1) Set preliminary judgment about materiality

2) Allocate preliminary judgment about materiality to segments

3) Estimate total misstatement in segment

4) Estimate the combined misstatement

5) Compare combined estimate with preliminary or revised judgment about materiality

Steps 1-2 = Planning extent of tests

Steps 3-5 = Evaluating Results

require the auditor to decide on the combined amount of misstatements in the financial statements that they would consider material early in the audit as they are developing the overall strategy for the audit.  While a professional engagement, it may change during the engagement.

The judgement must be documented in the audt files. It is the maximum amount by which the auditor believes the statements could be misstated and not be material

Materiality is a relative rather than an absolute concept

Bases are needed for evaluationg materiality

Qualitative factors also affect materiality

is necessary because auditors accumulate evidence by segments rather than for the financial statements as a whole.

Materiality should be allocated only to balance sheet accounts.

1. Auditors expect certain accounts to have more misstatements than others

2. Both overstatements and understatements must be considered

3. Relative audit costs affect the allocation

1) The first are misstatements that arise from differences between management's and the auditor's judgment about estimates of account balances

2) The second are projections of misstatements based on the auditor's tests of a sample from a population.

helps auditors decide how much and what types of evidence to accumulate in each cycle

PDR=AAR/ (IR x CR)

PDR = planned detection risk

AAR = acceptable audit risk

IR = inherent risk

CR = control risk

is the risk that audit evidence for a segment will fail to detect misstatements exceeding tolerable misstatement.

PDR is dependent on the other 3 factors in the model.

PDR determines the amount of substantive evidnece that the auditor plans to accumulate, inversely with the size of planned detection risk. Ex. more evidnce is needed to reduce DR.

measures the auditor's assessment of the likelihood that there are material misstatements in a segment before considering the internal controls.

IR is inversely related to PDR and directly related to evidence. 

measures the auditor's assessment of whether misstatements exceeding a tolerable amount in a segment will be prevented or detected on a timely basis by the client's internal controls. 

The more effective the internal controls, the lower the risk factor that can be assigned to control risk. 

The relationship between CR and PDR is inverse whereas the relationship is dircet btw CR and evidence

is 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.

Low AAR means auditors want more certainty that F/S are not materially misstated. Complete assurance is not possible. 

There is a direct relationship btw PDR and AAR and an inverse relationship btw AAR and evidence

Often auditors refer to the terms audit assureance (overall assurance or level of assurance) instead of acceptable audit risk.

Audit assurance is the complement of acceptable audit risk, that is 1-AAR

-The degree to which external users rely on the statements

-The likelihood that a client will have financial difficulties after the audit report is issued

-The auditor's evaluation of management's intergrity

When external users place heavy reliance on the F/S it is appropriate to decrease acceptable audit risk

Indicators of F/S reliance:

-Client's size

-Distribution of ownership

-Nature and amount of liabilities

Indicators:

-Liquidity Position

-Profits (losses) in Previous Years

-Method of Financial Growth

-Nature of the Client's Operations

-Competence of Management

1) The engagement may require more experienced staff

2) The engagment will be reviewed more carefully than usual