Midterm 2 Ch 9 Audit

Materiality defintion

• Magnitude of an omission or misstatement that makes it probable that a reasonable person’s opinion about FS would change if they knew about it

• Auditors must consider materiality both individually and in the aggregate (total immaterial adjustments are accumulated and examined to see if it accumulates to materiality threshold

During the client’s audit, you found the following errors, each of which is immaterial by itself: $200000 overstatement of ending inventory and $300000 of assets capitalized that should have been expensed. What is the effect on NI?

• $200000 overstatement of ending inventory

• $300000 overstatement of assets

• COGS decreases by $200000

• Expenses decrease by $300000

What if auditor finds material misstatement?

• The client must make adjustment for it or else auditor will issue qualified or adverse opinion

Preliminary materiality level

Maximum amount the auditor believes the FS could be misstated and not affect the decisions of reasonable users

Most common way to set planning materiality

• Percentage of net income before taxes (5-10%), second is total assets (0.5-1%), or occasionally total revenue (0.5-1%)

Tolerable misstatement PCAOB (performance materiality AICPA)

• Auditors determine the amount of planning materiality to allocate to each account

• Usually set lower than planning materiality and accounting firms each have their own method of assigning it

• Usually different for each account

3 difficulties when assigning materiality to particular BS accounts

1. Auditors expect some accounts to have more misstatement than others

2. Both understatements and overstatements are typically considered

3. Relative cost of evidence collection for particular accounts

AICPA audit risk model

• Planning tool to help determine the amount of evidence to accumulate

• Evidence (planned detection risk)=(Acceptable Audit Risk)/(Inherent Risk*Control risk)

• “low” “medium” and “high” risk levels

Planned detection risk

• HAS TO DO W AUDITOR

• Used to determine the amount of evidence to accumulate

• Measures the risk that audit evidence won’t detect misstatements exceeding a tolerable amount

• Inverse relationship w evidence collection: Higher PDR means less evidence needed. If the auditor can accept a higher risk of missing a misstatement, they can do less testing

Inherent risk

• Auditor’s prediction of where misstatements are most and least likely

• Inherent risk has direct relation with evidence

Factors affecting IR

• Complex transactions: inherently more risky (ex. debt obligations, M&As, goodwill)

• Accounting estimates when estimates are involved, the subjectiveness makes it riskier (ex. environmental, self insurance)

4 factors auditors should consider when assessing inherent risk

1. Prior audit results: May indicate some areas are more susceptible to errors

2. Related party transactions: Increases likelihood of misstatement over those areas

3. Non routine transactions: Increases likelihood of misstatement

4. Number and size of transactions: Higher volume and larger size increases misstatement likelihood

Control Risk

• Risk that material misstatements won’t be prevented or detected on a timely basis by company’s internal control system.

• When CR is high: Internal controls are bad

• CR has direct relation with evidence

What does control risk represent?

• An assessment as to whether the client internal controls are effective

• Auditor’s decision to make assessment at a level below the maximum

Acceptable Audit Risk

• The risk that the auditor will issue an unmodified opinion on materially misstated financial statements

• Zero risk is certainty and 100% risk if complete uncertainty

• AAR has an inverse relation with evidence

• High AAR: Auditor is ok with a lot of risk

Engagement risk

• Risk the audit firm will be sued even though the audit report is correct

• Engagement risk has direct relation with evidence and inverse relation with acceptable audit risk

3 factors that affect engagement risk

1. The extent that the FS users rely on F/S (ex. client size, public vs private clients, # of creditors)

2. Likelihood the client will have financial trouble after audit report is issued: Higher risk of financial problems means higher engagement risk

3. Management integrity: Questionable integrity means higher engagement risk