Audit Risk & Materiality

Introduction
} References
} ISA 315
} Para 6 – 19
} Para 100 – 119
} Jackson and Stent
} Materiality – Chapter 7/15 – 7/22
} Audit Risk – Chapter 7/23 - 7/27
} Audit Risk and Materiality – Chapter 7/27 – 7/29

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Audit Risk
— Definition of Audit Risk
¡ The risk that the auditor expresses an inappropriate audit opinion
when the annual financial statements are materially misstated
¡ I.e. he gives an unqualified opinion when it should be qualified

— Risk-based approach to auditing

¡ In order to minimise the auditor’s exposure to audit risk
¡ Identification of financial statement assertions that may be at risk of
misstatement
¡ Responds to this risk by
÷ designing an audit strategy and audit plan
÷ that will reduce the risk
÷ that material misstatement, will not be detected, to an acceptable level

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Audit Risk
— ISA 315
¡ Identify and assess the risks of material misstatement
÷ At the financial statement level
÷ At the assertion level

— The link between ISA 315 and Audit Risk?

¡ A failure to identify factors that may give rise to the risk of
material misstatement (and a failure to respond to such
risks)® Increase in audit risk
¡ Failure to understand
¢ The entity and its environment
¢ The accounting system and internal control systems

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Audit Risk: The Client Risks
} Client Risks
} Inherent Risk
} Built-in risk
} Risk that exists before internal controls are put in place!!!
} Risks related to specific type of industry and type of client
} Control Risk
} Relates to whether inherent risks will be prevented or detected by
the entity’s internal controls
} If the entity’s internal controls are NOT working as intended
¨ There is a risk that misstatement will occur (that will NOT be addressed
by the client)
¨ Auditor needs to be aware of this ® implications for AFS

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Audit Risk: The Client Risks
} Control risk
} Control activities
} Control environment
} The entity’s risk assessment process
} The information system
} Control activities
} Monitoring of internal controls
} Essential to evaluate the effect of the identified weaknesses (in
system) on the financial statement assertions

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Audit Risk: The Auditor’s Risk
} Detection risk
} Risk that the auditor will not detect a misstatement that exists
and could be material
} Risk that is inherent in the client’s operations and IS NOT addressed
by the client’s control system
} Detection risk is a function of the effectiveness of the auditor’s
audit procedures
} Detection risk may arise because
} Inappropriate audit procedure
} Misapplication of a procedure
} Misinterpretation of the results of a procedure
} There is an INVERSE relationship between [IR & CR] and DR

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Assessing risk at two levels
— At financial statement level
— Will potentially affect many assertions
¡ Factors that may affect audit risk at the financial statement level
÷ Management's integrity
¢ Manipulation of AFS to meet their own needs
÷ Management’s experience and knowledge
¢ Errors in AFS
÷ Pressure on management
¢ Many business failures in industry
¢ Need to raise loans
÷ Nature of entity’s business
÷ Factors affecting the industry
¢ Economic conditions
¢ Consumer demand for company’s products
¡ Need to consider how these factors will impact on the AFS

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Assessing risk at two levels
} At financial statement level
} Responding to such risk includes
} Assigning staff with appropriate skills and experience
} More supervision of staff
} Professional scepticism
} elements of unpredictability
} Changes to the way in which the audit has been conducted

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Assessing risk at two levels
} At assertion level
} Risk at financial statement level “trickles” down, and becomes
risk at the assertion level
} E.g. Poor management integrity
} Factors that may affect audit risk at the assertion level
} Susceptibility of an account to misstatement
} Complexity of transactions
} Degree of judgement involved
} Susceptibility of assets to loss or misappropriation
} Complex and unusual transactions (at year-end)
} Transactions not subjected to routine processing
} The auditor’s response ® audit procedures

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Audit risk – an approach
} You should be able to
} Identify a risk
} Describe the risk i.e. why is it a risk?
} Perform audit procedures to address the risk
} Starting with the audit plan
} Follow through into the detailed audit procedures

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Audit Risk
} Refer to Risk handout

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Materiality
} Audit report confirms whether or not the AFS are
materially misstated

} Accept that AFS are not 100% correct

} Contain a margin of uncertainty
} Where misstatement > acceptable margin of uncertainty
} Misstatement is material
} Affects user’s decisions (based on AFS)

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Materiality
— The nature of materiality
¡ It is subjective
÷ Professional judgement is required
¡ It is relative
÷ E.g. Coca Cola vs. the corner cafe
÷ The balance sheet vs. the income statement

¡ It is qualitative and quantitative

÷ Qualitative
¢ Where an amount > amount set as material
÷ Quantitative
¢ Judged against a factor other than an amount
¨ E.g. Important disclosure that is omitted

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Planning Materiality
} The relationship between planning materiality and audit
risk
} Inverse relationship
} Higher audit risk
¨ Set materiality lower in order to compensate for this
} Lower audit risk
¨ Set materiality higher
¨ Chance of material misstatement going undetected is lower
} Inverse relationship between audit risk and materiality
} Impact on nature, timing and extent of audit procedures
} The risk of material misstatement will have a direct impact on setting
of planning materiality levels

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Setting of materiality
} Auditor must consider and set materiality during the
following stages of the audit
} Planning stage
} Planning materiality
¨ In order to develop the AUDIT PLAN
} Completion stage
} Final materiality
¨ In order to measure the effect of AUDIT DIFFERENCES

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Planning Materiality
} It is a benchmark against which to measure quantitative
misstatements

} Considerations
} Amount of misstatement
} Quantitative
} Nature of misstatement
} Qualitative
} 2 Levels at which materiality is considered
} Overall level
} Individual level

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Planning materiality
} Exam technique – when calculating materiality
} Stability of indicators – which figures to use
} Budget or actual
¨ Budgeted figures – will these figures be achieved?
¨ Un-audited figures of current year – whole year’s figures?
} Prior year audited figures
} Balance sheet or Income Statement
} Consider the nature of the business
} Which would be most appropriate ?
¨ Look at “activity” on B/S and I/S.
¨ Who are the users? Would they use the I/S or the B/S mostly?

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Planning materiality
} Exam technique – when calculating materiality
} Calculation
} E.g. use of DP6
} Conclusion
} Do not leave materiality in a range – need a number!!
} Where it is a high risk audit – be conservative
¨ Examples
¨ Incentive to overstate assets and understate liabilities
¨ Possible Going Concern
¨ Risks related to particular assets, liabilities etc
¨ Risks related to the accounting system
Planning materiality
} Quantitative indicators of materiality
} E.g. DP6
} Turnover ½ - 1%
} Gross profit 1 – 2%
} Net income 5 – 10%
} Total assets 1 – 2%
} Equity 2 – 5%

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Planning materiality
} Qualitative indicators of materiality
} Consider when quantifying materiality
} Examples include
} Control environment
} Effectiveness of internal controls
} Integrity of management
} Appropriateness of accounting policies and the disclosure thereof
} Statutory requirements and regulations
} Problems and errors – previous years
} Results of analytical procedures
} Possibility of illegal transactions

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Planning Materiality
} Example of how to calculate planning materiality

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Final Materiality
} Is established at the end of the audit
} Is the standard against which identified misstatements are
measured, in order to determine the effect on the AFS

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