) Thus, DR is set at approximately .10 [DR = .05/(.80 x .60)] for testing the accounts receivable balance.
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LIMITATIONS OF THE AUDIT RISK MODEL

The audit risk model assumes that the components of the model (IR, CR, and DR) are independent of each other. However, in practice, the risk of a material misstatement (IR) occurring may be a function of the clients internal controls (CR). The auditors assessments of IR and CR may be different from the actual levels of IR and CR. The audit risk model does not consider the possibility of nonsampling risk.
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DETECTION OF MISSTATEMENT DUE TO ERROR OR FRAUD

Errors are unintentional misstatements or omissions of amounts or disclosures and may involve Mistakes in gathering or processing accounting data from which financial statements are prepared. Unreasonable accounting estimates arising from oversight or misinterpretation of facts. Mistakes in the application of accounting principles.
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DETECTION OF MISSTATEMENT DUE TO ERROR OR FRAUD (cont.)
Fraud involves intentional misstatements that can be classified into two types: fraudulent financial reporting misappropriation of assets.
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Fraudulent financial reporting may involve acts such as the following: Manipulation, falsification, or alteration of accounting records or supporting documents from which the financial statements are prepared. Misrepresentation in, or intentional omission from, the financial statements of events, transactions, or significant information. Intentional misapplication of accounting principles.
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Examples of misappropriation or defalcation include: Embezzling of cash receipts. Stealing assets. Causing the entity to pay for goods or services not received.
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Risk factors that relate to the possible presence of material misstatements in the financial statements can be grouped into three categories: Managements characteristics and influence over the control environment. Industry conditions. Operating characteristics and financial stability.
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Risk factors that relate to the misappropriation of assets can be grouped into two categories: Susceptibility of assets to misappropriation. Controls.
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RESPONDING TO RISK FACTORS AND ASSESSING DETECTION RISK

Based on the assessment of the risk factors that affect client business risk and the risk of material misstatement, the auditor assess inherent risk and control risk. The auditor then determines the level of detection risk and designs audit procedures to respond to the risk factors identified.
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DOCUMENTATION OF THE AUDITORS RISK ASSESSMENT

The auditor should document that the risk of material misstatement was assessed, including how risk factors were considered. Where risk factors are identified, the documentation should describe the risk factors identified the auditors response to those risk factors.
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COMMUNICATION ABOUT MATERIAL MISSTATEMENT

Communications with Management Communications with the Audit Committee of the Board of Directors
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AUDITORS RESPONSIBILITY FOR ILLEGAL ACTS

Conduct the audit in accordance with GAAS Identify relevant laws and regulations Assess risk of misstatement from an illegal act Obtain written representation from management
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FACTORS TO CONSIDER WHEN ASSESSING RISK OF AN ILLEGAL ACT

Violations of such laws or regulations by the entity in the current or prior period Recent, well-publicized violations of such laws by others within the industry Active monitoring of such laws by a regulatory agency The complexity of such laws or regulations Managements lack of experience in interpreting or applying such laws because they are unusual or recently enacted
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CIRCUMSTANCES ENCOUNTERED THAT MAY INDICATE ILLEGAL ACTS

Unusually large cash receipts or payments, transfers to numbered bank accounts or accounts in financial institutions with which the entity normally does not do business Unsupported payments Increased or unusual legal or consulting fees Allegations about illegal acts made by suppliers, creditors, or employees Payment of unusual fines or penalties Media comment

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