Materiality and Risk,Chapter 9,Learning Objective 1,Apply the concept of materiality to the audit.,Materiality,It is a major consideration in determining the appropriate audit report to issue.,Materiality,The auditors responsibility is to determine whether financial statements are materially misstated.,If there is a material misstatement, the auditor will bring it to the clients attention so that a correction can be made.,Steps in Applying Materiality,Planning extent of tests,Step 1,Set preliminary judgment about materiality,Step 2,Allocate preliminary judgment about materiality to segments,Steps in Applying Materiality,Evaluating results,Step 3,Estimate total misstatement in segment,Step 4,Estimate the combined misstatement,Compare combined estimate with judgment about materiality,Step 5,Learning Objective 2,Make a preliminary judgment about what amounts to consider material.,Set Preliminary Judgment About Materiality,This preliminary judgment is the maximum amount by which the auditor believes the statements could be misstated and still not affect the decisions of reasonable users.,Auditors decide early in the audit the combined amount of misstatements of the financial statements that would be considered material.,Factors Affecting Judgment,Materiality is a relative rather than an absolute concept.,Bases are needed for evaluating materiality.,Qualitative factors also affect materiality.,Guidelines,Accounting and auditing standards do not provide specific materiality guidelines to practitioners.,Professional judgment is to be used at all times in setting and applying materiality guidelines.,Learning Objective 3,Allocate preliminary materiality to segments of the audit during planning.,Allocate Preliminary Judgment About Materiality to Segments,This is necessary because 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),Learning Objective 4,Use materiality to evaluate audit findings.,Estimated Total Misstatement and Preliminary Judgment,Cash Accounts receivable Inventory Total estimated misstatement amount Preliminary judgment about materiality,$ 4,000 20,000 36,000 $50,000,$ 2,000 12,000 31,500 $45,500,$ N/A 6,000 15,750 $16,800,$ 2,000 18,000 47,250 $62,300,Tolerable Misstatement,Known Misstatement and Direct Projection,Sampling Error,Total,Account,Estimated Misstatement Amount,N/A = Not applicable Cash audited 100 percent,Estimated Total Misstatement and Preliminary Judgment,Net misstatements in the sample ($3,500), Total recorded population value ($450,000), Total sampled ($50,000),= Direct projection estimate of misstatement ($31,500),Learning Objective 5,Define risk in auditing.,Risk,Auditors accept some level of risk in performing the audit.,An effective auditor recognizes that risks exist, are difficult to measure, and require careful thought to respond.,Responding to risks properly is critical to achieving a high-quality audit.,Risk and Evidence,Auditors gain an understanding of the clients business and industry and assess client business risk.,Auditors use the audit risk model to further identify the potential for misstatements and where they are most likely to occur.,Illustration of Differing Evidence Among Cycles,Sales and collection cycle,Acquisition and payment cycle,Payroll and personnel cycle,Inherent risk,A,Medium,High,Low,Control risk,B,Medium,Low,Low,Acceptable audit risk,C,Low,Low,Low,Planned detection risk,D,Medium,Medium,High,Illustration of Differing Evidence Among Cycles,Inventory and warehousing cycle,Capital acquisition and repayment cycle,Inherent risk,A,High,Low,Control risk,B,High,Medium,Acceptable audit risk,C,Low,Low,Planned detection risk,D,Low,Medium,Learning Objective 6,Describe the audit risk model and its components.,Audit Risk Model for Planning,PDR = AAR (IR CR),PDR = Planned detection risk,AAR = Acceptable audit risk,IR = Inherent risk,CR = Control risk,where:,Learning Objective 7,Consider the impact of engagement risk on acceptable audit risk.,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 auditors evaluation of managements integrity,Methods Practitioners Use to Assess Acceptable Audit Risk,Methods Used to Assess Acceptable Audit Risk,External users reliance on financial statements,Examine financial statements Read minutes of the board Examine form 10K Discuss financing plans with management,Factors,Methods Practitioners Use to Assess Acceptable Audit Risk,Likelihood of financial difficulties,Analyze financial statements for difficulties using ratios Examine inflows and outflows of cas