Essay Chapter 9 Lecture Notes

Chapter 9: Materiality and Risk

1. AU-C 320: Auditor’s Responsibility to Apply Materiality during Fieldwork (Planning and Performing)
a. Required to determine performance materiality on all audits.
b. Develop overall materiality threshold, and then think about areas of financial statements that user key on for decisions. This requires secondary materiality thresholds.
i. Primary benchmark: net income before taxes; misstated percentage ii. Secondary benchmark: current assets, total assets, current liabilities
c. Definitions:
i. Performance materiality: materiality level slightly lower than true threshold; by using this to plan the audit and make decisions it will result in more rigorous and increased likelihood of considering things materiality; introduces conservatism
1. Establish at financial statement level, then..
2. Allocate down to balance sheet accounts; amount by each of accounts cannot be misstated by (old term: tolerable misstatement)
3. When allocating of performance materiality to elements, the percentage of materiality can be higher because you would be over-auditing (1) netting effect: overstate/understate of bases (2) highly unlikely that all accounts will be misstated by full performance materiality
2. AU-C 350: Evaluation of Misstatements
a. When we implement auditing procedures, we will find misstatements. How do we determine materiality?
3. AU-C 450: Material Misstatements
a. Auditors should communicate with management all misstatements (except trivial)
b. Controller does not need to fix everything; negotiate
4. AU-C 200: Overall Objectives of Auditor
a. Definition of audit risk: a function of the risk of material misstatement and detection risk
i. Financial statement level, reporting level, element (audit risk model) level

A. Audit risk
a. Overall financial statement level audit risk:
i. Do not need to quantify, but can…
i. Confidence level: 1 – audit risk = audit assurance ii. If you set audit risk at 5%, you can state, “I am 95% confident that I am going to detect material misstatement.” “95% assurance,” or “low, medium, high” ii. What determines value of audit risk? Doesn’t exist, defaults to your professional judgment.
i. Influences: business/engagement risk for CPA firm; our perception that we could be sued
a. Greater engagement risk, less audit risk we will accept
B. Materiality thresholds used in audit:
1. Developing audit programs
2. During fieldwork
3. Evaluate the effect of discovered misstatements
i. How to set materiality threshold? Use professional judgment.
i. When setting threshold:
1. Relative rather than absolute concept
2. Set materiality threshold in terms of key benchmarks being misstated; may have multiple
3. Qualitative factors affect materiality decisions ii. As materiality threshold falls, our audit becomes more rigorous; must dig deeper to find misstatements
B. Elements (assertion level) we are building an audit program for:
a. Audit risk at element level: in terms of audit risk model
i. You will have audit risk model for each element ii. Allocate down to each account
b. Audit risk model:
i. AR = IR (inherent risk) X CR (control risk) X DR (detection risk) ii. Planning tool that auditors use to plan substantive testing (designed to find misstatements); no law that says you must quantify! iii. How to get value of audit risk (for sales receivable cycle, example)
1. Overall audit risk at financial statement level that is allocated down to element iv. How to get value for inherent risk (risk that element will be materially misstated assuming no internal control):
1. Professional judgment includes: nature of client’s business, results of previous audits, initial vs. repeat engagement, complex transactions, related parties
v. How to get value for control risk (risk that the client’s system of internal control will fail to detect misstatements inherently occurring in year):
1. Based on testing of internal control system
2. Some auditors combine IR & CR for client:

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