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8/10/2019 Materiality Messier Modify (1)
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2000 The McGraw-Hill Companies, Inc.,Irwin/McGraw-Hill
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MATERIALITY
AND
AUDIT RISK
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MATERIALITY
Def (ISA 320):
Materiality is the magnitude of an omission or misstatementof 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.
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ISA 320 specifies 3 main characteristics of
materiality:
Misstatements are considered material if, individually or in the
aggregate, they could reasonably be expected to influence the
economic decisions of users based on the financial statements;
Judgements about materiality are made in the context of
surrounding circumstances, and are affected by the size
(quantitative - the monetary amount involved) and/or nature of
misstatements (qualitative); and
Judgements about materiality are based on considerations of
common financial information needs of users as a group.
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Materiality
Auditing standards require auditors to design the audit to
obtain reasonable assurance about whether the financial
statements as a whole are free from material misstatement,
whether due to fraud or error.
The concept of materiality is applied by the auditor when:
Planning and performing the audit;
Evaluating the effect of identified misstatements on the audit and of
uncorrected misstatements, if any, on the financial statements; and
Forming an opinion on the financial statements.
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STEPS IN APPLYING MATERIALITY
1: Establish a preliminary judgment about materiality.
2: Allocate the preliminary judgment about materiality to
account balances or class-of transactions.
3: Estimate the likely misstatement and compare to
materiality.
4: Estimate the combined misstatement
5: Compare combined estimate with preliminary or revised
judgement about materiality
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Set Preliminary Judgment about Materiality
This preliminary judgment is the maximum amount by whichthe auditor believes the statements could be misstated andstill not affect the decisions of reasonable users.
Setting a preliminary judgement helps auditor planning theappropriate evidence to accumulate.
Low materiality in term of dollar amount, more evidence is
required than for a high amount.
Ideally, auditors decide early in the audit the combinedamount of misstatements of the financial statements thatwould be considered material.
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Guideline
No specific guidance given in the ISAs.
ISA Guide Rules of Thumb suggests using percentages
ranging from 60% to 85% (of overall or specific materiality),
depending on the risk of material misstatements.
The higher the risk of material misstatements, the lower
percentage should be used.
Professional judgment is to be used at all times in setting and
applying materiality guidelines.
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Factors that may be considered in
establishing benchmarks include:
The elements of the financial statements
~ What are the major elementsassets, liabilities, equities etc.
Whether there are items on which users of the entitys financial
statements will pay attentionperformance (profit, revenue)
The nature of the entity
The entitys ownership structure and the way it is financed
Qualitative factors also affect materiality.
- Amount involving fraud
- Misstatement arising from contractual obligation
- Misstatement immaterial might be material due to change of trend
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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
Materiality allocatedTolerable Misstatement or error (ISA 530).
Most practitioners allocate materiality
to balance sheet accounts.Why????????
1. Most income stt misstatements have an equal effect on
the BS because of the double entry bookkeeping system
2. Because there are fewer BS than IS accounts in most
audits and most audit procedures focus on BS accounts.
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Allocate Preliminary (cont)
Major difficulties in allocating materiality to BS accounts:
1. Auditors expect certain accounts to have more
misstatement than others
2. Both overstatement and understatements must be
considered
3. Relative audit costs affect the allocation
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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
$ 0
12,000
31,500
$43,500
$ N/A
6,000
15,750
$16,800
$ 0
18,000
47,250
$60,300
Tolerable
misstatement
Direct
projection
Sampling
error* TotalAccount
Estimated misstatement amount
*estimate for sampling error is 50%
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Estimated Total Misstatement and Preliminary
Judgment
Net misstatements in the sample
$3,500 $50,000 $450,000 = $31,500
Total recorded population value
Total sampled
= Direct projection estimate of misstatement
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Conclusion
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Conclusion
What if Estimated combined misstatement larger than
prelimenary Judgement:
1
2
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AUDIT RISK
Audit risk is the risk that the auditor may unknowingly
fail to appropriately modify the opinion on financial
statements that are materiality misstated.
Auditor business risk is the exposure to loss or injury toprofessional 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, assuming no related internal
controls.
At the beginning of an engagement, the auditormust assess those 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 controls. Chapter 6 contains a detailed discussion of this topic.
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DETECTION RISK (DR)
Detection risk is the risk that the auditor will not
detect a material misstatement that exists in the
financial statements.
Detection risk is composed of two risks or
uncertainties:
Sampling risk
Nonsampling risk
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USE OF THE AUDIT RISK MODEL
1. Set a planned level of audit risk.
2. Assess inherent risk and control risk.
3. Solve the audit risk equation for theappropriate 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 issolved:
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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ASSESSING CLIENT BUSINESS RISK
Client business risk is the risk that an entitys business
objectives will not be attained as a result of the external
and internal factors, pressures, and forces brought to
bear on the entity and, ultimately the risk associated
with the entitys survival and profitability.
Once the clients business risks have been determined,
the auditor must determine how those risks relate to
audit risk.
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THE RELATIONSHIP OF CLIENTBUSINESS RISK TO AUDIT RISK
Assess client business risk
Assess the risk of material misstatementdue to error or fraud
Factorsaffecting
IR
Factorsaffecting
CR
AR IR CR DR= X X
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The auditor must have a thorough understanding of the
clients industry, including knowledge about
The critical issues facing the industry.
The significant industry business risks.
The structure and profitability of the industry.
The relationship between the industry and the broad
economic business environment.
ASSESSING CLIENT BUSINESS RISK
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The auditor must then understand how the client fits
within the industry, including knowledge about the
following:
The entitys position within the industry.
The entitys plans for increasing or maintaining market
share, profitability, and so on.
Threats to the entitys position in the industry.
How the entity deals with its customers and competitors.
How the entity measures and monitors performance.
ASSESSING CLIENT BUSINESS RISK
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ASSESS THE RISK OF MATERIALMISSTATEMENT 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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ASSESS THE RISK OF MATERIALMISSTATEMENT DUE TO
ERROR OR FRAUD
Fraudinvolves intentional misstatements that can be
classified into two types:
fraudulent financial reporting misappropriation of assets.
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ASSESS THE RISK OF MATERIALMISSTATEMENT DUE TO
ERROR OR FRAUD
Fraudulent financial reporting includes acts such as the
following:
Manipulation, falsification, or alteration of accountingrecords 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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ASSESS THE RISK OF MATERIALMISSTATEMENT DUE TO
ERROR OR FRAUD
Misappropriation or defalcation includes the following:
Embezzling of cash receipts.
Stealing assets. Causing the entity to pay for goods or services not
received.
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ASSESS THE RISK OF MATERIALMISSTATEMENT DUE TO
ERROR OR FRAUD
Risk factors that relate to the 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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ASSESS THE RISK OF MATERIALMISSTATEMENT DUE TO
ERROR OR FRAUD
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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Factors Affecting Acceptable Audit Risk
The degree to which external users rely on the statements
The likelihood that a client will have financial difficultiesafter the audit report is issued
The auditors evaluation of managements integrity
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Making the Acceptable Audit Risk Decision
Methods used to assess
acceptable audit risk
External usersreliance on
financial
statements
Examine financial statements. Read minutes of the board.
Examine form 10K.
Discuss financing plans
with management.
Factors
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Making the Acceptable Audit Risk Decision
Likelihoodof financial
difficulties
Analyze financial statementsfor difficulties using ratios.
Examine inflows and outflows
of cash flow statements.
Management
integrity
See Chapter 8 for client
acceptance and continuance.
Methods used to assess
acceptable audit riskFactors
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Factors Affecting Inherent Risk
Nature of the clients business
Results of previous audits Initial versus repeat engagement
Related parties
Non-routine transactions
Judgment required to correctly record account balancesand transactions
Makeup of the population
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Relationships of Risk to Evidence
Acceptableaudit risk
Inherentrisk
Controlrisk
Planneddetection
risk
Amount ofevidencerequiredSituation
HighLow
Low
Medium
High
LowLow
High
Medium
Low
LowLow
High
Medium
Medium
HighMedium
Low
Medium
Medium
LowMedium
High
Medium
Medium
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3
4
5
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DOCUMENTATION OF THEAUDITORS RISK ASSESSMENT
The auditor should document that the risk of material
misstatement and how risk factors were considered.
Where risk factors are identified, the documentation shoulddescribe
the risk factors identified
the auditors response to those risk factors.
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LIMITATIONS OF THEAUDIT 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, dependencies exist between these
components (the risk of an misstatement occurring, IR, may
be a function of 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.