Auditing I

Materiality and Audit Risk

By:
Group 4
Eka Setyaningsih (141521474)
Natya Nindyagitaya (141521573)

Atma Jaya Yogyakarta University

Faculty of Economics
2016

The Financial Accounting Standards Board defines materiality as the magnitude of an

omission or misstatements of accounting information, in the light of surrounding circumstance,
make it probable that the judgement of a reasonable person relying on the information would
have been changed or influenced by the omission or misstatement. In other word, materiality is
the bigness of omission or misstatement that can influence the user in making decisions.
Materiality levels of one entity to another are different. When the misstatement is significant to
change or influence informed user decision, it means material misstatements already happen.
Materiality is not an absolute number. Materiality lies in the gray area between what might be
immaterial and what might be material. Therefore, the risk assessment about materiality is
always a matter of professional judgment.
Auditors make preliminary judgments about materiality for two purposes. First, they
make preliminary judgments about materiality in order to make decisions about the scope of
audit procedures or to determine materiality levels of audit planning. Second, the auditor makes
judgments about materiality to evaluate whether known misstatements are significant enough to
require the entity to adjust the financial statements ar the auditor will issue a qualified opinion. In
this chapter we focus on the first purpose. In planning an audit, the auditor should assess
materiality at two levels. There are the financial statement levels and the account balance level.
Financial statement materiality is the minimum aggregate misstatement in a financial
statement that is important enough to prevent statement from not being presented fairly in
conformity with GAAP. In audit planning, the auditor should recognize that there may be more
than one level of materiality relating to the financial statements. In making a preliminary
judgment about materiality, the auditor initially determines the overall level of materiality for
each statement. Materiality judgments involve both quantitative and qualitative considerations.
There is no official guidelines on quantitative measures of materiality.
Account balance materiality is the minimum misstatement that can exit in an account
balance for it to be considered materially misstated. Misstatement up to that level is known as
tolerable misstatement. In making judgments about materiality at the account balance level, the
auditor must consider the relationship between it and financial statement materiality. This
consideration should lead the auditor to plan the audit to detect misstatements that may be
immaterial individually, but that, when aggregated with misstatements in other account balances,
may be material to the financial statements taken as a whole.

When the auditors preliminary judgments about financial statement materiality are
quantified, a preliminary estimate of materiality for each account may be obtained by allocating
financial statement materiality to individual accounts. In making the allocation, the auditor
should consider the amount of misstatement that would influence a financial statement user and
the probabel cost of verifying the account.
Actually materiality is related to audit evidence. The relationship is the larger or more
significant account balance is, the greater the amount of evidence needed. At the end of the audit,
the auditor first reevaluates materiality at the financial statement level given new knowledge that
may be obtained at the end of the audit. Then, the auditor needs to consider the evidence
obtained during the audit. Evidence is often obtained through sampling plans, and when
sampling is used the results of a sample need to be projected on the entire population. When
evaluating the significance of known and projected misstatements, the auditor should also
consider qualitative issues.
Materiality and audit risk are closely related. Both of them become an important
consideration in an audit process. Audit risk is the risk that the auditor may unknowingly fail to
appropriately modify his or her opinion on financial statements that are materially misstated. In
other word, audit risk is a possibility of the auditor to give an inappropriate audit opinion on
financial statements that contain of material misstatements. The auditor controls neither inherent
risk nor control risk. The auditor performs risk assessment procedures to develop knowledgeable
perspective about risk factors that are present in a clients situation.
To implement the concept of materiality in an audit process, there are three steps. First,
risk assessment. In this step, the auditor should determine the two kind of materiality, there are
materiality for financial statements as a whole and performance materiality. Materiality for
financial statements as a whole or referred as the overall materiality based on the perspective of
the auditor. In general, it is determined as many as the number of materiality that used by the
financial statements maker. With the professional judgement, the auditor will establish the
highest number of materiality of misstatements. So it will not influence economic decisions.
Materiality performance enables the auditor to handle the risk of misstatements on the type of
transaction, account balances, or disclosures without changing the overall materiality. Materiality
performance enables the auditor to establish the number of materiality based on the overall
materiality, but lower than it. this lower level has a function as the buffer between materiality
performance and overall performance. In several situations, misstatements can be smaller than

the materiality of financial statements as a whole but has an impact to the informed users
decision. Specific materiality performance is determined lower than specific materiality.
Then plan procedures of risk assessment that should be performed and identify and assess
the risk of material misstatement. The auditor should perform the following procedures to
identify the risk of material misstatement. First, make inquiries of management and others within
the entity to obtain their views about the risk of fraud and how it is addressed. Auditors usually
begin by making inquiries of management about their awareness of fraud risk and programs that
have been put in a place to prevent or detect fraud. Second, consider any unusual or unexpected
relationships that have been identified in performing analytical procedures in audit planning.
Third, consider other information obtained while planning the audit.
The second step is risk respond. In this step, the auditor determines the nature, the timing,
and the extent of further audit procedures. Then change the number of materiality due to the
change in circumstances during the audit processing. And the third step is reporting. In this step,
the auditor evaluates misstatements that have not been corrected by the entity and formulate the
auditor opinion.
As we know, there are three components of audit risk, they are inherent risk, control risk
and detection risk. There are several reasons why the audit risk concept is important. First, it
provides a framework for making decisions about the risk of financial statement misstatement.
Second, the audit risk model provides a framework for making decisions about the appropriate
level of detection risk.
Audit risk model expresses the relationship among the audit risk components as follows:
AR = IR x CR x DR

AR = Audit Risk
IR = Inherent Risk
CR = Control Risk
DR = Detection Risk
According to the appendix to AU 350, Audit Sampling (SAS Nos. 39, 43, and 45),
detection risk consists of two components: AP (Analytical Procedures) risk and TD (Test of
Details) risk. Analytical procedures risk is the risk that substantive analytical procedures will fail
to detect material misstatements in the financial statements. Test of details risk is the risk that test
of details of transactions and balances will fail to detect material misstatements in the financial
statements. Thus, the relationship can be expressed as follows:

AR = IR x CR x AP x TD

If auditors use non-quantitative expressions for risk, they use a risk components matrix.
The acceptable levels of test of details risk are inversely related to inherent, control, and
analytical procedures risk assessments.

The matrix assumes that audit risk is restricted to a low level. For example, if inherent risk is
assessed at the maximum, control risk is at moderate, and analytical procedures risk at moderate,
the acceptabel elvel of detection risk for test of details is low.
There are some steps involved in using the audit risk model. First, auditors should
develop a knowldegeable perspective about the risk of misstatement in the financial statement. In
this step, auditor should assess inherent risk, control risk, and consider the effects of the risk of
fraud on inherent and control risk assessments. Second, determine an appropriate level of
analytical procedure risk. Third, plan tests of details risk to restrict audit risk to an appropriately
low level.
Inherent risk is the susceptibility of an assertion to a material misstatement, assuming that
there are no controls. There are two types of risks that auditor should consider in making
decision about inherent risk, they are risks that have a pervasive effect on the financial

statements and may affect many accounts and assertions and risks that may pertain only to a
specific assertion for a specific account. When the risk factors are identified, the auditor should
evaluate whether they are of a magnitude and a likelihood that they will result in material
misstatements in the financial statements. Furthermore, if significant inherent risks are identified,
the auditor should respond by obtaining evidence about internal control during the current audit
period and by obtaining significant evidence through tests of details of transactions and balances.
GAAS state that the auditor should determine which of the identified risks are, in the
auditors judgment, significant inherent risks that require special audit consideration. Some
examples of significant inherent risks are the risk of fraud; recent economic, accounting, or other
developments that require special attention; or a complex transaction. The auditor should identify
significant inherent risks during audit planning and respond to it. There are four auditors
responses to significant inherent risks: (1) assessing inherent risk as maximum or high for
relevant assertions, (2) obtaining evidence about the effectiveness of design of internal controls
related to the assertion, (3) ensuring that evidence about internal controls over significant
inherent risks is obtained during the current audit period, and (4) obtaining significant evidence
through tests of details of transactions and balances.
Control risk is the risk that a material misstatement could occur in an assertion will not be
prevented or detected on a timely basis by the entitys internal controls. To reduce control risk,
there must be an effective internal controls over an assertion. Control risk can never be zero
because internal controls cannot provide compete assurance that all material misstatements will
be prevented or detected. Also for this reason, auditors cannot change the actual level of control
risk for an assertion. However, auditors can vary the assessed level of control risk by modifying
the procedures used to obtain an understanding of the internal controls related to the assertion
and the procedures used to perform tests of controls. In assessing control risk, an auditor
determines a planned assessed level of control risk. It is based on assumptions about the
effectiveness of the design and operation of the clients internal controls. An actual assessed level
of control risk is subsequently determined for each assertion based on evidence obtained from
the study and evaluation of the clients system of internal control when performing further audit
procedures.
Detection risk is the risk that the auditor will not detect a material misstatement that
exists in an assertion. As we know, detection risk consists of analytical procedures risk and tests

of details risk. Both of them are controlled by the effectiveness of auditing procedures and their
application by the auditor and can be changed by the auditor. To decrease detection risk, there
must be an effective audit procedures and also substantive tests performed at or near the balance
sheet date. In the planning phase of the audit, a planned acceptable level of detection risk for
analytical procedures and for tests of details is determined for each significant assertion using the
audit risk model discussed previously.
Actually audit risk is inversely related to audit evidence. The inverse relationship is the
lower the level of detection risk to be achieved, the greater the amount of evidence needed.
Besides, there is also an interrelationship among materiality, detection risk, and substantive audit
evidence. It is if we want to reduce detection risk, the auditor must obtain more persuasive
evidence from substantive audit tests while holding the materiality level constant.