9 - 1©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Materiality and RiskMateriality and Risk
Chapter 9Chapter 9
9 - 2©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 1Learning Objective 1
Apply the concept of materialityApply the concept of materiality
to the audit.to the audit.
9 - 3©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
MaterialityMateriality
The auditor’s responsibility is toThe auditor’s responsibility is todetermine whether financialdetermine whether financialstatements are materially misstated.statements are materially misstated.
If there is a material misstatement,If there is a material misstatement,the auditor will bring it to the client’sthe auditor will bring it to the client’sattention so that a correction can be made.attention so that a correction can be made.
9 - 4©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Steps in Applying MaterialitySteps in Applying Materiality
StepStep11
Set preliminarySet preliminaryjudgment aboutjudgment aboutmateriality.materiality.
PlanningPlanningextentextentof testsof tests
StepStep22
Allocate preliminaryAllocate preliminaryjudgment aboutjudgment aboutmaterialitymaterialityto segments.to segments.
9 - 5©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Steps in Applying MaterialitySteps in Applying Materiality
EvaluatingEvaluatingresultsresults
StepStep33
Estimate totalEstimate totalmisstatement in segment.misstatement in segment.
StepStep44
Estimate theEstimate thecombined misstatement.combined misstatement.
Compare combinedCompare combinedestimate with judgmentestimate with judgmentabout materiality.about materiality.
StepStep55
9 - 6©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 2Learning Objective 2
Make a preliminary judgmentMake a preliminary judgment
about what amounts toabout what amounts to
consider material.consider material.
9 - 7©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Set Preliminary Judgment about Set Preliminary Judgment about MaterialityMateriality
This preliminary judgment is the maximumThis preliminary judgment is the maximumamount by which the auditor believes theamount by which the auditor believes thestatements could be misstated and still statements could be misstated and still notnotaffect the decisions of reasonable users.affect the decisions of reasonable users.
Ideally, auditors decide early in the auditIdeally, auditors decide early in the auditthe combined amount of misstatementsthe combined amount of misstatementsof the financial statements that wouldof the financial statements that wouldbe considered material.be considered material.
9 - 8©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Factors Affecting JudgmentFactors Affecting Judgment
Materiality is a relative ratherMateriality is a relative ratherthan an absolute concept.than an absolute concept.
Bases are needed forBases are needed forevaluating materiality.evaluating materiality.
Qualitative factors alsoQualitative factors alsoaffect materiality.affect materiality.
9 - 9©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
GuidelinesGuidelines
Accounting and auditing standardsAccounting and auditing standardsdo not provide specific materialitydo not provide specific materialityguidelines to practitioners.guidelines to practitioners.
Professional judgment is to be usedProfessional judgment is to be usedat all times in setting and applyingat all times in setting and applyingmateriality guidelines.materiality guidelines.
9 - 10©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 3Learning Objective 3
Allocate preliminary materialityAllocate preliminary materiality
to segments of the auditto segments of the audit
during planning.during planning.
9 - 11©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Allocate Preliminary Judgment Allocate Preliminary Judgment About Materiality to SegmentsAbout Materiality to Segments
This is necessary because evidence isThis is necessary because evidence isaccumulated by segments rather thanaccumulated by segments rather thanfor the financial statements as a whole.for the financial statements as a whole.
Most practitioners allocate materialityMost practitioners allocate materialityto balance sheet accounts.to balance sheet accounts.
SAS 39 (AU 350)SAS 39 (AU 350)
9 - 12©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 4Learning Objective 4
Use materiality to evaluateUse materiality to evaluate
audit findings.audit findings.
9 - 13©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Estimated Total Misstatement and Estimated Total Misstatement and Preliminary JudgmentPreliminary Judgment
CashCashAccounts receivableAccounts receivableInventoryInventoryTotal estimatedTotal estimated misstatement amountmisstatement amountPreliminary judgmentPreliminary judgment about materialityabout materiality
$ 4,000$ 4,000 20,00020,000 36,00036,000
$50,000$50,000
$ 0$ 0 12,00012,000 31,50031,500
$43,500$43,500
$ N/A$ N/A 6,0006,000 15,75015,750
$16,800$16,800
$ 0$ 0 18,00018,000 47,25047,250
$60,300$60,300
TolerableTolerablemisstatementmisstatement
DirectDirectprojectionprojection
SamplingSamplingerrorerror** TotalTotalAccountAccount
Estimated misstatement amountEstimated misstatement amount
*estimate for sampling error is 50%*estimate for sampling error is 50%
9 - 14©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Estimated Total Misstatement and Estimated Total Misstatement and Preliminary JudgmentPreliminary Judgment
Net misstatements in the sampleNet misstatements in the sample
$3,500 ÷ $50,000 $3,500 ÷ $50,000 ×× $450,000 = $450,000 = $31,500 $31,500
×× Total recorded population value Total recorded population value
÷ Total sampled÷ Total sampled
= Direct projection estimate of misstatement= Direct projection estimate of misstatement
9 - 15©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 5Learning Objective 5
Define risk in auditing.Define risk in auditing.
9 - 16©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
RiskRisk
Auditors accept some level of riskAuditors accept some level of riskin performing the audit.in performing the audit.
An effective auditor recognizes thatAn effective auditor recognizes thatrisks exist, are difficult to measure,risks exist, are difficult to measure,and require careful thought to respond.and require careful thought to respond.
Responding to risks properly is criticalResponding to risks properly is criticalto achieving a high-quality audit.to achieving a high-quality audit.
9 - 17©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Risk and EvidenceRisk and Evidence
Auditors gain an understanding of theAuditors gain an understanding of theclient’s business and industry andclient’s business and industry andassess client business risk.assess client business risk.
Auditors use the audit risk model to furtherAuditors use the audit risk model to furtheridentify the potential for misstatementsidentify the potential for misstatementsand where they are most likely to occur.and where they are most likely to occur.
9 - 18©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Illustration of Differing Evidence Illustration of Differing Evidence Among CyclesAmong Cycles
Sales andSales andcollectioncollectioncyclecycle
AcquisitionAcquisitionand paymentand paymentcyclecycle
Payroll andPayroll andpersonnelpersonnelcyclecycle
InherentInherentriskriskAA MediumMedium HighHigh LowLow
ControlControlriskriskBB MediumMedium LowLow LowLow
AcceptableAcceptableaudit riskaudit riskCC LowLow LowLow LowLow
PlannedPlanneddetection riskdetection riskDD MediumMedium MediumMedium HighHigh
9 - 19©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Illustration of Differing Evidence Illustration of Differing Evidence Among CyclesAmong Cycles
Inventory andInventory andwarehousingwarehousingcyclecycle
Capital acquisitionCapital acquisitionand repaymentand repaymentcyclecycle
InherentInherentriskriskAA HighHigh LowLow
ControlControlriskriskBB HighHigh MediumMedium
AcceptableAcceptableaudit riskaudit riskCC LowLow LowLow
PlannedPlanneddetection riskdetection riskDD LowLow MediumMedium
9 - 20©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 6Learning Objective 6
Describe the audit risk modelDescribe the audit risk model
and its components.and its components.
9 - 21©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Audit Risk Model for PlanningAudit Risk Model for Planning
PDR = AAR ÷ (IR PDR = AAR ÷ (IR ×× CR) CR)
PDRPDR = Planned detection risk = Planned detection risk
AARAAR = Acceptable audit risk = Acceptable audit risk
IRIR = Inherent risk = Inherent risk
CRCR = Control risk = Control risk
9 - 22©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 7Learning Objective 7
Consider the impact ofConsider the impact of
engagement risk onengagement risk on
acceptable audit risk.acceptable audit risk.
9 - 23©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Impact of Engagement Risk on Impact of Engagement Risk on Acceptable Audit RiskAcceptable Audit Risk
Auditors decide engagement risk and useAuditors decide engagement risk and usethat risk to modify acceptable audit risk.that risk to modify acceptable audit risk.
Engagement risk closely relates to clientEngagement risk closely relates to clientbusiness risk.business risk.
9 - 24©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Factors Affecting Acceptable Factors Affecting Acceptable Audit RiskAudit Risk
The degree to which external usersThe degree to which external usersrely on the statementsrely on the statements
The likelihood that a client will haveThe likelihood that a client will havefinancial difficulties after thefinancial difficulties after theaudit report is issuedaudit report is issued
The auditor’s evaluation of The auditor’s evaluation of management’s integritymanagement’s integrity
9 - 25©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Making the Acceptable Audit Risk Making the Acceptable Audit Risk DecisionDecision
Methods used to assessMethods used to assessacceptable audit riskacceptable audit risk
External users’External users’reliance onreliance onfinancialfinancialstatementsstatements
• Examine financial statements.Examine financial statements.• Read minutes of the board.Read minutes of the board.• Examine form 10K.Examine form 10K.• Discuss financing plansDiscuss financing plans
with management.with management.
FactorsFactors
9 - 26©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Making the Acceptable Audit Risk Making the Acceptable Audit Risk DecisionDecision
LikelihoodLikelihoodof financialof financialdifficultiesdifficulties
• Analyze financial statementsAnalyze financial statementsfor difficulties using ratios.for difficulties using ratios.
• Examine inflows and outflowsExamine inflows and outflowsof cash flow statements.of cash flow statements.
ManagementManagementintegrityintegrity
• See Chapter 8 for clientSee Chapter 8 for clientacceptance and continuance.acceptance and continuance.
Methods used to assessMethods used to assessacceptable audit riskacceptable audit riskFactorsFactors
9 - 27©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 8Learning Objective 8
Consider the impact of severalConsider the impact of several
factors on the assessmentfactors on the assessment
of inherit risk.of inherit risk.
9 - 28©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Factors Affecting Inherent RiskFactors Affecting Inherent Risk
Nature of the client’s business Nature of the client’s business Results of previous auditsResults of previous audits Initial versus repeat engagementInitial versus repeat engagement Related partiesRelated parties Nonroutine transactionsNonroutine transactions Judgment required to correctly recordJudgment required to correctly record
account balances and transactionsaccount balances and transactions Makeup of the populationMakeup of the population
9 - 29©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 9Learning Objective 9
Discuss the relationship ofDiscuss the relationship of
risks to audit evidence.risks to audit evidence.
9 - 30©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Relationship of Risk Factors,Relationship of Risk Factors,Risk, and EvidenceRisk, and Evidence
D = Direct relationship; I = Inverse relationshipD = Direct relationship; I = Inverse relationship
FactorsFactorsinfluencinginfluencing
risksrisks
Acceptable audit riskAcceptable audit risk
PlannedPlanneddetectiondetection
riskrisk
PlannedPlannedauditaudit
evidenceevidence
InherentInherentriskrisk
Control riskControl risk
II
DD
II
IIDD
II DD
9 - 31©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Relationship of Risk Factors,Relationship of Risk Factors,Risk, and EvidenceRisk, and Evidence
The engagement may require moreThe engagement may require moreexperienced staff.experienced staff.
The engagement will be reviewed moreThe engagement will be reviewed morecarefully than usual.carefully than usual.
Auditors can change the audit to respond to risks.Auditors can change the audit to respond to risks.
9 - 32©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Audit Risk for SegmentsAudit Risk for Segments
Both control risk and inherent risk areBoth control risk and inherent risk aretypically set for each cycle, eachtypically set for each cycle, eachaccount, and often even each auditaccount, and often even each auditobjective, not for the overall audit.objective, not for the overall audit.
9 - 33©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Relating Risk of Fraud to Risk Relating Risk of Fraud to Risk Model ComponentsModel Components
The risk of fraud can be assessed for theThe risk of fraud can be assessed for theentire audit or by cycle, account, and objective.entire audit or by cycle, account, and objective.
Specific response could includeSpecific response could includerevising assessments of acceptablerevising assessments of acceptableaudit risk, inherent risk, and control risk.audit risk, inherent risk, and control risk.
9 - 34©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Tolerable Misstatement, Risks,Tolerable Misstatement, Risks,and Balance-related Objectivesand Balance-related Objectives
It is common to assess inherent and controlIt is common to assess inherent and controlrisk for each balance-related audit objective.risk for each balance-related audit objective.
It is not common to allocate materialityIt is not common to allocate materialityto objectives.to objectives.
9 - 35©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Measurement LimitationsMeasurement Limitations
One major limitation in the application of theOne major limitation in the application of theaudit risk model is the difficulty of measuringaudit risk model is the difficulty of measuringthe components of the model.the components of the model.
9 - 36©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Relationships of Risk to EvidenceRelationships of Risk to Evidence
AcceptableAcceptableaudit riskaudit risk
InherentInherentriskrisk
ControlControlriskrisk
PlannedPlanneddetectiondetection
riskrisk
Amount ofAmount ofevidenceevidencerequiredrequiredSituationSituation
HighHigh
LowLow
LowLow
MediumMedium
HighHigh
LowLow
LowLow
HighHigh
MediumMedium
LowLow
LowLow
LowLow
HighHigh
MediumMedium
MediumMedium
HighHigh
MediumMedium
LowLow
MediumMedium
MediumMedium
LowLow
MediumMedium
HighHigh
MediumMedium
MediumMedium
11
22
33
44
55
9 - 37©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Tests of Details of Balances Tests of Details of Balances Evidence Planning WorksheetEvidence Planning Worksheet
Auditors develop various types of worksheetsAuditors develop various types of worksheetsto aid in relating the considerations affectingto aid in relating the considerations affectingaudit evidence to the appropriateaudit evidence to the appropriateevidence to accumulate.evidence to accumulate.
9 - 38©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 10Learning Objective 10
Discuss how materiality and riskDiscuss how materiality and risk
are related and integrated intoare related and integrated into
the audit process.the audit process.
9 - 39©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Tolerable Misstatements, Risk, Tolerable Misstatements, Risk, and Planned Evidenceand Planned Evidence
D = Direct relationship; I = Inverse relationshipD = Direct relationship; I = Inverse relationship
AcceptableAcceptableaudit riskaudit risk
InherentInherentriskrisk
ControlControlriskrisk
TolerableTolerablemisstatementmisstatement
PlannedPlanneddetection riskdetection risk
PlannedPlannedaudit evidenceaudit evidence
II
DD
II
II II
II
DD
DD
9 - 40©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Evaluating ResultsEvaluating Results
AcAR = IR AcAR = IR ×× CR CR ×× AcDR AcDR
AcAR AcAR = Achieved audit risk= Achieved audit risk
IRIR = Inherent risk = Inherent risk
CRCR = Control risk = Control risk
AcDRAcDR = Achieved detection risk = Achieved detection risk
9 - 41©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Audit Risk Models for Planning Audit Risk Models for Planning Evidence and Evaluating ResultsEvidence and Evaluating Results
AcceptableAcceptableauditauditriskrisk
InherentInherentriskrisk
ControlControlriskrisk
AchievedAchieveddetectiondetection
riskrisk
SubstantiveSubstantiveauditaudit
evidenceevidence
AchievedAchievedauditauditriskrisk
CompareCompare
DD
II
DD
DD
D = Direct relationshipD = Direct relationshipI = Inverse relationshipI = Inverse relationship
9 - 42©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Revising Risks and EvidenceRevising Risks and Evidence
The audit risk model is primarily aThe audit risk model is primarily aplanningplanning model and is therefore ofmodel and is therefore oflimited use in evaluating results.limited use in evaluating results.
Great care must be used in revisingGreat care must be used in revisingthe risk factors when the actual resultsthe risk factors when the actual resultsare not as favorable as planned.are not as favorable as planned.
9 - 43©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
End of Chapter 9End of Chapter 9