Exam 2 - Chapter 9 - Materiality and Risk

Question 1

FASB defines materiality as:

Answer 1

Magnitude of a misstatement that is grand enough that– if left out– would alter the decision of a reasonable person.

Question 2

What are the 5 steps in applying materiality?

Answer 2

1. Set materiality for the financial statements
2. Determine performance materiality
3. Estimate total misstatement in segment
4. Estimate the combined misstatement
5. Compare combined estimate to judgement about materiality

Question 3

What is performance materiality?

Answer 3

Overall materiality reduced by the sum of the expected misstatements not to be found by auditor.

• requires judgement by auditor based on previous audits

Question 4

What is the preliminary judgement about materiality?

Answer 4

Auditors are to make a judgement about the combined amount of misstatements considered material during the planning phase.

Question 5

How do financial users affect materiality?

Answer 5

Auditors must consider who the users are that make decisions based on the financial statements.

(does company have debtholders, etc…)

Question 6

What is the revised judgement about materiality?

Why might it occur?

Answer 6

If auditor changes the preliminary judgement about materiality.

• The factors that the auditor used to make the preliminary judgement have changed

^{Example: auditor used prior year financial statements before the release of current year. Had to change based on current year.}

Question 7

How might auditors use benchamarks to decide on preliminary materiality judgement?

Answer 7

Auditors use specific accounts to determine base cumulative materiality amount (profit based businesses usually based on net income before taxes)

Certain accounts affect other accounts and need various materiality thresholds.

Question 8

What are some qualitative factors that affect judgement of materiality?

Answer 8

• Amounts involving fraud are usually considered more important than errors
• Nonmaterial misstatements may be material in situations that consequences may arise
• Changes that go against trends may be considered material

Question 9

How might auditors set minimum and maximum misstatement amounts:

Answer 9

• If amounts do not exceed minimum, auditor deems the account fairly stated
• If amounts exceed maximum, the auditor deems the account misstated
• If amounts fall between the minimum and maximum, auditor should consider benchmarks and qualitative factors.

Question 10

The process of determining performance materiality can be stated as:

Answer 10

Allocation of preliminary judgment about materiality to segments.

Question 11

Why do most auditors focus on balance sheet accounts when allocating performance materiality?

Answer 11

Income statement accounts often reflect what the balance sheet contains.

• Would be like double counting to focus on both balance sheet and income statement

Question 12

What are the three major difficulities auditors face in allocating judgment of materiality to balance sheet accounts?

Answer 12

1. Auditors expect certain accounts to have more misstatements
2. Both overstatements and understatements must be considered
3. Relative audit costs affect the allocation

Question 13

What are the two rules in allocating performance materiality?

Answer 13

Performance materiality for one account cannot exceed 60% of total preliminary materiality judgement.

The sum of all performance materiality cannot exceed 2x the total preliminary materiality judgement

Question 14

Why can performance materiality amounts total up to 2x the total preliminary judgment of materiality?

Answer 14

• Account misstatement is not likely to max the total performance materiality in every chosen account
• Certain accounts will be overstated; certain accounts will be understated; will net out

Question 15

How does setting performance materiality help plan evidence of audits?

Answer 15

The lower the dollar amount of the materiality threshold, the more audit evidence needed to be gather (essentially more detailed test, and costly)

Question 16

What are the two types of misstatements auditors will document when performing audit procedures?

Answer 16

Known misstatements

When the auditor can determine the exact amount of misstatement

Likely misstatements

• Differences in management’s and auditor’s judgement of account (uncollectibles)
• Significant proportional misstatement of sample accounts that could mean material misstatement of total population

Question 17

What is the audit risk model?

Answer 17

Helps auditors decide how much and what type of evidence to accumulate for each audit objective:

Question 18

What is planned detection risk?

What are the two key points to note?

Answer 18

Risk that audit evidence will fail to detect misstatements exceeding performance materiality

Key points:

• PDR is dependent on other audit risk model factors
• PDR determines the amount of evidence to gather (high PDR=low amount of evidence; low PDR = high amount of evidence)

Question 19

What is inherent risk?

• What is its relationship to evidence and PDR?

Answer 19

Auditor’s assessment of the susceptibility to material misstatement

• Directly related to evidence amount (high IR = high evidence)
• Inversely related to PDR.

Question 20

What is control risk?

Answer 20

Measures the risk that material misstatement would not be detected on timely basis by client’s internal controls

Question 21

The combination of inherent risk and control risk is known as:

Answer 21

Risk of material misstatement

(both factors are combined to determine required evidence, therefor both factors are equal in determining risk)

Question 22

What is acceptable audit risk?

What does a lower acceptable audit risk indicate?

Answer 22

Measure of how willing the auditor is to accept that financial statements may be misstated after audit is completed with an unqualified opinion

Low AAR indicates that auditors want to ensure there are no material misstatements

Question 23

What is engagement risk?

What is the impact of engagement risk on acceptable audit risk?

Answer 23

The risk the auditor will be harmed after completion of audit even if audit report is correct

High engagement risk likely requires additional evidence and review audit more thoroughly; high engagement risk = lower acceptable audit risk

Question 24

What are the three main factors that affect engagement risk?

Answer 24

• The degree to which external users rely on statements
• Likelihood that client will have financial difficulties after audit
• Auditor’s evaluation of management’s integrity

Question 25

What are some indicators that client will face financial difficult after an audit?

Answer 25

• Liquidity position: client always short of cash/working capital
• Profits are at loss in previous years
• Method of financing growth: client relies heavily on debt
• Nature of client’s operations

Question 26

What are some factors that affect inherent risk?

Answer 26

• Nature of client’s business
• Results of previous audits
• Initial versus repeat engagement
• Related parties
• Complexity of nonroutine transactions
• Judgement needed to record account balances

Question 27

How are materiality and risk related and integrated into the audit process?

Answer 27

Risk is a measure of uncertainty

Materiality is measure of magnitude

They are inseparable; taken together, auditors are able to assign a mangnitude of materiality present with the acceptable risk.