Audit Risk and Materiality

In preparation for an external audit, it is necessary to discuss the company's liability. In terms of an audit, the liability is measured by risk and materiality. Once an accounting staff understands the elements of risk, the relationship risk has with materiality, and how it is integrated into the audit process, they will be able to understand how an auditor will determine the company's level of risk.

Risk and Materiality Relationship

Risk and materiality share the relationship that an auditor must state an opinion of financial statements and the statement is either qualified or not, contingent upon the validity of the financial statements. The auditor's opinions on the financial statements are appropriate or inappropriate. If the opinion is inappropriate than an there is a chance that the auditor inadvertently failed to appropriately state an opinion about "financial statements that are materially misstated" (AU Section 312, 2002). When the audit risk is blatant the auditor will reveal the nature of the risk and state that he/she has obtained reasonable assurance that "material misstatements are detected" (AU Section 312, 2002).

As stated, an appropriate stated opinion of the financial statements is based upon their validity. Validity is gained by the discovery that account balances are valid, transactions are classed properly and there are proper and sufficient disclosures. When there is a flaw in these areas, the magnitude of the flaws, misstatements, or omissions must be considered. This is what defines the word materiality. The magnitude of these errors "makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by omissions or misstatements" (Messer, Jr., Glover, & Prawitt, 2008).

How Risk and Materiality is Related

Risk and materiality are reliant upon each other. The degree of risk, either high or low, largely depends upon the level of materiality. When an auditor finds a high magnitude of materiality then the risk is lower because the auditor will recognize the problems and will be able to issue a statement accordingly. However, if the auditor finds a low magnitude of materiality, then the risk is high because the auditor will be unable to decipher any omissions or misrepresentations and will possibly, unbeknownst to the auditor, issue a qualified statement.

Risk and Materiality Integration

The level of the audit risk is set by the auditors issued statement. The auditor will basically support that the financial statements are true and correct or the auditor will reveal that he/she has found misrepresentations. The acceptable level of risk is set in the planning phase by the risk of material misstatement (Messier, Jr., et al, 2008).

Example

If there is a net income that is $5,000,000 and a planning materiality of 4.5% the planning materiality will be $225,000. This is the maximum acceptable level of risk.

References:

AU Section 312, (2002). AU Section 312. Audit Risk and Materiality in Conducting an
Audit. Retrieved September 6, 2007 from: http://www.pcaobus.org/standards/interim_standards/auditing_standards/au_312.html

Messer, Jr., W.F., Glover, S. M., & Prawitt, D. F., (2008). Auditing & Assurance Services: A Systematic Approach. (5th ed.). New York: McGraw-Hill Irwin.