Relationship between Materiality and Audit Risk

Relationship between Materiality and Audit Risk

• inverse relationship between materiality and the level of audit risk
• If materiality level is lower, audit risk is increased

First, quick recap:

• Materiality = how big / important an error must be before it matters to users of the financial statements.
• Audit risk = the risk that the auditor gives the wrong opinion on financial statements that are materially misstated.

They are linked in planning the audit:

When the auditor changes materiality, it affects audit risk and the amount of audit work needed.

1. Inverse relationship (concept)

For a given level of audit work:

Lower materiality (stricter, more sensitive) →

• Even smaller errors are considered material.
• Higher chance that something “material” is missed.
• So audit risk would be higher if auditor doesn’t increase work.

Higher materiality (less strict) →

• Only bigger errors are material.
• Lower chance that a material error is missed.
• So audit risk would be lower if work stays the same.

Therefore, auditors must adjust their procedures so that final audit risk stays acceptably low.

2. How auditors balance them in practice

In planning, the auditor decides:

• Acceptable audit risk (must be low).
• Materiality level (how big a misstatement is “material”).

Then they design their work:

If they set lower materiality (more strict):

• They must reduce detection risk
• → More evidence, larger samples, more detailed testing
• → To keep audit risk low.

If they set higher materiality (less strict):

• They can accept slightly higher detection risk
• → May need less work, smaller samples
• → But still must keep overall audit risk acceptably low.

3. Simple way to explain in exam

You can write something like:

Materiality and audit risk are closely related in audit planning. Materiality is the size or nature of misstatement that could influence users’ decisions, while audit risk is the risk that the auditor gives an inappropriate opinion on materially misstated financial statements. 

If the auditor sets a lower materiality level, more misstatements will be considered material, so to keep audit risk low the auditor must perform more audit procedures and reduce detection risk. 

If a higher materiality level is used, fewer misstatements are material and the auditor may accept a higher detection risk, but overall audit risk must still be kept at an acceptably low level.