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MaterialityMateriality
Audits provide Audits provide reasonable reasonable assuranceassurance that the financial that the financial statements are free of statements are free of material material misstatementsmisstatements..
User FocusUser Focus
Materiality is defined in terms of Materiality is defined in terms of financial statement usersfinancial statement users
• Therefore no hard and fast rulesTherefore no hard and fast rules
• Need to consider Need to consider multiple usersmultiple users and and multiple basesmultiple bases
FIGURE 9 - 1FIGURE 9 - 1 Steps in Applying MaterialitySteps in Applying Materiality
Estimatetotal misstatement
in segment
Step3
Estimatethe combinedmisstatement
Step4
Comparecombined
estimate withpreliminary or
revised judgmentabout materiality
Step5
Set preliminary
judgment aboutmateriality
Step1
Allocatepreliminary
judgment aboutmaterialityto segments
Step2
Planning extent of testsPlanning extent of tests
Evaluating resultsEvaluating results
Set Preliminary Judgment About Set Preliminary Judgment About MaterialityMateriality
Base Base XX (function of client)(function of client)
PercentagePercentage(function of audit risk)(function of audit risk)
----------------------------
= = Preliminary estimate of materialityPreliminary estimate of materiality
Materiality PercentageMateriality Percentage
Typically 3-6% for net income, lower Typically 3-6% for net income, lower percentages for larger bases such as percentages for larger bases such as assets or revenuesassets or revenues
High risk Low %High risk Low %
Low risk High %Low risk High %(less evidence; less assurance)(less evidence; less assurance)
Increase in Increase in Less Less
materiality materiality evidenceevidence required required
Materiality/Evidence Materiality/Evidence RelationRelation
As lower acceptable levels of audit risk and As lower acceptable levels of audit risk and materiality are established, the auditor materiality are established, the auditor should plan more work on individual should plan more work on individual accounts to:accounts to:
1. Find smaller errors.1. Find smaller errors.
2. Find larger errors.2. Find larger errors.
3. Increase tolerable error in accounts.3. Increase tolerable error in accounts.
4. Increase materiality in the accounts.4. Increase materiality in the accounts.
Figure 9-3Figure 9-3 Balance (000) TMBalance (000) TMCash 828 6Cash 828 6AR 18,957 265AR 18,957 265Inventory 29,865 265Inventory 29,865 265Current Assets 1,377 60Current Assets 1,377 60P,P&E 10,340 48P,P&E 10,340 48AP 4,720 108AP 4,720 108Notes 28,300 0Notes 28,300 0Accruals 5,884 132 Accruals 5,884 132 Equity 22,463 Equity 22,463 0 0 Total (materiality = 442) 884Total (materiality = 442) 884
Factors affecting tolerable Factors affecting tolerable misstatementmisstatement
Larger allocationLarger allocation Smaller allocationSmaller allocation
Large balanceLarge balance Small balanceSmall balance
Errors expectedErrors expected Few errors Few errors expected expected
Costly to test orCostly to test or Less costly to testLess costly to testTestable with APTestable with AP
Steps in Applying MaterialitySteps in Applying MaterialityPlanning phase Set preliminary judgment Planning phase Set preliminary judgment
Allocate materiality Allocate materiality to segments to segments
Evaluating Evaluating Estimate total Estimate total resultsresults misstatement in segmentmisstatement in segment
Estimate combined Estimate combined misstatementmisstatement
Compare combined Compare combined misstatement to misstatement to materiality estimatemateriality estimate
Projecting ErrorsProjecting Errors
Balance in accts. receivable: Balance in accts. receivable: 1,000,0001,000,000
Accts. receivable tested:Accts. receivable tested: 250,000250,000
Overstatement errors:Overstatement errors: 10,00010,000
Projected error = Projected error =
(10,000/250,000) x 1,000,000(10,000/250,000) x 1,000,000 ==
40,00040,000 + allowance for sampling error+ allowance for sampling error
TolerableTolerable Est. of Total Est. of Total MisstatementMisstatement Misstmt. Misstmt.
Over- Under-Over- Under- Over- Under- Over- Under-AccountAccount stmt. stmt. stmt. stmt. stmt. stmt. stmt. stmt.CashCash 2,000 2,000 3,000 3,000 2,000 2,000 -0- -0-
A/RA/R 12,00012,000 18,00018,000 4,000 4,000 19,000 19,000
InventoryInventory 8,000 8,000 14,00014,000 3,000 3,000 10,000 10,000
PrepaidsPrepaids 3,000 3,000 5,000 5,000 2,000 2,000 1,000 1,000
TotalTotal 25,00025,000 40,00040,000 11,000 11,000 30,000 30,000
Preliminary estimate of materiality:Preliminary estimate of materiality:Overstatements Overstatements = = 12,50012,500 Understatements Understatements = = 20,00020,000
Options When Projected Errors Options When Projected Errors Exceed MaterialityExceed Materiality
• Record an adjustmentRecord an adjustment
– Usually limited to actual errorsUsually limited to actual errors
• Perform more testingPerform more testing
– Better error estimateBetter error estimate
– Lower sampling riskLower sampling risk
• Qualify OpinionQualify Opinion
Options Applied to Prob. 9-25Options Applied to Prob. 9-25
Projected understmt. errorsProjected understmt. errors $30,000 $30,000
MaterialityMateriality 20,00020,000
Min. necessary error reduction 10,000Min. necessary error reduction 10,000
Auditor could record adjustment for at least Auditor could record adjustment for at least $10,000 and/or perform additional testing $10,000 and/or perform additional testing (focusing on AR and inventory because largest (focusing on AR and inventory because largest
projected errors)projected errors)
Audit Risk ModelAudit Risk Model
PDR = PDR = AARAAR
IR x CRIR x CRwhere:where:PDRPDR = Planned detection risk= Planned detection riskAARAAR = Acceptable audit risk= Acceptable audit riskIRIR = Inherent risk= Inherent riskCRCR = Control risk= Control risk
or: or: AAR = IR x CR x PDRAAR = IR x CR x PDR
Planned Detection RiskPlanned Detection Risk
Risk that the Risk that the auditorauditor fails to detect fails to detect a material errora material error
• Determines amount of evidenceDetermines amount of evidence
• Dependent variableDependent variable because it is because it is determined by other risk model determined by other risk model factorsfactors
Decrease Decrease More evidence More evidence
PDRPDR required required
Acceptable Audit RiskAcceptable Audit Risk
Risk that the auditorRisk that the auditor fails to fails to modify opinion when f/s are modify opinion when f/s are misstatedmisstated
• Depends upon use of financial Depends upon use of financial statementsstatements
• Client’s financial positionClient’s financial position
Inherent RiskInherent Risk
Likelihood of error in a segment Likelihood of error in a segment (without considering effectiveness (without considering effectiveness of controls)of controls)
• Varies Varies by accountby account (errors are more (errors are more likely in some accounts than likely in some accounts than others)others)
• Varies Varies by objectiveby objective within accounts within accounts
Inherent Risk FactorsInherent Risk Factors
• Nonroutine transactionsNonroutine transactions
• Management estimatesManagement estimates
• Net realizable value issuesNet realizable value issues
• Subject to theft or manipulationSubject to theft or manipulation
Control RiskControl Risk
Risk that client’s internal controls Risk that client’s internal controls fail to detect an errorfail to detect an error
To assess control risk below To assess control risk below maximum:maximum:
• Must study and document controlsMust study and document controls
• Must test their effectivenessMust test their effectiveness
9-24 (b)9-24 (b)
Inherent risk and control risk differ from Inherent risk and control risk differ from planned detection risk in that they:planned detection risk in that they:
1. Arise from the misapplication of audit 1. Arise from the misapplication of audit procedures.procedures.
2. May be assessed in either quantitative or 2. May be assessed in either quantitative or nonquantitative terms.nonquantitative terms.
3. Exist independently of the financial 3. Exist independently of the financial statement audit.statement audit.
4. Can be changed at the auditor’s discretion.4. Can be changed at the auditor’s discretion.
Assessing Fraud RiskAssessing Fraud Risk
In addition to risk model assessment, auditors In addition to risk model assessment, auditors must assess risk of fraud on every must assess risk of fraud on every engagement related to:engagement related to:– Fraudulent financial reportingFraudulent financial reporting– Misappropriation of assetsMisappropriation of assets
These risk assessments may be incorporated in These risk assessments may be incorporated in the risk model assessments or considered the risk model assessments or considered separately.separately.
The “Fraud Triangle”The “Fraud Triangle”
OpportunitiesWeak Board of DirectorsWeak Internal Controls
Attitudes/RationalizationsLack of a Code of Conduct
Disregard for Financial Reporting
Incentives/PressuresTight Debt Covenants
Unrealistic Analyst Expectations
AAR =AAR = IR IR xx CRCR x PDR x PDRAuditAudit Risk anRisk an Risk internalRisk internal Risk Risk
thethe RiskRisk error willerror will controls won’tcontrols won’t auditorauditor
occuroccur detect itdetect it won’t won’t detect itdetect it
IR x CR = Risk of Material MisstatementIR x CR = Risk of Material Misstatement
Factor Assessment LevelFactor Assessment Level CommentComment
AAR Entire auditAAR Entire audit Based on use of f/s Based on use of f/s IRIR Objective level Objective level Assessed based Assessed based
each cycle/account on likelihoodeach cycle/account on likelihood of error of error
CRCR Objective level Depends on Objective level Depends on each cycle/ existence and each cycle/ existence and
account effectiveness of account effectiveness of controls controls
PDR Objective levelPDR Objective level Determined by Determined by each cycle/ each cycle/ other risk model other risk model
accountaccount factors factors
PDR = PDR = AAR AAR
IR x CRIR x CRPDR decreases PDR decreases Evidence Evidence
increasesincreasesEverything else can be expressed as a Everything else can be expressed as a
function of DRfunction of DR1.1. AAR decreases - AAR decreases - PDR decreases (evid. inc.)PDR decreases (evid. inc.)
2.2. IR decreasesIR decreases - - PDR increases (evid. dec.)PDR increases (evid. dec.)
3.3. CR decreasesCR decreases - - PDR increases (evid. dec.)PDR increases (evid. dec.)
Materiality PercentageMateriality Percentage
High AAR High %High AAR High %
(low risk audit) (low risk audit)
Low AAR Low %Low AAR Low %(high risk audit)(high risk audit)
Problem 9 - 32 #1 = min. evidenceProblem 9 - 32 #1 = min. evidenceSituationSituation
RiskRisk 11 22 33 44 55 66
AARAAR HH HH LL LL HH MM
IRIR LL HH HH LL MM MM
CRCR LL LL HH HH MM MM
PDRPDR HH MM LL LL MM MM
PlannedPlanned
EvidenceEvidence LL MM HH HH MM MM
Problem 9 - 32 #3 = max. evidenceProblem 9 - 32 #3 = max. evidenceSituationSituation
RiskRisk 11 22 33 44 55 66
AARAAR HH HH LL LL HH MM
IRIR LL HH HH LL MM MM
CRCR LL LL HH HH MM MM
PDRPDR H H MM LL LL MM MM
PlannedPlanned
EvidenceEvidence LL MM HH HH MM MM
Effect onEffect on Effect onEffect on
Change in factorChange in factor PDR PDR EvidenceEvidence
1. Increase in AAR1. Increase in AAR IncreaseIncrease DecreaseDecrease
2. Increase in CR2. Increase in CR DecreaseDecrease IncreaseIncrease
3. Increase in PDR3. Increase in PDR NANA DecreaseDecrease
4.4. Increase in IR Increase in IR DecreaseDecrease IncreaseIncrease
5. Increase in IR,5. Increase in IR, No effect*No effect* No effectNo effect
Decrease in CR inDecrease in CR in
same amountsame amount
CR IR AAR PECR IR AAR PE
a. Increase LTD a. Increase LTD N N N N D D I I
(First answer to collected homework given as an (First answer to collected homework given as an example)example)