MATERIALITY AND

AUDIT RISK
 OBJECTIVES
1. Define and explain materiality
2. Define and explain audit risk
3. Explain the fundamental concepts of materiality and audit risk
4. Determine how materiality and audit risk affect the nature and timing of audit
procedures
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MATERIALITY
Material omissions or misstatements of items are
material if they could, individually or collectively,
influence the economic decisions that users make
on the basis of the financial statements

Materiality depends on the size and nature of the

omission or misstatement judged in the surrounding
circumstances
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MATERIALITY
While an auditor should consider the needs of the
users of an entity’s financial statements when
determining the appropriate benchmark, they should
consider nature of the entity and the industry in
which it operates as a factor on which to base their
materiality calculations

Generally, Profit Before Tax is considered to be the

most important metric for any user of the FS.

Materiality can be set in a range of 3 to 10 percent

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MATERIALITY
Three types of materiality for audits:
MATERIALITY DEFINITION
Overall materiality “Materiality level of the FS as a whole”; It is the
highest amount of misstatements that could be
included in the FS without affecting the economic
decisions of the users
Specific materiality “Materiality level for particular transactions, account
balances and disclosures”

Performance materiality It is used by the auditor to reduce the risk to an

appropriate low level that the accumulation of
unidentified and uncorrected misstatements exceed
overall materiality and specific materiality
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APPLICATION OF MATERIALITY
Expensing vs. Depreciating Assets

A company that uses capitalization limit fully

expenses immaterial items when they are
purchased rather than depreciating them over their
useful life

Example: Office supplies are directly recorded as

office supplies expense than prepayments
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AUDIT RISK
Audit risk is a function of the risks of material
misstatement and detection risk

Audit Risk = Inherent risk x Control risk x Detection risk

The assessment of risks is based on audit procedures to

obtain information necessary for that purpose and
evidence obtained throughout the audit

Assessment of risks is a matter of professional judgment

rather than a matter capable of precise measurement
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RISK OF MATERIAL MISSTATEMENT

Risk of Material Misstatement (ROMM) may

exists in two levels:

1. The overall financial statement level

2. The assertion level for classes of

transactions, account balances, and
disclosures
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RISK OF MATERIAL MISSTATEMENT

Risk of material misstatement at the overall

financial statement level refer to ROMM that
relate pervasively to the financial statements
as a whole and potentially affect many
assertions (Existence, Completeness, Rights
and Obligations, Valuation and Presentation
and Disclosure)
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EXISTENCE OR OCCURRENCE
Existence asserts that each balance sheet and income
statement balances actually exists

Occurrence asserts that each of the income statement

events and transactions actually did occur

Audit procedures for the existence assertion are verify

cash with banks, physical count of inventories and external
confirmation of receivables, vouching transactions

Audit procedures for occurrence transactions ensure that

reported sales are not fraudulent
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RIGHTS AND OBLIGATIONS

Rights and obligations asserts that management have
ownership rights for all amounts reported as assets on the
company’s balance sheet and the amounts reported as
liabilities represents the company’s own obligations

Ownership does not immediately mean possession in the

case of inventories on consignment from a consignor

Obligations must be properly disclosed in the financial

statements
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COMPLETENESS OR CUT OFF

Completeness asserts that all transactions, events, assets,
liabilities and equities that should have been recorded
have been recorded.

Completeness asserts that all disclosures that should have

been included in the footnotes have been presented

Cut off refers to accounting for revenue, expense and

other transactions in the proper period

Audit procedure for completeness is tracing (source

document to accounting records
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VOUCHING AND TRACING

Vouching is to address the existence assertion
Tracing is used to address the completeness assertion
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VALUATION AND ALLOCATION

Valuation and allocation asserts that transaction and

events have been recorded accurately and that assets,
liabilities, and equity have been valued in accordance with
applicable financial reporting framework

Audit procedures for valuation include comparing vendor

invoices with inventory prices, obtaining lower of cost or
net realizable value of inventories, evaluating collectability
of receivables and recalculating depreciation
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PRESENTATION AND DISCLOSURE

Presentation and disclosure asserts that all transactions

and events have been presented correctly in accordance
with applicable financial reporting framework and that all
relevant information has been disclosed to financial
statement users

Audit procedures include analyzing repairs and

maintenance to ensure that it has been expensed rather
than capitalized
FINANCIAL STATEMENT ASSERTION 16
FINANCIAL STATEMENT ASSERTION 17
FINANCIAL STATEMENT ASSERTION
18
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RISK OF MATERIAL MISSTATEMENT

Risk of material misstatement at the assertion

level consists of two components:

• Inherent risks
• Control risks

Inherent and control risks are the entity’s risk

meaning they are independent from the audit
of financial statements
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RISK OF MATERIAL MISSTATEMENT

INHERENT RISK

Inherent risk is higher for some assertions and

related classes of transactions, account
balances and disclosures than for others.

It may be higher for complex calculations or for

accounts consisting of amounts derived from
accounting estimates that are subject to
significant estimation uncertainty
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RISK OF MATERIAL MISSTATEMENT

INHERENT RISK

External circumstances give rise to business risks

may also influence inherent risks:

• Obsolescence of products due to technological

development can overstate inventories
• Insufficient working capital
• Declining industry (large number of business
failures
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RISK OF MATERIAL MISSTATEMENT

CONTROL RISK

It is a function of the effectiveness of the design,

implementation and maintenance of internal control
by management to address identified risks that
threaten the achievement of the entity’s objectives
relevant to the preparation of the entity’s financial
statements
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RISK OF MATERIAL MISSTATEMENT

CONTROL RISK

A well designed and operated internal control can

only reduce, but not eliminate, risks of material
misstatement in the financial statements due to
inherent limitations of the internal controls
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RISK OF MATERIAL MISSTATEMENT

Inherent limitations of internal controls:

1. Possibility of human errors or mistakes

2. Controls being circumvented by collusion
3. Inappropriate management override
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DETECTION RISK

Detection risk relates to the nature, timing,

and extent of the auditor’s procedures that
are determined by the auditor to reduce audit
risk to an acceptably low level. It is a function
of the effectiveness of an audit procedure and
its application by the auditor
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DETECTION RISK

The acceptable level of detection risk bears

an inverse relationship to the assessed risk of
material misstatement in the assertion level
(inherent and control risk)

Hence, the greater the ROMM, the less

detection risk that can be accepted and more
persuasive the audit evidence required by the
auditor
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INHERENT LIMITATIONS OF AN AUDIT

Inherent limitations of an audit arise from:

1. Nature of financial reporting
2. Nature of audit procedures
3. The need for the audit to be conducted
within a reasonable period of time and at a
reasonable cost
4. Most audit evidence are persuasive rather
than conclusive
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NATURE OF FINANCIAL REPORTING

The preparation of financial statements

involves judgment by management in
applying the requirements of the entity’s
applicable financial reporting framework to the
facts and circumstances of the entity

Example: (Accounting estimates for doubtful

accounts, depreciation and amortization)
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NATURE OF AUDIT PROCEDURES

There are practical and legal limitations on the auditor’s

ability to obtain audit evidence:

• There is a possibility that management may not

provide the complete information that is relevant to
the preparation and presentation of the FS
• Fraud may involve sophisticated and carefully
organized schemes designed to conceal it
• An audit is not an official investigation into alleged
wrongdoing. The auditor is not given specific legal
powers, such as the power to search
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TIMELINESS OF FINANCIAL REPORTING AND

THE BALANCE BETWEEN BENEFIT AND COST

The matter of difficulty, time or cost involved is not a

valid basis for the auditor to omit an audit procedure for
which there is no alternative or to be satisfied with audit
evidence that is less than persuasive

Appropriate planning assists in making sufficient time

and resources available for the conduct of the audit
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TIMELINESS OF FINANCIAL REPORTING AND

THE BALANCE BETWEEN BENEFIT AND COST

It is necessary for the auditor to:

• Plan the audit so that it will be performed in an

effective manner
• Direct audit effort to areas most expected to contain
ROMM
• Use testing and other means of examining
populations for misstatements
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CONDUCT OF AN AUDIT IN ACCORDANCE

WITH PSA’S

1. The PSA provide the standards for the auditor’s work

in fulfilling the overall objectives of the auditor
2. The scope, effective date and any specific limitation
of the applicability of a specific PSA is made clear in
the PSA
3. In performing the audit, the auditor may be required
to comply with legal or regulatory requirements in
addition to PSA
4. The auditor may also conduct the audit in
accordance with both PSAs and auditing standards
of a specific jurisdiction or country