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313425-20211-Nov22v21
Materiality & Audit Risk
Materiality-ISA320
Accepted Audit Risk = Risk of Material Misstatements * Planned Detection Risk
RMM = Inherent Risk * Control Risk
I.
II.
A.
B.
C.
1.
The International Standards on Audit ISA320, Materiality in Planning and
Performing An Audit.
This pronouncement states that the auditor's objective is to apply the concept
of materiality appropriately in planning and performing the audit.
Materiality:
The concept of materiality can be described as:
“an understanding of what is important” in financial reporting based on the
auditor's perception of the users’ needs.
A definition of materiality from the FASB's Conceptual Framework project
(specifically, Statement on Financial Accounting Concepts No. 2) follows:
“The magnitude of an omission or misstatement of accounting information
that, in the light of 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.” (Note that
this definition emphasizes that materiality judgments involve both
quantitative and qualitative considerations.)
The determination of materiality is a matter of professional judgment, and
involves both quantitative (the relative magnitude of the items in question)
and qualitative (the surrounding circumstances) considerations.
The auditor considers the concept of materiality throughout the audit
process, including (a) in planning and performing the audit; (b) in evaluating
the effect of uncorrected misstatements on the entity's financial statements;
and (c) in forming the auditor's opinion.
In planning the audit —The auditor should determine the materiality for
the financial statements as a whole in connection with establishing the
overall audit strategy.
The auditor should determine performance materiality in connection with
assessing the risks of material misstatement and determining the nature,
timing, and extent of further audit procedures at the relevant assertion level.
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Note: If Risk Of Material Misstatement High: Auditor should be more
careful & would Increase/Decrease Materiality Level at planning stage>
Client A-1000[Given]
Client B-5000[Given]
What does that mean for Field work Stage (Substantive Evidence Stage)?
For Accounts Receivable Balances: Auditor will Test/Examine any Account
Receivable Balance Equals or Exceeds balance of 1000
*At Final Stage [ Conclusion]
Auditor would Modify his/her opinion for uncorrected misstatements that
exceeds $1000
When planning a sample for a substantive test of details, the auditor's
consideration of tolerable misstatement for the sample would be related to
the preliminary judgment of materiality.
The auditor determines the nature, timing, and extent of auditing procedures
to be applied in order to obtain reasonable assurance of detecting material
misstatements in the financial statements.
The preliminary judgment of materiality is the auditor's first estimate of
amounts that could be considered to be material.
Definitions
Performance Materiality: The amount(s) set by the auditor at less than
materiality for the financial statements as a whole to reduce to an
appropriately low level the probability that the aggregate of uncorrected and
undetected misstatements exceeds materiality for the financial statements as
a whole; if applicable, it is also the amount(s) set by the auditor at less than
the materiality level(s) for particular classes of transactions, account
balances, or disclosures.
Tolerable Misstatement: The application of performance materiality to a
particular sampling procedure.
2.
Revision during the audit:
The auditor should revise materiality for the financial statements as a whole
and, if applicable, the materiality level(s) for specific classes of transactions
or account balances when the auditor becomes aware of information
affecting the auditor's initial judgments. The auditor should also determine
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whether “performance materiality” should be revised and whether the
nature, timing, and extent of further audit procedures are appropriate.
MCQ
Based on new information gained during an audit of a non-issuer, an auditor
determines that it is necessary to modify materiality for the financial
statements as a whole. In this circumstance, which of the following statements
is accurate?
a- The auditor is required to reperform audit procedures already completed on
the audit using the revised materiality.
b- The auditor should consider disclaiming an opinion due to a scope limitation.
c- The revision of materiality at the financial statement levels will not affect the
planned nature and timing of audit procedures, only the extent of those
procedures.
d- Materiality levels for particular classes of transactions, account balances, or
disclosures might also need to be revised.
Documentation:
The auditor should document the following matters:
1. Materiality for the financial statements as a whole
2. Materiality level(s) for particular classes of transactions, account
balances, or disclosures, as applicable
3. Performance materiality
4. Any revision of those considerations during the audit engagement.
MCQ
1. An auditor finds several errors in the financial statements that the client
prefers not to correct. The auditor determines that the errors are not material
in the aggregate. Which of the following actions by the auditor is most
appropriate?
a- Document the errors in the summary of uncorrected errors and document the
conclusion that the errors do not cause the financial statements to be
misstated.
b- Document the conclusion that the errors do not cause the financial
statements to be misstated, but do not summarize uncorrected errors in the
audit documentation.
c- Summarize the uncorrected errors in the audit documentation, but
do not document whether the errors cause the financial statements to be
misstated.
d- Do not summarize the uncorrected errors in the audit documentation, and
do not document a conclusion about whether the uncorrected errors cause
the financial statements to be misstated.
Considerations that May Affect the Auditor's Materiality Judgment:
IQuantitative guidelines:
In practice, auditors frequently apply a variety of “benchmarks” as a starting
point in determining the appropriate materiality levels. A few examples of
frequently used general guidelines follow (these are not specifically
identified in the AICPA/ISA auditing standards, however):
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1. 5% to 10% of net income or earnings before taxes
2. 0.50% to 2% of the larger of net sales or total assets
5. 5% of owners’ equity for private companies
II- Qualitative matters:
Amounts involving fraud:
Amounts involving fraud are usually considered more important than unintentional
errors of equal dollar amounts because fraud reflects on the honesty and
reliability of the management or other personnel involved. For example, an
intentional misstatement of inventory would be more important to users than a
clerical error in inventory of the same amount.
Misstatements affecting contractual obligations:
Misstatements that are otherwise minor may be material if there are possible
consequences arising from contractual obligations. For example, if a
misstatement causes a required minimum working capital balance to exceed
the minimum, when the correct balance is less than the minimum, this
misstatement likely would be important to users.
Amounts affecting a trend in earnings. Amounts that are otherwise immaterial may
be material if they affect a trend in earnings. An example is if reported income
has increased three percent annually for the past five years but income for the
current year has declined one percent, that change may be material. Similarly,
a misstatement that would cause a loss to be reported as a profit may be of
concern.
Public versus private companies: A lower materiality threshold may apply
to public companies owing to more exposure to litigation and because the
owners of private companies may be closer to the day-to-day operations
and, therefore, have different information needs.
Unstable versus stable industry— A lower materiality threshold may apply
to a company in an unstable industry, which is by nature more susceptible
to business failure.
1. Tolerable misstatement:
(which, in practice, is sometimes referred to as “tolerable error”):
This term refers to the maximum error in a population that the auditor is
willing to accept. This should be established in such a way that tolerable
misstatement, combined for the entire audit plan, does not exceed
materiality for the financial statements taken as a whole.
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Audit Risk-ISA200
Definition of Audit Risk:
“The risk that the auditor expresses an inappropriate -clean-audit
opinion when the financial statements are materially misstated. Audit
risk is a function of the risks of material misstatement and detection
risk.” (Source—ISA 200, Overall Objectives of the Independent Auditor
and the Conduct of an Audit in Accordance with [IAASB].)
AR = RMM * DR
Acceptable Audit Risk: because audit Risk can not be Zero, the auditor
should accept Certain level of Audit Risk, & this would be the exact
opposite of the assessed Audit Risk
If the Auditor Decide that Circumstances Surrounding the Auditee
Company are [ Bad Reputation of management, Difficult Situation for
the company, High number of affected Stakeholders ] which mean High
level of Audit Risk …….The auditor should Accept low level of Audit
risk……Acceptable Audit Risk Low…
If Acceptable Audit Risk is 5%...it means the auditor accept the
possibility of incorrect audit opinion of 5%...the auditor shall perform
audit procedures that will guarantee correct audit opinion with 95%
Client A: Audit Risk High
Client B: Audit Risk Low
Acceptable Audit Risk 5%...Client B
Acceptable Audit Risk 1% Client A…Obtain Evidence to be sure with
99% that audit opinion is correct
Planned Detection Risk: because Detection Risk can not be Zero, the
auditor should accept Certain level of Detection Risk, & this would be
the exact opposite of the assessed Detection Risk
Acceptable Audit Risk = RMM * Planned Detection Risk
RMM = Financial Statements Level:[ Management Integrity,
Competence of Employees, Surrounding Circumstances]
Assertion Level: [Accounts Receivable
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RMM: Assertion Level: [ Inherent Risk * Control Risk]
AR= [Inherent Risk * Control Risk] * Detection Risk
Acceptable Audit Risk = [Inherent Risk * Control Risk] * Acceptable Detection Risk
RMM=[ it is about the Auditee Work=Auditor Assess the Risk only=Auditor can not change the
numbers]
Acceptable Detection Risk=[ it is about the Auditor Work=To Decrease the Acceptable DR=
Auditor should increase Evidence Obtained] :
Case A:Acceptable DR: 1% means : Auditor Will Gather Evidence sufficient To Make Him/her
Confident with 99% that No Material Misstatements Not detected.
Case B:Acceptable DR: 8% means : Auditor Will Gather Evidence sufficient To Make Him/her
Confident with 92% that No Material Misstatements Not detected.
Acceptable Audit Risk = RMM * Planned Detection Risk
Planned DR = Acceptable AR / RMM
What would be the relationship between:
Inherent Risk & Control Risk
Planned DR = Acceptable AR / [ Inherent Risk
*Control Risk]
Acceptable Audit Risk = [ IR *CR] * Planned Detection Risk
•
Note that the concept of audit risk is really a probability and that audit
risk and materiality are interrelated by the definition of audit risk.
•
Reasonable Assurance: The presence of audit risk is indicated in the
auditor's report by reference to reasonable assurance, meaning that audit
risk cannot be reduced to a zero probability (which would imply “absolute
assurance”) owing to the inherent limitations of an audit. Reasonable
assurance is defined as follows: “In the context of an audit of financial
statements, a high, but not absolute, level of assurance.” Note
that reasonable assurance means a “high level of assurance” and a “low
level of audit risk.”
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Basic Auditor Responsibility
The auditor should properly plan and perform the audit to obtain reasonable
assurance that material misstatements, whether caused by errors or fraud,
are detected.
Considerations at the Financial Statement Level
The one overriding audit planning objective is to limit audit risk to an
appropriately low level (as determined by the auditor's judgment), which
involves the following:
A.Determining the extent and nature of the auditor's risk assessment
procedures
B.Identifying and assessing the risk of material misstatement
C.Determining the nature, timing, and extent of further audit procedures
D.Evaluating whether the financial statements taken as a whole are presented
fairly in conformity with applicable accounting framework.
II.
Risk of Material Misstatement
The risk of material misstatement (RMM) is defined as: “The risk that the
financial statements are materially misstated prior to the audit.”
RMM exists at two levels:
(1) the overall financial statement level; and
(2) the assertion level for classes of transactions, account balances, and
disclosures.
A.RMM at the Overall Financial Statement Level:
This refers to risks that are “pervasive” to the financial statements and that
potentially affect many assertions.
RMM at the Assertion Level
The auditor assesses RMM at the assertion level for the purpose of
determining the nature, timing, and extent of further audit procedures to
obtain sufficient appropriate audit evidence.
RMM at the assertion level consists of two components:
RMM= IR * CR
(1) inherent risk;
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(2) control risk (see below).
B.At the assertion level, audit risk consists of three component risks:
(1) inherent risk (IR);
(2) control risk (CR);
and detection risk (DR).
RMM consists of inherent risk and control risk.
AR = IR × CR × DR
DR = AR / [IR *CR]
If Acceptable Detection Risk was high that means Lower Level of Audit
Evidence (Less in Quantity & Quality)
Definitions
Inherent Risk (IR): The probability that a material misstatement would occur in
the particular audit area in the absence of any internal control policies and
procedures.
Control Risk (CR): The probability that a material misstatement that occurred
in the first place would not be detected and corrected by internal controls that
are applicable.
Detection Risk (DR): The probability that a material misstatement that was not
prevented or detected and corrected by internal control was not detected by the
auditor's substantive audit procedures (i.e., an undetected material
misstatement exists in a relevant assertion).
III.
1.
Variations on the above Audit Risk Model
A. AR = RMM × DR, where:
“Risk of material misstatement” (RMM)—the auditor's combined
assessment of inherent risk and control risk (if IR and CR are not
separately assessed).
Note that RMM = IR × CR
1.
B. AR = RMM × TD × AP, where:
DR can be broken into two components involving the likelihood
that the auditor's two basic categories of substantive procedures fail
to detect a material misstatement that exists:
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(1) “tests of details risk” (TD) and;
(2) “substantive analytical procedures risk (AP).”
Note that DR = TD × AP
AR = IR × CR × TD × AP
IV. Quantification of the Risk Components
A. The component risks do not necessarily have to be quantified; for
example, they could be assessed qualitatively as high, medium, or low.
B. Each component is considered from left to right in order: audit risk is set,
then inherent risk is assessed, then control risk is assessed, and finally the
implications for the appropriate level of detection risk are considered.
C. “Detection risk” is the only component risk that is specifically the
auditor's responsibility”.
D. “inherent risk” arises because of the particular audit area under
investigation.
E. “control risk” reflects management's responsibility to design and
implement internal controls.
Note that the auditor must “assess” inherent risk and control risk, but the
auditor actually makes the decisions that, in effect, result in some level of
detection risk, which should take into consideration the auditor's
assessment of the risk of material misstatement.
1.
If IR and CR are seen by the auditor as too high, the auditor must
compensate by decreasing DR.
2. If IR and CR are perceived as low, the auditor may consider accepting a
higher DR.
F.
Increasing or decreasing DR is accomplished by adjusting the nature,
timing, and/or extent of the auditor's substantive audit procedures. These
might be viewed as the auditor's three strategic variables that, in effect,
“set” DR based on the auditor's professional judgment about the
following:
1.Nature: What specific audit procedures to perform (perhaps shifting the
relative emphasis placed on the “soft evidence” analytical procedures versus
the “hard evidence” tests of details)?
2.Timing: When will the procedures be performed? At an “interim” date (prior
to year-end) or at “final” (after year-end when the books have been closed) and
the auditor is actually auditing the numbers that the entity intends to report in
its financial statements)?
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3.Extent: Are large samples required for the auditor's test work or can somewhat
smaller sample sizes be justified? How extensively should substantive
procedures be performed?
AR = IR * CR * DR
MCQs
1- Detection risk differs from both control risk and inherent risk
in that detection risk
a.
b.
c.
d.
Exists independently of the financial statement audit.
Can be changed at the auditor's discretion.
Arises from risk factors relating to fraud.
Should be assessed in nonquantitative terms.
Planned Detection Risk Low : Auditor should Obtain evidence to reach low
level Of Planned Detection Risk
2- Which of the following audit risk components may be
assessed in nonquantitative terms?
Inherent risk
Yes
Yes
No
Yes
Control risk
Yes
No
Yes
Yes
Detection risk
No
Yes
Yes
Yes
3-Use the audit risk model to calculate audit risk (to the closest
percent) in the following circumstance:
Control risk
40%
Inherent risk
40%
Detection risk 40%
1%.
6%.
13%.
40%.
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Materiality Questions
1. Which of the following would an auditor most likely use in determining
the auditor's preliminary judgment about materiality?
a.
b.
c.
d.
The results of the initial assessment of control risk.
The anticipated sample size for planned substantive tests.
The entity's financial statements of the prior year.
The assertions that are embodied in the financial statements.
2. An auditor finds several errors in the financial statements that the client
prefers not to correct. The auditor determines that the errors are not material
in the aggregate. Which of the following actions by the auditor is most
appropriate?
a- Document the errors in the summary of uncorrected errors and document
the conclusion that the errors do not cause the financial statements to be
misstated.
b- Document the conclusion that the errors do not cause the financial
statements to be misstated, but do not summarize uncorrected errors in the
audit documentation.
c- Summarize the uncorrected errors in the audit documentation, but
do not document whether the errors cause the financial statements to be
misstated.
d- Do not summarize the uncorrected errors in the audit documentation, and
do not document a conclusion about whether the uncorrected errors cause
the financial statements to be misstated.
3. In considering materiality for planning purposes, an auditor believes that
misstatements aggregating $10,000 would have a material effect on an entity's
income statement, but that misstatements would have to aggregate $20,000 to
materially affect the balance sheet.
Ordinarily, it would be appropriate to design auditing procedures that would be
expected to detect misstatements that aggregate
$10,000
$15,000
$20,000
$30,000
4. Which of the following statements is not correct about materiality?
a- The concept of materiality recognizes that some matters are important for fair
presentation of financial statements in conformity with GAAP, while other
matters are not important.
b- An auditor considers materiality for planning purposes in terms of the largest
aggregate level of misstatements that could be material to any one of the
financial statements.
c- Materiality judgments are made in light of surrounding circumstances and
necessarily involve both quantitative and qualitative judgments.
d- An auditor's consideration of materiality is influenced by the auditor's
perception of the needs of a reasonable person who will rely on the financial
statements.
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5. Which of the following would an auditor most likely use in determining
the auditor's preliminary judgment about materiality?
abcd-
The anticipated sample size of the planned substantive tests.
The entity's annualized interim financial statements.
The results of the internal control questionnaire.
The contents of the management representation letter.
6. When issuing an unmodified opinion, the auditor who evaluates the
audit findings should be satisfied that the
a- Amount of known misstatement is documented in the management
representation letter.
b- Estimate of the total likely misstatement is less than a material mount.
c- Amount of known misstatement is acknowledged and recorded by the
client.
d- Estimate of the total likely misstatement includes the adjusting entries
already recorded by the client.
Population =10000
Sample = 5% from population = 500
Define materiality to be 10%
If the auditor finds errors amounted to 100
Discovered Errors= 100
Total Likely misstatement = 100/500 * 10000 = 2000 = 20%
The difference between the discovered Error of 100 & Likely
misstatement of 2000 =1900 imagined misstatements.
7. When planning a sample for a substantive test of details, an auditor should
consider tolerable misstatement for the sample. This consideration should
a- Be related to the auditor's business risk.
b- Not be adjusted for qualitative factors.
c- Be related to preliminary judgments about materiality levels.
d- Not be changed during the audit process.
8. Based on new information gained during an audit of a non-issuer, an auditor
determines that it is necessary to modify materiality for the financial
statements as a whole. In this circumstance, which of the following statements
is accurate?
a- The auditor is required to reperform audit procedures already completed
on the audit using the revised materiality.
b- The auditor should consider disclaiming an opinion due to a scope
limitation.
c- The revision of materiality at the financial statement levels will not affect
the planned nature and timing of audit procedures, only the extent of
those procedures.
d- Materiality levels for particular classes of transactions, account balances,
or disclosures might also need to be revised.
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9- Holding other planning considerations equal, a decrease in the
amount of misstatement in a class of transactions that an auditor
could tolerate most likely would cause the auditor to
abc-
Apply the planned substantive tests prior to the balance sheet date.
Perform the planned auditing procedures closer to the balance sheet date.
Increase the assessed level of control risk for relevant financial statement
assertions.
d- Decrease the extent of auditing procedures to be applied to the class of
transactions.
10- Which of the following procedures would an auditor most likely
perform in the planning stage of an audit?
a- Make a preliminary judgment about materiality.
b- Confirm a sample of the entity's accounts payable with known
creditors.
c- Obtain written representations from management that there
are no unrecorded transactions.
d- Communicate management's initial selection of accounting policies to
the audit committee.
11- Which of the following is correct concerning performance
materiality on an audit?
It will ordinarily be less than financial statement materiality.
It should be established at beginning of an audit and not be revised
thereafter.
It should be established at separate amounts for the various financial
statements.
It need not be documented in the working papers.
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Audit Risk Questions
Question 1
As a result of control testing, a CPA has decided to reduce control
risk. What is the impact on substantive testing sample size if all other
factors remain constant?
The sample size would be irrelevant.
The sample size would be higher.
The sample size would be lower.
The sample size would be unaffected.
Question 2
Inherent risk and control risk differ from detection risk in which of the
following ways?
Inherent risk and control risk are calculated by the client.
Inherent risk and control risk exist independently of the audit.
Inherent risk and control risk are controlled by the auditor.
Inherent risk and control risk exist as a result of the auditor's judgment about
materiality.
Question 3
The acceptable level of detection risk is inversely related to the
Assurance provided by substantive tests.
Risk of misapplying auditing procedures.
Preliminary judgment about materiality levels.
Risk of failing to discover material misstatements.
Question 4
The risk that an auditor will conclude, based on substantive tests,
that a material error does not exist in an account balance when, in
fact, such error does exist is referred to as
Sampling risk.
Detection risk.
Nonsampling risk.
Inherent risk.
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Question 5
Inherent risk and control risk differ from detection risk in that inherent
risk and control risk are
Elements of audit risk while detection risk is not.
Changed at the auditor's discretion while detection risk is not.
Considered at the individual account-balance level while detection risk is not.
Functions of the client and its environment while detection risk is not.
Question 6
As the acceptable level of detection risk increases, an auditor may
change the
Assessed level of control risk from below the maximum to the maximum
level.
Assurance provided by tests of controls by using a larger sample size than
planned.
Timing of substantive tests from year end to an interim date.
Nature of substantive tests from a less effective to a more effective
procedure.
Question 7
When an auditor increases the assessed level of control risk because
certain control procedures were determined to be ineffective, the
auditor would most likely increase the
Extent of tests of controls.
Level of detection risk.
Extent of tests of details.
Level of inherent risk.
Question 8
Inherent risk and control risk differ from detection risk in that they
Arise from the misapplication of auditing procedures.
May be assessed in either quantitative or nonquantitative terms.
Exist independently of the financial statement audit.
Can be changed at the auditor's discretion.
Question 9
Holding other planning considerations equal, a decrease in the number of
misstatements in a class of transactions that an auditor could tolerate most
likely would cause the auditor to:
a.
b.
c.
d.
Apply the planned substantive tests prior to the balance sheet date.
Perform the planned auditing procedures closer to the balance sheet date.
Increase the assessed level of control risk for relevant financial statement assertions.
Decrease the extent of auditing procedures to be applied to the class of transactions.
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Question 10
As a result of control testing, a CPA has decided to reduce control risk. What is the
impact on substantive testing sample size if all other factors remain constant?
The sample size would be irrelevant.
The sample size would be higher.
The sample size would be lower.
The sample size would be unaffected.
Question11
Use the audit risk model to calculate audit risk (to the closest
percent) in the following circumstance:
Control risk
40%
Inherent risk
40%
Detection risk 40%
1%.
6%.
13%.
40%.
Question 12
Which of the following audit risk components may be assessed in
nonquantitative terms?
Control
risk
Detection
risk
Inherent
risk
Yes
Yes
No
Yes
No
Yes
Yes
Yes
Yes
No
Yes
Yes
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Question13
In a financial statement audit, inherent risk is evaluated to help an
auditor assess which of the following?
a. The internal audit department's objectivity in reporting a material misstatement of a financial
statement assertion it detects to the audit committee.
b. The risk that the internal control system will not detect a material misstatement of a financial
statement assertion.
c. The risk that the audit procedures implemented will not detect a material misstatement of a
financial statement assertion.
d. The susceptibility of a financial statement assertion to a material misstatement assuming there
are no related controls.
Question14
Failure to detect material dollar misstatements in the financial statements is a
risk which the auditor primarily mitigates by
Performing substantive procedures.
Performing tests of controls.
Assessing internal control.
Obtaining a client representation letter.
Question 15
As the acceptable level of detection risk decreases, the assurance directly provided
from
Substantive procedures should increase.
Substantive procedures should decrease.
Tests of controls should increase.
Tests of controls should decrease.
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Example:
1-
Net Income
2015
100000
2016
120000
2017
141600
2018
145000
135000
Growth of Net Income
Suppose that The Auditor identify materiality as of 15000
Find Errors with 10000.
Materiality measure would be =145000-141600=3400
Example2: if 2020 =Net income = 100
Materiality would be $100
Example-3:
Case: A; Materiality 1000: More Evidence= More Assurance
Case B: Materiality 5000
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