AU Section 312 - Audit Risk and Materiality

Audit Risk

AU Section 312 and 350 of the AICPA Professional Standards recognize that there is some uncertainty when an auditor provides an opinion on whether an entity's financial statements are fairly presented. This uncertainty is referred to as audit risk. Audit risk is a function of three risks, inherent, control, and detection risk. Inherent risk is the risk that a material misstatement will occur with a management assertion assuming no internal control. Control risk is the risk that a material misstatement will occur or not be prevented by entity internal control. Detection risk is the risk that a material misstatement with a management assertion will not be detected by the auditor's substantive tests. The mathematical formulation for audit risk is:

An auditor needs to consider these three risks to ensure that the overall risk of inappropriately issuing an unqualified opinion is limited to an appropriate level.

AU Section 312 and 319 of the AICPA Professional Standards indicates that the auditor use the assessed levels of control risk and inherent risk to determine the acceptable level for detection risk. Inherent risk is the risk that a material misstatement will occur with a management assertion assuming no internal control. Detection risk is the risk that a material misstatement with a management assertion will not be detected by the auditor's substantive tests. As the assessed level of control risk and inherent risk decrease the acceptable level for detection risk can increase. An increase in the acceptable level for detection risk reduces the assurances required from substantive tests. The auditor's objective in following this risk assessment process is to limit to an appropriate level the risk that an unqualified opinion will be issued when a material misstatement exists. This risk is referred to as audit risk. The mathematical formulation of this model for determining the nature, timing, and extent if substantive tests is as follows:

These risk assessments can be made in quantitative terms (i.e., 10%, 50%, 100%) or non-quantitative terms (i.e., Low, Medium, or High).

Materiality

The auditors' responsibility when conducting an audit is to provide reasonable assurance that the financial statements are fairly presented in all material respects. AU Section 312 of the AICPA Professional Standards notes that financial statements are materially misstated when they contain misstatements whose effect, individually or in the aggregate, results in financial statements that are not fairly presented. Materiality assessments are a matter of professional judgement requiring auditors to consider the needs of individual financial statement users.

Materiality should be considered by auditors when planning and evaluating the results of an audit. No authoritative guidance is provided on factors that should be considered when establishing materiality for planning or evaluation purposes. During the planning phase of an audit, auditors establish materiality to determine the nature, timing, and extent of audit procedures to perform. Auditors commonly establish a quantitative amount for materiality during the planning phase. This quantitative amount will be referred to as "planning materiality" as it can change if audit circumstances change. Factors to consider when establishing planning materiality include:

• Users of the financial statements (i.e., creditors, stockholders, suppliers, employees, customers, regulators),
• Size of financial statement elements (i.e., Current Assets, Current Liabilities, Total Assets, Total Revenues, Net Income),
• Trends (i.e., Earnings, Revenues, Cash Flows).

After establishing planning materiality for an audit, the auditor allocates planning materiality among various classes of transactions or financial statement elements. The amount of planning materiality allocated to individual financial statement elements or classes of transactions is described by AU Section 350 of the AICPA Professional Standards as "tolerable misstatement." Tolerable misstatement is the amount an individual financial statement account can differ from its true amount without affecting the fair presentation of the financial statements taken as a whole.

Planning materiality is allocated to classes of transactions or accounts because auditors normally group related transaction classes and accounts together and design and execute an audit strategy for each of these groupings (audit cycle approach). The level of tolerable misstatement assigned to an individual transaction class or account should be less than planning materiality. This allows the auditor to design an audit approach that provides reasonable assurance that the financial statements taken as a whole do not contain material misstatements (i.e., material misstatements do not exist after individual account misstatements are aggregated together). No authoritative guidance exists that describes the criteria auditors should consider when allocating planning materiality to financial statement elements. As a result, some practitioners simply allocate planning materiality in proportion to the size of balances of the various financial statement accounts. While commonly used, such an approach may not adequately control audit risk at the lowest cost because it fails to consider other important factors that are relevant to the allocation decision. Auditors may consider the following factors to allocate planning materiality:

• The cost of collecting evidence for a particular account,
• The competency of evidence available for a particular account,
• Expected misstatement,
• Size of account balances, and
• Relevance of the account balances to user decisions.

Auditors commonly allocate planning materiality to balance sheet accounts rather than income statement accounts because most income statement misstatements have an equal effect on the balance sheet. This result occurs because of the double-entry bookkeeping system.

While the tolerable misstatement assigned to a particular account is less than planning materiality the sum of tolerable misstatement assigned to all accounts is commonly greater than planning materiality. In many audits it is reasonable to expect that some individual accounts will be misstated less than tolerable misstatement and that misstatements across accounts will offset each other. This expectation is not reasonable when the auditor believes that there is a high likelihood of management fraud. If management is intentionally trying to misstate the financial statements it is likely that misstatements will be systematically biased in one direction. On the other hand, if management is not trying to misstate the financial statements it is likely that unintentional misstatements will occur haphazardly. A haphazard process should result in more misstatements offsetting each other than a systematically biased process. For example, intentional misstatements to improve profitability will have the same income increasing effects across accounts whereas unintentional misstatements generally will not. Therefore, the sum of tolerable misstatements can normally be higher than planning materiality when management fraud is not expected.