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If you are thinking about this in the context of the audit risk model:
Audit risk (the ultimate risk) = Inherent risk (IR) x Control risk (CR) x Detection risk (DR)The auditor assesses the risk of material misstatement arising through IR and CR. DR is “managed” by the auditor to ensure that the level of audit risk acceptable.
The components of risk are not necessarily calculated as percentages but may also be thought of in terms of high/medium/low. For example, let’s say audit risk is 5%:
IR is assessed at a 75% risk that material problems could arise (that’s high)
CR is assessed at a 20% risk that controls may miss material errors (that’s relatively low)
Using the model 0.05 = 0.75 × 0.2 × DR
Therefore DR = 0.33 (that’s “medium”)
This means that the levels of substantive tests planned should be adequate, even if there is a 33% chance that they fail to detect material errors or omissions.thanks so much; this was very helpful in esp explaining how the different risk affects the other.
How ever, lets say for a question – “If a Preliminary Estimation of materiality is $2 million, is performance materiality likely to be $1 million or $3 million?
I do not understand the term “Preliminary Estimation”
I see now that you are referencing one of the revision test Qs. The “preliminary estimate” of materiality is made at the planning stage and is called “planning materiality” – this is determined in relation to the financial statements as a whole (and hence sometimes called “overall materiality”).
Performance materiality is used in the performance of audit procedures – it assists in deciding which accounts to concentrate on, determining sample sizes etc. Logically, it cannot exceed the preliminary estimate (if $2m is considered material for the financial statements as a whole it will clearly be material to individual accounts) and is typically reduced (e.g. by 25-50%). This recognises the risk that the aggregate of errors and omissions each less than $2m may exceed $2m. The auditor will identify smaller errors and omissions if performance materiality is LESS than planning materiality.
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