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3 - 1©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 6Learning Objective 6
Explain how materiality affectsExplain how materiality affects
audit reporting decisions.audit reporting decisions.
3 - 2©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
MaterialityMateriality
Materiality is an essential consideration in Materiality is an essential consideration in determining the appropriate type of report determining the appropriate type of report for a given set of circumstances. for a given set of circumstances.
A misstatement in the financial statementsA misstatement in the financial statementscan be considered material if knowledge ofcan be considered material if knowledge ofthe misstatement would affect a decisionthe misstatement would affect a decisionof a reasonable user of the statements.of a reasonable user of the statements.
3 - 3©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Levels of MaterialityLevels of Materiality
Amounts are immaterial.Amounts are immaterial.
Amounts are material but do not overshadowAmounts are material but do not overshadowthe financial statements as a whole.the financial statements as a whole.
Amounts are so material or so pervasive thatAmounts are so material or so pervasive thatoverall fairness of the statements is in question.overall fairness of the statements is in question.
There are three level of materiality are used There are three level of materiality are used
for determining the type of opinion to issue:for determining the type of opinion to issue:
3 - 4©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Levels of MaterialityLevels of Materiality Amounts are immaterialAmounts are immaterial When a misstatement in the financial When a misstatement in the financial
statements exists but is unlikely to affect the statements exists but is unlikely to affect the
decisions of a reasonable user, it is decisions of a reasonable user, it is
considered to be immaterial. An unqualified considered to be immaterial. An unqualified
opinion is therefore appropriate. opinion is therefore appropriate.
Amounts are material but do not Amounts are material but do not overshadow the financial statements overshadow the financial statements as a wholeas a whole
The second level of materiality exists when a The second level of materiality exists when a
misstatement in the financial statements misstatement in the financial statements
would affect a user’s decision, but the overall would affect a user’s decision, but the overall
statements are still fairly stated and statements are still fairly stated and
therefore useful. therefore useful.
3 - 5©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Levels of MaterialityLevels of Materiality Amounts are so material or so Amounts are so material or so
pervasive that overall fairness of the pervasive that overall fairness of the statements is in questionstatements is in question
The highest level of materiality exists when The highest level of materiality exists when
users are likely to make incorrect decisions if users are likely to make incorrect decisions if
they rely on the overall financial statements.they rely on the overall financial statements.
When the highest level of materiality exists, When the highest level of materiality exists,
the auditor must issue either a disclaimer of the auditor must issue either a disclaimer of
opinion or an adverse opinion, depending on opinion or an adverse opinion, depending on
which conditions exist. which conditions exist.
When determining whether an exception is When determining whether an exception is
highly material, the extent to which the highly material, the extent to which the
exception affects different parts of the financial exception affects different parts of the financial
statements must be considered. statements must be considered. This is called This is called
Pervasiveness.Pervasiveness.
3 - 6©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Relationship of Materiality toRelationship of Materiality toType of OpinionType of Opinion
MaterialityMaterialityLevelLevel
Significance in Terms ofSignificance in Terms ofReasonable Users’ DecisionsReasonable Users’ Decisions
Type ofType ofOpinionOpinion
Users’ decisions are unlikelyUsers’ decisions are unlikelyto be affected.to be affected.ImmaterialImmaterial UnqualifiedUnqualified
Users’ decisions are likelyUsers’ decisions are likelyto be affected.to be affected.MaterialMaterial QualifiedQualified
Users’ decisions are likelyUsers’ decisions are likelyto be significantly affected.to be significantly affected.
HighlyHighlymaterialmaterial
DisclaimerDisclaimeror adverseor adverse
3 - 7©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Materiality DecisionsMateriality Decisions
Failure toFailure tofollow GAAPfollow GAAP
Audit reportAudit report
UnqualifiedUnqualified QualifiedQualifiedopinion onlyopinion only AdverseAdverse
3 - 8©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Materiality DecisionsMateriality DecisionsWhen a client has failed to follow GAAP, the When a client has failed to follow GAAP, the
audit report will be audit report will be unqualifiedunqualified, , qualified qualified
opinion onlyopinion only, , or adverseor adverse, depending on the , depending on the
materiality of the departure. materiality of the departure.
Several aspects of materiality must be Several aspects of materiality must be
considered.considered.Dollar amount compared with a baseDollar amount compared with a base
MeasurabilityMeasurability
Nature of the itemNature of the item
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Dollar amount compared with a baseDollar amount compared with a base
The primary concern in measuring The primary concern in measuring
materiality when a client has failed to materiality when a client has failed to
follow GAAP is usually the total dollar follow GAAP is usually the total dollar
misstatement in the accounts involved, misstatement in the accounts involved,
compared with some base. compared with some base.
Misstatements must be compared with Misstatements must be compared with
some measurement base before a some measurement base before a
decision can be made about the decision can be made about the
materiality of the failure to follow GAAP. materiality of the failure to follow GAAP.
Common bases include net income, total Common bases include net income, total
assets, current assets, and working assets, current assets, and working
capital. capital.
3 - 10©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Dollar amount compared with a baseDollar amount compared with a base
To evaluate overall materiality, the To evaluate overall materiality, the
auditor must also combine all unadjusted auditor must also combine all unadjusted
misstatements and judge whether there misstatements and judge whether there
may be individually immaterial may be individually immaterial
misstatements that, when combined, misstatements that, when combined,
significantly affect the statements. significantly affect the statements.
When comparing potential misstatements When comparing potential misstatements
with base, the auditor must carefully with base, the auditor must carefully
consider all accounts affected by a consider all accounts affected by a
misstatements (pervasiveness).misstatements (pervasiveness).
3 - 11©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
The dollar amount of some misstatements The dollar amount of some misstatements
cannot be accurately measured. cannot be accurately measured.
For example, a client’s unwillingness to For example, a client’s unwillingness to
disclose an existing lawsuit or the disclose an existing lawsuit or the
acquisition of a new company subsequent acquisition of a new company subsequent
to the balance sheet date is difficult if not to the balance sheet date is difficult if not
impossible to measure in terms of dollar impossible to measure in terms of dollar
amounts. amounts.
The materiality question the auditor must The materiality question the auditor must
evaluate in such situations is the effect on evaluate in such situations is the effect on
statement users of the failure to make the statement users of the failure to make the
disclosure.disclosure.
MeasurabilityMeasurability
3 - 12©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
The decision of a user may also be affected by The decision of a user may also be affected by
the kind of misstatement. The following may the kind of misstatement. The following may
affect a user’s decision and therefore the affect a user’s decision and therefore the
auditor’s opinion in a different way than most auditor’s opinion in a different way than most
misstatements. misstatements.
— Transactions are illegal or fraudulent.Transactions are illegal or fraudulent.
— An item may materially affect some future period, An item may materially affect some future period,
even though it is immaterial for the current period even though it is immaterial for the current period
only. only.
— An item has a “psychic” effect (for example, the An item has a “psychic” effect (for example, the
item changes a small loss to a small profit, item changes a small loss to a small profit,
maintains a trend of increasing earnings, or allows maintains a trend of increasing earnings, or allows
earnings to exceed analysts’ expectations)earnings to exceed analysts’ expectations)
— An item may be important in terms of possible An item may be important in terms of possible
consequences arising from contractual obligations.consequences arising from contractual obligations.
Nature of the itemNature of the item
3 - 13©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Materiality DecisionsMateriality Decisions
ScopeScopelimitationlimitation
Audit reportAudit report
UnqualifiedUnqualified Qualified scopeQualified scopeand opinionand opinion DisclaimerDisclaimer
3 - 14©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
When there is a scope limitation in an audit, the When there is a scope limitation in an audit, the
audit report will be unqualified, qualified scope audit report will be unqualified, qualified scope
and opinion, or disclaimer, depending on the and opinion, or disclaimer, depending on the
materiality of the scope limitation. materiality of the scope limitation.
The auditor will consider the same The auditor will consider the same three factorsthree factors
included in the previous discussion about included in the previous discussion about
materiality decisions for failure to follow GAAP, materiality decisions for failure to follow GAAP,
but they will be considered differently. but they will be considered differently.
The size of potential misstatements, rather The size of potential misstatements, rather
than known misstatements, is important in than known misstatements, is important in
determining whether an unqualified report, a determining whether an unqualified report, a
qualified report, or a disclaimer of opinion is qualified report, or a disclaimer of opinion is
appropriate for a scope limitation. appropriate for a scope limitation.
Materiality Decision – Scope LimitationMateriality Decision – Scope Limitation
3 - 15©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
For example, a recorded accounts payable of For example, a recorded accounts payable of
$400,000 was not audited, the auditor must $400,000 was not audited, the auditor must
evaluate the potential misstatements in accounts evaluate the potential misstatements in accounts
payable and decide how materially the financial payable and decide how materially the financial
statements could be affected. The pervasiveness statements could be affected. The pervasiveness
of these potential misstatements must also be of these potential misstatements must also be
considered.considered.
It is typically more difficult to evaluate the It is typically more difficult to evaluate the
materiality of potential misstatements resulting materiality of potential misstatements resulting
from a scope limitation than for failure to follow from a scope limitation than for failure to follow
GAAP. Misstatements resulting from failure to GAAP. Misstatements resulting from failure to
follow GAAP are known. follow GAAP are known.
Those resulting from scope limitations must Those resulting from scope limitations must
usually be subjectively measured in terms of usually be subjectively measured in terms of
potential or likely misstatements. potential or likely misstatements.
Materiality Decision – Scope LimitationMateriality Decision – Scope Limitation
3 - 16©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
For client-imposed restriction, the auditor For client-imposed restriction, the auditor
should be concerned about the possibility should be concerned about the possibility
that management is trying to prevent that management is trying to prevent
discovery of misstated information.discovery of misstated information.
In such cases, auditing standards In such cases, auditing standards
encourage a encourage a declaimer of opiniondeclaimer of opinion when when
materiality is in question.materiality is in question.
When restriction resulted from conditions When restriction resulted from conditions
beyond the client’s control, beyond the client’s control, a qualification a qualification
of scope and opinionof scope and opinion is more likely. is more likely.
Materiality Decision – Scope LimitationMateriality Decision – Scope Limitation
3 - 17©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
1.1. Evaluate the existence of the MisstatementsEvaluate the existence of the Misstatements
2.2. Evaluate the dollar amount of misstatements Evaluate the dollar amount of misstatements which effect of the financial statements.which effect of the financial statements.
3.3. Combine all unadjusted misstatements Combine all unadjusted misstatements
4.4. Carefully consider all accounts affected by a Carefully consider all accounts affected by a misstatements (evaluate the pervasiveness of misstatements (evaluate the pervasiveness of the misstatements) the misstatements)
5.5. Compare the amount of the misstatements Compare the amount of the misstatements with some base.with some base.
6.6. Evaluate the nature of misstatementsEvaluate the nature of misstatements
7.7. Judge whether the misstatements are material Judge whether the misstatements are material or immaterial.or immaterial.
Summery of Materiality DecisionSummery of Materiality Decision
3 - 18©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 7Learning Objective 7
Draft appropriately modifiedDraft appropriately modified
audit reports under a varietyaudit reports under a variety
of circumstances.of circumstances.
3 - 19©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Discussion of ConditionsDiscussion of ConditionsRequiring DepartureRequiring Departure
Auditor’s scope has been restricted.Auditor’s scope has been restricted.
Statements are not in conformity with GAAP.Statements are not in conformity with GAAP.
Auditor is not independent.Auditor is not independent.
3 - 20©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Scope Restricted by ClientScope Restricted by Clientor Other Conditionsor Other Conditions
ImmaterialImmaterial MaterialMaterial
Level of MaterialityLevel of Materiality
ExtremelyExtremelyMaterialMaterial
UnqualifiedUnqualifiedreportreport
Qualified scope, additionalQualified scope, additionalparagraph, and qualifiedparagraph, and qualified
opinion (except for)opinion (except for)
DisclaimerDisclaimerof opinionof opinion
3 - 21©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Statements Not Prepared in Statements Not Prepared in Accordance With GAAPAccordance With GAAP
ImmaterialImmaterial MaterialMaterial
Level of MaterialityLevel of Materiality
ExtremelyExtremelyMaterialMaterial
UnqualifiedUnqualifiedreportreport
Additional paragraphAdditional paragraphand qualified opinionand qualified opinion
(except for)(except for)
AdverseAdverseopinionopinion
3 - 22©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
The Auditor Is Not IndependentThe Auditor Is Not Independent
ImmaterialImmaterial MaterialMaterial
Level of MaterialityLevel of Materiality
ExtremelyExtremelyMaterialMaterial
Disclaimer of opinionDisclaimer of opinion(regardless of materiality)(regardless of materiality)
3 - 23©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 8Learning Objective 8
Determine the appropriate auditDetermine the appropriate audit
report for a given audit situation.report for a given audit situation.
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Auditor’s Decision ProcessAuditor’s Decision Process
Determine whether any condition existsDetermine whether any condition existsrequiring a departure from a standardrequiring a departure from a standardunqualified report.unqualified report.
Decide the materiality for each condition.Decide the materiality for each condition.
Decide the appropriate type of report.Decide the appropriate type of report.
Write the audit report.Write the audit report.
3 - 25©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Number of ParagraphsNumber of Paragraphsin the Reportin the Report
Standard unqualifiedStandard unqualified 33Unqualified with explanatory paragraphUnqualified with explanatory paragraph 44Unqualified shared report with other auditorsUnqualified shared report with other auditors 33Qualified – opinion onlyQualified – opinion only 44Qualified – scope and opinionQualified – scope and opinion 44Disclaimer – scope limitationDisclaimer – scope limitation 33AdverseAdverse 44
Type of ReportType of Report
3 - 26©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 9Learning Objective 9
Discuss the impact of e-commerceDiscuss the impact of e-commerce
on audit reporting.on audit reporting.
3 - 27©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
Impact of E-Commerce onImpact of E-Commerce onAudit ReportingAudit Reporting
Auditors are not required to read informationAuditors are not required to read informationcontained in electronic sites.contained in electronic sites.
Most public companies provide access to financialMost public companies provide access to financialinformation through their home Web page.information through their home Web page.
Auditing standards note that electronic sitesAuditing standards note that electronic sitesare not considered “documents.”are not considered “documents.”
3 - 28©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Beasley/Elder Arens/Beasley/Elder
End of Chapter 3End of Chapter 3