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1、Materiality and Risk,Chapter 9,Auditing Definition,Auditing reduces information risk to a socially acceptable level. To accomplish this, Set materiality (yardstick) Manage risks.,Materiality,The auditors responsibility is to determine whether financial statements are materially misstated.,If there i
2、s a material misstatement, the auditor will bring it to the clients attention so that a correction can be made.,Materiality,Information is material when it is likely to influence the economic decisions of financial statement users. Planning materiality (preliminary judgment) is the largest amount of
3、 uncorrected dollar misstatement that could exist in published financial statements and still fairly present financial statements in conformity with GAAP. Tolerable misstatement is the amount an account can be off and still be considered fairly stated.,Steps in ApplyingMateriality,Step 1,Set prelimi
4、nary judgment about materiality.,Step 2,Allocate preliminary judgment about materiality to segments.,Planning extent of tests,Steps in ApplyingMateriality,Step 3,Estimate total misstatement in segment.,Step 4,Estimate the combined misstatement.,Evaluating results,Compare combined estimate with judgm
5、ent about materiality.,Step 5,Auditors use materiality to:,Plan the audit, directing attention, determining the nature, timing and extent of procedures to be performed. Evaluate the evidence, something to measure against Guide for decisions about audit report Planning Materiality is determined prior
6、 to evidence gathering,Determining Whats Material,Not required to define materiality as a specific dollar amount. Rule of thumb for materiality is under 5% is not material where over 10% would be material. Auditors judgment determines materiality,Factors that affect auditors judgement on materiality
7、,Absolute size - half a million Relative size - in relation to F/S such as 5% of net income. Qualitative aspects (nature) - management fraud v.s. employee fraud Circumstances - what will F/S be used for, how widely published Uncertainty - lower materiality level because of risk of being wrong. Cumul
8、ative error - errors may accumulate into a material error,Preliminary Assessment of Materiality,Helps the auditor avoid surprises such as: Not auditing enough - litigation Auditing too much - costly Fine tunes the audit for effectiveness and efficiency.,Assigning Materiality to Accounts,Top Down, de
9、fine total materiality and divide amongst the accounts Bottoms-up, assign materiality to each account and add the amounts to get total materiality for the F/S. The amount assigned to the account is the tolerable misstatement.,Allocate Preliminary Judgment About Materiality to Segments,This is necess
10、ary because evidence is accumulated by segments rather than for the financial statements as a whole.,Most practitioners allocate materiality to balance sheet accounts.,SAS 39 (AU 350),Estimated TotalMisstatement Example,Net misstatement of the sample,$3,500 $50,000 $450,000 = $31,500,Total sampled,T
11、otal recorded population value,Direct projection estimate of misstatement,=,Example of Estimatefor Sampling Error,Tolerable Direct Sampling Account Misstatement Projection Error Total Cash$ 4,000$ 0$ N/A$ 0 Accounts receivable 20,000 12,000 6,000* 18,000 Inventory 36,000 31,500 15,750* 47,250 Total
12、estimated misstatement amount$43,500$16,800$60,300 Preliminary judgment about materiality$50,000 *estimate for sampling error is 50%,Analytical Procedures can help determine materiality,Mathematical analysis of the F/S Required as part of planning and review for an audit. Attention Directing Helps t
13、o reduce risk.,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.,Managing Risk using the Mode
14、l,Audit Risk = Inherent Risk x Control Risk x Detection Risk AR = IR x CR x DR,Inherent Risk,The risk that material misstatements have entered the accounting system. Based on type of business, environment, type of management, etc. What errors could occur?,Control Risk,Control risk is the probability
15、 that the clients internal control activities will fail to detect material misstatements. What has client done to mitigate inherent risks?,Detection Risk,The probability that audit procedures will fail to produce evidence of material misstatements. This is the only part of the risk model the auditor
16、 controls by planning the nature, timing and extent of audit procedures.,Audit Risk,The risk that an auditor will issue an inappropriate opinion. Manage audit risk by Evaluating the clients inherent and control risk Adjusting audit procedures (detection risk),Who Controls the Risks,The auditor controls the audit risk by controlling detection risk. Inherent and control risk are controlled by the client and the business the client is in.,Anchoring,Anchoring is the auditor using a carryove
