Comparison risk ranking applications: here's one method of allocating tolerable misstatement.

Here's one method of allocating tolerable misstatement.

Audit engagements can be viewed as a process of identifying, evaluating and ranking risk. Although decisions on risk ultimately are a function of audit judgment, CPAs can use various techniques to facilitate the process. This article illustrates one such technique: A detailed model for allocating tolerable misstatement is presented and other applications are suggested.

THE DELPHI TECHNIQUE 

Project Delphi was a U.S. Air Force study conducted in the early 1950s by the Rand Corporation, a California think tank. It lead to the development of an analytical approach to problem solving based on the conclusions of a small group of three to seven individuals (a Delphi team) with specialized knowledge of a particular topic. A similar - and considerably more expensive - method, "expert systems," also has emerged. Expert systems use a computerized hierarchy of rules elicited from individuals with particular knowledge of a field. This article illustrates a versatile Delphi ranking technique that costs little in money and time when compared to some of the auditing expert systems that recently have been developed.

PRELIMINARY MATERIALITY 

ALLOCATION

Audit risk is the risk that auditors may fail to appropriately modify an opinion because of a material financial statement misstatement. Some degree of audit risk will always exist because of inherent limits of the audit process. Statement on Auditing Standards no. 47, Audit Risk and Materiality in Conducting an Audit, suggests auditors should consider materiality in planning an audit. One common method of doing so is establishing a preliminary estimate of materiality. Such estimates constitute the aggregate dollar amount the financial statements could be misstated and still be fairly presented. Once established, this materiality estimate usually is distributed among various classes of transactions or financial statement elements as tolerable misstatement - the amount each of the individual financial statement elements can differ from their true amount without affecting the fair presentation of the financial statements taken as a whole.

Although various approaches to allocating tolerable misstatement may be employed, the example shown below assumes a straightforward distribution among financial statement elements.

On first consideration, it might appear appropriate to simply allocate aggregate preliminary materiality in proportion to the balances of the various financial statement elements. This would be an acceptable approach if

* The nature of the various financial statement elements were the same.

* The difficulty of attaining the necessary level of assurance as to the validity of the various assertions contained in each financial statement element were equivalent.

* There were no restrictions on audit strategy or resources.

In reality, however, some financial statement elements, such as land, may be significant in amount yet the minimal risk of misstatement and the easy availability of evidence means few audit resources are needed to reduce the risk of undetected misstatement to an acceptably low level. A different situation exists for other elements, such as inventory, for which the misstatement risk is more significant and audit evidence is more difficult or costly to obtain. Allocating a disproportionate amount of tolerable misstatement to financial statement elements such as inventory increases audit efficiency by reducing the audit resources needed to achieve the desired level of audit risk.

Although the concept may be clear, the actual allocation of the aggregate preliminary materiality estimate to the tolerable misstatement of individual financial statement elements is complex. A number of factors - classified overall as inherent risk, control risk and detection risk - must be considered. Of course, these risks vary among different industries, clients, audit periods and financial statement assertions. Although some CPA firms have developed a structured approach for allocating tolerable misstatement amounts to financial statement elements, other firms determine this allocation within broad guidelines.

There is nothing intrinsically wrong with an informal approach to tolerable misstatement allocation because all methods, including highly structured approaches, ultimately reflect audit judgment. However, the significance of the allocation in terms of the conduct of the audit, coupled with the complexity of the judgment being made, support a deliberative approach. There also is a need in all audits to document adherence to auditing standards, particularly the exercise of due care in planning the work to be performed.

To allocate tolerable misstatement using our approach, a Delphi team is selected. The three-to-seven person team typically includes the engagement partner, manager in-charge auditor, statistical or computer specialists or other personnel with knowledge pertinent to the specific engagement Inclusion of less experienced members of the audit team as observers may be desirable in terms of staff training and enhancing team members' understanding of the client.

Typically, each team member has an equal vote, but members' votes can be weighted. For example, the engagement partner might cast two votes. Of course regardless of the team's conclusions, the engagement partner still is free to exercise his or her prerogative when making the final tolerable misstatement allocation.

This same technique also can be used by single practitioners acting as a "team" of one. The benefits of arriving at a carefully reasoned and documented result are retained even though different points of view are necessarily forgone.

EXAMPLE - ALLOCATION OF

PRELIMINARY MATERIALITY

For illustration purposes, the simplest possible financial statements were sought. To this end, a development-stage company with financial statement elements (condensed and rounded to the nearest $5,000) as shown in exhibit 1, page 87, was used.

A three-person Delphi team was assembled, which determined a preliminary materiality amount of $10,000. Allocating this $10,000 as tolerable misstatement for the financial statement elements using our comparative risk ranking approach was accomplished as follows.

The process began with a risk ranking sheet in the format of exhibit 2, page 88, which shows a completed sheet with the financial statement elements as row and column headings among which the preliminary materiality is to be distributed, the votes of the three-member Delphi team in the cells in the body of the sheet and the final computed rankings along the left outside margin.

THE RANKING SHEET

The first step in preparing the ranking sheet was to enter the financial statement elements to be ranked, as row headings down the left and also as column headings across the stair-stepped top. With this row and column configuration, the financial statement element identifying each column can be individually compared with the various elements identifying each row.

The Delphi team discussed the various risk factors coupled with the effectiveness and efficiency of obtaining audit evidence as the basis for voting on each pairing. A team may wish to use checklists or other supporting materials to ensure no pertinent factors are omitted.

As individual column elements were compared with each of the row elements, the votes for each pair of elements were entered in the lower left and upper light sections of their individual cells. The sum of votes in each cell always equals the votes cast in this case, three.

For example in determining the relevant risks and audit considerations bearing on the allocation of tolerable misstatement only to the two elements "cash and securities" and "notes payable," each team member allocated 0.9 of his or her vote to "notes payable" and 0.1 to "cash and securities," resulting in the two totals in the cell of 2.7 (0.9 + 0.9 + 0.9) and 0.3 (0.1 + 0.1 + 0.1).

The process was repeated for each of the other five financial statement elements under "cash and securities" in the first column and then repeated for each pair of elements under the remaining columns. A major strength of this ranking technique is that only two items need to be compared at any one time.

Although stockholders' equity (paid-in capital plus accumulated development stage loss) was included here, it most likely would have been omitted had the firm audited this company in prior years. Assigning it a tolerable misstatement amount might be then redundant because it is the balancing residual of the other accounts. This shows how financial statement elements might be omitted when setting up the comparison risk ranking sheet if the Delphi team feels allocation of tolerable misstatement is inappropriate because of redundancy, lack of materiality or a low misstatement risk.

After voting was completed for all cells, the comparative overall ranking shown outside the left margin was computed as follows. For the cash and securities comparative ranking, votes in the upper light half of each cell under the cash and securities column heading were totaled and shown outside the left margin as 5.8 (0.3 + 1 + 1 + 1.5 + 1 + 1).

To determine the notes payable comparative ranking, first the votes in the upper right of each cell under the notes payable column were totaled as 10.7 (2.7 + 2 + 2 + 2 + 2). This yields a partial result because only the five elements in the column have been totaled (paid-in-capital, accumulated development stage loss, research and development expenses, salary expenses and miscellaneous expense). To include the sixth element (cash and securities), the votes in the lower left of the cell in the notes payable row must be added to the partial total (add 2.7 to the partial total 10.7 to get 13.4).

To find the final ranking of any element, add the votes in the upper right of the column cells to the votes of the lower left of the row cells. Only "cash and securities" and "miscellaneous expenses" have all their votes added in a single direction, as shown in the diagram at left.

Finally, to allocate tolerable misstatement amounts to the various account balances, the separate values outside the left margin were summed to 63 (5.8 + 13.4 + 9.8 + 9 + 9 + 8 + 8). The $10,000 preliminary estimate of materiality was then allocated proportionately, cash and securities 5.8/63 X $10,000 = $900 (rounded), and so forth.

OTHER APPLICATIONS

Auditors regularly need to evaluate and rank alternatives. The illustrated ranking technique applies in such instances. For example, a formal evaluation of inherent risk factors may be required. To make the evaluation, a breadth of knowledge about the client, the industry and the economic environment is needed. A group is more likely to have the desired degree of intimate knowledge over such a diverse range of fields than is one person. Augmenting checklists with the expertise group members have in relation to a client, the client's industry, overall economic conditions and other factors ensures that relevant risks are identified and accurately ranked.

Substantive testing can be reduced when reliance can be placed on internal controls. Assessing control risk in terms of financial statement assertions also requires appraisal of the interaction of diverse factors. Again, such complex assessments are improved by bringing to bear group expertise. Using a Delphi team, the controls a reduction in control risk is predicated on can be formed into ranked lists related to financial statement assertions.

Nonaudit uses also exist. For example, development of a new computer system was stalled because of the user group's inability to reach a decision about the relative risks. Several attempts to resolve the conflicts were unsuccessful. Finally, users met as a Delphi team using the comparison risk ranking technique. Forced to focus and vote on only one pair of features at a time, the group quickly generated a ranked list and the project was able to proceed.

COMPLEX EVALUATIONS

Auditors need to formally assess a wide variety of factors. Increasingly, these assessments need to be documented, not only for use in performing an audit and for internal review but also for peer review purposes. The complexity of making such evaluations supports the participation of more than one qualified individual. Yet, given differing evaluations among group members, it is necessary to find a method of expeditiously reaching a conclusion. The comparative ranking technique discussed here separates the factors involved in a decision so group members consider only two at any one time. Once voting is complete, the final ranking is a simple mechanical process that is easily understood. A valuable by-product of this technique is the automatic documentation of the overall exercise of due care, audit planning, conclusions reached and the process used.

EXECUTIVE SUMMARY

* Auditors can use a team approach to help them make judgments about estimating materiality - the amount by which financial statements can be misstated and still fairly presented - and allocating this materiality total as tolerable misstatement among financial statement elements.

* A number of factors - inherent risk, control risk and detection risk - must be considered in allocating the preliminary materiality estimate to the tolerable misstatement of individual financial statement elements. CPA firms have adopted various approaches for making this allocation.

* A Delphi team of three to seven members, typically including the engagement partner, manager, in-charge auditor, statistical or computer specialists and other pertinent personnel, votes to allocate tolerable misstatement after discussing specific aspects of the audit. A ranking sheet, as well as other audit tools such as checklists, assists in - and documents - this process.

* The Delphi team ranking technique also can be used to make other decisions, both audit and nonaudit related. Frequently, complex assessment are improved by bringing to bear group expertise.

Ray Roberts, CPA, is professor of accounting, School of Business and Economics, California State University, Hayward. Steven T. Giorgione, CPA, is a sole practitioner in Las Vegas.

The authors thank Jerry FitzGerald, PhD, for providing the software used to print exhibit 2.