Chapter 9 Essays Flashcards
Discuss the three main factors that affect an auditor’s preliminary judgment about materiality.
The three main factors that affect an auditor’s judgment about materiality are:
Materiality is a relative rather than an absolute concept. A misstatement of a given size might be material for a small company, whereas the same dollar misstatement could be immaterial for a larger one.
Bases are needed for evaluating materiality. Since materiality is relative, it is necessary to have bases for establishing whether misstatements are material. Net income before taxes is normally the most commonly used base, but other possible bases include current assets, total assets, current liabilities, and owners’ equity.
Qualitative factors also affect materiality. Certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same, such as misstatements involving frauds.
Due to qualitative factors, certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same. Identify two qualitative factors that might significantly affect an auditor’s materiality judgment, and give an example of each.
Qualitative factors that affect an auditor’s materiality judgment include:
Amounts involving fraud. Amounts involving fraud are usually considered more important than unintentional errors of equal dollar amounts because fraud reflects on the honesty and reliability of the management or other personnel involved. For example, an intentional misstatement of inventory would be more important to users than a clerical error in inventory of the same amount.
Misstatements affecting contractual obligations. Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations. For example, if a misstatement causes a required minimum account balance to exceed the minimum, when the correct balance is less than the minimum, this misstatement likely would be important to users.
Profit vs. loss. Misstatements that cause a loss to be reported as a profit or misstatements that affect trends in earnings are likely to be important to users.
. Explain why it is necessary to allocate the preliminary judgment about materiality to individual accounts (segments) in the financial statements. Also explain why allocating to balance sheet accounts is more common than allocating to income statement accounts.
Allocating the preliminary judgment about materiality to individual accounts is necessary because evidence is accumulated for accounts rather than for the financial statements as a whole. Allocating to accounts establishes a tolerable misstatement amount for each account, which helps the auditor decide the appropriate audit evidence to accumulate for each account. Most practitioners allocate materiality to balance sheet accounts rather than income statement accounts because there are fewer balance sheet than income statement accounts.
Why do most practitioners allocate the preliminary judgment about materiality to balance sheet accounts?
Most income statement misstatements have an equal effect on the balance sheet because of the double-entry bookkeeping system. Because there are fewer balance sheet accounts than income statement accounts in most audits and most audit procedures focus on balance sheet accounts, allocating materiality to balance sheet accounts is the most appropriate alternative.
Discuss how auditors use the audit risk model when planning an audit.
The audit risk model is used primarily for planning purposes in deciding how much evidence to accumulate in each cycle. The auditor decides an acceptable level of audit risk, assesses inherent risk and control risk, and then uses the relationship depicted in the following model to determine an appropriate level for planned detection risk:
PDR = AAR
IR x CR
In practice, auditors rarely assign numerical probabilities to inherent risk, control risk, or acceptable audit risk. It is more common to assess these risks as high, medium, or low. For each of the four situations below, fill in the blanks for planned detection risk and the amount of evidence you would plan to gather (“planned evidence”) using the terms high, medium, or low.
SITUATION 1 2 3 4 Acceptable audit risk Low Low High High Inherent risk High Low Low Low Control risk High Low Medium Low Planned detection risk \_\_\_\_\_\_ \_\_\_\_\_\_ \_\_\_\_\_\_ \_\_\_\_\_\_ Planned evidence \_\_\_\_\_\_ \_\_\_\_\_\_ \_\_\_\_\_\_ \_\_\_\_\_\_
- low, high
- medium, medium
- medium, medium
- high, low
Below are four situations that involve the audit risk model as it is used for planning audit evidence requirements in the audit of inventory. For each situation, calculate planned detection risk.
SITUATION 1 2 3 4 Acceptable audit risk 1% 10% 10% 5% Inherent risk 100% 100% 50% 20% Control risk 100% 100% 40% 30% Planned detection risk \_\_\_\_\_\_ \_\_\_\_\_\_ \_\_\_\_\_\_ \_\_\_\_\_\_
: 1. 1%; 2. 10%; 3. 50%; 4. 83.3%
Describe the audit risk model and each of its components.
The planning form of the audit risk model is stated as follows:
PDR = AAR IR x CR where: PDR = planned detection risk AAR = acceptable audit risk IR = inherent risk CR = control risk Planned detection risk is a measure of the risk that audit evidence for an account will fail to detect misstatements exceeding a tolerable amount, should such misstatements exist. Planned detection risk determines the amount of substantive evidence that the auditor plans to accumulate. Acceptable audit risk is a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued. It is influenced primarily by the degree to which external users will rely on the statements, the likelihood that a client will have financial difficulties after the audit report is issued, and the auditor’s evaluation of management’s integrity. Inherent risk is a measure of the auditor’s assessment of the likelihood that there are material misstatements in an account before considering the effectiveness of internal control. Control risk is a measure of the auditor’s assessment of the likelihood that misstatements exceeding a tolerable amount in an account will not be prevented or detected by the client’s internal controls.
There are several factors that affect an audit firm’s business risk and, therefore, acceptable audit risk. Discuss three of these factors.
Business risk and acceptable audit risk are affected by:
The degree to which external users will rely on the statements. For large, publicly held clients, business risk is greater, and acceptable audit risk will be less, than for small, privately held clients, all things being equal.
The likelihood that a client will have financial difficulties after the audit report is issued. Business risk is greater, and acceptable audit risk will be lower, when the client is experiencing financial difficulties.
The auditor’s evaluation of management’s integrity. Business risk is greater and acceptable audit risk will be lower when the client’s management has questionable integrity.
Discuss each of the five steps in applying materiality in an audit, and identify the audit phase(s) in which each step is performed. List these steps in the order in which they occur.
Step 1. Set preliminary judgment about materiality. This is the combined amount of misstatements in the financial statements that would be considered material. This decision is made in the planning stage of the audit.
Step 2. Allocate preliminary judgment about materiality to segments. In this step, the auditor normally allocates the preliminary judgment about materiality to the balance sheet accounts. The amount of materiality allocated to an account is referred to as that account’s tolerable misstatement. This allocation is performed in the audit planning stage.
Step 3. Estimate total misstatement in segment. In this step, the auditor projects the sample results to the population. An allowance for sampling risk is also calculated. This would be performed after the substantive tests for each account are completed.
Step 4. Estimate the combined misstatement. In this step, the projected errors for each account are added, along with total sampling error, to calculate the combined misstatement. This would be performed after all substantive tests have been completed.
Step 5. Compare combined estimated misstatement with preliminary or revised judgment about materiality. If the combined estimated misstatement is less than or equal to the judgment about materiality, then the auditor concludes the financial statements are fairly presented. This would be performed after all substantive tests have been completed, in the final review stage of the audit.
Using your knowledge of the relationships among acceptable audit risk, inherent risk, control risk, planned detection risk, tolerable misstatement, and planned evidence, state the effect on planned evidence (increase or decrease) of changing each of the following factors, while the other factors remain unchanged.
decrease 1. An increase in acceptable audit risk. .
increase 2. An increase in inherent risk. .
decrease 3. A decrease in control risk. .
decrease 4. An increase in planned detection risk. .
decrease 5. An increase in tolerable misstatement.
