Exam 2 - Chapter 9 - Materiality and Risk Flashcards
FASB defines materiality as:
Magnitude of a misstatement that is grand enough that– if left out– would alter the decision of a reasonable person.
What are the 5 steps in applying materiality?
- Set materiality for the financial statements
- Determine performance materiality
- Estimate total misstatement in segment
- Estimate the combined misstatement
- Compare combined estimate to judgement about materiality
What is performance materiality?
Overall materiality reduced by the sum of the expected misstatements not to be found by auditor.
- requires judgement by auditor based on previous audits
What is the preliminary judgement about materiality?
Auditors are to make a judgement about the combined amount of misstatements considered material during the planning phase.
How do financial users affect materiality?
Auditors must consider who the users are that make decisions based on the financial statements.
(does company have debtholders, etc…)
What is the revised judgement about materiality?
Why might it occur?
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.
How might auditors use benchamarks to decide on preliminary materiality judgement?
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.
What are some qualitative factors that affect judgement of materiality?
- 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
How might auditors set minimum and maximum misstatement amounts:
- 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.
The process of determining performance materiality can be stated as:
Allocation of preliminary judgment about materiality to segments.
Why do most auditors focus on balance sheet accounts when allocating performance materiality?
Income statement accounts often reflect what the balance sheet contains.
- Would be like double counting to focus on both balance sheet and income statement
What are the three major difficulities auditors face in allocating judgment of materiality to balance sheet accounts?
- Auditors expect certain accounts to have more misstatements
- Both overstatements and understatements must be considered
- Relative audit costs affect the allocation
What are the two rules in allocating performance materiality?
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
Why can performance materiality amounts total up to 2x the total preliminary judgment of materiality?
- 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
How does setting performance materiality help plan evidence of audits?
The lower the dollar amount of the materiality threshold, the more audit evidence needed to be gather (essentially more detailed test, and costly)
What are the two types of misstatements auditors will document when performing audit procedures?
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
What is the audit risk model?
Helps auditors decide how much and what type of evidence to accumulate for each audit objective:
What is planned detection risk?
What are the two key points to note?
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)
What is inherent risk?
- What is its relationship to evidence and PDR?
Auditor’s assessment of the susceptibility to material misstatement
- Directly related to evidence amount (high IR = high evidence)
- Inversely related to PDR.
What is control risk?
Measures the risk that material misstatement would not be detected on timely basis by client’s internal controls
The combination of inherent risk and control risk is known as:
Risk of material misstatement
(both factors are combined to determine required evidence, therefor both factors are equal in determining risk)
What is acceptable audit risk?
What does a lower acceptable audit risk indicate?
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
What is engagement risk?
What is the impact of engagement risk on acceptable audit risk?
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
What are the three main factors that affect engagement risk?
- 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
What are some indicators that client will face financial difficult after an audit?
- 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
What are some factors that affect inherent risk?
- 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
How are materiality and risk related and integrated into the audit process?
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.
