INTEGRATED CPA REVIEW – AUDITING J.

RAMIREZ

MODULE 7
IDENTIFYING AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENTS
THROUGH UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT

The risk of material misstatement may be separated into two components – inherent risk and control risk.

Inherent risk is the possibility of material misstatement of an assertion before considering the client’s
internal control. Factors that affect inherent risk relate to either the nature of the client and its environment
or the nature of the particular financial statement element.

In assessing inherent risk, it is often useful to segregate transactions into three types – routine, non routine
and estimation.

Routine transactions involve recurring financial statement activities recorded in the accounting records in
the normal course of business. This type of transactions restricts inherent risk, although controls certainly
must be implemented to assure proper recording.
Examples:
1. Sales
2. Purchases
3. Cash disbursements
4. Cash receipts
5. Payroll transactions

Non routine transactions involve activities that occur only periodically. Inherent risk may be high in this
type of transactions because they are not part of the normal flow of transactions and specialized skills may
be needed to perform the activity.
Examples:
1. Taking of physical inventories
2. Calculating depreciation expense
3. Adjusting financial statements for foreign currency gains and losses

Estimation transactions are those activities that create accounting estimates. These activities have high
inherent risk because they involve management judgments or assumptions.
Examples:
1. Estimating the allowance for uncollectible accounts.
2. Establishing warranty reserves
3. Assessing assets for impairment
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Control risk is the risk that a material misstatement could occur in a relevant assertion and not be
prevented or detected on a timely basis by the client’s internal control. It is a function of the effectiveness
of both the design and operation of internal control in achieving the client’s objectives relevant to the
preparation of financial statements.

Both inherent risk and control risk exist independently of the audit of financial statements. That is, the risk
of misstatement exists regardless of whether an audit is performed. The auditor may make separate
assessments of the two risks or an overall assessment of the risk of material misstatement for the relevant
assertions.

Detection risk is the risk that the auditor will fail to detect a material misstatement that exists in relevant
assertion. It is a function of the effectiveness of audit procedures and their application by the auditors.
Unlike inherent and control risk, it does not exist when no audit is performed. Rather than “assessing
detection risk”, auditors seek to restrict it through performance of substantive procedures.

Measuring Audit Risk

AR = IR x CR x DR

Audit Risk is the risk that the auditor gives an inappropriate audit opinion when the financial statements
are materially misstated.

In setting the desired audit risk, auditors seek an appropriate balance between the costs of an incorrect
audit opinion and the costs of performing the additional procedures necessary to reduce audit risk.

The first step involves obtaining an understanding of the entity and assessing the level of business risks.
Auditors then consider the effect these factors could have on the risk of material misstatements at the
financial statement level.

Relationship among risk components

Given that an auditor’s objective is to achieve an acceptably low level of audit risk as is practicable, and
recognizing the cost of performing audit procedures, there is an inverse relationship between the assessed
levels of inherent and control risks and the level of detection risk that the auditor can accept. Thus, if
inherent and control risks are assessed as being low, the auditor can tolerate a higher level of detection
risk, enabling a reduction in the extent of substantive procedures that must be undertaken. However, it is
important to note that an auditor may tolerate different levels of risks in different audits, depending on the
auditor’s professional judgment of the perceived consequences of the risks being taken.

The audit risk model provides a framework for auditors to follow in responding to these assessed risks
through their choice of audit procedures. PSAs are not specific on what is acceptable level of audit risk,
and use of the audit risk model requires a significant degree of judgment by the auditor. In relating the
components of audit risk, the auditor generally expresses each component in non-quantitative terms (low,
medium and high)
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Acceptable detection risk matrix

Auditor’s assessment
of
control risk
High Medium Low

High Lowest Lower Medium

Auditor’s
assessme Medium Lower Medium Higher
nt of
inherent
Low Medium Higher Highest
risk

Materiality
Materiality underlies the application of accounting and auditing standards and thus has a pervasive effect
in a financial statement audit. An auditor is able to give an unqualified audit opinion if the financial
statements are free from material misstatements. Materiality is particularly important for the auditor at two
of the key phases of the audit process: planning (determining the timing, nature, and extent of audit
procedures) and at the final stage when evaluating the extent of material misstatements as a basis of audit
opinion.

“Materiality means that an information which if omitted, misstated or not disclosed has the potential to
adversely affect decisions about the allocation of scarce resources made by users of the financial report or
discharge of accountability by management or the governing body of the entity.”

There is an inverse relationship between materiality and audit risk and the auditor should take the
relationship into consideration when determining the nature, timing and extent of audit procedures. Where
the auditor considers that there is a higher risk of misstatement, materiality will be set at a lower level.

Factors to consider what is material

1. Size of the item

Size must be considered in relative terms, for example, as a percentage of the relevant base (net
income, total assets, sales) rather than an absolute amount.
2. Nature of the item (qualitative characteristic)
a. The events or transactions giving rise to the misstatements.
b. The legality, sensitivity, normality and potential circumstances of the event or transaction
c. The identity of any other parties involved and
d. The amounts and disclosure notes affected.

3. Circumstances of occurrence.
a. The users of the accounting information’s economic decision-making process.
b. The context of the accounting information in which an item or error occurs.
4. Reliability, precision and amount of evidence
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Performance Materiality

This is set to reduce to an appropriately low level the probability that the aggregate of uncorrected and
undetected misstatements in the financial statements exceeds materiality for financial statements as a
whole.

Preliminary judgments about materiality

The auditor must assess the risks associated with each client and each audit engagement. As stated in PSA
315 Redrafted, the auditor shall identify and assess the risks of material misstatement at the financial
statement level and at the assertion level for classes of transactions, account balances and disclosures.

This assessment is referred to as “planning materiality” and may differ from the materiality levels used
at the conclusion of the audit in the evaluation of audit findings because surrounding circumstances may
change, and additional information about the entity will have been obtained during the course of the audit

The preliminary judgment or estimate about materiality represents the maximum amount by which
a set of financial statement could be misstated and still cause the auditor to believe that the decisions of
reasonable users would be affected. One of the common criteria in setting preliminary judgment about
materiality is the size of the client company.
Tolerable Misstatement

This is the amount of planning materiality that is allocated to an account balance or class of transactions.
The process of allocation may be done judgmentally or using formal quantitative approaches.
.
Materiality at the financial statement level

Quantitative guideline
In assessing quantitative importance of a misstatement, the auditor needs to relate the peso amount of the
error to the financial statements under examination. AASB provides some quantitative threshold guidance
to help determine materiality:
a. An amount that is equal to or greater than 10% of the appropriate base amount is presumed to be
material.
b. An amount that is equal to or less than 5% of the appropriate base amount is presumed not to be
material.
c. Whether an amount between 5% and 10% is material is a matter of professional judgment.

The resulting materiality amount in pesos is known as planning materiality.

Qualitative considerations
These relate to the causes of misstatements or to misstatements that do not have quantifiable effect. A
misstatement that is quantitatively immaterial may be qualitatively material.
a. The significance of the misstatement to the particular entity.
b. The pervasiveness of the misstatement.
c. The effect of misstatement on the financial statement as a whole.

Materiality at the account balance level

Account balance misstatement is the minimum misstatement that can exist in an account balance or it to
be considered materially misstated. Misstatement up to that level is known as “tolerable error”. This is
the amount of planning materiality that is allocated to an account balance or class of transactions. The
recorded balance of an account generally represents the upper limit on the amount by which an account
can be overstated. Thus accounts with balances smaller than materiality are sometimes said to be
immaterial in terms of risk of overstatements.
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Relationship between materiality and audit evidence

Materiality, like risk, is a key factor that affects the auditor’s judgment about the sufficiency of audit
evidence. It is generally correct to say, that the lower the materiality level, the greater the amount of
evidence that is needed (inverse relationship). This is also same as saying that it takes more audit evidence
to obtain reasonable assurance that any misstatement in the recorded inventory does not exceed P100,000
than it does to be assured the misstatement does not exceed P200,000. It is also generally correct to say
that the larger or more significant an account balance is, the greater the amount of evidence that is needed.
(direct relationship). This is also the same as saying that more evidence is needed for inventory when it
represents 30% of the total assets than when it represents 10%.

Using materiality to evaluate audit evidence

If there are misstatements in the accounts, then the auditor may perform additional audit procedures to
ask that management correct the errors. If the uncorrected errors exceed the materiality and management
refuses to make adjustments, then the auditor may consider issuing a qualified or adverse audit opinion.
The uncorrected aggregated misstatements (also known as likely misstatements) that the auditor needs
to examine when considering whether they misstate the financial statements include:
a. Specific misstatements identified by the auditor.
b. The auditor’s best estimates of the other misstatements that cannot be specifically identified (projected
errors).
Steps in Applying Materiality

During Planning

1. Establish a preliminary judgment about materiality.

2. Determine Tolerable Misstatement

At Audit Completion
3. Estimate likely misstatements and compare the totals to the preliminary judgment about
materiality.

Estimate Likely Misstatements and Preliminary Judgments about Materiality

In evaluating whether the financial statements are prepared, in all material respects, in accordance with an
applicable financial reporting framework, the auditor should assess whether the aggregate of uncorrected
misstatements that have been identified during the audit is material.

The aggregate of uncorrected misstatements which is also known as estimate likely misstatements
comprises:
1. Specific misstatements identified by the auditor including the net effect of uncorrected
misstatements identified during the audit or previous periods.
2. The auditor’s best estimate of other misstatements which cannot be specifically identified.

If the aggregate of the uncorrected misstatements that the auditor has identified approaches the
performance materiality level, the auditor would consider whether it is likely that undetected misstatements,
when taken with aggregate uncorrected misstatements could exceed materiality level, In such case, the
auditor would consider reducing audit risk by performing additional or extended procedures or by requesting
management to adjust financial statements for identified misstatements.
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Audit Strategies
The audit strategy significantly affects detailed work performed in the audit. The interrelationship among
audit evidence, materiality and the components of audit risk affects the auditor’s decision on the type of
audit strategy chosen – “predominantly substantive approach” and “lower assessed level of control risk
approach”.

If the auditor assesses that appropriate controls do not exist or are likely to be ineffective, then no reliance
can be placed on internal controls – control risk is assessed at relatively high level and therefore
“predominantly substantive approach” will be adopted. More substantive procedures will be performed. An
audit strategy that relies on internal controls to support the use of a reduced level of substantive procedures
is sometimes referred to as “lower assessed level of control risk approach” also known as “combined
approach”. This is not a single strategy, but a range of strategies determined by the relative effectiveness
of applicable control procedures (combined with assessments of inherent risk and materiality).

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