Audit Practice II: Materiality and Risk

Audit Practice and Procedures II

• This is a course module.
• The focus of Week Five is Materiality and Risk.

Recap of Last Class

• Audit Evidence
• Types of Audit Evidence
• Audit Plan
• Audit Documentation

Relationship of Materiality to Type of Opinion

• Immaterial: User decisions are unlikely to be affected. Unqualified opinion.
• Material: User decisions are likely to be affected only if the information is important to the decisions being made. The overall financial statements are presented fairly. Qualified opinion.
• Highly material: Most or all users' decisions based on the financial statements are likely to be significantly affected. Disclaimer or adverse opinion.

Materiality

• The magnitude of an omission or misstatement of accounting information.
• In the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced.
• Auditors are responsible for determining if financial statements are materially misstated.
• If a material misstatement is discovered, it must be brought to the client's attention for correction.
• If the client refuses, a qualified or adverse opinion is issued.

Auditor's Responsibility

• The phrase "obtain reasonable assurance" informs users that auditors do not guarantee the fair presentation of financial statements. Some risk that the statements are not fairly stated exists, even when the opinion is unqualified.
• The phrase "free of material misstatement" informs users that the auditor's responsibility is limited to material financial information. Materiality is important because it is impractical to provide assurances on immaterial amounts.

Steps in Applying Materiality

• Set materiality for the financial statements as a whole.
• Determine performance materiality.
• Estimate total misstatement in segment.
• Estimate combined misstatement.
• Compare combined estimate with preliminary or revised judgment about materiality.
• Planning; extent of tests; Evaluating results.

Materiality for Financial Statements as a Whole

• Auditing standards require deciding on the combined amount of misstatements in the financial statements that are considered material early in the audit.
• This is the preliminary judgment about materiality, which may change during the engagement and must be documented in the audit files.
• It's the maximum amount by which the statements could be misstated without affecting decisions of reasonable users.

Factors Affecting Preliminary Materiality Judgment

• Materiality is a relative concept, depending on company size.
• Benchmarks are needed to evaluate materiality (e.g., net income, net assets).
• Qualitative factors also affect materiality (e.g., fraud, contractual obligations, trends in earnings).

Determine Performance Materiality

• Performance materiality is lower than materiality for the financial statements as a whole.
• It's used to reduce the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole.
• Determining performance materiality is necessary because auditors accumulate evidence by segments, rather than for the entire financial statements.

Auditors' Difficulties in Allocating Materiality

• Auditors expect some accounts to have more misstatements than others.
• Both overstatements and understatements must be considered.
• Relative audit costs affect allocation.

Audit Risk

• Auditing standards require the auditor to obtain an understanding of the entity and its environment, including its internal control, to assess the risk of material misstatements in the client’s financial statements.

Audit Risk Model for Planning

• PDR = AAR × IR × CR
  • PDR = Planned Detection Risk
  • AAR = Acceptable Audit Risk
  • IR = Inherent Risk
  • CR = Control Risk

Audit Risk Model Components

• Planned Detection Risk: The risk that audit evidence for an audit objective will fail to detect misstatements exceeding performance materiality.
• Inherent Risk: The auditor’s assessment of the susceptibility of an assertion to material misstatement, before considering the effectiveness of related internal controls.
• Control Risk: Measures the auditor’s assessment of the risk that a material misstatement could occur in an assertion and not be prevented or detected by the client’s internal controls.
• Acceptable Audit Risk: The measure of how willing the auditor is to accept that financial statements could be materially misstated after the audit.

Assessing Acceptable Audit Risk

• Auditors must decide on acceptable audit risk, preferably during audit planning. Engagement risk is considered, risk the auditor or audit firm might face after the audit. Client business risk is directly related.

Factors Affecting Acceptable Audit Risk

• External users' reliance on statements (e.g., company size, ownership, liabilities)
• Likelihood of financial difficulties (e.g., liquidity, profits/losses, financing method)
• Management integrity

Liquidity, profits (losses), Method of financing growth & Competence of management

• These factors are indicators of increased probability of financial failure, according to the slides.

Factors Affecting Inherent Risk

• Nature of the client's business
• Results of previous audits
• Initial versus repeat engagement
• Related parties
• Complex or nonroutine transactions
• Judgment required to correctly record account balances
• Makeup of the population
• Factors related to fraudulent financial reporting
• Factors related to misappropriation of assets

Financial Statements Assertions

• International auditing standards and AICPA classify assertions into three categories:
  • Assertions about classes of transactions and events for the period under audit.
  • Assertions about account balances at period end.
  • Assertions about presentation and disclosure.

Assertions About Classes of Transactions and Events

• Occurrence: Recorded transactions have occurred and pertain to the entity.
• Completeness: All transactions that should have been recorded have been recorded.
• Accuracy: Amounts and other data relating to transactions and events have been recorded appropriately.
• Classification: Transactions and events have been recorded in the proper accounts.
• Cutoff: Transactions and events have been recorded in the correct accounting period.

Assertions About Account Balances

• Existence: Assets, liabilities, and equity interests exist.
• Completeness: All assets, liabilities, and equity interests that should have been recorded have been recorded.
• Valuation and allocation: Assets, liabilities, and equity interests are included at appropriate amounts.
• Rights and obligations: The entity holds or controls the rights to assets, and liabilities are the obligation of the entity.

Assertions About Presentation and Disclosure

• Occurrence and rights and obligations: Disclosed events and transactions have occurred and pertain to the entity.
• Completeness: All required disclosures have been included in the financial statements.
• Accuracy and valuation: Financial and other information is disclosed appropriately and at appropriate amounts.
• Classification and understandability: Financial and other information is appropriately presented and described and disclosures are clearly expressed.

General Transaction-Related Audit Objectives

• Occurrence: Recorded transactions actually occurred.
• Completeness: All transactions that should have been recorded were recorded.
• Accuracy: Recorded transactions are stated at correct amounts.
• Posting and summarizing: Recorded transactions are included and summarized properly in master files.
• Classification: Transactions are included in correct accounts.
• Timing: Transactions are recorded on correct dates.

Balance-Related Audit Objectives

• Balance related audit objectives are similar to transaction-related objectives; they address account balances (e.g., Accounts Receivable, Inventory, Notes Payable).
• Related audit objectives to manage assertions.

Interim Audit

• Examination of books of accounts before the annual audit.
• Aims for early identification of threats and corrective measures.
• Helps determine profitability and dividend suitability.
• Improves efficiency and fraud detection.

Interim Audit Characteristics

• Conducted between two periods, sometimes called a half-yearly audit.
• In-depth analysis of all transactions over a defined period.
• May be conducted to determine book value of a company’s share.
• Organizations with an interim audit are often considered more reliable.

Final Audit

• Completed after the financial year-end, after the final accounts are prepared.
• It also known as a periodic audit.
• Starts after the close of books of accounts.

Advantages of Final Audit

• Economical: The fee can be based on time spent.
• Staff Duties: No clash between accounting and audit staff.
• Convenient for Management: Clear queries on the same day.
• Minimum Time Period: Less time required compared to continuous audits.
• Planned Work: Audit work completed under planning, with a scheduled program.
• Work Continuity: No breaks in the audit process.
• No Change in Figures: The books are in the custody of auditors, so manipulating is not easy after completion of accounts.
• Small Business: The fee is less compared to continuous audits.
• No Relations: Auditor and accounting staff don’t develop friendly relations.
• Full Information: The auditor can take decisions on audit completion and submission.
• Thorough Checking: Complete checking or sampling.
• Legal Requirements: Compliance with legal requirements is verified.
• Performance: Weakness in employees' and management’s performance can be determined.

Disadvantages of Final Audit

• Late Correction: Errors are located after the year-end and corrections take longer.
• Accounts Delayed: Delays in preparing financial accounts.
• Audit Report: Delay in providing the completed audit report.
• Low Moral Check: Lower pressure on employees to maintain high work standards.
• Planned Frauds: Employees may have more time to commit fraud.
• Past Data: Audit is based on the previous year’s data; present or future matters are not considered.
• Thorough Checking: Difficulty in thorough checking when audit sampling is used.
• Planning for Future: Difficult time constraints if financial forecasts are needed.
• Limited Time: Limited time for the auditor to conclude audit work for all clients.