AUDITING
CHAPTER 2
Standards, Materiality, &
Risk
By
David N. Ricchiute
TOPICS
Audit & Attestation standards
Auditing concepts
Audit risk
Materiality in financial
statement audit
2 GBW Ch. 2 8th ed
EARLY DEVELOPMENT OF
STANDARDS
1941 Accounting Series Release
(ASR)#21
SEC requires audit report
Audit conducted in accordance with
generally accepted standards
1948 AICPA approves generally
accepted auditing standards (GAAS)
3 GBW Ch. 2 8th ed
RECENT DEVELOPMENT
OF STANDARDS
1970s practitioners criticized GAAS
as not sufficiently specific
1986 Attestation standards
developed
Umbrella for engagement standards
GAAS applies exclusively to financial
statement audits
4 GBW Ch. 2 8th ed
COMPARING GAAS &
ATTESTATION
Attestation GAAS
Broad range of Financial
engagements statement audit
including audit
Umbrella for all attest Audit one of
services many attest
engagements
5 GBW Ch. 2 8th ed
GENERAL STANDARDS
Attestation GAAS
Adequate technical training Adequate technical
training
Adequate knowledge
Assertion can be evaluated
by reasonable criteria &
consistently measured or
estimated
Independence in mental Independence in
attitude mental attitude
Due professional care Due professional care
6 GBW Ch. 2 8th ed
FIELDWORK
STANDARDS
Attestation GAAS
Adequately planned & Adequately planned &
supervised supervised
Understanding internal
control
Sufficient evidence Sufficient competent
evidential matter
7 GBW Ch. 2 8th ed
REPORTING
STANDARDS
Attestation GAAS
Assertion identified
Conclusion about Conclusion about
conformity with conformity with GAAP
established criteria Consistent use of GAAP
State significant Adequate informative
reservations disclosures
Opinion on statements
Limited use to parties as a whole
agreeing on procedures
8 GBW Ch. 2 8th ed
STANDARDS FOR PUBLIC
COMPANY ENGAGEMENTS
Sarbanes-Oxley Act of 2002
Creates Public Company Accounting
Oversight Board (PCAOB)
Delegates authority to PCAOB to
Oversee, regulate accounting and auditing
professions
Develop accounting, auditing standards or
Accept accounting standards from FASB
Accept auditing standards from AICPA
9 GBW Ch. 2 8th ed
AUDITING CONCEPTS
Independence
Due care
Evidence
Reporting
10 GBW Ch. 2 8th ed
INDEPENDENCE
EXPLAINED
In fact
State of mind
Attitude of impartiality
In appearance
Free of overt interest in client
11 GBW Ch. 2 8th ed
CONSULTING & PUBLIC
COMPANY ENGAGEMENTS
2000
… consulting & other services may shorten
the distance between the auditor &
management. Independence—if not in fact,
then certainly in appearance—becomes a
more elusive proposition. … In this dual
role, the auditor, who guards the integrity
of the numbers, now both oversees &
answers to management.
Arthur Levitt, Jr., “Renewing the Covenant with Investors”
Speech at NYU Center for Law & Business, 5/10/00.
12 GBW Ch. 2 8th ed
SEC PUBLIC COMPANIES
INDEPENDENCE REFORMS
2000
Engagement team model of
independence
Team & immediate family prohibited from
investments in clients
Increased restrictions for IT and internal
audit consulting
Required disclosure audit/nonaudit fees
in proxy statement
13 GBW Ch. 2 8th ed
SARBANES-OXLEY, &
INDEPENDENCE 2002
Establishes PCAOB
Addresses accountability for
corporate & criminal fraud
Limits audit firm’s consulting
services to public company
clients
Client board of directors to
approve consulting services
provided by auditor
14 GBW Ch. 2 8th ed
SERVICES PROHIBITED BY
SARBANES-OXLEY
For public companies:
Bookkeeping, other accounting services
Information systems design,
implementation
Valuation or appraisal services
Actuarial services
Internal audit outsourcing services
Management functions, human
resources
Broker, dealer, investment advisor
Legal, expert services
Other services to be determined
15 GBW Ch. 2 8th ed
SEC, INDEPENDENCE, &
PUBLIC COMPANIES 2003
Further independence regulations
Rotate engagement partner 5-7 years
Restrict firm’s independence for 1
year when client hires member of
audit team
Violates independence if auditor’s
compensation based on selling service
other than attest
Require auditor report certain matters
to client’s audit committee
Critical accounting policies
16 GBW Ch. 2 8th ed
DUE CARE EXPLAINED
Care when providing
professional services
Adequate training for
professional services
17 GBW Ch. 2 8th ed
DUE CARE IN LAW
Every man who offers his service to another & is
employed assumes the duty to exercise such
skill as he possesses with reasonable care &
diligence. …if one offers his service, he is
understood as holding himself out to the public
as possessing the degree of skill commonly
possessed by others in the same employment
& if his pretensions are unfounded, he
commits a species of fraud upon every man
who employs him . . .
Cooley on Torts
18 GBW Ch. 2 8th ed
DUE CARE &
WORLDCOM 2002
2nd largest long-distance carrier restated
financial statements for 5 quarters
Network access fees capitalized instead of
expensed
Overstated net income by $11 billion
Overstated balance sheet by $75 billion
Not GAAP
Auditor knew but did not challenge
19 GBW Ch. 2 8th ed
DUE CARE &PRUDENT
PRACTITIONER
Foresee unreasonable risk to others
Attend to extra risks
Consider unusual circumstances or
relationships
Identify unfamiliar situation & take
precautions
Resolve doubt
Keep current
Review work of assistants
20 GBW Ch. 2 8th ed
DUE CARE
OPERATIONALIZED
Auditor obtains knowledge of
business to understand events,
transactions, practices with
significant effect on financial
statements
Plan audit to limit audit risk to
low level
Assess possible errors on
balance sheet
21 GBW Ch. 2 8th ed
EVIDENCE EXPLAINED
Underlying accounting data
Journals, ledgers,
reconciliations, accounting
manuals
Corroborating information
Receiving reports, invoices,
contracts, representations
from 3rd parties
22 GBW Ch. 2 8th ed
EVIDENCE
Basis for all decisions
Evidential matter
Planning & supervision
Internal control
23 GBW Ch. 2 8th ed
SUFFICIENCY &
COMPETENCE
Sufficiency
Quantity useful evidence collected at
reasonable cost
Competence
Validity: varies with source
Relevance: related to assertion
24 GBW Ch. 2 8th ed
EVIDENCE HIERARCHY
Independent sources more reliable than
management
Banks, debtors
Evidence obtained directly more
persuasive than indirect evidence from
management
Physical examination, observation,
computation, inspection
Effective internal control systems
produce more reliable evidence
25 GBW Ch. 2 8th ed
SUPERVISION
EXPLAINED
Planning
Developing objectives & strategy
Supervision
Directing assistants toward
objectives
Determining when objectives
are met
26 GBW Ch. 2 8th ed
INTERNAL CONTROL
Policies & procedures of management &
board of directors
Provides reasonable assurance their
objectives will be achieved
Auditor must understand client’s
internal controls
To plan audit
To design audit tests
27 GBW Ch. 2 8th ed
REPORTING EXPLAINED
Report states conclusion
Attestation report
Whether management’s assertion
conforms with stated criteria
Audit report
Whether financial statements conform
to GAAP
28 GBW Ch. 2 8th ed
AUDIT REPORT
CONCLUSION
In our opinion, the financial
statements referred to above
present fairly, in all material
respects, the financial position of the
company . . ., & the results of its
operations and its cash flows . . ., in
conformity with generally accepted
accounting principles.
29 GBW Ch. 2 8th ed
STRATEGY FOR RISK
Risk of omissions or misstatements
Design engagement to control material
omissions or misstatements
Provide reasonable not absolute
assurance of detecting omissions or
misstatements
30 GBW Ch. 2 8th ed
ATTESTATION RISK
Probability that attester may
unknowingly fail to modify a written
conclusion about an assertion that is
materially misstated
D. N. Ricchiute, Auditing, 8th ed.
31 GBW Ch. 2 8th ed
AUDIT RISK
Probability that auditor may
unknowingly fail to modify opinion
on financial statements that are
materially misstated
D. N. Ricchiute, Auditing, 8th ed.
32 GBW Ch. 2 8th ed
COMPONENTS OF
AUDIT RISK
Client sources of risk
Inherent risk
Control risk
Auditor source of risk
Detection risk
33 GBW Ch. 2 8th ed
COMPONENTS OF
AUDIT RISK DEFINED
Inherent risk
Risk that errors will occur
Control risk
Risk that internal controls won’t prevent,
detect, correct errors
Detection risk
Risk that audit procedures won’t find
errors
34 GBW Ch. 2 8th ed
INHERENT RISK
SOURCES
Risk that errors will occur
Business
Industry
Management’s predisposition
to manage earnings
Aggressive use of GAAP
Specific accounts
Liquid assets vs. nonliquid assets
35 GBW Ch. 2 8th ed
CONTROL RISK
SOURCES
Risk that internal controls won’t
prevent, detect, correct errors
Outdated technology
Outdated software
Lack of respect for controls by top
management
36 GBW Ch. 2 8th ed
DETECTION RISK
SOURCES
Likelihood that errors could occur
and not be detected by audit
procedures
Nature of audit procedures
Extent of audit procedures
Timing of audit procedures
Auditor’s judgment
37 GBW Ch. 2 8th ed
AUDIT RISK MODEL:
SAS No. 47
AR = IR x CR x DR
DR = AR
IR x CR
38 GBW Ch. 2 8th ed
AUDITOR’S BUSINESS
RISK
The probability that a practitioner
might incur damages despite
issuing an appropriate report
Ex.: litigation
Factors affecting auditor’s
business risk
Aggressive financial reporting
Management integrity or reputation
Conflicts of interest & regulatory
problems
Industry characteristics
39 GBW Ch. 2 8th ed
AUDITOR’S RESPONSE
TO BUSINESS RISK
If business risk is higher, adjust audit
risk assessment
Set audit risk lower
Decrease acceptable level of detection risk
Increase evidence
Drop client
If assurance levels all same, do not
adjust audit risk
40 GBW Ch. 2 8th ed
AUDIT FAILURE
DEFINED
Failing to perform procedures that
would reduce audit risk to a
relatively low level
Ex.: Sunbeam
Sunbeam’s auditor a) identified
reserves not in compliance with
GAAP; b) proposed adjustments which
management rejected; c) accepted
reserves as stated after incorrectly
applying materiality analysis
41 GBW Ch. 2 8th ed
MATERIALITY
The magnitude or an omission or
misstatement of accounting
information that, in the judgment of
a reasonable person relying on the
information, would have been
changed or influenced by the
omission or misstatement.1
Statement of Financial Accounting Standards No. 2, “Qualitative
Characteristics of Accounting Information,” Stamford: FASB, 1980, par
132.
42 GBW Ch. 2 8th ed
MATERIALITY IN
PRACTICE
Preliminary estimate of materiality
for planning guides audit effort,
evidence collection
SAS No. 22, “Planning & Supervision”
43 GBW Ch. 2 8th ed
AUDIT RISK,
MATERIALITY, AUDIT
EFFORT
Inverse relationship between audit
risk and materiality
Low audit risk suggests it would take
larger amounts to be material
Inverse relationship between
materiality and audit effort (hours
worked)
Higher materiality threshold suggests
less audit effort
44 GBW Ch. 2 8th ed
QUANTITATIVE
MATERIALITY CRITERIA
Effect on
Net income
Total assets
Total revenue
45 GBW Ch. 2 8th ed
SAS 99 ON
MATERIALITY
Auditors should
Not rely solely on quantitative
materiality criteria
Judge materiality of misstatements
both individually & in aggregate
Recognize that intentional but
immaterial misstatements are
inappropriate & may be unlawful
46 GBW Ch. 2 8th ed
MATERIALITY
CONSIDERATIONS
Misstatement may not be immaterial if:
Affects debt compliance requirements
Masks change in earnings
Conceals unlawful transaction
Prompts undue expectations
Hides failure to meet analysts’ expectations
Associated with an estimate
Affects management’s compensation
47 GBW Ch. 2 8th ed
ALLOCATING
PRELIMINARY
MATERIALITY ESTIMATES
On the basis of
Relative magnitude of financial
statement accounts
Relative variability of financial
statement accounts
Professional judgment
48 GBW Ch. 2 8th ed
