Materiality Flashcards
(8 cards)
An auditor is performing attribute testing on a sample of 150 documents. The test results in 8 deviations from the control procedure. If the tolerable rate is 6%, the expected population deviation rate is 4%, and the allowance for sampling risk is 1%, the auditor will most likely
A. Increase the level of control risk because the tolerable rate plus the allowance for sampling risk exceeds the expected population deviation rate.
B. Accept the sample results and reduce control risk because the sample deviation rate plus the allowance for sampling risk exceeds the tolerable rate.
C. Accept the sample results and reduce control risk because the sample deviation rate is less than the tolerable rate.
D. Increase the level of control risk because the sample deviation rate plus the allowance for sampling risk exceeds the tolerable rate.
D. Increase the level of control risk because the sample deviation rate plus the allowance for sampling risk exceeds the tolerable rate.
8/150 = 5.33% (sample deviation rate)
5.33 + 1 = 6.33
This is higher than the tolerable rate
In assessing the tolerable rate of deviations of a test of controls that was performed using statistical sampling, an auditor should consider that
A. Deviations from pertinent controls do not affect the risk of material misstatement in the accounting records.
B. Deviations from pertinent controls at a given rate ordinarily result in misstatements at a lower rate.
C. When the degree of assurance desired in a sample is high, the auditor should allow for a high level of sampling risk.
D. Increasing the number of items selected for the test of controls usually increases the tolerable rate of deviations.
B. Deviations from pertinent controls at a given rate ordinarily result in misstatements at a lower rate.
Tests of controls are used to test the rate of deviation from a prescribed control. The tolerable rate (TR) is the maximum deviation rate an auditor is willing to accept before concluding the control is ineffective. If auditors decide the TR for a cash control tested is 10%, it means that in any given sample, the control is considered ineffective if the deviation is above 10%. However, even when the deviation rate for the control is above the TR, it does not mean the account balance is more than 10% misstated.
An accountant may not have followed a control 20% of the time but may have properly accounted for the cash. When considering the TR (ie, maximum rate) of deviation, auditors should consider that although a control deviation may be high, it does not necessarily imply the rate of misstatement is the same.
(Choice A) The deviation rate is used to determine whether the control is effective. The effectiveness of the control affects the assessed level of control risk, and therefore the risk of material misstatement.
(Choice C) If the desired assurance in a sample is high, the allowance for sampling risk is low, not high. Low allowance for sampling risk provides high confidence that the results of the sample represent the population.
(Choice D) There is an inverse relationship between the tolerable rate of deviation and sample size. Increasing the tolerable rate will decrease, not increase, the number of selected items.
Things to remember:
Deviations from a prescribed control will increase the risk of material misstatement for a specific account. However, in assessing the tolerable rate (ie, maximum rate) of deviations of a test of control, auditors should consider that control deviations at a given rate ordinarily result in actual misstatements at a lower rate.
In a nonissuer integrated audit engagement, the measure of materiality used to test the effectiveness of internal control
A. Has no relationship to the measure of materiality set for financial statement testing.
B. Must be the same measure of materiality used for financial statement testing.
C. Will never be stricter, and may be less strict, than the measure of materiality used for financial statement testing.
D. Will never be less strict, and may be stricter, than the measure of materiality used for financial statement testing.
B. Must be the same measure of materiality used for financial statement testing.
Materiality is an amount that if omitted or misstated can affect decisions (eg, invest in a company, allow a company to borrow money) based on financial statements. Auditors must use professional judgment to determine what amount would affect such decisions if it were missing or omitted from financial information.
In an integrated audit, the auditor expresses opinions on both the fairness of the financial statements and the effectiveness of the internal control over financial reporting (ICFR). During the planning process, the auditor determines what amount of error (ie, measure of materiality) can occur without negatively affecting decisions based on the financial statements or the audit report. The measure of materiality must be the same for tests of both the financial statements and the effectiveness of ICFR (Choices C and D).
(Choice A) The auditor might initially determine a measure of materiality for testing the effectiveness of ICFR and a different measure of materiality for financial statement testing. However, the auditor must then establish a single measure of materiality (usually the lower of the two levels) to guide all audit tests.
Things to remember:
An integrated nonissuer audit involves testing and expressing opinions on the fairness of financial statements and the effectiveness of internal control over financial reporting. A single measure of materiality must be used for both testing purposes.
In order to reduce the risk that the aggregate of undetected misstatements in the group financial statements of a nonissuer exceeds the materiality for the group financial statements as a whole, an auditor should establish a
A. Materiality for the group financial statements that is lower than the component materiality.
B. Materiality for the group financial statement that exceeds prior-year materiality for the group financial statements.
C. Component materiality that is lower than the materiality for the group financial statements.
D. Component materiality that is equal to the materiality for the group financial statements.
C. Component materiality that is lower than the materiality for the group financial statements.
A CPA firm that audits entities with smaller reporting segments will use component auditors to perform audits at those reporting segments. The group engagement team collects the component auditors’ work near the end of the audit engagement and uses it to form an opinion about the entity’s consolidated financial statements (F/S).
Because each component is only a part of the entire consolidated (group) F/S, the component materiality will be smaller in relation to that of the group (Choices A and D). The objective is to reduce the risk that the aggregate undetected misstatements of all components exceed the materiality for the group F/S.
For example, suppose materiality for the group is calculated using 5% of net assets. If the consolidated assets were $100,000, then the group’s materiality threshold would be $5,000. This threshold would be too large to use for individual components because it allows for misstatements that would otherwise be considered material at the component level to go undetected.
Notice that the allocated materiality thresholds for each component are much smaller than the $5,000 group materiality because the percentage (5%) is applied to a smaller amount. This allows for smaller misstatements to be detected, thus, reducing the risk that in the aggregate, undetected misstatements exceed the group’s materiality.
(Choice B) Prior year materiality is not relevant when computing materiality for the current year.
Things to remember:
When determining materiality for a group audit, the component’s materiality will generally be smaller than that of the group. The objective is to reduce the risk that the aggregate undetected misstatements of all components exceed the materiality of the group.
Which of the following statements is correct with regard to the consideration of materiality when an auditor is planning and performing a financial statement audit of an issuer?
A. When determining a tolerable misstatement threshold, an auditor should take into account the amount of misstatements that were accumulated in prior periods.
B. An auditor should determine a tolerable misstatement threshold at the overall financial statement level but not at the account or disclosure level.
C. An auditor does not need to express materiality as a specified, quantitative amount.
D. When the reevaluation of materiality results in a significantly lower amount than initially established, an auditor would generally not modify audit procedures.
A. When determining a tolerable misstatement threshold, an auditor should take into account the amount of misstatements that were accumulated in prior periods.
Materiality is the significance of an error or omission in the F/S. A misstatement is considered material if it could affect the decisions of F/S users. Auditors establish performance materiality (ie, tolerable misstatement thresholds) for particular accounts or disclosures to identify material misstatements that might result from the aggregation of small errors. By designing procedures to detect misstatements around the tolerable misstatement threshold, auditors can avoid overlooking significant misstatements (Choice B).
The tolerable misstatement threshold is set low enough that any undetected misstatements are unlikely to aggregate into a material misstatement. To determine how low is appropriate, the auditor considers the nature, cause, and dollar amount of misstatements accumulated in audits of prior periods. For example, if prior audits revealed a very large number of small errors, the auditor might set performance materiality lower to catch a larger percentage of misstatements.
(Choice C) Although the RMM may be set qualitatively (eg. “high,” “low”), materiality is set at a specified quantitative amount.
(Choice D) When new information causes the auditor to lower F/S materiality, audit procedures generally need to be modified to identify smaller misstatements.
Things to remember:
A tolerable misstatement threshold is used to identify material misstatements that might result from the aggregation of small errors. To determine that threshold, the auditor considers the nature, cause, and dollar amount of misstatements accumulated in audits of prior periods.
Which of the following elements ultimately determines the specific auditing procedures that are necessary in the circumstances to afford a reasonable basis for an opinion?
A. Auditor judgment.
B. Materiality.
C. Relative risk.
D. Reasonable assurance.
A. Auditor judgment.
(Choice A) This answer is correct because the measure of the validity of evidence for audit purposes is based upon the judgment of the auditor. This audit judgment is used to estimate levels of materiality, and relative risk.
(Choice B) This answer is incorrect because estimating levels of materiality is only one aspect of audit judgment used to determine necessary auditing procedures.
(Choice C) This answer is incorrect because evaluating relative risk is only one aspect of audit judgment used to determine necessary auditing procedures.
(Choice D) This answer is incorrect because while auditors obtain reasonable assurance of detecting misstatements, this is not what ultimately determines what specific audit procedures that are necessary.
Which of the following conditions necessitates a larger sample size?
A. A high level of detection risk.
B. A low frequency of misstatement.
C. A low level of tolerable misstatement.
D. A low assessed level of control risk.
C. A low level of tolerable misstatement.
Attribute sampling, which is generally used to test I/C, involves estimating the rate of occurrence of a characteristic (eg, unapproved purchase orders) in a population. Variables sampling techniques are appropriate when an auditor is estimating or projecting a numerical amount, usually during tests of details. The factors that affect sample size are largely the same for both types of sampling.
Tolerable deviation/misstatement rate (TDR): the maximum rate of deviation in controls or amounts of errors in tests of details that can occur without the auditor concluding the controls are ineffective or an account is misstated. The lower the TDR, the higher the sample size.
Expected deviation/misstatement rate (EDR): the frequency of either control deviations or errors in tests of details, based on the auditor’s risk assessment. Generally, the lower the EDR, the lower the sample size (Choice B).
Allowable risk of overreliance/incorrect acceptance (ARO): the amount of risk an auditor is willing to accept that the sample will cause the auditor to rely on a control that is not operating effectively or wrongly conclude that an amount is not materially misstated. The higher the ARO, the smaller the sample size.
In variables sampling, but not attribute sampling, sample size is directly proportional to the standard deviation of the population.
(Choices A and D) Lower control risk means lower risk of material misstatement (RMM) and a higher acceptable level of detection risk. This generally supports using smaller (not larger) sample sizes because RMM is directly proportional to EDR and indirectly proportional to ARO.
Things to remember:
Sample size is directly proportional to the expected deviation/misstatement rate and indirectly proportional to both the tolerable deviation/misstatement rate and the allowable risk of overreliance/incorrect acceptance.
As a lower level of materiality is established, the auditor should plan more work on individual accounts to
A. Find smaller misstatements.
B. Find larger misstatements.
C. Increase the tolerable misstatement in the accounts.
D. Decrease the risk of assessing control risk too low.
A. Find smaller misstatements.
When planning an audit, the auditor must determine materiality levels. Materiality is the amount of error that could negatively influence F/S users and is often established based on the individual account (eg, revenue, A/R). Once a materiality level is determined, the auditor must assess the risk of material misstatement (RMM).
A lower materiality level means that smaller errors in individual accounts could negatively influence F/S users. When small errors materially affect the F/S, the RMM may also increase. Therefore, the auditor must design tests that detect smaller errors (ie, misstatements) to determine whether the F/S are materially correct.
(Choice B) When materiality levels are low, the auditor must design tests that identify smaller, not larger, misstatements.
(Choice C) Materiality levels are directly linked to tolerable misstatements in accounts. Therefore, a low materiality level would decrease, not increase, the tolerable misstatement.
(Choice D) Control risk exists when I/C fails to prevent or detect and correct errors. I/C tests provide the auditor with the information needed to assess control risk. Effective I/C testing, not lower materiality levels, decreases the risk of assessing control risk too low.
Things to remember:
A lower materiality level means smaller errors in individual accounts could negatively influence F/S users. Therefore, the auditor must design tests that detect smaller errors (ie, misstatements) to determine whether the F/S are materially correct
