Explain the relationship between materiality, audit risk and audit evidence Describe the audit risk model Understand the nature of the relationship between the components of audit risk Explain the characteristics of accounts with high inherent risk

1. QUESTION

2. Explain the relationship between materiality, audit risk and audit evidence
3. Describe the audit risk model
4. Understand the nature of the relationship between the components of audit risk
5. Explain the characteristics of accounts with high inherent risk

5.    Describe the factors affecting the client and its environment

6.    Identify factors that determine the auditors’ assessment of the risk of material misstatement

7. Identify the types of audit evidence and procedures
8. Understand the relationship between the assessment of the risk of material misstatement and audit evidence

9.    Define audit procedures and understand their relationship to assertions

10. Identify and define audit procedures used for obtaining audit evidence
11. Identify the audit assertion tested by an audit procedure
12. Understand the reliability of the types of evidence
13. Know the objectives of audit documentation
14. Describe the function, content, and organization of audit documentation

Describe the purposes and types of analytical procedures

ANSWER

Understanding the Relationship Between Materiality, Audit Risk, and Audit Evidence

Introduction

In the field of auditing, materiality, audit risk, and audit evidence are crucial concepts that auditors consider to perform effective and efficient audits. These concepts are interrelated and form the foundation of the audit process. This article aims to explain the relationship between materiality, audit risk, and audit evidence, and provide insights into related topics such as the audit risk model, inherent risk, factors affecting the client and its environment, and audit procedures.

Relationship between Materiality, Audit Risk, and Audit Evidence

Materiality refers to the magnitude of an omission or misstatement in financial statements that would impact the decisions of financial statement users. Auditors assess materiality to determine the significance of potential misstatements. Audit risk, on the other hand, is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk consists of three components: inherent risk, control risk, and detection risk.

Audit evidence is the information gathered by auditors to support their audit conclusions and provide reasonable assurance that financial statements are free from material misstatement. It includes both financial and non-financial information obtained through various procedures such as inspection, observation, inquiry, and confirmation. The sufficiency and appropriateness of audit evidence determine the level of assurance the auditor can provide.

The Audit Risk Model

The audit risk model is a fundamental tool used by auditors to plan and execute audits effectively. It can be expressed using the formula: Audit Risk = Inherent Risk × Control Risk × Detection Risk. This model indicates that audit risk can be managed by adjusting the assessment of its components.

Inherent risk represents the susceptibility of an account balance or class of transactions to material misstatement before considering the effectiveness of internal controls. Accounts with high inherent risk typically involve complex transactions, significant judgment, or high estimation uncertainty (Tuovila, 2022). Examples include revenue recognition, valuation of investments, and the determination of contingent liabilities.

Control risk reflects the risk that a material misstatement could occur in an account balance or class of transactions, and the internal controls would not prevent or detect it on a timely basis. The assessment of control risk depends on the effectiveness of the entity’s internal control environment.

Detection risk represents the risk that auditors’ procedures fail to detect a material misstatement. It can be managed through the appropriate design and execution of substantive procedures and tests of controls.

 Factors Affecting the Client and its Environment

Auditors consider various factors related to the client and its environment that may influence the risk of material misstatement. These factors include the entity’s industry, regulatory environment, management integrity, the complexity of operations, technological advancements, and economic conditions. Understanding these factors helps auditors assess the risks associated with the entity and tailor their audit procedures accordingly.

 Types of Audit Evidence and Procedures

Audit evidence can be classified into different types, such as physical evidence, documentary evidence, third-party confirmations, analytical procedures, and oral evidence. Each type of evidence has varying degrees of reliability, with external confirmations and documentary evidence generally considered more reliable than oral evidence.

Audit procedures refer to the specific actions undertaken by auditors to obtain audit evidence. These procedures include inspection of records and documents, observation of activities, inquiry of management and employees, re-performance of controls, analytical procedures, and substantive testing (SafetyCulture, 2023). The choice of procedures depends on the assessed risks, inherent characteristics of the accounts, and the auditor’s professional judgment.

Relationship between Risk Assessment and Audit Evidence

The auditors’ assessment of the risk of material misstatement guides the selection and nature of audit procedures and the amount of evidence to be obtained. Higher assessed risks would require more extensive procedures and stronger evidence to reduce detection risk. Conversely, lower assessed risks may allow auditors to rely more on controls and perform fewer substantive procedures.

Audit Procedures and Assertions

Audit procedures are designed to test specific assertions made by management regarding the financial statements. Assertions include completeness, existence or occurrence, rights and obligations, valuation or allocation, and presentation and disclosure. For example, an audit procedure like vouching may test the existence or occurrence assertion by tracing a transaction from the source documents to the recorded entry in the financial statements.

Objectives and Organization of Audit Documentation

Audit documentation, also known as working papers, serves as the record of the audit work performed and the basis for the audit report. It should provide sufficient evidence to support the auditors’ conclusions and facilitate review and supervision (AS 1215: Audit Documentation, n.d.). Audit documentation should be well-organized, including engagement letters, risk assessments, planning, and audit procedures performed, significant findings, and conclusions.

Conclusion

Materiality, audit risk, and audit evidence are integral components of the audit process. Auditors consider the relationship between these concepts to plan and execute effective audits. Understanding the inherent risk of accounts, the factors affecting the client and its environment, and the different types of audit evidence and procedures help auditors mitigate audit risk and provide reasonable assurance to financial statement users. By following established frameworks and professional judgment, auditors can enhance the reliability and quality of the audit process.

References

AS 1215: Audit Documentation. (n.d.). Default. https://pcaobus.org/oversight/standards/auditing-standards/details/AS1215 

SafetyCulture. (2023, May 5). A Simple Guide to Audit Procedures | SafetyCulture. https://safetyculture.com/topics/audit-procedures/ 

Tuovila, A. (2022). Inherent Risk: Definition, Examples, and 3 Types of Audit Risks. Investopedia. https://www.investopedia.com/terms/i/inherent-risk.asp