Ch. 7: Materiality and Risk (Audit)

Concept of Materiality

Some matters may be important for fair presentation of financial statements in conformity with GAAP while others are not important

• Does something matter? 

• Matter is material if there’s a substantial likelihood that a reasonable user’s judgement would be influenced

Materiality 

The amount of misstatement that would affect the judgement of a reasonable person

• User-based Concept: Through the eyes of users who use financial statements

Tolerable Misstatement

The maximum error in a specific population (account balance) that an auditor is willing to accept 

• Auditor- based concept: If auditors do their job, then tolerable misstatements would be material 

Omission

Misstatement of the financial statement amount, classification, or presentation not reported in conformity with GAAP

• No disclosure 

• Common= A/R

1. Amount on financial statement is wrong

2. Amount on financial statement is omitted

3. Disclosure is wrong

4. Force to make disclosure and didn’t 

Known Misstatement

Type of misstatement where exact amount of misstatement is known

• Management is happy to book

• Sampling = Major Problem 

Likely Misstatement

Type of misstatement where exact amount of misstatement is unknown and auditor must make best guess 

• Management hates to book

Free Material Disorganization

If in one situation, materiality matters, it doesn’t mean that it will matter in another situation

• Materiality is contextual

Qualitative Threshold

Helps determine what’s important by determine what is important to users and what factors make investors change their mind in decision making?

Quantitative Threshold

Helps determine what is material by determining magnitude of financial statement impact by assessing a benchmark and finding a range in benchmark (% of benchmark)

• Must always adjust materiality threshold 

Materiality Threshold

Number users care about based on of benchmark

• Materiality threshold 

Performance Materiality Threshold

Number slightly less than materiality that auditors use to plan and perform audit

• Auditors will test all accounts with balances greater than threshold and will correct any misstatements greater than threshold 

Clearly Trivial Threshold

Amount significantly lower than materiality, where auditors can completely ignore all misstatements

• Designed to help auditors be more efficient

Risk

Exposure to the chance (Uncertainty) of injury or loss

• 2 components

  • 1. Probability

  • 2. Outcome 

Audit Risk

The risk than an auditor expresses an inappropriate audit opinion when the audited financial statements are materially misstated

• Risk of audit failure 

=Inherent Risk * Control Risk * Detection Risk

Risk of Material Misstatement

The risk that the unaudited financial statements contain a material misstatement

• Inherent Risk * Control Risk

Inherent Risk

Risk that an error will occur

• Based on type of business the client runs, the nature of the client, and industry

• Auditors CanNOT control 

• Auditors must assess

Control Risk

The risk that an error will not be prevented/ detected/ corrected by client’s internal controls

• Risk client will miss it

• Auditors CanNOT control

• Auditors must assess 

Detection Risk

Risk that the auditor will NOT detect a material misstatement that exists in the unaudited financial statements  

• Can reduce risk through substantive procedures: Nature, Extent, Timing 

  • Auditor can control risk