Arens14e Ch09 PPT Ge

Considering Materiality
and Audit Risk

Chapter 9
©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 5-5

Learning Objective 1
Apply the concept of materiality to the audit.

Materiality
Major consideration in determining the appropriate audit repo
Referenced in audit report’s scope paragraph
What is meant by the term “material”?
FASB Concept Statement 2 defines Materiality as

:The magnitude of an omission or misstatement of accounting information
that in the light of surrounding circumstances, makes it probable that the
judgment of a reasonable person relying on the information would have
been changed or influenced by the omission or misstatement.

Materiality
Auditor’s responsibility = determine whether

financial statements are materially misstated.
Auditor will bring material misstatements to the

client’s attention so corrections can be made.

Steps in Applying Materiality

Make a preliminary judgment about what

amounts to consider material.

Set Preliminary Judgment About
Materiality
Auditors set materiality thresholds early in the

engagement.
Thresholds represent the maximum statements

that could be misstated and still not affect
users decisions.

Factors Affecting Judgment
Materiality is a relative rather

than an absolute concept.
Bases are needed for

evaluating materiality.
Qualitative factors also

affect materiality.

Qualitative Factors
Considerations that may render material a

quantitatively small misstatement include:
Loan covenants Changing trend
Management compensation
Financial statements users Conceals an illegal act

Guidelines
Accounting and auditing standards do not

provide specific materiality guidelines.
Professional judgment is used to set and

apply materiality guidelines.
©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9 - 10

Allocate preliminary materiality to segments

of the audit during planning.

Allocate Preliminary Judgment
About Materiality to Segments
Evidence is accumulated by segments

rather than for the financial statements
as a whole.
Most practitioners allocate materiality

to balance sheet accounts.
 SAS 107 (AU 312)

Use materiality to evaluate audit findings.

Known and Likely Misstatements
Auditor can determine the misstated

amount in an account (“Known”)
Two types of “Likely” misstatements:

 Judgmental differences
 Projections of misstatements from
audit samples

Estimated Total Misstatement
and Preliminary Judgment

Estimated Total Misstatement
and Preliminary Judgment
Estimated Net misstatements in Sample ($3,500)

Misstatement = × Total recorded
Total sampled ($50,000) population value
($31,500)
($450,000)

Define risk in auditing.

Risk
Auditors accept some level of

risk in performing the audit.
Risks exist, are difficult to

measure, and require careful
thought in response.
Proper risk response is critical

to achieving a high-quality audit.

Risk and Evidence
Auditors need to understand the client’s

business and assess business risk.
The audit risk model helps identify the

potential and likelihood of misstatements.

Audit Risk Model for Planning
PDR = AAR ÷ (IR × CR)
where: PDR = Planned detection risk
AAR = Acceptable audit risk
IR = Inherent risk
CR = Control risk

Audit Risk Model for Planning

Illustration of Differing Evidence
Among Cycles
Sales and Acquisition Payroll and
collection and payment personnel
cycle cycle cycle
Inherent
A Medium High Low
risk
Control
B Medium Low Low
risk
Acceptable
C Low Low Low
audit risk
Planned
D Medium Medium High
detection risk
Illustration of Differing Evidence
Among Cycles
Inventory and Capital acquisition
warehousing and repayment
cycle cycle
Inherent
A High Low
risk
Control
B High Medium
risk
Acceptable
C Low Low
audit risk
Planned
D Low Medium
detection risk
Describe the audit risk model and

its components.

Audit Risk Model Components
Planned
Inherent
Detection
Risk
Risk
Acceptable
Control Audit
Risk Risk

 Planned detection risk is the risk that audit
evidence for a segment will fail to detect
misstatements exceeding tolerable
misstatement.
 Planned detection risk is dependent on the

other three factors in the model.

 Inherent risk measures the auditor’s
assessment of the likelihood that there are
material misstatements due to error or
fraud in a segment before considering the
effectiveness of internal control.
 Control risk measures the auditor’s
assessment of whether misstatements
exceeding a tolerable amount in a
segment will be prevented or detected on
a timely basis by the client's internal
controls.
 Acceptable audit risk is a measure of how
willing the auditor is to accept that the
financial statements may be materially
misstated after the audit is completed and
an unqualified opinion has been issued.

Consider the impact of engagement risk

on acceptable audit risk.

Engagement Risk
What is Engagement Risk?
. Engagement Risk is the risk that the auditor or

audit firm will suffer harm after the audit is
finished. In other words, it is the risk of lawsuit or
unfavorable publicity resulting from being
associated with this client.

Impact of Engagement Risk on
Acceptable Audit Risk
Auditors decide engagement risk and use

that risk to modify acceptable audit risk.
Engagement risk closely relates to client

business risk.

Factors Affecting Acceptable
Audit Risk
 The degree to which external users
rely on the statements
The likelihood that a client will have

financial difficulties after the
audit report is issued
The auditor’s evaluation of

management’s integrity

Methods Practitioners Use to
Assess Acceptable Audit Risk

Consider the impact of several factors on

the assessment of inherent risk.

Factors Affecting Inherent Risk
Nature of Client’s Audit Experience
Business
 Prior audit results
 Initial vs. repeat engagement
 Industry practices
 Audit judgment required to
 Non-routine transactions
correctly record balances and
 Makeup of the population
transactions
Culture
 Related parties
 Factors related to fraudulent
financial reporting
 Factors related to
misappropriation of assets
Discuss the relationship of risks

to audit evidence.

Relationship of Factors Influencing
Risks to Risks and Risks to Planned
Evidence
Acceptable audit risk
D D I
Factors I Planned I Planned

Inherent
influencing detection audit
risk
risks risk evidence
I D
Control risk
D = Direct relationship; I = Inverse relationship
Relationship of Factors Influencing
Risks to Risks and Risks to Planned
Evidence
Auditors can change the audit to respond
to risks
The engagement may require more

experienced staff
The engagement will be reviewed more

carefully than usual

Audit Risk for Segments
Both control risk and inherent risk are

typically set for each cycle, each
account, and often even each audit
objective, not for the overall audit.

Tolerable Misstatement, Risks,
and Balance-related Audit
Objectives
It is common to assess inherent and control
risk for each balance-related audit objective
It is not common to allocate materiality

to objectives

Risk and Evidence

Measurement Limitations
One major limitation in the audit risk model is

the difficulty of measuring the components
of the model.
Known Unknown
Preliminary Actual level of
Assessed Level +/- risk achieved
of Risk on the audit

Relationships of Risk to
Evidence
Planned Amount of
Acceptable Inherent Control detection evidence
Situation audit risk risk risk risk required
1 High Low Low High Low

2 Low Low Low Medium Medium
3 Low High High Low High
4 Medium Medium Medium Medium Medium
5 High Low Medium Medium Medium

Tests of Details of Balances
Evidence Planning Worksheet
Auditors develop various types of worksheets

to aid in relating the considerations affecting
audit evidence to the appropriate evidence
to accumulate.

Discuss how materiality and risk are related

and integrated into the audit process.

Relationship of Tolerable
Misstatement and Risks to
Planned Evidence
Acceptable
audit risk D D I
Planned I Planned
Inherent detection risk audit evidence
risk I
I D I
Control
risk
Tolerable
misstatement
D = Direct relationship; I = Inverse relationship
Revising Risks and Evidence
The auditor must revise the original

assessment of the appropriate risk.
The auditor should consider the effect

of the revision on evidence requirements,
without the use of the audit risk model.

End of Chapter 9

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Considering Materiality

and Audit Risk

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 5-5

Apply the concept of materiality to the audit.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9-2

Major consideration in determining the appropriate audit repo

Referenced in audit report’s scope paragraph

What is meant by the term “material”?

FASB Concept Statement 2 defines Materiality as

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9-3

Auditor’s responsibility = determine whether

Auditor will bring material misstatements to the

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9-4

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9-5

Make a preliminary judgment about what

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9-6

Auditors set materiality thresholds early in the

Thresholds represent the maximum statements

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9-7

Materiality is a relative rather

Bases are needed for

Qualitative factors also

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9-8

Considerations that may render material a

Loan covenants Changing trend

Financial statements users Conceals an illegal act

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9-9

Accounting and auditing standards do not

Professional judgment is used to set and

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9 - 10

Allocate preliminary materiality to segments

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9 - 11

Evidence is accumulated by segments

Most practitioners allocate materiality

 SAS 107 (AU 312)

Use materiality to evaluate audit findings.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9 - 13

Auditor can determine the misstated

Two types of “Likely” misstatements:

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9 - 14

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9 - 15

Estimated Net misstatements in Sample ($3,500)

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9 - 16

Define risk in auditing.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9 - 17

Auditors accept some level of

Risks exist, are difficult to

Proper risk response is critical

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9 - 18

Auditors need to understand the client’s

The audit risk model helps identify the

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9 - 19

PDR = AAR ÷ (IR × CR)

where: PDR = Planned detection risk

AAR = Acceptable audit risk

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9 - 20

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 9 - 21

Describe the audit risk model and