Question

A firm uses the audit risk model, AR=RMMxDR, to plan audit programs, as described below.

Audit Risk: The firm’s AR ranges, for any materiality amount, are:

                                            VERY LOW                         1% to <5%

                          LOW                                    5% to <10%

                          MODERATE                      10% to 30%

                                            HIGH                                    Not permissible

These ranges are modified according to the type of risk, as described below.

If an auditor doesn’t specify a numerical risk level for AR, the auditor must specify a category (VL, L or M, but not H). The firm’s planning software will then assume that VL=1%, L=5% and M=10%.

Preliminary Risk of Material Misstatement, RMMp: This risk is based on the auditor’s judgment regarding the design effectiveness of the system in place. If the auditor doesn’t specify a risk level for RMMp, the auditor must specify a category (VL, L or M or H). The firm’s planning software will then assume that VL=5%, L=10%, M=30% and H=100%.

Risk of Material Misstatement, RMM: RMM is the auditor’s assessment of the operating effectiveness of controls, which is determined from the auditor’s tests of controls.

Detection Risk, DR: The auditor should specify a value for DR that is consistent with AR and RMM.

That is, DR = AR / RMM and is dependent on the auditor’s choices of AR and RMM. If application of the risk levels for AR and RMM, pursuant to the above guidelines, results in DR≥50%, then the auditor sets DR=50%. DR > 50% is not permissible under the firm’s guidelines.

Suppose the auditor specifies only the categories for AR and RMMp, not numerical values. Briefly explain the reason for the firm’s software planning tool setting AR to the low end of the range for each category and RMM to the high end of the range for each category.

A. The auditor sets AR to LOW, and RMM, the operating effectiveness, is found to be MODERATE. Calculate planned DR in accordance with the planning guideline.

B. The auditor sets AR to LOW, and RMM, the operating effectiveness, is found to be HIGH. Calculate planned DR in accordance with the planning guideline.

C. The auditor sets AR to MODERATE, and RMM, the operating effectiveness, is found to be LOW. Calculate planned DR in accordance with the planning guideline.

           3.    Assume that scope of the examination remains constant.

   A. What effect does increasing the materiality amount have on DR?

   B. What effect does increasing the materiality amount have on AR?

                 

            4.   Assume that the operating effectiveness of controls, RMM, is determined.

                   A. If M is increased, but AR and DR are unchanged, what is the effect on the scope of the

                   examination? [Your answer should be either: enhanced, unchanged or reduced]

                  B. If scope is enhanced, but not AR, what is the possible effect on the amount of misstatement that could

                  be detected at that fixed level of AR? [This is equivalent to asking: What is the effect

Answer 1

Answer 3:     

The effects of increasing materiality amount on detection risk (DR):

The detection risk will enhanced as a result of increasing materiality amount since the small amounts will be verified with less intensity.

The effects of increasing materiality amount on audit risk (AR):

The overall audit risk will increase subsequent to the increase of materiality amount as the audit procedures will be accordingly designed to check the transactions and items above the material amount.

Answer 4:

The scope of examination will be reduced with the increase in materiality levels thus, the extent of verification of financial transactions will be affected with the increase in materiality amount. The financial transactions with amount below the materiality levels will not be examined as extensively as these would have been had the financial transactions been at par with the materiality levels.    

In case of enhancement of scope the amount of misstatements that could be detected would have increased significantly.