Audit Risk and Materiality.

Audit Risk:
Audit risk is the risk that an auditor expresses an inappropriate opinion on the finacial statements.
Many times most of us think that after an audit, the statements are perfect and free from error. However, auditors just provide reasonable assurance that the statements are free from error. Secondly, the auditors' opinion means that the statements are free from material misstatement.
Inappropriate opinions include:

1. Issuing a qualified opinion where no qualification is necessary.
2. Issuing an unqualified audit report where a qualification is reasonably justified.
3. Failing to emphasize  a significant matter in the audit report.

Auditing is directly related to areas that pose the greatest risk.

The audit risk model:
Audit risk = Inherent risk x Control risk x Detection risk

Where:
Audit risk - This can be looked at as the product of the different risks which may be encountered in the performance of the audit.
The qualified tolerance for most firms is 5% or less.
Inherent risk - This is risk of a material misstatement in the finacial statements arising due to error or omission as a result of factors other than the failure of controls.
This risk is considered to be higher where a high degree of judgement and estimation is involved.
Control risk - Risk that a material misstatement might not be detected or prevented on time by the internal control systems.
This risk is connsidered to be high where the audit entity does not have adquate internal controls to prevent fraud.
Detection risk - Risk that the auditor fails to detect a material misstatement in the financial statements.
This risk can be reduced by the auditor increasing the number of sampled transactions for detailed testing.

Assessing the audit risk:
The inherent risk and control risk is assessed by the auditor at three levels. That is;

1. Low risk
2. Medium risk
3. High risk

High inherent and control risks call for a low detection risk so as to have an overall low audit risk. The auditor therefore needs to carry out more detection procedures to be convincingly assured about the financial statements being free from material misstatements.

Materiality:
Materiality refers to the truthfulness of the material. It is the magnitude of an omission or misstatement of accounting information that makes it probable that the judgement of the persons (such as management, investors and shareholders) relying on that information would have been changed by the misstatement. Materiality is a matter of proffesional judgement,
Net income before taxes is often the primary basis needed for evaluating materiality. Determination of materiality requires "delicate assessment of the interferences a 'reasonable shareholder' would draw from a given set of facts and the significance of those interferences to him..."

The steps in applying materiality are as outlined below:

1. Set preliminary judgement about materiality.
2. Allocate preliminary judgement about materiality to the segments.
3. Estimate total misstatements in each of the segments.
4. Estimate the combined misstatements.
5. Compare combined estimate with preliminary or revised judgement about materiality.

Materiality needs to be considered at two instances and these are:

1. When planning and designing the audit process.
2. When allocating the chances of errors in the financial statements in accordance to GAAP.

REFERENCE:
www.readyratios/reference/audit/audit_risk.html
TSC Industries, 4626 U.S. at 450