 Hello and welcome to this session in which we will discuss how risk and materiality influence or affect the audit evidence. First what I'm going to do, I'm going to briefly discuss what is risk, what is materiality in our materiality or performance materiality was discussed much, much more in details in several recording, that's fine but today I'm going to discuss it briefly in order to draw the relationship between risk materiality and evidence. Now I can summarize this whole lecture in one statement which I will at the end but it's very important as an accounting student, as a CPA candidate to understand how risk and materiality affect evidence. So let's start by defining risk. What is risk? Risk quantified or measure uncertainty. Now as auditors we have to assess the risk associated with auditing financial statements, we can set the risk at 5, 10 or 15 percent and this is going to help us determine how much evidence do we need to select, the nature of the audit procedures that we need to perform. So it will help us determine the scope, nature of the audit and procedures needed to obtain audit evidence and we talked about this when we discuss risk of material misstatement. On the other hand materiality measures or assesses the magnitude of the mistake. Now materiality was explained in several recordings. If you want to understand this in this concept is our tolerance for mistake and materiality is a subjective concept. It can vary depending on the context of the audit. So materiality is a figure that we have to set. How much are we willing to tolerate mistake? When is a mistake material? At what dollar amount? Again that is a subjective concept and we explain why in the recording. So the auditor will need to assess materiality when planning and conducting an audit also it will help in the nature, extent and audit procedures. So now the relationship between risk, materiality and audit evidence is all interconnected. Why? Because the auditor will need to take into account the risk, materiality in order to determine the evidence. What is the evidence? How much do we need to collect determine the amount type of audit evidence required to support the audit opinion and that's why they are all interrelated. So I'm going to explain using a simple example first then use an example for a financial statement to illustrate these concepts. Before we proceed any further I have a public announcement about my company farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. 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Let's assume you want to travel from New York to Boston and you have two options you can take the plane fly from New York to Boston or you can take the train and I'm going to be throwing some figures some percentages but those are not real just to make the point let's assume there's a 5% chance of an accident occurring whether you take the plane or you take the train you know that's not true but let's assume that's the case so the risk of an accident occurring is 5% so the risk is the same whether you take a plane and whether you take the train how about the consequences or the magnitude or the materiality of the risk is it the same if an accident happened on a plane what would happen to the passengers what would happen to the passengers if an accident happened on a train well here what we go here's what we're gonna say and again I'm using extreme numbers or extreme example to make the point if a plane goes down there's a 0% you surviving on that plane so the consequences are great if a train accident occurred we're gonna assume there's a more than 50 surviving a train accident so notice the risk is the same the risk of the accident occurring is the same however the materiality the magnitude the consequences of the risk is not the same so the plane it's a higher risk higher magnitude same risk higher magnitude of the risk higher materiality of the risk so let's assume you are an inspector with the government agency you know what what's going to happen is this as an inspector and here what we mean by inspector you know auditor but let's assume you're an inspector to kind of make this example realistic your inspector of the transportation agency you are more likely to be more nervous more nervous means you want to do more work when inspecting the plane why because the consequences of missing something is great you don't want to take that chance so notice the materiality you want to check everything you want to check the tires the engine the software the equipment the lights the brakes everything on that plane you want to check or you want to check as much as possible on the plane because the materiality is higher than inspecting the train now again this is in theory as an inspector you need to do your work whether it's a plane train a bus or anything else but i'm trying to make the point here so let's take the analogy from the airplane and the train trip and superimpose it on two companies we're gonna look at two companies one company we're gonna consider the risky and what what we mean by risky is they have a high inherent control and a high control risk a high risk of material misstatement and we're gonna compare this to a company will they have a low inherent risk and a low control risk which is a low risk of material misstatement if you don't understand what risk of material misstatement is inherent risk or control risk and how they all relate to each other you want to go to my audit risk model all you have to accept now is we have a risky company and not a risky company and we're gonna you know go further and say that a risky company will have more mistakes notice each axe here is a mistake notice there are more axes more mistakes in the risky company now how to set materiality for these two companies so if you're setting materiality for these two companies what do you want to do if the company is risky remember if the company is risky and i'm gonna go step further remember risk and magnitude they kind of go hand and hand if the company is risky and the magnitude is even riskier what do i have to do like remember that inspector i have i want to catch as many mistakes and look at them as possible so my tolerance goes down my tolerance goes down now let's assume i'm gonna just just to choose a number randomly i'm gonna set my materiality at 100 000 for this company and this is the materiality 100 000 so notice if i set my materiality at 100 000 i'm going to ignore or not really look into those four mistakes and i'm gonna be catching those the one that's above 100 000 look at them because the one below they're not as material as important and let's assume i'm going to set the same materiality for the risky company so if i go and i set my materiality here look what's gonna happen i'm going to be ignoring or missing all these mistakes notice it's a risky company i set my materiality high i'm gonna be missing a lot i'm gonna be missing all these mistakes so what do i have to do then if i want to be more careful i i'm the inspector i'm the auditor and i want to catch as many mistakes because the company is risky i would lower my materiality i would lower my materiality why because i want to expand my net i want to catch as many mistakes as possible now if i want to i will set it up at zero but that's not possible and inspect everything because we sample we can do that right but i have to set my materiality at some point so lower materiality so in theory set materiality to zero it's trying to catch everything low materiality so simply put the lower the materiality the more evidence i have to collect because i'm gonna be trying to catch as much as possible so that's the important relationship i was trying to tell you at the beginning there's an inverse relationship between materiality and the amount of evidence if i set my materiality low i need to catch as much evidence as possible i have to do more work as my materiality which is the risk for mistakes my tolerance for mistakes goes down i need to collect more evidence once again materiality goes down i need more evidence and the opposite is true what should you do now go to far hat lectures and look at additional resources that's going to help you understand this concept materiality control risk inherent risk the risk of materialness statement how they they all relate to evidence invest in yourself the CPA exam is worth it good luck and study hard