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Auditing and Assurance Services (12th Edition)

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1 Chapter 9 Materiality and Risk Review Questions 9-1 The planning phases are: accept client and perform initial planning, understand the client’s business and industry, assess client business risk, perform preliminary analytical procedures, set materiality and assess acceptable audit risk and inherent risk, understand internal control and assess control risk, gather information to assess fraud risk, and develop overall audit plan and audit program. Evaluation of materiality is part of phase five. Risk assessment is part of phase three (client business risk), phase five (acceptable audit risk and inherent risk), phase six (control risk), and phase seven (fraud risk). 9-2 Materiality is defined as: the magnitude of an omission or misstatement of accounting information that, in light of the surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement. "Obtain reasonable assurance," as used in the audit report, means that the auditor does not guarantee or insure the fair presentation of the financial statements. There is some risk that the financial statements contain a material misstatement. 9-3 Materiality is important because if financial statements are materially misstated, users' decisions may be affected, and thereby cause financial loss to them. It is difficult to apply because there are often many different users of the financial statements. The auditor must therefore make an assessment of the likely users and the decisions they will make. Materiality is also difficult to apply because it is a relative concept. The professional auditing standards offer little specific guidance regarding the application of materiality. The auditor must, therefore, exercise considerable professional judgment in the application of materiality. 9-4 The preliminary judgment about materiality is the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of reasonable users. Several factors affect the preliminary judgment about materiality and are as follows: 1. Materiality is a relative rather than an absolute concept. 2. Bases are needed for evaluating materiality. 3. Qualitative factors affect materiality decisions. 4. Expected distribution of the financial statements will affect the preliminary judgment of materiality. If the financial statements are widely distributed to users, the preliminary judgment of materiality will probably be set lower than if the financial statements are not expected to be widely distributed. 5. The level of acceptable audit risk will also affect the preliminary judgment of materiality. 9-1
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9-5 Because materiality is relative rather than absolute, it is necessary to have bases for establishing whether misstatements are material. For example, in the audit of a manufacturing company, the auditor might use as bases: net income before taxes, total assets, current assets, and working capital. For a
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