Audit Risk and Materiality – Desired and Achieved Audit Risk

Audit risk is the risk that the financial statements are materially misstated and the auditor fails to detect such a misstatement.

Audit risk and materiality are closely related. Materiality must be established before audit risk has any meaning. For example, a 4% risk of a $20,000 misstatement of income has a completely different meaning than a 4% risk of a $200,000 misstatement.

Desired audit risk is the subjectively determined risk that the auditor is willing to take that the financial statements are not fairly stated after the audit is completed and an unqualified opinion has been reached. The lower the desired audit risk, the more sure the auditor wants to be that the financial statements are not materially misstated. Zero risk would be certainty, and a 100% risk would be complete uncertainty. Audit risk can range anywhere from zero to one (0 to 100 percent), but no more or less. Complete assurance (zero risk) of the accuracy of the financial statements is not economically practical. The auditor cannot guarantee the complete absence of material errors and irregularities.

The concept of desired audit risk can be more easily understood by thinking in terms of a large number of audits, say ten thousand. What portion of these audits could include material errors without having an adverse effect on society? Certainly, the portion would be below ten percent. It is probably much closer to one or one-half of 1% or perhaps even one-tenth of 1%. If an auditor feels the appropriate percentage for a given audit is one, desired audit risk is 1%.

Achieved audit risk is the actual level of risk, after the audit is completed and an unqualified opinion issued, that the statements are materially misstated. Achieved risk must be less than desired risk or the auditor should not issue an unqualified opinion.

The auditor achieves a reduction of audit risk by gathering evidence. The lower the desired audit risk, the more evidence the auditor must obtain. Since an increased amount of evidence means increased cost, the decision concerning the proper audit risk is one of cost versus benefit. The important question is : at what point does the cost of acquiring more evidence exceed the benefit obtained from the additional information? When the desired risk is reached, the auditor should stop accumulating evidence.

The auditor will have sufficient competent evidence when the achieved audit risk equals desired audit risk. Lower audit risk could be achieved, but cost would be increased.

If the auditor believes the additional cost exceeds the additional benefit from continuing the accumulate evidence, but audit risk is still not satisfactory, he has several options. He may negotiate for a higher audit fee, issue a disclaimer of opinion, bear the additional costs himself, or withdraw from the engagement (Hrd).

Source of this article : Auditing – An Integrated Approach, Alvin A.Arens & James K. Loebbecke

The Nature of Audit Risk and Materiality

Audit risk is the risk that the financial statements are materially misstated and the auditor fails to detect such a misstatement. The auditor must perform the audit to reduce audit risk to a low level.

Audit risk is a function of two components :

1. Risk of material misstatement, which is the risk that an account or disclosure item contains a material misstatement, and
2. Detection risk, which is the risk that the auditor will not detect such misstatements.

To reduce audit risk to a low level requires the auditor to :

1. Assess the risk of material misstatement, and, based on that assessment,
2. Design and perform further audit procedures to reduce overall audit risk to an appropriately low level.

The concept of materiality recognizes that some matters are more important for the fair presentation of the financial statements than others. In performing your audit, you are concerned with matters that, individually or in the aggregate, could be material to the financial statements. Your responsibility is to plan and perform the audit to obtain reasonable assurance that you detect all material misstatement, whether caused by error or fraud.

The accounting standards define Materiality as the magnitude of an omission or misstatement of accounting information that, in light or surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed by the omission or misstatement.

Thus, materiality is influenced by your perception of the needs of financial statement users who will rely on the financial statements to make judgments about your client.

ISA 320 Materiality in Planning and Performing an Audit, in paragraph A1 states that :

In conducting an audit of financial statements, the overall objectives of the auditor are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and to report on the financial statements, and communicate as required by the ISAs, in accordance with the auditor’s findings. The auditor obtains reasonable assurance by obtaining sufficient appropriate audit evidence to reduce audit risk to an acceptably low level.

Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of the risks of material misstatement and detection risk.

Materiality and audit risk are considered throughout the audit, in particular, when :

1. Identifying and assessing the risks of material misstatement;
2. Determining the nature, timing and extent of further audit procedures; and
3. Evaluating the effect of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report.

Source : WILEY – Practitioner’s Guide to GAAS 2010, Steven M.Bragg and ISA 320 Materiality in Planning and Performing an Audit

Materiality in the Context of an Audit

ISA 320 Materiality in Planning and Performing an Audit paragraph 2 states that financial reporting frameworks often discuss the concept of materiality in the context of the preparation and presentation of financial statements. Although financial reporting frameworks may discuss materiality in different terms, they generally explain that :

• Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements;
• Judgments about materiality are made in light of surrounding circumstances, and are affected by the size or nature of a misstatement, or a combination of both; and
• Judgments about matters that are material to users of the financial statements are based on a consideration of the common financial information needs of users as a group. The possible effect of misstatements on specific individual users, whose needs may vary widely, is not considered.

Para. 3 states that such a discussion, if present in the applicable financial reporting framework, provides a frame of reference to the auditor in determining materiality for the audit. If the applicable financial reporting framework does not include a discussion of the concept of materiality, the characteristics referred to in para. 2 provide the auditor with such a frame of reference.

The auditor’s determination of materiality is a matter of professional judgment, and is affected by the auditor’s perception of the financial information needs of users of the financial statements. In this context, it is reasonable for the auditor to assume that users :

1. Have a reasonable knowledge of business and economics activities and accounting and a willingness to study the information in the financial statements with reasonable diligence;
2. Understand that financial statements are prepared, presented and audited to levels of materiality;
3. Recognize the uncertainties inherent in the measurement of amounts based on the use of estimates, judgment and the consideration of future events; and
4. Make reasonable economic decisions on the basis of the information in the financial statements

The concept of materiality is applied by the auditor both in planning and performing the audit, and 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 in the auditor’s report.

In planning the audit, the auditor makes judgments about the size of misstatements that will be considered material. These judgments provide a basis for :

1. Determining the nature, timing and extent of risk assessment procedures;
2. Identifying and assessing the risks of material misstatements; and
3. Determining the nature, timing and extent of further audit procedures

The materiality determined when planning the audit does not necessarily establish an amount below which uncorrected misstatements, individually or in the aggregate, will always be evaluated as immaterial. The circumstances related to some misstatements may cause the auditor to evaluate them as material even if they are below materiality. Although it is not practicable to design audit procedures to detect misstatements that could be material solely because of their nature, the auditor consider not only the size but also the nature of uncorrected misstatements, and the particular circumstances of their occurrence, when evaluating their effect on the financial statements (Hrd).

Audit Approach

The Audit Approach is a risk analysis methodology that focuses on the combined impact of the environment in which a client operates, the client's management information and financial results, and the effectiveness of the client's internal controls. It is based on a thorough, up-to-date understanding of the client's business and industry, which is obtained through a comprehensive analysis of the external and internal operating environments. It enables us to design an audit programme that includes the most effective and efficient combination of test responsive to a client's unique circumstances. In addition, it provides a uniform method for developing and documenting the basis for the audit programme.

The Audit Approach enables us to plan our effort to be proportionate to the risk of material error in specific accounts and transactions. This provides the basis for planning the minimum effort necessary to limit audit risk in each area to a low level. As a result, every audit procedure has a specific purpose that is related to the company's particular situation – nothing is "routine" and hence potentially unnecessary. By following this approach we can avoid overauditing and underauditing, and we can distribute our audit work more evenly throughout the year.

MATERIALITY AND AUDIT RISK

Professional standards require us to consider materiality and audit risk when planning the nature, timing and extent of our audit procedures, and when evaluating the results of those procedures. Materiality is determined at two levels during the initial planning stage :

1. An overall level as relates to the accounts taken as a whole – planning materiality; and
2. An individual balance or class of transactions level – tolerable error.

Audit risk is defined as the risk that an auditor may unknowingly fail to modify his or her opinion on accounts that are materially misstated. We address materiality and audit risk at an overall level to help us develop an audit strategy that will provide sufficient evidence to enable us to evaluate whether the accounts are materially misstated.

At the account balance or class of transactions level, audit risk is the product of the risks that :

1. Factors in a company's internal or external operating environment, before considering the functioning of internal controls, will lead to a material error – inherent risk;
2. A material error will not prevented or detected on a timely basis by the system of internal control – control risk; and
3. The auditor's procedures will fail to detect a material error not detected by the system of internal control – detection risk.

The Audit Approach provides a methodology for relating these risk concepts to materiality and correlating them to the nature, timing, and extent of our audit procedures. This is accomplished through the Specific Risk Analysis and the Preliminary Audit Approach.

SPECIFIC CONTROL OBJECTIVES

A key element of the Audit Approach is the relationship of specific control objectives to transactions and accounts. Specific control objectives are derived from the five general control objectives that an accounting system should be expected to achieve. The first three of the five – authorization, recording, and safeguarding – relate to establishing the system of accountability and provide for the prevention of errors and irregularities. The fourth general objective – reconciliation – ties together the system of accountability established by the first three and, along with the fifth objective – valuation – provides for the detection of errors and irregularities.

We have translated these general objectives into specific control objectives that are related to the accounts and transactions of a business. Specific control objectives relate to the activities in each operating component that originate and process transactions. Each type of transaction results in either debits or credits to various accounts. Because a number of accounts and transactions are normally affected by a single specific control objective, the specific control objectives provide convenient and efficient reference points for considering the inputs to the Specific Risk Analysis.

PHASES OF THE AUDIT APPROACH

We can divide an audit into three phases – initial planning, programme development, and programme execution. On paper, each phase – and each step within it – appears as a separate activity. However, in practice, the phases and steps are closely interrelated and should not be regarded as distinct steps that are set aside when done. Throughout any audit, we should be alert for new developments that may affect the client's business or industry. We should continue to challenge the effectiveness and efficiency of audit procedures, and modify them if necessary (Hrd).