1

Lecture 3
Materiality and Audit Risk
 2
Learning Outcomes
 Explain the concept of materiality and audit risk
 Describe various factors that influence the
determination of materiality level
 Describe ,identify and apply the components of
audit risk
 Describe the limitation of audit risk model
 Explain the relationship between materiality and
audit risk
 3 Audit Risk -ISA
 ISA 200- Overall Objectives of the Independent Auditor and
the Conduct of an Audit in Accordance with International
Standards on Auditing
 ISA 315- (Revised), Identifying and Assessing the Risks of
Material Misstatement through Understanding the Entity and
Its Environment
 ISA 330- The Auditor’s Responses to Assessed Risks
 Audit risk
4

 Audit risk is the risk that the auditor gives an

inappropriate audit opinion when the financial
statement is materially misstated
 In setting the desired audit risk, auditors seek an
appropriate balance between the costs of an
incorrect audit opinion and the costs of performing
the additional audit procedures necessary to reduce
audit risk

4
 5 Audit Risk
 Risk is a fundamental concept that underlies the
audit process

 The Audit Risk Model

Audit Risk =
Inherent Risk X Control Risk X Detection Risk
 6 Audit Risk (AR)
 Audit Risk is the risk of Auditor forming the wrong or
inappropriate opinion. For eg. If the desired AR is 5%,
there is 5 chances in 100 of giving the wrong opinion
 This is due to the risk that a material misstatement
could be present in the financial statement without being
detected
 7 ISA 200-Objective and General Principles
Governing an Audit of FS

 ISA 200 states that the auditor should plan and

perform the audit to reduce audit risk to an
acceptably low level that is consistent with the
objective of an audit
 The auditing standards however , do not provide
specific quantitative guidance on what constitutes a
low level of AR
 8 Acceptable Audit Risk-Qualitative
approach
 An audit firm may find it more appropriate to use qualitative
terms to implement the audit risk model.
 For example, acceptable or desired audit risk might be
classified into 3 categories : very low, low and moderate. It
is unlikely that an audit planned in accordance with
approved auditing standards would consider a high level of
audit risk
 9 Audit Risk Model

Audit Inherent Control Detection

= X X
Risk Risk Risk Risk
(Desired)
 The audit risk model
10

 This model provides foundation for the current

emphasis on the risk-based audit approach and it assists
the auditor in determining the scope of auditing
procedures for a particular account balance or class of
transactions
 The auditor needs to consider risks of material
misstatement at 2 levels
-The overall financial statement level
-The assertion level for individual account balances and
classes of transaction
 11
Use of audit risk model
 Audit Risk is used as an audit planning tool
 3 steps are involved in the auditor’s use of the
audit risk model at the account balance or class of
transaction level:
1) Setting a planned level of audit risk
2) Assessing inherent risk and control risk
3) Solving the audit risk equation for appropriate
level of detection risk (planned detection risk)
 Quantified audit risk model
12

 The audit risk model provides a framework for

auditors to follow in responding to these assessed
risks through their choice of audit procedures
 The audit risk model expresses the relationship
among the audit risk (AR) components as follows:
AR = IR  CR  DR
That is, Audit risk = Inherent risk  Control risk 
Detection risk

12
Audit Risk Model

Dependent on the
Also referred to as
company & its
the risk of material
industry
misstatement

Audit Risk = Inherent Risk × Control Risk × Detection Risk

Set by the auditor at the start of Adjusted by the auditor to

the audit balance the equation
 Risk of material misstatements (ROMM)
Risk of Material Misstatement
We have already seen that inherent risk and control risk combined are the risk of material
misstatement. But what does this mean in practical terms?
•Risks of material misstatement are the risks that the financial statements are
materially misstated. It stands to reason that risk of material misstatement is the
equivalent of audit risk, but taken from the perspective of the company whose financial
statements are being audited, so matches audit risk but ignores the detection risk
managed by the auditor.
 ROMM
Risk of Material Misstatement (continued)
• The most obvious examples would be material errors in the statement of profit or loss
and other comprehensive income or statement of financial position, but the whole of
the financial statements need to be considered.
• For example, the non-disclosure of a contingent liability, whilst not affecting the
figures, would still lead to misstated financial statements as they would not comply
with accounting standards.
 Inherent Risk

Inherent risk
 Is the possibility that a material misstatement could occur in an assertion, either
individually or when aggregated with other misstatements, assuming there are no
related controls
 Inherent risk exists independently of the audit of financial statements and thus auditors
cannot change the actual level of inherent risk
 As defined by auditing standards, inherent risk is confined to the risk of material misstatement
 Inherent risk
17

 Inherent risk is the risk which arises because of the nature of

the business or its trading environment or condition in
which the business is operating
 Examples:
A company engaged in long term construction contracts is
inherently more risky than a business which delivers
building supplies

 A business which handles a lot of cash is more risky than one

which deals only through the bank
 18
Factors Affecting Inherent Risk

 Nature of the client’s business

Inherent risk is likely to vary from business to business for accounts such as inventory, accounts
and loans receivable, and property, plant, and equipment.
 Results of previous audits
Misstatements found in the previous year’s audit have a high likelihood of occurring again.
Many types of misstatements are systematic in nature, and organizations are slow
in making changes to eliminate them.
 Initial versus repeat engagement
Most auditors use a larger inherent risk for initial audits than for repeat engagements
in which no material misstatements had been found.
 Related parties
Related party transactions are those between parent and
subsidiary companies, and management or owners and the company.
 19
Factors Affecting IR (continued)

 Non routine transactions

Transactions that are unusual for the client are more likely to be recorded incorrectly.
Examples include fire losses, major property acquisitions, etc.
 Judgment required to correctly record
account balances and transactions
Many account balances require estimates and a great deal of management judgment
including:
Uncollectible accounts receivable
Obsolete inventory
Warranty liabilities
 Makeup of the population
Accounts receivable where most accounts are significantly overdue
Transactions with related parties
Disbursements made payable to cash
Inventory with a slow turnover
 Factor affecting inherent risk – business
20
level

Other factors influencing inherent risk are:

 The integrity of managers or directors
 Management competence and experience
 Pressures on management or directors which might
predispose them to misstate financial statements (e.g.
profit forecasts)
 The complexity of the entity (technology, capital
structure, geographical spread)
 Factors affecting the industry (competition)
 Information technology
 Inherent Risk
Inherent risk (continued)
Factors affecting individual account balances or transactions:
• Financial statements prone to misstatement
• Complex accounts
• Assets at risk of being lost or stolen
• Quality of the accounting system
• High volume transactions
• Unusual transactions
• Staff issues
 Control Risk
Control risk
This is the risk that a misstatement could occur in an assertion and that could be material,
either individually or when aggregated with other misstatements, will not be
prevented, or detected and corrected, on a timely basis by the entity's internal control.

Control risk is a function of the effectiveness of the internal control structure as good
controls reduce risk

• Examples of Control Risk

- Collusion
- Management overrides
- Human errors or mistakes
 Control Risk
Control risk (continued)
At the planning stage the auditor assesses control risk by evaluating the system. In
particular the auditor will consider the following components.
•Control environment
•Entity's risk assessment procedures
•Information system
•Control activities
•Monitoring of controls
You should be familiar with the elements of an internal control system from your earlier
studies.
 Process of assessing control risk
24

 Use professional judgement to assess the control

environment
 Assess the design effectiveness of control procedures and
their ability to prevent or correct misstatements
 Assess whether controls were effectively applied
throughout the period under audit

24
 Detection Risk
Detection risk
This is the risk that the auditor will not detect a misstatement that exists in an assertion
that could be material, either individually or when aggregated with other
misstatements.

Detection risk = Sampling risk + Non-sampling risk

26 Detection risk
 Detection risk results from 2 types of risks and
uncertainties namely:
Sampling risk-arises because in many instances auditor
does not perform 100% test.
Non-Sampling risk-occurs because the auditor used an
inappropriate audit procedures, failed to detect a
misstatement when applying an appropriate audit
procedures.
 Detection Risk
Detection risk (continued)
Due to the nature of an audit some detection risk will always exist (the auditor obtains
reasonable assurance, not absolute assurance).
How can the effectiveness and application of procedures be improved to help reduce
detection risk?
•Adequate planning
•Assignment of more experienced staff to the audit team
•Applying professional scepticism
•Increased supervision and review of audit work
 Audit risk components (cont.)
28

Detection risk
 Is the risk that an auditor’s substantive procedures will not detect any
material misstatements that exist in an assertion, either individually or
when aggregated with other misstatements
 Detection risk is a function of the effectiveness of substantive
procedures and their application by an auditor and thus is fundamental
to the amount of audit work undertaken
 Unlike inherent and control risk, the actual level of detection risk is
controllable by the auditor through:

28
29

Having Determined
Audit Risk
Inherent Risk
Control Risk

Detection Risk is just a balancing figures

DR = AR/ (IR X CR)
30 Assessment of DR-Quantitative

Client No. AR IR CR DR
1 5% 40% 50% 25%
2 5% 60% 80% 10%
3 10% 50% 25% 80%
4 10% 80% 50% 25%
 
31 Assessment of DR-Qualitative
method

Client No. Audit Risk Inherent Risk Control Risk Detection Risk

1 Moderate High Low Moderate

2 Very low Low Very low High

3 Low Moderate High Low

4 Very low High Moderate Low

32 Acceptable Audit Risk
The following factors mean that audit risk should be kept lower:
Reliance by External Users

When external users place heavy emphasis on the

financial statements, acceptable audit risk should be
kept low. The following generally results in more
users of the financial statements:
Larger clients
Publicly held corporations
Extensive use of liabilities
 33
Acceptable Audit Risk
Likelihood of Financial Failure
There is a greater chance of having to defend the quality of the audit when there is
a financial failure. Failure indicators include:
Shortage of funds
Declining net income or continued losses
t as technology
Risky industries such
Management lacking competency to deal with financial difficulties
Integrity of management
If a client has questionable integrity, the auditor is likely to assess acceptable audit
risk lower. Indications of integrity problems include:
Frequent disagreements with prior auditors, the IRS, and/or SEC
Frequent turnover of key financial and internal audit personnel
Ongoing conflicts with labor unions and employees
 Assessing Risks of Material Misstatement- ISA
315
 
“The auditor should identify and assess the risks of material misstatement at the
financial statement level, and at the assertion level for classes of transactions,
account balances, and disclosures. For this purpose, the auditor: 
identifies risks throughout the process of obtaining an understanding of the
entity and its environment, including relevant controls that relate to the risks, and
by considering the classes of transactions, account balances, and disclosures in
the financial statements
relates the identified risks to what can go wrong at the assertion level
considers whether the risks are of a magnitude that could result in a material
misstatement of the financial statements
 considers the likelihood that the risks could result in a material misstatement of
the financial statements
 35 Risk Assessment Procedures

The auditor obtains an understanding of the entity and

its environment by performing the following risk
assessment procedures:
(a)Inquiries of management and others
(b)Analytical Procedures
(c)Observation and inspection
 The relationships among risk components
36

 An auditor’s objective is to achieve an acceptably low level of

audit risk, as is practicable
 Recognising the cost of performing audit procedures, there is an
inverse relationship between the assessed levels of inherent and
control risks and the level of detection risk that the auditor can
accept
 Auditors, although unable to control inherent risk (IR) and
control risk (CR), can assess these risks and design substantive
procedures to produce an acceptable level of detection risk, thus
reducing the audit risk to an acceptable level

36
 37 Limitations of the AR model.
 The actual level of audit risk may be greater than the
audit risk indicated by the formula.
 The assessment of IR and CR may be higher or lower
than the actual IR and CR that exist for the client.
 The audit risk model also does not specifically
consider the possibility of auditor error
38 Fraud RISK
Fraud from the auditor’s perspective , involves
intentional misstatements that can be classified into 2
types
(i)Misstatements arising from fraudulent financial
reporting
(ii)Misstatements arising from misappropriation of
assets
 Fraudulent financial reporting
39

 Manipulation , falsification, or alteration of accounting

records or supporting documents from which financial
statements are prepared.
 Misrepresentation or intentional omission in the
financial statements of events, transactions ,or other
significant information
 Intentional misapplication of accounting principles
relating to amounts, classification, manner of
presentation or disclosure
 40 Misappropriation of assets

 Embezzling cash receipts

 Stealing assets
 Causing the entity to pay for goods or services not
received.
 41
Condition

 Three conditions generally present when

fraud exists:
 (1) An incentive or pressure to perpetrate
fraud
 (2) An opportunity to carry out the fraud
 (3)An attitude/rationalisation to justify the
fraudulent action.
 42
Fraudulent Financial Reporting

Risk factors relating to incentive/pressures

a) Financial stability or profitability is threatened by economic , industries
or entity operating conditions
b) Excessive pressure exists for management to meet requirements or
expectations of third parties
c) Management or BOD’s personal financial situation is threatened by the
entity’s financial performance arising from certain situations
d) There is excessive pressure on management or operating to meet
financial targets set up by the BOD or management , including sales or
profitability incentive goals
 43
Fraudulent Financial Reporting

Risk factors relating to opportunities

(a) The nature of the industry or the entity’s operations provide
opportunities to engage in fraudulent financial reporting due to
certain situations
(b) There is ineffective monitoring
(c)There is a complex or unstable organisational structure
(d) Internal control components are deficient
 44 Misappropriation of assets
Risk factor relating to incentive/pressures
a) Personal financial obligations may create pressure for
management or employees with access to cash or
other assets susceptible to theft to misappropriation
these assets
 45
Misappropriation of assets

Risk factors relating to opportunities

a) Certain characteristics or circumstances may increase the
susceptibility of assets to misappropriation
b) Inadequate internal control over assets may increase the
susceptibility of misappropriation of those assets
Refer to page 93
Risk factors relating to attitudes
Refer to page 93- Table 3-11 OF Margaret Boh
 46
Response to fraud

Risks of material misstatement due to fraud are

considered significant risk
The auditor performs further procedures in response to
assessed risk of fraud in the following ways:
1) A response that has an overall effect on the conduct of
the audit
2) A response to identified risks relating to accounts and
balances at assertion level
3) A response to address the risks of fraud relating to
management override of controls
47
Response to management override
of controls

 Testing Journal entries

 Reviewing accounting estimates for biases
 Understand Business Rationale of significant
Transactions
 48
Risk of Fraud in Revenue
Recognition

 A risk area that ISA 240 has specifically highlighted

is the risk of fraud in revenue recognition
 Experience has shown that fraudulent financial
reporting is often committed by intentional
overstatement of revenue
 Communication to management ,those charged with
49 governance and others about Fraud

 ISA 260
 Fraud identified should be brought to the attention
of appropriate level of management
 Fraud involving senior management and fraud that
causes material misstatement of FS should be
reported directly to those charged with governance
of the entity such as BOD.
 Identifying Client Business Risk
50

 Business Risk is a broader concept than the risk of

materially misstated financial statements. However
most business risks have the potential to affect the
financial statements either immediately or in the long
run.
 The auditor’s concern is those business risks that may
result in material misstatement and consequently
affect audit and detection risk
 Business Risk
Business risk

Business
Businessrisksrisks
'result
'resultfrom
fromsignificant
significantconditions,
conditions,events,
events,circumstances
circumstances
ororactions
actionsthat
thatcould
couldadversely
adverselyaffect
affectthe
theentity's
entity'sability
ability
totoachieve
achieveitsitsobjectives
objectivesand
andexecute
executeitsitsstrategies,
strategies,oror
from the setting of inappropriate objectives
from the setting of inappropriate objectives and and
strategies.'
strategies.'
The entity’s strategies and related business
52 risks

 An entity’s strategies are the operational approaches by

which management intends to achieve its objectives
 Business risks result from significant conditions, events,
circumstances, actions or inactions that could adversely
affect the entity’s ability to achieve its objectives and
execute its strategies

52
 Business Risk
Business risk (continued)
Business risks can be split into three categories to enable better identification:
•Financial risk
•Operational risk
•Compliance risk
 Risk 14
Financial risks
These are the risks arising from the company's financial activities or the financial
consequences of operations. Examples include the following.
•Business continuity problems (ie going concern)
•Overtrading
•Credit risk
•Interest risk
•High cost of capital
•Unrecorded liabilities
Change in interest rate
 Fluctuation of foreign exchange rates
 Business Risk
Operational risk
These are the risks arising from the operations of the business such as stockouts, physical
disasters, loss of key staff, poor brand management and loss of orders.
• Developments in the industry
• New products and services
• Expansion of the business

• e.g. a potential business risk might be that the estimated demand associated with an expansion
has not been accurately estimated
• Current and prospective financing requirements
• e.g. a business risk is loss of financing due to inability to meet debt covenant requirements
 Business Risk
Compliance risk
These are the risks arising from non compliance with laws, regulations, policies,
procedures and contracts. Examples include the following.
•Breach of listing rules
•Breach of national legislation
•Litigation risk
•Sales tax problems
•Tax penalties
•Health and Safety risks
Change in Government policies and rules and regulations
sanctions imposed by public or regulatory bodies (eg Bursa Malaysia and the
professional accounting bodies)
 Risk consideration in Evaluating Audit
Results
 An assessment of audit risk, that recognises the components of
audit risks, should be undertaken at the audit planning stage and
later integrated into the audit of individual account balances or
transaction classes.
 It is an important aspect of the analytical procedures, which
underpin all cost-effective audits, and should also occur at the final
audit of the financial report, and in the assessment of the firm as a
going concern.
 Thus, risk analysis techniques should be applied at the micro level
in the audit of account balances and at the macro level in an overall
appraisal of the firm and its financial report.
Business risk vs Audit Risk
Business risk vs Audit Risk
Business risk vs Audit Risk
 Audit strategies
61

 The audit strategy taken is an important decision that

significantly affects the detailed work performed in the audit
 The interrelationship amongst evidence, materiality and the
components of audit risk affects the auditor’s decision on the
type of strategy chosen
 If the auditor assesses that appropriate controls do not exist or
are likely to be ineffective, then a predominantly substantive
approach will be adopted
 Substantive procedures are those that substantiate the amounts
recorded in the financial statements, and they are normally
costly to perform

61
 Audit strategies (cont.)
62

 A more efficient audit can be performed if controls are judged

to be effective enough to enable a reduction in the level of
substantive procedures undertaken
 An audit strategy that relies on internal controls to support the
use of a reduced level of substantive procedures is sometimes
referred to as a lower assessed level of control risk approach
 This is not a single strategy, but a range of strategies
determined by the relative effectiveness of applicable control
procedures (combined with assessments of inherent risk and
materiality)

62
 Audit strategies (cont.)
63

 The auditor must make four separate decisions before

adopting such a strategy, and each decision (except the first)
must be supported by relevant evidence:
 Is it cost-effective to adopt a lower assessed level of
control risk strategy?
 Are control procedures effectively designed?
 Are control procedures effectively operated?
 Do the results of substantive procedures confirm the
assessment of control risk?

63
 The auditor’s response to the results of
64
the risk assessment-ISA 330

 Based on the assessment of the entity’s business risk

and risk of material misstatement due to error or
fraud , the auditor should decide what responses to
take given the risk assessment
 The main consideration for the auditor based on the
assessed risks of material misstatement at the assertion
level is nature, timing and extent of audit procedures
 Relationship between Materiality and Audit
Risks

 concepts of risks and materiality go hand-in-hand in the sense that

the auditor collects evidence to determine the risk that a material
misstatement exists in the financial statements.
 There is an inverse relationship between materiality and the level of
audit risk and in determining the nature, timing and extent of audit
procedures, auditors should take into account this inverse
relationship.
 The auditor’s assessment of materiality and audit risk when
evaluating the results of audit procedures may be different at the
time of initially planning the engagement because of a change in
circumstances or because of a change in the auditor’s knowledge as
a result of the audit.
66 Audit Risks and Audit Fee
 According to audit pricing theory, auditors
generally price their services according to the size
of the client , the complexity of the client’s
operations and the level of assessed audit risks for
the client
 Audit Fees=f (Size,Complexity,Audit Risks)
 Materiality
67

 ISA 320 (Revised)-Materiality in planning

and performing audit
 ISA 450 (New)-Evaluation of misstatement
identified during audit
 ISA 700 (amended)-Forming an opinion
and reporting on Financial statements
 68
Materiality MFRS 101/ISA 320
 Information is material if its non-disclosure/omission
could influence the economic decisions of users taken
on the basis of the financial statements.
 Materiality depends on the size of the item or error
judged in the particular circumstances of its omission
or misstatement.
 Materiality Levels

Materiality for the financial statements as a whole

Particular classes of
transactions, account
balances or disclosures,
if any

Performance Performance materiality for

materiality(s) for assessing risks and planning further
above, if any audit procedures

69
 Materiality for Financial Statements as a Whole

 Users’ information needs drive overall materiality level

 No specific methodologies prescribed − use of
professional judgment is key to the approach
 Often a percentage of a chosen benchmark may be an
appropriate starting point
 Standard provides guidance on choosing an
appropriate benchmark
 No specific guidance on percentages provided
 Consider whether adjustments to benchmark needed
for significant changes in entity’s circumstances
70
Materiality for Particular Classes of Transactions,
Account Balances, or Disclosures

 Lower materiality levels used if specific items

would influence users’ economic decisions taken
on the basis of the financial statements
.However, this does not mean a materiality level
needs to be determined for every line item or
disclosure
 Consider whether there are any relevant factors
that may indicate whether there are particular
items that would influence users’ judgments

71
72
Materiality
 Materiality underlies the application of
auditing standards and thus has a pervasive
effect in a financial statement audit
 Auditors must consider materiality in
planning the audit and evaluating the fair
presentation (Review stage) of the
financial statements

72
 73
The concept of materiality
 The concept of materiality links ISAs 320, 450
and 700.
 It is applied in both planning and performing the
audit & review; in evaluating the effect of
identified misstatements on the audit and of
uncorrected misstatements,
 if any, on the financial statements; and in
forming the opinion on the financial statements.
 ISA 450
ISA 450 Evaluation of misstatements identified during the audit
•The auditor has a requirement to communicate in a timely fashion all misstatements
identified during the audit to those charged with governance to ensure that no
management bias exists in the decision taken on what constitutes an 'immaterial
misstatement' and hence what is and is not corrected as a result of the audit.
Management must also provide written representations that all uncorrected errors are
immaterial.
The auditor shall include in the audit documentation:
– The amount below which misstatements would be regarded as clearly trivial
– All misstatements accumulated during the audit and whether they have been
corrected
– The auditors conclusion as to whether uncorrected misstatements are material,
individually or in aggregate, and the basis for that conclusion
 75
Risk-based audit
In performing a risk-based audit,the auditor needs to
consider materiality when:
 Performing risk assessment procedures
 Determine the nature,event and timing of further
audit procedures based on the assessed risk
 Evaluating the effect of identified misstatements on
the auditor’s report.
 Materiality
76

 The assessment of what is material is a matter of the auditors’

professional judgement of the needs of the reasonable person
relying on the information
 There is an inverse relationship between materiality and audit
risk
 The higher the level of audit risk, the lower the materiality
level and the auditor should take this relationship into
consideration when determining the nature, timing and extent
of audit procedures

76
 77
TWO LEVEL OF
MATERIALITY IN AUDIT
 PLANNING
Level 1 : Financial statement level (overall
materiality), because the auditor expresses an opinion
on the financial statements taken as a whole.
 Level 2 : Account balances and class of transactions
level (account balances level), because the auditor
verifies account balances in reaching an overall
conclusion on the fairness of the financial statements.
 Applying Materiality
78
3 STEPS

1. Establish a preliminary judgment about materiality

2. Determine tolerable misstatement. Allocate the
preliminary judgement about materiality to account
balances or classes of transactions (Segment)
3. Estimate likely misstatement, Estimate the combine
misstatement and compare total to the preliminary
judgement about materiality
 Step 1 -Set Preliminary Judgment
79
About Materiality

Auditors decide early in the audit

the combined amount of misstatements
of the financial statements that would
be considered material.

This preliminary judgment is the maximum

amount by which the auditor believes the
statements could be misstated and still not
affect the decisions of reasonable users.
80 Factors Affecting Judgment

Materiality is a relative rather

than an absolute concept.

Bases are needed for

evaluating materiality.

Quantitative and Qualitative factors also

affect materiality.
 Common Bases Quantitative
81
Factors for Considering
Materiality

 Common Bases for Establishing Materiality:

 Total Assets
 Total Revenues
 Net Income before Tax
 Gross Profit
 Average of 3 years’ Income before Tax
82 Materiality-Quantitative
guidelines
 ISA 320 requires the auditor to calculate materiality for the audit
as a whole.
 The following benchmarks may be used.Benchmark %
 Profit before tax 5
 Gross profit 0.5–1
 Revenue 0.5–1
 Profit after tax 5–10
 Total assets 1–2
 Net assets 2–5
 83
Quantitative guidelines

 The following are the guidance is for materiality

BASED ON PROFIT AFTER TAX:
 an amount that is equal to or greater than 10% of the
appropriate base amount is presumed to be material
 an amount that is equal to or less than 5% of the
appropriate base amount is presumed not to be
material
 Logically following from the above, whether an
amount between 5% and 10% is material is a matter
of judgement

83
84
 Materiality-Guidelines
85

In determining where in the range to establish materiality, the

auditor would generally use % at the lower end range if any of
the following factors are present:
 First year engagement
 Known material weaknesses in controls
 Significant Management Turnover
 Unusually high market pressures
 Higher than normal fraud risk
 Higher than normal risk of bankruptcy in the near term
 86
Qualitative factors
 Material misstatements in prior years
 Potential for fraud or illegal acts
 Small amounts may violate covenants in a loan
agreement
 Small amounts may affect the trend in earnings
 Small amounts may cause entity to miss forecasted
revenue or earning
 Non-compliance of law
 Qualitative factors that affect an auditor’s
87
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.
88 Guidelines

Accounting and auditing standards

do not provide specific materiality
guidelines to practitioners.

Professional judgment is to be used

at all times in setting and applying
materiality guidelines.
89
Step 2- Allocate preliminary judgment about
materiality to segments
(Determine Tolerable Misstatements)

Most practitioners allocate materiality

to statements of financial position.

This is necessary because evidence is

accumulated by segments rather than
for the financial statements as a whole.
 90 Step 2
 This step involves determining tolerable misstatement
based on planning materiality. Tolerable misstatement is
the amount of planning materiality that is allocated to an
account balance ( AR, inventory) or class of transactions
( purchases or revenue).
 The purpose of allocating a portion of the preliminary
judgement about materiality is to plan the scope of audit
procedures for individual account balance or class of
transactions
 91 Step 3

 Estimate likely total misstatement in segment

 Estimate the combined misstatement
 Compare Totals to the preliminary judgement about
materiality.
 92 Step 3 (continued)
 Step 3 is completed near the end of the audit , when
the auditor evaluates all the evidence that has been
gathered
 Based on the results of audit procedures conducted,
the auditor aggregates misstatements for each
account balance or class of transactions
93 Step 3 (continued)
 The aggregate amount includes
-known misstatements
-projections based on the sample data collected
-misstatement not adjusted in the prior period
The auditor compares this aggregate misstatement to the
preliminary judgement about materiality
 Relationship between materiality
94
and audit risk
 There is an inverse relationship between materiality and the level
of audit risk ,that is, the higher the materiality level, the lower the
audit risk and vice versa. Accordingly, if after planning for
specific audit procedures, the auditor determines that acceptable
materiality level is lower, audit risk is increased. The auditor
would have to compensate this by either:
 Reducing the level of assessed control risk ,when this is possible;
or
 Reducing the detection risk by modifying the nature, timing and
extent of substantive procedures.
 95 Definition of Misstatement
 Misstatement = difference between what is reported
and what is expected by the Financial Reporting
Framework or needed for true and fair view/fair
presentation
 Misstatements include-ISA 450
 Factual misstatements
 Judgmental misstatements
 Projected misstatements
 Clearly trivial misstatements are not considered in
evaluation of identified misstatements
 Communication and Correction of
96
Misstatements
 Communicate all misstatements accumulated during the audit on a
timely basis to management
 Request management to correct them
 Obtain reasons for any misstatement not corrected
 Take that understanding into account when evaluating whether
financial statements are free from material misstatement
 Communicate with TCWG uncorrected misstatements and their
effect on the auditor’s opinion
 Revision of Materiality
 Materiality levels not cast in stone once
determined
 Adjust as necessary as the audit progresses for
 Changes in entity’s circumstances
 New information
 Change in understanding of entity and its operations
 If materiality levels adjusted, consider whether
nature, timing, and extent of further audit
procedures also need adjustment (Refer to the
handout)
97
98 Case Studies

Margaret Boh -Textbook

 Q-3.31 Cendant Corporation (Cendant)
 Q-3.32 New Tek Copiers
99
End of Lecture