Chapter (2)

Considering Materiality and Risk

1. Apply the concept of materiality to the audit.

What is the meaning of “Materiality”?

Auditing standards define “Materiality” as → The magnitude of misstatements that

individually, or when aggregated with other misstatements, could reasonably be expected to
influence the economic decisions of users made on the basis of the financial statements.

Illustration → (The Concept of Materiality)

ABC Electronics is a company with an annual revenue of $200 million. During an audit, two types of
misstatements are discovered in their financial statements:

1. Misstatement in Revenue Reporting → A revenue of $3 million from a key product line was accidentally
counted twice due to an accounting error.
2. Misstatement in Office Supplies Expense → The expense for office supplies was overstated by $10,000
due to a clerical error.

Immaterial Misstatement (2) Material Misstatement (1)

10,000 Auditor $3,000,000

The Materiality level

t
0.5% X Total Revenues ($200 M) = $1,000,000
t M
Auditor will bring material misstatements to the
Client’s attention so corrections can be made Auditor’s responsibility
Determine whether financial
The Absence of client`s correction of the material statements are materially misstated.
misstatement → The auditor will most likely issue
a qualified or adverse report.

Steps in Applying Materiality

Notice →
- The auditor in 1st step → determines materiality for the
financial statements as a whole → (Planning)
- Second → the auditor determines performance materiality,
which is materiality for segments of the audit (classes of
transactions, account balances or disclosures → (Planning)
- Step 3 → occurs throughout the engagement, when
auditors estimate the amount of misstatements in each
segment as they evaluate audit evidence → (Testing)
- Near the end of the audit → during the engagement
(completion phase), auditors proceed through → the final
2 steps.
 Steps in Applying Materiality

1. Step (1) → Set Preliminary Judgment About Materiality (PJM): (Whole F/S)
- Preliminary Judgment About Materiality → is the maximum amount by which the
auditor believes the statements could be misstated and still not affect the decisions of
reasonable users.

Auditor

Notes → Difference between “Materiality” and “Preliminary Judgment Materiality”

Materiality Preliminary Judgment about Materiality
Amount ($) Amount ($)
Affects decision of a Reasonable user. Does not affect decision of a Reasonable user.

2. Step (2) → Determine Performance Materiality/Tolerable misstatements “T.M”

(Materiality Segmentation or allocation among accounts): (Individual account
balances or segments)
- Determine Performance Materiality/Tolerable misstatements → is based on professional
judgment and reflects the amount of misstatement an auditor is willing to accept in a
particular segment. As the allocation of the preliminary judgment about materiality to
Individual account balances or segments.
Example to Illustrate the Difference between (PJM and TM)
Let's consider a company, XYZ Corp, with total assets of $500 million and revenue of $100 million.
Step 1: Setting PJM: The auditor determines that a misstatement would be material if it is more than 0.5%
of total revenue. Therefore, the PJM is set at $500,000 (0.5% of $100 million) for the entire F/S.
Step 2: Determining Performance Materiality (TM): The auditor decides to segment this global
materiality threshold among different accounts. For instance, for the inventory account (which is significant
for XYZ Corp), the auditor sets a performance materiality level of $100,000. This means that within the
inventory account, the auditor is willing to accept a total misstatement of up to $100,000, but not more.

▪ Most practitioners allocate materiality to balance sheet accounts.

▪ Performance materiality is inversely related to the amount of evidence an auditor will
accumulate. Understanding the Inverse Relationship:
- Low TM: Requires more evidence because the auditor needs to be more certain that the misstatements
in that segment are not exceeding the low TM.

- High TM: Requires less evidence because there is more room for potential misstatements before
reaching the TM.
3. Step 3 : Step 5 Estimate Misstatement in segment and Combined them then Compare
with Preliminary Judgment (Evaluation)
▪ When auditors perform audit procedures for each segment of the audit, they make
Projections (estimation) of misstatements based on the auditor`s tests of a sample from
a population in segment then the whole financial statements.

Rule (1) → Direct projected Misstatement in segment (Account) is Calculated as follows:

= % of Misstatements in the Sample of segment X Population Recorded value of segment

Misstatements in the Sample of segment

Total dollar of That segment

Example:
- Net misstatements in the sample of certain account is ($3,500).
t
- Total sampled dollar of that account ($50,000).
- Total recorded population value of the account ($450,000).
And it is required from you as an auditor that:
1. What is Direct projection estimate of misstatement in the account?
2. The TM level is $20,000? Is the misstatement require modification by Management? Why?
What is the type of opinion?
3. The projected total Misstatements is $10,000,000 while PJM is $500,000? Is the misstatement
require modification by Management? Why? What is the type of opinion?

Answer
1. Direct projection estimate of misstatement in the account =
% of Misstatements in the Sample of segment (7%) X Population Recorded value ($450,000)
= $31,500

Misstatements in the Sample of segment (3,500) = 0.07 Or 7%

Total dollar of That segment (50,000)
2.

t
For Account Direct projection estimates of misstatement
in the account = $31,500

TM = 20,000

- The direct projection estimate of $31,500 exceeds the performance materiality level of $20,000.
- Requirement for Modification by Management: Yes, the misstatement requires modification.
Since the estimated misstatement is greater than the performance materiality, it indicates that
the misstatement could be material for the account and hence needs to be corrected.
- Type of Opinion: The audit opinion depends on whether the misstatement is corrected and the
overall impact of all misstatements on the financial statements. If such misstatements are
pervasive and uncorrected, it could lead to a qualified or adverse opinion, but this decision
requires a comprehensive evaluation of the entire financial statements.
3.

For The entire F/S Projected total Misstatements =

$10,000,000

PJM = 500,000

- The projected total misstatements significantly exceed the preliminary judgment of materiality
(PJM) of $500,000.
- Requirement for Modification by Management: Yes, the misstatement definitely requires
modification. Since the total estimated misstatements far exceed the PJM, this suggests a
material misstatement of the financial statements as a whole.
- Type of Opinion: If these misstatements are not corrected, the auditor is likely to issue a qualified
or adverse opinion, indicating that the financial statements are not presenting a true and fair
view of the company's financial position. The exact type of opinion would depend on the
pervasiveness and nature of the misstatements.

Risk of Material Misstatements

▪ The risk of material misstatement → is the risk that the financial statements contain a
material misstatement due to fraud or error prior to the audit.
▪ The risk of material misstatement exists at two levels:
- Overall financial statement level →
(Projected total misstatement for the whole financial statement>PJM) → Adverse Opinion.

- Assertion (Account or Segment) level →

(Projected total misstatement for the Segment or account>TM) → Qualified Opinion.

Questions Part
[Link] auditors allocate the preliminary judgment about materiality to account balances, the
materiality allocated to any given account balance is referred to as:
A) the materiality range.
B) the error range.
C) tolerable materiality.
D) performance materiality.
Answer → D
2) The first step in applying materiality is
A) estimating the misstatement in a segment for each functional cycle.
B) setting a judgment about materiality for the financial statements as a whole.
C) estimating the combined effects of errors.
D) comparing the error estimate with the materiality levels.
Answer: B
3) If the auditor sets a low dollar amount as materiality,
A) more evidence is required than for a high amount.
B) less evidence is required than for a high amount.
C) the same amount of evidence is required as for a high dollar amount.
D) it has no effect on the amount of evidence required.
Answer: A
4) Determining materiality requires professional judgment.
A) True
B) False
Answer: A
5) If an auditor establishes a relatively high level for materiality, then the auditor will:
A) accumulate more evidence than if a lower level had been set.
B) accumulate less evidence than if a lower level had been set.
C) accumulate approximately the same evidence as would be the case were materiality lower.
D) accumulate an undetermined amount of evidence.
Answer: B
6) When auditors allocate the preliminary judgment about materiality to account balances, the materiality
allocated to any given account balance is referred to as (Exam 2023):
A) the materiality range.
B) the error range.
C) tolerable materiality.
D) performance materiality.
Answer: D
7) Auditors generally allocate the preliminary judgment about materiality to the:
A) balance sheet only.
B) income statement only.
C) income statement and balance sheet.
D) statement of cash flows.
Answer: A
8) When allocating performance materiality:
A) it is easy to predict in advance which accounts are mot likely to be misstated.
B) only overstatements need to be considered.
C) professional judgment is critical.
D) the sum of all the performance materiality levels cannot exceed the preliminary judgment about
materiality.
Answer: C
9) If an auditor assigns a tolerable misstatement of $1,000 to accounts payable, he or she would need to obtain
more audit evidence for that account than if $100,000 had been assigned.
A) True
B) False
Answer: A
 2. Audit Risk

What is the meaning of “Risk” ?

Risk → Uncertainty.

What is the meaning of “Audit Risk” ?

Audit Risk → Auditors accept some level of uncertainty in performing the audit function
(i.e. the situation the audit opinion incorrect).

Risk Assessment Procedures

▪ The assessment of risks is a matter of professional judgment, rather than a precise

measurement.
▪ The performance of risk assessment procedures is designed to help the auditor obtain an
understanding of the entity for purposes of assessing the risk of material misstatement
when planning the audit.
▪ Responding to these risks properly is critical to achieving a high-quality audit.

3. Audit Risk Model

Audit Risk Model → The audit risk model helps auditors decide how much and what types of
evidence to accumulate for each relevant audit objective.
▪ The audit risk model assessments may be quantitative or non-quantitative.
▪ Most firms prefer non-quantitative assessments of risk (such as low, moderate, and high)
due to the difficulty in precisely quantifying measures of risk.

Audit Risk = Inherent Risk (IR) X Control Risk (CR) X Detection Risk
 The Four risks in the audit risk model

[Link] detection risk →

[Link] risk →The risk posed by an error or omission in a financial statement due to a
factor other than a failure of internal control. In a financial audit, inherent risk is most likely
to occur when transactions are complex or due to nature of business. Inherent risk is the risk
of a material misstatement in a company`s financial statements without considering internal
controls.

[Link] risk: Control risk is the chance of a material misstatement in a company s financial
statements because there aren’t any relevant internal controls to mitigate a particular risk
or the internal controls in place malfunctioned.

[Link] audit risk: Acceptable audit risk is a measure of how willing the auditor is to
accept that the financial statements may be materially misstated after the audit is completed
and an unqualified opinion has been issued. The auditor cannot guarantee the complete
absence of material misstatements.
 Audit Risk Model

Relationship of Risks to Planned Evidence

 Multiple Choice Questions

1) The first step in applying materiality is

A) estimating the misstatement in a segment for each functional cycle.
B) setting a judgment about materiality for the financial statements as a whole.
C) estimating the combined effects of errors.
D) comparing the error estimate with the materiality levels.
Answer: B
2) The purpose of allocating planning materiality to balance sheet accounts is to
A) assess the appropriate evidence to accumulate for each account on the balance sheet.
B) assess the appropriate evidence to accumulate for each account on both the balance sheet and income
statement.
C) reduce the amount of procedures done in the course of the audit.
D) increase the possibility that fraud or illegal activities would be detected by audit procedures.
Answer: B
3) Which of the following would not increase the risks of material misstatement at the overall
financial statement level?
A) effective oversight by the board of directors
B) deficiencies in management's integrity
C) inadequate accounting systems
D) all of the above
Answer: A
4) The auditor's responsibility section in an audit report states that "…the standards require that
we plan and perform the audit to obtain ________ assurance about whether the financial statements
are free of material misstatement." What type of assurance is given?
A) immediate
B) limited
C) reasonable
D) absolute
Answer: C
5) ________ risk represents the auditor's assessment of the susceptibility of an assertion to material
misstatement, before considering the effectiveness of the client's internal control.
A) Material
B) Account balance
C) Control
D) Inherent
Answer: D
6) Risk of material misstatement at the assertion level
A) is only relevant to account balances.
B) determines the nature, timing, and extent of further audit procedures.
C) refers to risks that are pervasive to the financial statements as a whole.
D) consists of business risk and inherent risk.
Answer: B
7) The risk of material misstatement exists only at the overall financial statement level.
Answer: FALSE
8) Significant changes in the industry may increase the risk of material misstatement at the assertion
level.
Answer: FALSE
9) Inherent risk and control risk exist independent of the audit of the financial statements.
Answer: TRUE
10) Risk assessment procedures include inquiries of management and others by the auditor. As part
of these procedures, the auditor should talk to
A) internal auditors.
B) board of directors.
C) individuals involved with regulatory compliance.
D) all of the above.
Answer: D
11) Risk assessment procedures include
A) a required discussion among the staff members of the audit and the client regarding material misstatements
in the financial statement.
B) determination of the type of audit opinion to issue.
C) observation of the entity's operations.
D) assessing acceptable audit risk.
Answer: C
12) The performance of risk assessment procedures is designed to help the auditor obtain an
understanding of the entity.
Answer: TRUE
13) Auditing standards require the engagement partner to be included in discussions about the
susceptibility of the client's financial statements to material misstatements.
Answer: TRUE
14) Auditors are not allowed to make inquires of employees who are not considered management,
such as marketing or sales personnel.
Answer: FALSE
15) When considering the risk of misstatement due to fraud,
A) the risk of not detecting a material misstatement due to fraud is lower than the risk of not detecting a
misstatement due to error.
B) the risk is only made at the financial statement level.
C) auditing standards require the auditor to presume that risk of fraud exist in expense transactions.
D) auditing standards outline procedures the auditor should perform to obtain information from management
about their consideration of fraud.
Answer: D
16) Individuals engaged in conducting a fraud will generally not misrepresent information to the
auditor.
Answer: FALSE
3) The auditor's risk assessment for fraud should be ongoing throughout the audit.
Answer: TRUE
17) A ________ risk represents an identified and assessed risk of material misstatement that, in the
auditor's professional judgment, requires special audit consideration.
A) material
B) substantial
C) financial statement
D) significant
Answer: D
18) Which of the following will generally be considered a significant risk?
A) a sale to a customer
B) the determination of the amount of bad debt expense
C) the purchase of inventory
D) obtaining a loan from the bank
Answer: B
19) Significant risks often relate to routine transactions.
Answer: FALSE
20) The auditor must perform substantive tests related to assertions deemed to have significant
risks.
Answer: TRUE
21) Based on audit evidence gathered and evaluated, an auditor decides to increase the assessed level
of control risk from that originally planned. To achieve an overall audit risk level that is substantially
the same as the planned audit risk level, the auditor would
A) increase materiality levels.
B) decrease detection risk.
C) decrease substantive testing.
D) increase inherent risk.
Answer: B
22) When dealing with audit risk,
A) auditors cannot accept any level of risk in performing the audit function.
B) most risks that auditors encounter are relatively easy to measure.
C) the audit risk model is only used for classes of transactions.
D) the audit risk model helps the auditor to decide how much and what types of evidence to accumulate.
Answer: D
23) The measurement of the auditor's assessment of the susceptibility of an assertion to material
misstatement, before considering the effectiveness of related internal controls is defined as
A) audit risk.
B) inherent risk.
C) sampling risk.
D) detection risk.
Answer: B
24) The risk that audit evidence for an audit objective will fail to detect misstatements exceeding
performance materiality levels is
A) audit risk.
B) control risk.
C) inherent risk.
D) planned detection risk.
Answer: D
25) If the auditor decides to reduce acceptable audit risk, planned detection risk
A) increases.
B) decreases.
C) stay the same.
D) cannot be determined.
Answer: B
26) Inherent risk is ________ related to planned detection risk and ________ related to the amount of
audit evidence.
A) directly; inversely
B) directly; directly
C) inversely; inversely
D) inversely; directly
Answer: D
27) Auditors frequently refer to the terms audit assurance, overall assurance, and level of assurance
instead of
A) detection risk.
B) audit report risk.
C) acceptable audit risk.
D) inherent risk.
Answer: C
28) If planned detection risk is reduced, the amount of evidence the auditor accumulates will
A) increase.
B) decrease.
C) remain unchanged.
D) be indeterminate.
Answer: A
29) Planned detection risk
I. determines the amount of substantive evidence the auditor plans to accumulate.
II. is dependent on inherent risk and business risk.
A) I only
B) II only
C) I and II
D) neither I nor II
Answer: A
30) Inherent risk is often high for an account such as
A) inventory.
B) land.
C) capital stock.
D) notes payable.
Answer: A
31) Inherent risk and control risk
A) are inversely related to each other.
B) are inversely related to detection risk.
C) are directly related to detection risk.
D) are directly related to audit risk.
Answer: B
32) To what extent do auditors typically rely on internal controls of their public company clients?
A) extensively
B) only very little
C) infrequently
D) never
Answer: A
33) Auditors typically rely on internal controls of their private company clients
A) only as needed to complete the audit and satisfy Sarbanes-Oxley requirements.
B) only if the controls are determined to be effective.
C) only if the client asks an auditor to test controls.
D) only if the controls are sufficient to increase control risk to an acceptable level.
Answer: B
34) Which is a true statement about audit risk?
A) Audit risk measures the risk that a material misstatement could occur and not be detected by internal
control.
B) When auditors decide on a higher acceptable audit risk, they want to be more certain that the financial
statements are not materially misstated.
C) Audit assurance is the complement of acceptable audit risk.
D) There is an inverse relationship between acceptable audit risk and planned detection risk.
Answer: C
35) The risk of material misstatement refers to
A) control risk and acceptable audit risk.
B) inherent risk.
C) the combination of inherent risk and control risk.
D) inherent risk and audit risk.
Answer: C
36) When assessing risk, it is important to remember that
A) for acceptable audit risk, the SEC decides the risk the CPA firm should take for public clients.
B) inherent risk can be changed by the auditor.
C) detection risk can only be determined after audit risk, inherent risk, and control risk are determined.
D) control risk is determined by company management since they are responsible for internal control.
Answer: C
37) Which of the following is a correct relationship?
A) Acceptable audit risk and planned detection risk have an inverse relationship.
B) Control risk and planned detection risk have a direct relationship.
C) Planned detection risk and inherent risk have an inverse relationship.
D) All of the above are correct relationships.
Answer: C
38) In a financial statement audit, inherent risk is evaluated to help an auditor asses which of the
following?
A) the internal audit department's objectivity in reporting a material misstatement of a financial statement
assertion it detects to the audit committee
B) the risk the internal control system will not detect a material misstatement of a financial statement assertion
C) the risk that the audit procedures implemented will not detect a material misstatement of a financial
statement assertion
D) the susceptibility of a financial statement assertion to a material misstatement assuming there are no
related controls
Answer: D
40) Which of the following statements is not true?
A) Inherent risk is inversely related to the amount of audit evidence whereas detection risk is directly related
to the amount of audit evidence required.
B) Inherent risk is directly related to evidence whereas detection risk is inversely related to the amount of audit
evidence required.
C) Inherent risk is the susceptibility of the financial statements to material error, assuming no internal controls.
D) Inherent risk and control risk are assessed by the auditor and function independently of the financial
statement audit.
Answer: A
41) An auditor who audits a business cycle that has low inherent risk should
A) increase the amount of audit evidence gathered.
B) assign more experienced staff to that area.
C) expand planning procedures.
D) do none of the above.
Answer: D
42) The most important element of the audit risk model is control risk.
Answer: FALSE
43) The audit risk model that must be used for planning audit procedures and evaluating audit results
is: = AAR
Answer: FALSE
44) If acceptable audit risk is low, and inherent risk and control risk are both low, then planned
detection risk should be high.
Answer: TRUE
45) If the audit assurance rate is 95%, then the level of acceptable audit risk is 5%.
Answer: TRUE
30) A high detection risk equates to a low amount of audit evidence needed.
Answer: FALSE
46) For a private company client, auditors are required to test any internal controls they believe have
not been operating effectively during the period under audit.
Answer: FALSE
47) There is a direct relationship between acceptable audit risk and planned detection risk.
Answer: TRUE
48) Acceptable audit risk and the amount of substantive evidence required are inversely related.
Answer: TRUE
49) As control risk increases, the amount of substantive evidence the auditor plans to accumulate
should increase.
Answer: TRUE
50) Inherent risk and control risk are directly related.
Answer: FALSE
51) Audit assurance is the complement of planned detection risk, that is, one minus planned
detection risk.
Answer: FALSE
52) If an auditor believes the chance of financial failure is high and there is a corresponding increase
in business risk for the auditor, acceptable audit risk would likely
A) be reduced.
B) be increased.
C) remain the same.
D) be calculated using a computerized statistical package.
Answer: A
53) When management has an adequate level of integrity for the auditor to accept the engagement
but cannot be regarded as completely honest in all dealings, auditors normally
A) reduce acceptable audit risk and increase inherent risk.
B) reduce inherent risk and control risk.
C) increase inherent risk and control risk.
D) increase acceptable audit risk and reduce inherent risk.
Answer: A
54) When the auditor is attempting to determine the extent to which external users rely on a client's
financial statements, they may consider several factors except for
A) client size.
B) concentration of ownership.
C) nature and amounts of liabilities.
D) assessment of detection risk.
Answer: D
55) ________ is the risk that the auditor or audit firm will suffer harm after the audit is finished, even
though the audit report was correct.
A) Inherent risk
B) Audit risk
C) Engagement risk
D) Control risk
Answer: C
56) If an auditor believes the client will have financial difficulties after the audit report is issued, and
external users will be relying heavily on the financial statements, the auditor will probably set
acceptable audit risk as low.
Answer: TRUE
57) Overall assessment of acceptable audit risk is highly subjective.
Answer: TRUE
58) An acceptable audit risk assessment of low indicates a risky client requiring more extensive
evidence, assignment of more experienced personnel, and/or a more extensive review of audit files.
Answer: TRUE
59) Which of the following statements regarding inherent risk is correct?
A) Inherent risk is unaffected by the auditor's experience with client's organization.
B) Most auditors set a low inherent risk in the first year of an audit and increase it if experience shows that it
was incorrect.
C) Most auditors set a high inherent risk in the first year of an audit and reduce it in subsequent years as they
gain more knowledge about the company.
D) Inherent risk is dependent upon the strengths in client's internal control system.
Answer: C
60) Auditors begin their assessments of inherent risk during audit planning. Which of the following
would not help in assessing inherent risk during the planning phase?
A) obtaining client's agreement on the engagement letter
B) obtaining knowledge about the client's business and industry
C) touring the client's plant and offices
D) identifying related parties
Answer: A
61) Which of the following is not a primary consideration when assessing inherent risk?
A) nature of client's business
B) existence of related parties
C) effectiveness of internal controls
D) susceptibility to misappropriation of assets
Answer: C
62) Which of the following is an accurate statement regarding inherent risk?
A) The profession has established guidelines for setting inherent risk.
B) Auditors are generally conservative in setting inherent risk.
C) Factors impacting inherent risk will affect all cycles, balances, and disclosures.
D) Inherent risk has no impact on the amount of evidence gathered.
Answer: B
63) The risk of fraud should be assessed for the entire audit as well as by cycle, account, and
objective.
Answer: TRUE
64) The auditing profession has established guidelines for setting inherent risk.
Answer: FALSE
65) Accounts that require considerable judgment have a higher inherent risk.
Answer: TRUE
66) Which of the following is true regarding audit risk for segments?
A) Control risk must be assessed at the same level for all accounts.
B) Factors affecting inherent risk do not differ from account to account.
C) Acceptable audit risk is ordinarily assessed by the auditor during the substantive test of balances phase and
is held constant for each major cycle and account.
D) In some cases, a lower acceptable audit risk may be more appropriate for one account than for others.
Answer: D
67) Auditors respond to risk primarily by
I. changing the extent of testing.
II. changing the types of audit procedures.
A) I only
B) II only
C) I and II
D) neither I nor II
Answer: C
68) When using the audit risk model,
A) auditors find it relatively easy to measure the components of the model.
B) many auditors use broad and subjective measurement terms.
C) auditors find it easy to measure the amount of evidence implied by a given planned detection risk.
D) auditors are only concerned with understating accounts.
Answer: B
69) In applying the audit risk model, auditors are concerned about overstatements, not
understatements.
Answer: FALSE
70) One major limitation in the application of the audit risk model is the difficulty of measuring the
components of the model.
Answer: TRUE
71) Since the audit risk model is a planning model, it assists the auditor in evaluating results.
Answer: FALSE
72) When taken together, the concepts of risk and materiality in auditing
A) measure the uncertainty of amounts of a given magnitude.
B) measure uncertainty only.
C) measure magnitude only.
D) measure inherent risk.
Answer: A
73) Which of the following is a correct statement?
A) There is no relationship between materiality and risk in auditing.
B) Risk is a measure of magnitude or size.
C) The combination of performance materiality and the audit risk model factors determines planned audit
evidence.
D) Performance materiality is part of the audit risk model.
Answer: C
74) Performance materiality impacts inherent risk and control risk.
Answer: FALSE