Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
9Materiality and Risk
EXPLAIN TO ME ONE MORE TIME
THAT YOU DID A GOOD JOB,BUT
THE COMPANY WENT BROKE
Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
USER FOCUS
Materiality is defined in terms
of financial statement users
Therefore no hard and fast rules
Need to consider multiple users and multiple bases
Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
Audits provide reasonable assurance
that the financial statements are
free of material misstatements.
Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
FIGURE 9 - 1 Steps in Applying Materiality
Estimate
total misstatement
in segment
Step
3
Estimate
the combined
misstatement
Step
4
Compare
combined
estimate with
preliminary or
revised judgment
about materiality
Step
5
Set
preliminary
judgment about
materiality
Step
1
Allocate
preliminary
judgment about
materiality
to segments
Step
2
Planning extent of tests
Evaluating results
BS line items or cycles
Mat – TE or TM
Perform
tests
Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
SET PRELIMINARY JUDGMENT
ABOUT MATERIALITY
Base X (function of client)
Percentage (function of audit risk)
= Preliminary estimate of materiality
Factors Affecting Judgment
Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
Typically 5 - 10% for net income,lower
percentage for larger bases such as
assets or revenues
High Risk Low %
Low Risk High %
(less evidence; less assurance)
Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
Materiality / Evidence
Relation
Increase in
materiality Less
evidence
required
Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
Factors Affecting Tolerable
Misstatement
Large versus Small Allocation of Materiality
Small Balance Large Balance
Few Errors Expected Many Errors Expected
Costly to test Inexpensive to Test
Not testable with AP Testable with AP
Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
Options When Projected Errors
Exceed Materiality
Record an adjustment
- Usually limited to actual errors
Perform more testing
- Better error estimate
- Lower sampling risk
Qualify opinion
Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
Planned Detection Risk
Inherent Risk
Control Risk
Acceptable Audit Risk
Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
FACTORS AFFECTING
ACCEPTABLE AUDIT RISK
The Degree of Which External Users Rely on the Statements
The Likelihood that a Client Will Have Financial Difficulties
after the Audit Report Is Issued
The Auditor’s Evaluation of
Management’s Integrity
Impact of Business Risk
on Acceptable Audit Risk
Risk that the auditor
fails to modify opinion
when financial
statements
are misstated
Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
As lower acceptable levels of audit risk
and materiality are established,
the auditor should plan more
work on individual accounts to:
a,Find smaller errors?
b,Find larger errors?
c,Increase tolerable error in accounts?
d,Increase materiality in the account?
Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
Inherent Risk
Likelihood of errors or irregs
(assuming NO IC’s in place)
Varies by account (errors are more likely in
some accounts than others)
Varies by audit objective within accounts – what
are we testing for? Completeness? Exist?
Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
Nature of the Client’s Business
Factors Related to Misstatements Arising
from Fraudulent Financial Reporting
Results of Previous Audits
Initial Versus Repeat Engagement
Related Parties
Nonroutine Transactions
Judgment - Correctly Record Account
Balance and Transactions
Susceptibility of Assets to Misappropriation
Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
Risk that client’s internal controls fail
to prevent or detect an error
To assess control risk below maximum:
Must study and document control structure
Must test their effectiveness (in place and optg)
Arens,Loebbecke; Auditing,8/E
2000 Prentice Hall,Inc.
Planned Detection Risk
Risk that the auditor fails to
detect a material error
Determines amount of evidence
Dependent variable because it is
determined by other risk model factors
Decrease More evidence
PDR required