9-25 a.

b.

c.

d.

The justification for a lower preliminary judgment about materiality for

overstatements is directly related to legal liability and audit risk. Most
auditors believe they have a greater legal and professional responsibility
to discover overstatements of owners' equity than understatements
because users are likely to be more critical of overstatements. That does
not imply there is no responsibility for understatements.
There are two reasons for permitting the sum of tolerable misstatements
to exceed overall materiality. First, it is unlikely that all accounts will be
misstated by the full amount of tolerable misstatement. Second, some
accounts are likely to be overstated while others are likely to be
understated, resulting in net misstatement that is likely to be less than
overall materiality.
This results because of the estimate of sampling error for each account.
For example, the likely estimate of accounts receivable is an
understatement of $7,500 + or - a sampling error of $11,500. You would be
most concerned about understatement for accounts receivable because
the estimated understatement of $19,000 exceeds the tolerable
misstatement of $18,000 for that account.
You would be most concerned about understatement amounts since the
total estimated understatement amount ($30,000) exceeds the preliminary
judgment about materiality for understatements ($20,000). You would be
most concerned about accounts receivable given that the total
misstatement for that account exceeds tolerable misstatement for
understatement.

e.
1.
2.

This may occur because total tolerable misstatement was allowed

to exceed the preliminary judgment (see Part b for explanation).
The auditor must determine whether the actual total overstatement
amount actually exceeds the preliminary judgment by performing
expanded audit tests or by requiring the client to make an
adjustment for estimated misstatements.

9-31

a.
Acceptable audit risk 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. This is the
risk that the auditor will give an incorrect audit opinion.
Inherent risk A measure of the auditor's assessment of the likelihood that
there are material misstatements in a segment before considering the
effectiveness of internal control. This risk relates to the auditor's
expectation of misstatements in the financial statements, ignoring internal
control.
Control risk A measure of the auditor's assessment of the likelihood that
misstatements exceeding a tolerable amount in a segment will not be
prevented or detected by the client's internal controls. This risk is related
to the effectiveness of a client's internal controls.
Planned detection risk A measure of the risk that audit evidence for a
segment will fail to detect misstatements exceeding a tolerable amount,
should such misstatements exist. In audit planning, this risk is determined
by using the other three factors in the risk model using the formula PDR =
AAR / (IR x CR).
b.
Acceptable Audit Risk
IR x CR
PDR = AAR / (IR x CR)
Planned Detection Risk
in percent

1
.05
1.00
.05
5%

2
.05
.24
.208

3
.05
.24
.208

4
.05
.06
.833

20.8% 20.8%

83.3%

5
.01
1.00
.01
1%

6
.01
.24
.042
4.2%

c.
1.
2.
3.
4.

Decrease; Compare the change from situation 1 to 5.

Increase; Compare the change from situation 1 to 2.
Increase; Compare the change from situation 1 to 2.
No effect; Compare the change from situation 2 to 3.

d.
Situation 5 will require the greatest amount of evidence because
the planned detection risk is smallest. Situation 4 will require the least
amount of evidence because the planned detection risk is highest. In
comparing those two extremes, notice that acceptable audit risk is lower
for situation 5, and both control and inherent risk are considerably higher.

9-34

a
b
c
d
e
f
g
h
i
j

CONTROL
RISK

INHERENT
RISK

ACCEPTABLE
AUDIT RISK

PLANNED
EVIDENCE

N
N
D
N
N
D
I
I
I
D

N or I
N
N
I
N
D
I
I
I
I

D
D
N
N
I
N
N
D
N
N

I
I
D
I
D
D
I
I
I
C

9-32

a.
Low, medium, and high for the four risks and planned evidence
have meaning only in comparison to each other. For example, an
acceptable audit risk that is high means the auditor is willing to accept
more risk than in a situation where there is medium risk without specifying
the precise percentage of risk. The same is true for the other three risk
factors and planned evidence.
b.
1

Acceptable Audit Risk

IR x CR

PDR = AAR / (IR x CR)

Planned Evidence

L = low, M = medium, H = high

c.

(1)
(2)
(3)
(4)
(5)

EFFECT ON
PDR

EFFECT ON
EVIDENCE

Increase
Decrease
NA
Decrease
No effect

Decrease
Increase
Decrease
Increase
No effect