MATERIALITY AND RISKS

Prepared by: Alex Almodiel, CPA, MBA

Objectives
• To understand the concept of materiality.
• To comprehend the professional responsibilities of an auditor about
materiality.
• To learn the application of professional judgment when deciding about
materiality in planning the audit, accumulation of evidences and reporting
the results of the audit.
• To know the steps in applying materiality.
• To understand tolerable misstatements.
• To determine and distinguish different types of risks in an audit.
• To know how to assess risks.
• To learn the relevance of risks to audit procedures and audit evidences.
 Lesson 1
MATERIALITY AND PLANNING
EXTENT OF TESTS
Concept of Materiality to Audit
▪ Materiality is the magnitude of an omission or
misstatement of accounting information, that, in the
light of surrounding circumstances, makes it probable
that the judgment of a reasonable person relying on this
information would have been changed or influenced by
the omission or misstatement.
▪ Per ASC’s Framework for the Preparation and
Presentation of Financial Statements, information is
material if its omission or misstatement could influence
the economic decisions of users taken on the basis of the
financial statements. Materiality depends on the size of
the item or error judged in the particular circumstances
of its omission or misstatement. Thus, materiality
provides a threshold or cut-off point rather than being a
primary qualitative characteristic which information
must have if it is to be useful.
Application of Professional Judgment
▪ Materiality is based on the professional judgment of the
auditor.
▪ Professional judgment is the application of the accumulated
knowledge and experience gained through a relevant
accounting or auditing training, by making use of the ethical
standards, resulting in making informed decisions about the
courses of action that are appropriate in specific
circumstances, such as an audit mission and/or the accounting
of economic transactions, by observing accounting principles.
Steps in Applying Materiality
 STEP 1:
Set preliminary judgment about materiality.

✓ Understanding preliminary judgment

✓ Factors affecting preliminary judgment
✓ Materiality guidelines to practitioners
Preliminary Judgment About Materiality
▪ Preliminary judgement refers to the initial estimate of the
combined amount of misstatements in the financial
misstatements that would be considered material.
▪ The auditor’s preliminary judgment is the maximum amount
the financial statements could be misstated and still not affect
the decisions of reasonable users.
▪ Helps the auditor plan the appropriate evidence to
accumulate.
Factors Affecting Preliminary Judgment

A. Materiality is a relative rather than an absolute concept.

B. Bases are needed for evaluating materiality.
C. Qualitative factors also affect materiality.
MATERIALITY GUIDELINES TO PRACTITIONERS
▪ Accounting and auditing standards do not provide specific materiality guidelines
(only general guidelines) to practitioners.
▪ Some CPA firms have their own materiality guidelines that are used by their auditors
to determine what is material.
 STEP 2:
Allocate preliminary judgment about
materiality to segments.

✓ Importance of allocation of preliminary

judgments about materiality.
✓ Tolerable misstatements
✓ Example of allocation and interpreting the
preliminary judgments using examples
Importance of Allocating Preliminary
Judgment About Materiality to Segments
▪ Audit evidences are accumulated by segments rather than for
financial statements as a whole.
▪ The lower the preliminary judgment about materiality, the
more evidence needs to be accumulate.
▪ Materiality allocation can be either income statement or
balance sheet accounts.
Tolerable Misstatement
▪ Refers to a monetary amount set by the auditor in respect of
which the auditor seeks to obtain an appropriate level of
assurance that the monetary amount set by the auditor is not
exceeded by the actual misstatement in the population.
▪ If an auditor decides to allocate 100,000 pesos of a total
preliminary judgment about materiality of 200,000 pesos
accounts receivable balance, the tolerable misstatement is
100,000 pesos. This means that a financial statement showing
200,000 balance of accounts receivable, the auditor is willing
to consider accounts receivable fairly stated if it is misstated
by 100,000 pesos or less.
 SAMPLE MATERIALITY GUIDELINES
USED FOR THE ILLUSTRATION

1. Total Materiality (preliminary judgment of auditor – from Table 1.1) 737,000

2. Tolerable Misstatement for ANY ACCOUNT (cannot exceed 60% of 737,000) 442,000
3. Total tolerable Misstatements ( sum of all accounts - from Table 1.3) 1,474,000
• The total tolerable misstatements 1,474,000 pesos in the Statement of
Financial Position means the sum of all misstatements found on any
accounts should not exceed by that 1,474,000. If the detected total
misstatements of all the accounts exceeds that amount, the overall
financial statement is not fairly stated.
• Notice that the auditor did not assign tolerable misstatement on any
account that exceeds 442,000 pesos (because this is the maximum
amount of tolerable misstatement for any account).
• Notice that each account in the Statement of Financial Position has their
own tolerable statement (set by auditor individually based on his or her
professional judgment). For example, cash has 10,000 tolerable
misstatements which means that if the total misstatements affecting
cash exceeds 10,000, the cash account is not fairly stated. Another
example is the inventories tolerable misstatements amounting 442,000.
A large amount of tolerable misstatement is set to inventories. If the
tolerable misstatement set to inventories is 221,000 pesos instead, the
auditor will be required to accumulate more evidence.
• Notes payable with zero tolerable misstatement is set by the auditor.
The auditor is required to confirm all notes payable. Any misstatement is
considered material.
 STEP 3:
Estimate the total misstatement in segment.

✓ Evidence used as basis for estimation of

misstatement for each segment
✓ Estimated misstatement amount for each
segment
✓ Direct projection estimate of misstatement
✓ Sampling error
Evidence used as basis for estimation
of misstatement for each segment
▪ When the auditor performs audit procedures for each segment
of the audit, worksheet is kept for all misstatements found.
▪ For example, assume the auditor finds six client misstatements
in a sample of 200 in testing inventory costs. These
misstatements are used to estimate the total misstatements in
inventory. The total is called an estimate or often a “projection”
because only a sample, rather than an entire population, was
audited.
Terminologies

Estimated Misstatement The amount of misstatements that the auditor estimates is in

the population (direct projection estimate of misstatement plus
Amount sampling error).

Direct Projection Estimate Number of possible misstatements that may be detected if the
of Misstatement entire population is examined.

Occurs when an auditor does select a sample that represents the

Sampling Error entire population of data and the results found in the sample do
not represents that would be obtained from the entire
population.
Illustration
Assume that an auditor found 3,500 pesos of net overstatement amounts in
a sample of 50,000 pesos of the total population of 450,000 pesos. One way
to calculate the estimate of the misstatements is to make a direct projection
from the sample to the population and add an estimate for sampling error.
Comparing Estimated Misstatement Amount To
Tolerable Misstatement (Situation 1)
Comparing Estimated Misstatement Amount To
Tolerable Misstatement (Situation 2)
 Lesson 1
RISKS AND ITS RELATIONSHIP
TO MATERIALITY
 TYPES OF RISKS
Planned
Inherent Risk
Detection Risk
A measure of the risk that audit evidence for A measure of the auditor’s assessment of the
a segment will fail to detect misstatements likelihood that there are material misstatements
exceeding a tolerable amount, should such (errors or fraud) in a segment before
misstatements exist. considering the effectiveness of internal control.

Acceptable
Control Risk Audit Risk

A measure of the auditor’s assessment of the A measure of how willing the auditor is to accept
likelihood that misstatements exceeding tolerable that the financial statements may be materially
amount in a segment will not be prevented or misstated after the audit is completed and an
detected by the client’s internal controls. unqualified opinion has been issued.
Assessing Acceptable Audit Risk
1. The degree to which external users rely on the financial statements.
2. The likelihood that a client will have financial difficulties after the
audit report is issued.
3. The auditor’s evaluation of management’s integrity.

A low acceptable audit risk assessment means a “risky” client

requiring more extensive evidence, assignment of more
experienced personnel, and/or a more extensive review of
audit documentation. As audit progresses, additional
information about the client is obtained, and acceptable audit
risk may be modified.
Assessing Inherent Risk
1. Nature of client’s business
2. Results of previous audits
3. Initial versus repeat engagement
4. Related parties
5. Non-routine transactions
6. Judgment required to correctly record account balance and
transactions.
7. Makeup of the population.
END OF PRESENTATION

Q&A
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THANK YOU.
References
• Auditing & Assurance Services (A Systematic Approach) 4th Edition by Messier, Glover, and Prawitt
• Fundamentals of Auditing and Assurance Services 11th Edition by Alvin A. Arens, Randal J. Elder,
and Mark S. Beasley
• Philippine Standards on Auditing
• www.investopedia.com
• http://revista.cafr.ro/temp/Article_9503.pdf