5 - Risk Assessment Analytical Procedures, Establishing Materiality, and Identifying Significant Accounts and Disclosures

ratio analysis

. They use aggregated numbers (meaning high-level financial statement information, not detailed underlying accounts) and can include financial and non-financial data.

What does it mean to "scope" the audit?

In other words, you will only do significant audit procedures on accounts and disclosures greater than your tolerable misstatement amount, and you will do very little audit work on accounts and disclosures less than your tolerable misstatement

What analytical procedures are used in the planning phase?

In the planning phase (where we are now), we use the balance sheet and income statement to perform risk assessment analytics

For example, in your risk assessment analytic, you notice that operating expenses increased significantly compared to prior year, and as a percentage of sales. Senior management tells you that the increase is due to higher wages paid to hourly workers at stores in the U.S. What would you document in your planning workpaper?

In your planning workpaper, you would document the significant increase, like you saw in the spreadsheet, and then you would leave a keynote or tickmark that says "Per discussion with the CFO, increases in operating expenses are primarily due to higher wages for employees in the U.S. The audit team will do additional testing about U.S. wages in the Employee Compensation part of the audit file." Thus, you've identified a significant fluctuation, a potential explanation for the change given by management, and you've identified where the testing will be documented in the audit workpapers.

An account or disclosure is "in-scope" or "significant" if...

It is greater than OR equal to tolerable misstatement

Why do auditors make keynotes or tickmarks in their planning workpaper??

Later on, if someone were to come look at your audit, they would be able to see that you thought carefully about the risks of the audit, and then they would know where to go look at your audit work to see if you did enough work to address that risk.

Draw quantitative benchmarks and percentage thresholds most commonly used by audit firms

Net income before taxes 5.0-10.0% Total Assets 0.5%-2.0% Total Revenues 0.5%-2.0%

Who has the final decision on basing materiality?

Ultimately, the final decision is left with the audit partner and is based on professional judgment.

T/F: The higher the materiality, the lower the amount of audit work an auditor has to do.

true

According to PCAOB Auditing Standard 2105.02, "the Supreme Court of the United States has held that a fact is material if there is,

"a substantial likelihood that the . . . fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available.""14 In other words, If it wouldn't have changed the investor's investment decision, then it's not material.

What does the audit partner consider when deciding materiality??

1) The partner will likely consider risks identified during the overall risk assessment process, and the partner will also consider whether there is higher or lower litigation risk. 2)volatility in any of the benchmarkt #s (if net income is understated one year and overstated the next)

Audit standards mandate that auditors use analytical procedures at two difference parts of the audit:

1) planning 2) concluding

materiality is used for

1) scoping which accounts are subject to testing (based on tolerable misstatement, which we'll discuss below), and 2) deciding whether audit adjustments are material, individually or in the aggregate (which we'll discuss at the end of the semester)

2 exceptions to tolerable misstatement threshold

1. Liabilities and expenses (understated) 2. You identify any other unusual trends in the risk assessment analytics

Q: I've heard the phrase "performance materiality." What is this, and where does that fit into this discussion?

A: "Performance materiality" is another commonly used phrase that means the same thing as the "tolerable misstatement" that we described above. You might also hear this referred to as "tolerable error" or "tolerable difference.

Q: Do you calculate materiality for every account?

A: No, you only have ONE overall materiality for the entire audit.

Q: Do I use 'materiality' to select 'significant' accounts and disclosures?

A: No, you use 'tolerable misstatement,' which is equal to 50-70% of materiality

Q: In the real world, I'm not going to have this year's 10-K available in order to determine materiality. I can only do that with Walmart because the audit is already finished.

A: You're absolutely right. On a real audit, since we need to calculate materiality in order to plan our audit and scope the accounts we often take the 2nd or 3rd 10-Q (Q2/Q3) of the fiscal year, depending on what is available when we calculate our preliminary materiality as part of our planning procedures. If we were using Q3 numbers, then we'd use the Q3 balance sheet exactly as it is reported in the 10-Q. However, for the income statement, we would need to take the 9month income statement and multiply every number in the 9-month income statement by ('12/9'). This converts the 9 months' earnings into annualized 12 months' earnings. This will give us a good approximation of what the income statement will look like at the end of the fiscal year. Then, once we're in the field, we'll compare the draft financial statements (not yet public) to the estimates we made in planning, and as long as the numbers didn't change significantly, we'll stick with our original planning numbers

Why is it important to scope significant account and disclosures and what does that mean?

Based on our previous discussion, where we said that it's not even worth your time as an auditor to audit something if it's less than materiality, you may be tempted to look at the balance sheet, income statement, and footnotes and decide not to test any accounts that are less than $573 million. However, there is a risk that several accounts could have errors that are individually immaterial, but when aggregated together, they become material. To address this risk, auditors create a tolerable misstatement that is based on 50 - 70% of overall materiality. You will now use this value of tolerable misstatement to 'scope' the audit.

T/F: For-profit companies and Not-for-Profit both use the same benchmarks for materiality.

FALSE; Not-for-profit, governmental entities, and benefit plans will have different benchmarks. For example, a mutual fund (an asset-based company) would likely use assets or net assets. There are also many other benchmarks not mentioned here that auditors use to determine materiality, which you'll also learn about in ACCT 518.

T/F: You may have many materialities set per audit engagement.

FALSE; materiality will vary by company and by year, but there is only ONE materiality used per audit engagement

Why is volatility in any of the benchmark numbers taken into account?

For example, if net income before taxes varies significantly year-to-year, that's probably not a good benchmark for the company.

Q: Do you tell your client what number the audit team is using for materiality?

For long-standing auditor-client relationships, the client may have a pretty good guess for the number used by auditors for "materiality." However, we typically don't want to tell the client what number we use because we don't want them to purposefully manipulate financial statements to be just below our definition of "materiality.

Why would a partner not use pre-tax income as a benchmark for materiality?

If pre-tax net income varies significantly year-to-year, or if pre-tax net income is close to $0, or there is actually a loss and not income

Q: I've heard that there are both 'quantitative' and 'qualitative' factors for materiality. What's the difference, and what do I need to know for the exam?

In order to scope accounts (i.e., decide where to test), you have to start by setting a quantitative threshold for materiality. We call that 'overall materiality' - that's what you learned up above. However, at the end of the audit, you're going to be tasked with deciding whether the financial statements are free of material misstatement. At that point, you'll use this quantitative overall materiality, but you'll also consider a lot of other qualitative things, like whether there are potential misstatements that would change the financial statements from net income to a net loss, or whether you miss the analyst's forecast or management's forecast, or seasonally adjusted prior year earnings. We'll cover all of those qualitative aspects at the end of the semester. This means that for your midterm exam, you only need to understand this planning quantitative materiality and tolerable misstatement, but by the end of the semester, for the final exam, you'll need to understand both the quantitative and qualitative aspects of materiality.

Why would you audit anything below your tolerable misstatement?

One major exception to this rule is the risk of completeness. If you are worried that management has understated a liability or expense by a material amount, you may choose to use professional judgment to include that account in the list of significant accounts, regardless of whether the current year's balance is greater than tolerable misstatement. You would also go through the footnotes and identify any disclosures greater than $286 million and those would be subject to significant audit procedures also.

So how do we know what is 'significant' or 'material' to an investor?

Step 1: Set a Quantitative Overall Materiality Step 2: Scoping Significant Accounts and Disclosures Step 3: Risk Assessment Analytics

Quickly recap the auditing process

The goal here was to identify 'significant' accounts and disclosures, meaning that these are the accounts and disclosures where you will be doing the majority of your audit work. The audit standards don't have a formula for you to use to do this, but the firms have each established their own policies. For a publicly traded company with normal net income, you will most likely use 5% of Net Income before Taxes to get "materiality." You will then multiply that number by 50 - 70% (let's just use 50% for classroom discussions) to get "tolerable misstatement." Tolerable misstatement is what you use to "scope" accounts and disclosures. For all accounts and disclosures > tolerable misstatement, you will do significant audit testing. For accounts and disclosures < tolerable misstatement, you will do very limited procedures.

What is the goal of risk assessment analysis?

The goal is to identify significant or unusual changes in the accounts that could alert the auditor that there will be higher risk of material misstatement (because the account is very different compared to what we expected or what we audited last year).

So you may be asking yourself, "why is this a two-step process? Why don't I just pick 2.5% of Net Income before Taxes (5% materiality benchmark * 50% for tolerable misstatement) and call that materiality and scope my accounts using that smaller materiality?

The reason is that we don't think 2.5% would significantly alter an investor's investment decision. However, we're worried that enough 2.5% errors could hide across multiple small accounts and would potentially aggregate to something greater than 5%. Therefore, we "scope" based on the lower threshold of 2.5%.

flux analysis

compare year-over-year changes

vertical analysis

examine each balance sheet account and % of assets, and each income stmt account as a % of sales

Risk of completeness

exception to tolerable misstatement setting; If you are worried that management has understated a liability or expense by a material amount, you may choose to use professional judgment to include that account in the list of significant accounts, regardless of whether the current year's balance is greater than tolerable misstatement. This is relatively rare but does happen, especially if you see significant fluctuations in liability and expense accounts between years (see planning risk assessment analytic discussion below).

What analytics are included in the risk assessment analytics??

flux analysis vertical analysis ratio analysis

explain material misstatement

focusing our audit procedures on only those accounts that we believe are big enough to have errors that could lead to material misstatement; there may be accounts thate are so small, it's not worth our time auditing them because even if they were 100% wrong, it still wouldn't be material in the eyes of the investor

For most public accounting firms, will the auditor likely choose the higher end of materiality or lower end for privately traded clients?

higher end of materiality for privately traded clients bc of the lower litigation risk

Once you've identified the 'financial statement level' risks for the audit, you'll nex

identify the significant accounts and disclosures that will be the subject of testing

Non-financial data

includes things like number of store locations, number of products, etc

Would a company like WMT be audited with on the lower end of materiality or higher end?

lower end hoe

For most public accounting firms, will the auditor likely choose the higher end of materiality or lower end for publicly traded clients?

lower end of materiality because of the higher litigation risk

Most often, if the company is profitable, and there is no unusual volatility in earnings, the partner will use the materiality value that is based on....

net income BEFORE taxes **Note: The partner might have to choose between net income before discontinued operations and net income after discontinued operations if there are significant discontinued operations in the period.

Part two of the auditing process

planning activities 1. Preliminary Risk Assessment: Financial statement level risks 2. Preliminary Risk Assessment: Account-specific risks Materiality Identifying Significant Accounts Consideration of Fraud or Illegal Acts Management's Assertions 3. Designing Responses to Risk The Audit Risk Model Designing Audit Procedures and Types of Audit Evidence Workpaper Documentation

audit

provides reasonable assurance that the financial statements are free from material misstatement

After scoping significant accounts and disclosures, what is step 3?

risk assessment analytics

After seting a quantitative overall materiality, the next step in the preliminary risk assessment is ....

scoping significant accounts and disclosures

an audit is conduted on a ______ basis

test basis

what are "significant" accounts and disclosures

those that are above tolerable misstatement and any questionably others below that

Financial data

to $ related accounts in the financial statements

explain tolerable misstatement

to address the risk of several small errors aggregating together and becoming material, auditor create a tolerable misstatement that is based on 50-70% of overall matteriality. In the example above, $573 million is the overall materiality. If you wanted to use the lower end of the range, you would then multiply $573 million by 50% to get a tolerable misstatement of $286 million. You will now use this value of tolerable misstatement to 'scope' the audit.

What do you do with every significant change in accounts that you identify??

you will meet with a senior member of management and do inquiries (questions, interview, etc.) about why the account changed. Senior management will give you an explanation that you will then use to decide how to audit the account