MATERIALITY

AND
RISK

SECTION 8
Importance of Materiality and Risk
• Materiality and risk underlie the application of all
generally accepted auditing standards

• Must consider materiality and risk in:

1. Planning

2. Evaluation of F/S
Materiality
• Presented fairly in accordance with GAAP implies?

• From an accounting perspective, materiality involves the determination

of what information should be reported

• From an auditing perspective?

• CICA Handbook definition:

• A matter of judgment
• Thus handbook requires the auditor to consider

• Circumstances of the company

• The users of the F/S

• The auditor makes a preliminary judgment about

materiality levels in planning the audit

• May ultimately differ from materiality levels used in

evaluating audit findings
• Materiality involves both qualitative and quantitative
considerations

• In assessing the quantitative amount it is necessary to

relate the nature and dollar amount to the F/S

• In planning, the auditor is usually concerned with just

the quantitative

• Qualitative?
Financial Statement Materiality
• It is necessary for the auditor to assess materiality on the F/S because
the auditor's opinion on fairness extends to the F/S taken as a whole

• Thus what does it mean when F/S are materially misstated?

• Error or fraud

• In planning there can be more than one level of materiality relating to

the F/S
• Income statement materiality is often related to net income

• Any other choices?

• Balance sheet materiality is often related to total assets

• Other choices?

• The smallest aggregate level of errors considered material to

any one of the F/S should be used for planning
• Why is this rule appropriate?

1. The nature of the financial statements

2. Auditing procedures

• As an example consider the auditing procedure to

determine that year-end sales are recorded in the
proper period
Account Balance Materiality
• The maximum error that can exist in an account before it is
considered materially misstated

• Inverse relationship between materiality and audit evidence

• In making a preliminary judgment about materiality consider:

1. The likelihood of errors in the account

2. Expected audit costs

Calculating Materiality
• Any quantitative assessment of materiality must give full consideration
to the surrounding circumstances as they exist at that time

• Ratios and percentages

• Guidelines:

1. 5% to 10% of net income before taxes

2. 1% to 2% of total assets
3. 1% of equity
4. ½ % of gross revenue
5. A variable percentage of gross revenue
 If total revenue is
over but not over Materiality is
$0 $30 thousand $ 0 + .05
30 thousand 100 thousand 1,450 + .025
100 thousand 300 thousand 3,200 + .018
300 thousand 1 million 6,800 + .012
1 million 3 million 15,200 + .008
3 million 10 million 31,200 + .0054
10 million 30 million 69,000 + .0038
30 million 100 million 145,000 + .0025
100 million 300 million 320,000 + .00175
300 million 1 billion 670,000 + .0012
1 billion 3 billion 1,510,000 + .0008
3 billion 10 billion 3,110,000 + .00055
10 billion 30 billion 6,960,000 + .00038
30 billion …………. 14,560,000 + .00025
Source: Donald A. Leslie, “Materiality, the Concept and Its Application to Auditing.” (CICA,
1985 – p. 21)
Qualitative Factors

Should answer the following questions

1. Nature of the item?

2. Unusual or extraordinary?

3. Contingency?

4. Based on existing facts?

5. Relevant to F/S taken as a whole?

6. Relevant to the total of the accounts of which it forms a part?

7. Relevant to other related items?

Materiality in Tests of Controls
• The significance of an internal control deviation

• Deviations in internal controls may increase the risk

of errors occurring in the accounting records

• Such deviations do not necessarily give rise to

errors
• But the auditor must consider the possible relation of
the deviation errors to materiality

• The relationship between the value of the transaction

containing the deviations and some multiple of
materiality is of primary significance

1. The acceptable upper limit can be fixed at 5%

2. The acceptable upper limit can be given a frequency range of

3% to 8%

3. No criteria for the upper limit

Materiality in Tests of Transactions
and Details of Balances
• Should be directly related to the established level of materiality

• Statistical sampling

• Remember the inverse relationship

• Primary objective of allocating materiality to accounts is to

minimize audit costs without increasing audit risk
Allocating F/S Materiality to Accounts

• When the auditor’s preliminary judgment about F/S materiality is

quantified, a preliminary estimate of materiality for each account may be
obtained

• Allocations can be made to both the balance sheet and income statement
accounts

• An illustrative example:

Cash$ 200,000
Accounts Receivable 300,000
Inventories 1,000,000
Fixed Assets 2,700,000
• In this example, the auditor anticipates few errors in cash and plant
assets and some errors in accounts receivables and inventories

• Assume that the preliminary estimate of F/S materiality is

$100,000
Materiality
Cash$ 200,000 $ 1,000
Accounts Receivable 300,000 29,000
Inventories 1,000,000 60,000
Fixed Assets 2,700,000 10,000
$100,000

• This allocation may be revised

• What if $19,000 of errors were found in verifying accounts
receivable?

Materiality
Cash $ 200,000 $ 1,000
Accounts Receivable 300,000 19,000
Inventories 1,000,000 70,000
Fixed Assets 2,700,000 10,000
$100,000

• What has a great impact on allocating materiality?

The Concept of Audit Risk
• Audit risk is the risk that the auditor may unknowingly fail
to appropriately modify an opinion on the F/S that are
materially misstated

• If the auditor desires a probability or certainty of rendering

the correct opinion of 97%, what is the audit risk?

• The audit opinion is based upon the verification of account

balances, thus audit risk must be related to account balances
Components of Audit Risk
• Three components:

1. Inherent risk

2. Control risk

3. Detection risk
Inherent Risk

• Some accounts may be susceptible to loss through

fraud or theft

• Complex calculations for leases or pensions are more

likely to contain errors

• Inherent risk also extends to factors that affect the

financial statements as a whole
Control Risk

• A function of the effectiveness of the client’s system

of internal control

• Effective controls over an account

• Control risk can never be zero

Detection Risk

• A function of the effectiveness of the auditor’s

verification of account balances

• What influences detection risk?

• In estimating detection risk, the auditor should also

consider the likelihood that errors will be made in
judgment
• Inverse relation between the inherent risk and
control risk for an account and the detection risk for
that account

• DR IR

• DR  1/CR

• Inherent risk and control risk relate to the

circumstances of the client, but detection risk is
controlled by the auditor
The Audit Risk Model
• The three components can expressed in quantitative
terms

• They can also be expressed in non-quantitative

terms

• AR = IR x CR x DR
• Assume that the auditor made the following risk assessments
in examining inventories

• Desired audit risk 5%

• Inherent risk 50%
• Control risk 50%

• DR = AR / (IR x CR)
= 0.05/(0.5 x 0.5)
= 0.2
• The auditor may decide that the inherent risk cannot be
quantified and use a conservative approach
 Inherent Risk Control Risk Detection Risk Audit risk
HIGH .70 .6 x .8 x.7 = .34
•Small Samples
•Few substantive
tests
•Extensive reliance
on IC
HIGH .80
•System poorly designed
•System poorly executed
•Not tested (CR = 1.00) LOW .30 .6 x .8 x .3 = .14
•Large samples
•Many substantive
tests
HIGH .60 •No reliance on IC
•Assets susceptible to theft
•New client HIGH .70 .6 x .2 x .7 = .08
•Integrity doubtful •As above
•Non profitable and
needs financing LOW .20
•System well designed and
well executed
•Audit tests show system LOW .30 .6 x .2 x .3 = .04
effective •As above
 Inherent Risk Control Risk Detection Risk Audit risk
HIGH .70 .4 x .8 x.7 = .22
•Small Samples
•Few substantive
tests
•Extensive reliance
on IC
HIGH .80
•System poorly designed
•System poorly executed
•Not tested (CR= 1.00) LOW .30 .4 x .8 x .3 = .10
•Large samples
•Many substantive
tests
LOW .40 •No reliance on IC
•Assets not susceptible to
theft HIGH .70 .4 x .2 x .7 = .06
•Old client •As above
•Integrity believed high
•Profitable and easily LOW .20
financed •System well designed and
well executed
•Audit tests show system LOW .30 .4 x .2 x .3 = .02
effective •As above
Problem 1: Shown on the following three pages are the statements of earnings and
financial position for Prairie Stores Corporation.

Required:
a. Use professional judgment in reaching a preliminary judgment about materiality
based on revenue, net income before taxes, total assets, and shareholders equity.
Your conclusions should be stated I terms of percentages and dollars.
b. Assume you complete the audit and conclude that your preliminary judgment about
materiality has been exceeded. What should you do?
c. As discussed in part (b), likely net earnings from continuing operations before
income taxes were used as a base for materiality when completing the audit.
Discuss why most auditors use before tax net earnings instead of after tax net
earnings when calculating materiality based on the income statement.
 Statement of Earnings
Prairie Stores Corporation

For the 53 Weeks For the 52 weeks ended:

Ended May 3, 2002 28-Apr-01 29-Apr-00

Revenue $ 8,351,149 $ 6,601,255 $ 5,959,587

Net sales 59,675 43,186 52,418

Other income 8,410,824 6,644,441 6,012,005

Costs and expenses

Cost of sales 5,197,375 4,005,548 3,675,369

Marketing, general, and administrative expenses 2,590,080 2,119,590 1,828,169

Provision for loss on restructured operations 64,100

Interest expense 141,662 46,737 38,546

7,993,217 6,171,875 5,542,084

Earnings from continuing operations before income taxes 417,607 472,566 469,921
Income taxes 196,700 217,200 214,100

Earnings from continuing operations 220,907 255,366 255,821

Provision for loss on discontinued operations, net of income taxes $ 20,700 - -

Net earnings $ 200,207 $ 255,366 $ 255,821

 Statement of Financial Position
Prairie Stores Corporation
May 3, 2002 April 28, 2001

Assets
Current assets
Cash $ 39,683 $ 37,566
Temporary investments (at cost, which approximates market) 123,421 271,639
Receivables, less allowances of $16,808 in 2002 and $17,616 in 2001 899,752 759,001
Inventories
Finished product 680,974 550,407
Raw materials and supplies 443,175 1,124,149 353,795 904,202
Deferred income tax benefits 9,633 10,468
Prepaid expenses 57,468 35,911
Current assets $ 2,254,106 $ 2,018,787
Land, buildings, equipment, at cost, less accumulated amortization 1,393,902 1,004,455
Investments in affiliated companies and sundry assets 112,938 83,455
Goodwill and other intangible assets 99,791 23,145
Total assets $ 3,860,737 $3,129,842
Liabilities and Shareholders’ Equity
Current liabilities
Notes payable $280,238 $113,411
Current portion of long-term debt 64,594 12,336
Accounts and drafts payable 359,511 380,395
Accrued salaries, wages, and
vacations 112,200 63,557
Accrued income taxes 76,479 89,151
Other accrued liabilities including goods and services tax 321,871 269,672
Current liabilities 1,214,893 928,522
Long-term debt 730,987 390,687
Other noncurrent liabilities 146,687 80,586
Accrued income tax liability 142,344 119,715
Total liabilities 2,234,911 1,519,510
Shareholders’ equity
Common stock issued, 51,017 shares in 2002 and 50,992 in 2001 200,195 199,576
Retained earnings 1,425,631 1,410,756
Shareholders’ equity 1,625,826 1,610,332
Total liabilities and shareholders’ equity $ 3,860,737 $ 3,129,842
Problem 2: The following questions deal with the use of the audit risk model.
a. Assume that the auditor is doing a first-year municipal audit of Sackville, New
Brunswick, and concludes that the internal control is not likely to be effective.
1) Explain why the auditor is likely to set both inherent and control risks at 100
percent for most segments.
2) Assuming (1), explain the relationship of audit risk to planned detection risk.
3) Assuming (1), explain the effect of planned detection risk on evidence
accumulation compared with its effect if planned detection risk were larger.
b. Assume that the auditor is doing the third-year municipal audit of Sackville, New
Brunswick, and concludes that internal controls are effective and in inherent risk is
low.
1) Explain why the auditor is likely to set inherent risk and control risks for
material segments at a higher level than, say, 40 percent, even when the two
risks are low.
2) For the audit of fixed asset accounts, assume inherent and control risks of 50
percent each and an audit risk or 5 percent. Calculated planned detection risk.
3) For (2), explain the effect of planned detection risk on evidence accumulation
compared with its effect if planned detection risk were smaller.
c. Assume that the auditor is doing the fifth-year municipal audit of Sackville, New
Brunswick, and concludes that audit risk can be set high, and inherent and control
risk should be set low.
1) What circumstances would result in these conclusions.
2) For the audit of repairs and maintenance, inherent and control risk are set at 20
percent each. Audit risk is 5 percent. Calculate planned detection risk.
3) How much evidence should be accumulated in this situation?
Problem 3: Using the audit risk model, state the effect on control risk, inherent risk, audit
risk, and planned evidence for each of the following independent events. In each of
the events (a) to (j), circle one letter for each of the three independent variables and
planned evidence: I = increase, D = decrease, N = no effect, and C = cannot
determine from the information provided. Explain your reasoning.
a. The client's management martially increased long-term contractual debt:
Control risk IDNC Audit risk IDNC
Inherent risk IDNC Planned evidence IDNC

b. The company changed from a privately held company to a publicly held company:
Control risk IDNC Audit risk IDNC
Inherent risk IDNC Planned evidence IDNC

c. The auditor decided to assess control risk at a level below maximum; it was
previously assessed at maximum:
Control risk IDNC Audit risk IDNC
Inherent risk IDNC Planned evidence IDNC
d. The account balance increased materially from the preceding year without apparent
reason:
Control risk IDNC Audit risk IDNC
Inherent risk IDNC Planned evidence IDNC

e. You determined through the planning phase that working capital, debt to equity
ratio, and other indications of financial condition had improved during the past year:
Control risk IDNC Audit risk IDNC
Inherent risk IDNC Planned evidence IDNC

f. This is the second year of the engagement and there were few misstatements in the
previous year. The auditor also decided to increase reliance on internal control:
Control risk IDNC Audit risk IDNC
Inherent risk IDNC Planned evidence IDNC
g. About halfway through the audit, you discover that the client is constructing its own
building during idle periods, using factory personnel. This is the first time the client
has done this and it is being done at your recommendation:
Control risk IDNC Audit risk IDNC
Inherent risk IDNC Planned evidence IDNC

h. In discussions with management, you conclude that management is planning to sell

the business in the next few months. Because of the planned changes, several key
accounting personnel quit several months ago for alternative employment. You also
observe that the gross margin percent has significantly increased compared with that
of the preceding year:
Control risk IDNC Audit risk IDNC
Inherent risk IDNC Planned evidence IDNC

i. There has been a change in several key management personnel. You believe that
management is somewhat lacking in personal integrity, compared with the previous
management. You believe it is still appropriate to do the audit:
Control risk IDNC Audit risk IDNC
j. In auditing inventory, you obtain an understanding of internal control and perform
tests of controls. You find it significantly improved compared with that of the
preceding year. You also observe that due to technology changes in the industry, the
client’s inventory may be somewhat obsolete:
Control risk IDNC Audit risk IDNC
Inherent risk IDNC Planned evidence IDNC
Problem 4: Some accountants have suggested that the auditor’s report should include a
statement of materiality level and audit risk that the auditor used in conducting the
audit.
Required:
a. The proponents of such disclosure believe that the information would be useful to
users of the financial statements being reported on. Explain fully why you think they
have this view.
b. Some accountants oppose such disclosure. Explain why you think they are not in
favour of it.
c. What is you position on the issue?