Chapter 9 Multiple-Choice Questions 1. easy a
If it is probab probable le that that the judgment judgment of a reason reasonabl ablee person person would have been been change changed d or influe influence nced d by the omissio omission n or missta misstateme tement nt of inform informatio ation, n, then then that that inform informatio ation n is, by definition of FASB Statement No. 2: a. material. b. insignificant. c. significant. d. relevant.
2. easy b
The preliminary judgment about materiality is the amount by which the auditor believes the statements could be misstated and still not affect the decisions of reasonable users. a. minimum b. maximum c. mean average d. median average
3. easy d
Auditors are responsible for determining whether financial statements are materially misstated, so upon discovering a material misstatement they must bring it to the attention of: a. regulators. b. the audit firm’s managing partner. c. no on one in in pa partic ticular lar. d. the the clie client nt’s ’s mana manage geme ment nt..
4. easy c
The FASB definition of materiality emphasizes what class of financial statement users? a. Regulators. b. Informed investors. c. Rea Reasonable pe persons. d. Pote Potent ntia iall inve invest stor orss.
5. easy d
When auditors allocate the preliminary judgment about materiality to account balances, the materiality allocated to any given account balance is referred to as: a. the materiality range. b. the error range. c. tole tolerrable ble ma mater teriali iality ty.. d. tole tolerrable ble mis misstate tateme ment nt..
6. easy c
Why do auditors establish a preliminary judgment about materiality? a. To determine the appropriate level of audit experience required for the work. b. So that the client can know what records to make available to the auditor. c. To plan plan the the appr approp opri riat atee audit audit evide evidenc ncee to accum accumul ulat atee and and deve develop lop an overal overalll audit audit strategy. d. To fin final alize ize the the asse assess ssme ment nt of of contr control ol risk risk..
7. easy b
Auditor Auditorss are _____ to decide decide on the combine combined d amount amount of missta misstatem tement entss in the financ financial ial statements that they would consider material early in the audit. a. permitted b. required c. not allowed d. str strong ongly enc encour ouraged aged
8.
If an auditor establishes a relatively high level for materiality, then the auditor will:
Arens/Elder/Beasley Arens/Elder/Beasley
easy b
a. b. c. d.
9. easy d
The preliminary judgment about materiality and the amount of audit evidence accumulated are _____ related. a. directly b. indirectly c. not d. inversely
10. easy d
After th the pr preliminary ju judgment ab about ma materialit y has b beeen es established, au auditors m maay: a. not adjust it. b. adjust it downward only. c. adju adjust st it upwa upwarrd only only.. d. adjus adjustt it it eith either er down downwa ward rd or upwa upward rd..
11. easy c
In an audit area that has a lower inherent risk, it would be prudent to: a. increase the amount of audit evidence gathered. b. assign more experienced staff to that area. c. increa increase se the tolerab tolerable le missta misstatem tement ent for the area. area. d. expa expand nd pla plann nnin ing g pro proce cedu dure res. s.
12. easy d
Which of the following is least likely to be appropriate as the basis for determining the preliminary judgment about materiality in the audit of financial stat ements? a. Net income before taxes. b. Current assets. c. Owners’ equity. d. Inventory.
13. easy c
Auditing standards _____ that the basis used to determine the preliminary judgment about materiality be documented in the audit files. a. permit b. do not allow c. require d. stro trongly en encourage
14. easy d
Amounts involving involving fraud fraud are usually considere considered d _____ important important than unintentional unintentional errors errors of equal dollar amounts. a. le less b. no less c. no more d. more
15. easy a
Which of the following qualitative qualitative factors factors may significantly significantly influence influence whether whether an item is deemed to be material?
a. b. c. d.
Arens/Elder/Beasley Arens/Elder/Beasley
accumulate more evidence than if a lower level had been set. accumulate less evidence than if a lower level had been set. accumulate accumulate appro approximately ximately the same same evidenc evidencee as would be the the case case were were material materiality ity lower. lower. accumul accumulate ate an und undete etermin rmined ed amount amount of eviden evidence. ce.
Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations. Yes No Yes No
Misstatements that are otherwise immaterial may be material if they affect a trend in earnings Yes No No Yes
16. easy a
Auditors generall y allocate the preliminary judgment about materiality to the: a. balance sheet only. b. income statement only. c. incom incomee sta state teme ment nt and and balan balance ce shee sheet. t. d. sta stateme tement nt of cash cash flows lows..
17. easy c
Which of the following statements regarding inherent risk is correct? a. The inheren inherentt risk assigned assigned in the audit audit risk risk model model is unaffec unaffected ted by the auditor’ auditor’ss experienc experiencee with client’s organization. b. Most auditors set a low inherent risk in the first year of an audit and increase it if experience shows that it was incorrect. c. Most Mo st audi audito tors rs set set a high high inher inheren entt risk risk in the the firs firstt year year of an audi auditt and and redu reduce ce it in subsequent years as they gain experience, even when t here is inherent risk. d. The The inhe inhere rent nt risk risk assi assign gned ed in the the audit audit risk risk mode modell is depen depende dent nt upon the the stre streng ngth thss in client’s internal control system.
18. easy a
Auditors begin their assessments of inherent risk during audit planning. Which of the following would not help in assessing inherent risk during t he planning phase? a. Obtaining client’s agreement on the engagement letter. b. Obtaining knowledge about the client’s business and industry. c. Tour Touring ing the the clie client’ nt’ss p pla lant nt and and offi office ces. s. d. Iden Identi tify fyin ing g rela relate ted d part partie ies. s.
19. medium b
Auditors commonly allocate materiality to balance sheet accounts rather than income statement accounts because most income statement misstatements have a(n) _____ effect on the balance sheet. a. reduced b. equal c. undetermined d. increased
20. medium b
Which of the following is not a correct statement regarding the allocation of the preliminary judgment about materiality to balance sheet accounts? a. Auditors expect certain accounts to have more misstatements than others. b. The allocation has virtually no effect on audit costs because the auditor must collect sufficient appropriate audit evidence. c. Auditors Auditors expect expect to identify identify overstateme overstatements nts as as well well as understatem understatements ents in the the accounts accounts.. d. Rela Relativ tivee audit audit cos costs ts aff affec ectt the allo alloca catio tion. n.
21. medium b
What is the primar mary means of dealin ling with risk isk in planning decisio ision ns related to audit evidence? a. Selection of more effective tests of details of balances. b. Application of the audit risk model. c. Establis Establishin hing g a lower lower prelimin preliminar ary y judgme judgment nt about about mate materia riality lity.. d. Alloc Allocat atin ing g mater materia ialit lity y judgm judgmen entt to segme segments nts..
22. medium d
The phrase “in our opinion ion” in the the auditor tor’s report is is inte inten nded to inform users that audito itors: a. guarantee fair presentation of the financial statements. b. act as insurers of the accuracy of the statements. c. certify certify the the mater material ial pres present ented ed in the the state statemen ments ts by mana manage gemen ment. t. d. base base their their conclu conclusio sions ns about about the state statemen ments ts on profes profession sional al judgmen judgment. t.
23. medium d
Inherent risk is _______ related to detection risk and _______ related to the amount of audit evidence. a. directly, inversely b. directly, directly
Arens/Elder/Beasley Arens/Elder/Beasley
c. d.
inve inverrsely sely,, inve invers rsel ely y inv inversely, ly, dir directly tly
24. medium b
The five steps in applying materiality are listed below in random order. 1. Estimate the combined misstatement. 2. Estimate the total misstatement in t he segment. 3. Set prelimin preliminary ary judgment judgment about about materia materiality. lity. 4. Allocate Allocate preliminary preliminary judgme judgment nt about about materiality materiality to segments. segments. 5. Compar Comparee combine combined d estimate estimate with with prelim prelimina inary ry judgme judgment nt about about materi materiali ality. ty. The correct sequence from start to finish would be: a. 1 2 5 4 3. b. 3 4 2 1 5. c. 4 3 1 5 2. d. 5 1 3 2 4.
25. medium b
Which of the following statements is not correct? a. Materiality is a relative rather than an absolute concept. b. The most important base used as the criterion for deciding materiality is total assets. c. Qualita Qualitative tive fact factors ors as well well as quant quantitat itative ive facto factors rs affec affectt materia materiality lity.. d. Given equal dollar amounts, amounts, frauds frauds are usually usually considere considered d more important important than than error errors. s.
26. medium a
Since materiality is relative, it is necessary to have bases for establishing whether misstatements are material. Normally, the most common base for deciding materiality is: a. net income before taxes. b. net working capital. c. net net inc incom omee afte afterr tax taxes es.. d. total assets.
27. medium a
Certain types of misstatements are likely to be more important than other types to users, even if the dollar amounts are the same. Which of the following demonstrates this?
a. b. c. d.
Amounts involving frauds are considered more important than errors of equal amount Yes No Yes No
Misstatements that are otherwise immaterial may be material if they affect a trend in earnings. Yes No No Yes
28. medium b
Allocating Allocating the preliminary preliminary judgment about materiality to financial financial statements segments segments is necessary because: a. evidence is accumulated for the financial statements as a whole so materiality does not apply to them. b. evidence is accumulated by segments rather than for the financial statements as a whole. c. it is requir required ed by the AICPA’ AICPA’ss Code Code of Profes Professio sional nal Conduc Conduct. t. d. it is requ equired ired by the the SEC. SEC.
29. medium c
Which of the following statements is not correct? a. Either Either an overst overstate atemen mentt of an asset asset account account or an unders understate tatemen mentt of a liabili liability ty accoun accountt would have the same effect on the income statement. b. A misclassification in the balance sheet will have no effect on operating income. c. Either Either an overst overstate atemen mentt of an asset asset account account or an overst overstate atemen mentt of a liability liability accou account nt would have the same effect on the income statement. d. Either Either an unders understat tateme ement nt of an asset asset accoun accountt or an oversta overstateme tement nt of a liability liability accou account nt would have the same effect on the income statement.
Arens/Elder/Beasley Arens/Elder/Beasley
30. medium d
Regardless of how the preliminary judgment about materiality is allocated, the auditor must be confident that total combined misstatements in all accounts are: a. less than the preliminary judgment. b. equal to the preliminary judgment. c. more more than than the the prel prelimi imina nary ry judgm judgmen ent. t. d. less less than than or or equa equall to the the prel prelimi imina nary ry judg judgme ment. nt.
31. medium c
Auditors frequently refer to the terms audit assurance, overall assurance, and level of assurance to refer to ________. a. detection risk b. audit report risk c. acc accepta eptab ble audit udit risk risk d. inherent risk
32. medium c
_____ misstatements are those where the auditor can determine the amount of the misstatement in the account. a. Potential b. Likely c. Known d. Projected When a di different ex extent of of ev evidence is is ne needed fo for th the va various cy cycles, th the di difference is is ca caused by: a. errors in the client’s accounting system. b. a client’s need to achieve an unqualified opinion. c. an audi auditor tor’s ’s need need to fol follow low aud auditi iting ng sta stand ndar ards ds.. d. an auditor auditor’s ’s expectations expectations of errors errors and and assess assessment ment of internal internal control control..
33. medium d
34. medium a
If planned detec tection ion risk isk is reduced, the the amo mou unt of evide idence the audito itor accumulate latess will ill: a. increase. b. decrease. c. remain unchanged. d. be indetermina inate. te.
35. Medium a
Likely misstatements can result from:
a. b. c. d.
Computation of the sampling error for the cash account No Yes No Ye s
Differences between management’s and an auditor’s judgment about account balances Y es Yes No No
Projections of misstatements based on an auditor’s tests of a sample from a population Yes No Yes No
36. medium b
When discussing control risk (CR) and the audit risk model, which of the following is false? a. CR is a meas measure ure of of the auditor auditor’s ’s asses assessme sment nt of the the likel likeliho ihood od that that misst misstate atemen ments ts will will not be prevented or detected by internal control. b. If the auditor concludes that internal control is completely ineffective to prevent or detect errors, he/she would assign a low value (e.g., 0%) to CR. c. The relati relations onship hip betwee between n contr control ol risk risk and detect detection ion risk risk is invers inverse. e. d. The rela relation tionshi ship p between between cont control rol risk risk and and evide evidence nce need needed ed to suppo support rt accou account nt balanc balances es is direct.
37.
Which of the following is not a good indicator of the degree to which statements are relied on
Arens/Elder/Beasley Arens/Elder/Beasley
medium d
by external users? a. Client’s size, as measured by total assets or total revenue. b. Distribution of ownership among the public. c. Natu Nature re and and amo amoun untt of liab liabil ilit itie ies. s. d. Amoun Amountt of net net inco income me or or los losss aft after er taxe taxes. s.
38. medium a
If an auditor believes the chance of financial failure is high and there is a corresponding increase in business risk for the auditor, acceptable audit risk would likel y: a. be reduced. b. be increased. c. remain the same. d. be calc calcula ulated ted using using a compu computer terize ized d statis statistic tical al packa package. ge.
39. medium a
When management has an adequate level of integrity for the auditor to accept the engagement but cannot be regarded as completely honest in all dealings, auditors normally: a. reduce acceptable audit risk and increase inherent risk. b. reduce inherent risk and control risk. c. incre increas asee inhe inhere rent nt ris risk k and and con contr trol ol risk risk.. d. increa increase se accep acceptab table le audit audit risk risk and and redu reduce ce inher inherent ent risk risk..
40. medium b
One a. b. c. d.
41. medium d
Inherent risk is often low for an account such as: a. inventory. b. marketable securities. c. cash. d. acc account ountss receiv ceivaable. ble.
42. medium d
The auditor typically does not assess control risk and inherent risk for: a. each audit objective. b. each cycle. c. each account. d. the the overall audit. it.
43. 43. (Pub (Public lic)) medium a
To wha whatt exte extent nt do do audi auditor torss typic typical ally ly rely rely on int inter erna nall contr controls ols of their their pub public lic comp compan any y clie clients nts?? a. Extensively b. Only very little c. Infrequently d. Never
44. med medium ium b
Auditors t yp ypi ca cally rel y on internal controls of their private company clients: a. Only as needed to comp mpllete the the audit and satis tisfy Sarbanes-Oxley require irements. ts. b. Only if the controls are determined to be effective. c. Only Only if the the clie client nt ask askss an aud audito itorr to test test con contr trols ols.. d. Only if the contro controls ls are are sufficien sufficientt to incre increase ase Control Control Risk to an acceptable acceptable level.
45. medium a
Acceptable au audit ri risk is or ordinarily set by by the au auditor during pl planning and: a. held constant for each major cycle and account. b. held constant for each major cycle but varies by account. c. vari varies es by by each each maj major or cyc cycle le and and by eac each h acco accoun unt. t. d. varies varies by each each major major cyc cycle le but but is consta constant nt by by accou account. nt.
Arens/Elder/Beasley Arens/Elder/Beasley
ac accounting is issue th that do does n no ot re require ma management to to us use si significant ju judgments is is: the allowance for doubtful accounts. the useful life of equipment for tax purposes. obsolet lete inv inventory. the liabil liability ity for for war warra ranty nty paym paymen ents ts..
46. medium d
When the auditor is attempting to determine the extent to which external users rely on a client’s financial statements, they may m ay consider several factors except for: a. client size. b. concentration of ownership. c. type typess and and amou amount ntss of liab liabil ilit itie ies. s. d. asse assess ssme ment nt of of det detec ecti tion on ris risk. k.
47. medium b
A major difficulty in the application of the audit risk model is: a. defining the terms of the model. b. measuring the components of the model. c. understandin understanding g the effect effect on other factors factors in the model model when when one one factor factor is change changed. d. d. the failure failure of the Audit Standards Standards Board Board to accept accept it it and incorpora incorporate te it into into standard standards. s.
48. med medium ium a
When setting a preliminary judgment about materiality: a. morre evidence is required for a low dolla mo llar amo mou unt tha than for a high dolla llar amount. b. less evidence is required for a low dollar amount than for a high dollar amount. c. the same same amou amount nt of evide evidence nce is requ require ired d for eithe eitherr low or high high dolla dollarr amounts. amounts. d. there is no relationship relationship between between it and the dollar dollar amount amount of evidence evidence needed. needed.
49. challe llenging b
When allocating materiality, mo most practitioners choose to allocate to: a. the the in income state tateme men nt ac accounts be because th they ar are mo more im important. b. the balance sheet accounts because there are fewer. c. both balanc balancee sheet sheet and and income income statemen statementt accounts accounts becaus becausee there there could could be errors errors on either. either. d. all of the financ financial ial statement statementss because because there could be errors errors on other other stateme statements nts besides besides the income statement and balance sheet.
50. challenging c
The risk of material misstatement refers to: a. control risk and acceptable audit risk. b. inherent risk. c. the combina combination tion of inhere inherent nt risk risk and contro controll risk risk.. d. inhe inhere rent nt risk risk and and aud audit it risk risk..
51.
Auditors may assess inherent risk and control risk:
medium a a. b. c. d.
Jointly to determine the risk of material misstatement Yes No Yes No
Separately and combine their effects in the audit risk model Yes No No Yes
52. chal challe leng ngin ing g c
Which on one of the following statements ab about th the cycle ap approach to to auditing is not correct? a. Ther Theree are are diff differ eren ence cess amon among g cycl cycles es in the the freq freque uenc ncy y and and size size of expe expect cted ed erro errors rs.. b. There are differences among cycles in the effectiveness of internal controls. c. There are difference differencess among among cycles cycles on on the auditor’s auditor’s willingn willingness ess to accept accept risk that materia materiall errors exist after the auditing is complete. d. It is common common for for auditor auditorss to want an equa equally lly low likelih likelihood ood of error errorss for each each cycle cycle after after the auditor is finished.
53. challenging a
When the auditor has the same level of willingness to risk that material misstatements will exist after the audit is finished for all financial statement cycles: a. a different extent of evidence will likely be needed for various cycles. b. the same amount of evidence will be gathered for each cycle. c. the auditor auditor has not followe followed d gene general rally ly acce accepte pted d audi auditing ting standa standards rds.. d. the leve levell for each each cyc cycle le must must be no more more than than 2% so that that the entir entiree audit audit does does not not excee exceed d 10%.
Arens/Elder/Beasley Arens/Elder/Beasley
54. challe llenging b
Which of the following statements is not true? a. Inherent ris risk k is inversely relate lated d to detectio tion risk isk. b. Inherent risk is inversely related to evidence. c. Inherent Inherent risk risk is the susceptibility susceptibility of the the financia financiall statements statements to materia materiall error, error, assumin assuming g no internal controls. d. Inherent Inherent risk risk is the the auditor’s auditor’s assessmen assessmentt of the the likelihood likelihood that that errors errors exceed exceeding ing a tolerab tolerable le amount exist in a segment before considering the effectiveness of internal controls.
55. challenging c
Which of the following is not a primary consideration when assessing inherent risk? a. Nature of client’s business. b. Existence of related parties. c. Frequency Frequency and intensity intensity of manage management’s ment’s review review of accounting accounting transactio transactions ns and records. records. d. Susc Suscep epti tibi bili lity ty to def defal alca cati tion on..
56. challenging c
Which of the following is an example of the concept of of inherent ri risk? a. Huma Humans ns make more more erro errors rs than compu compute ters rs;; ther theref efor ore, e, a manu manual al accou account nting ing system system is riskier than a computerized system. b. Accounting systems with vouchers have many more controls built in, so the risk that there will be errors on the financial statements is reduced. c. Loans Loans receiv receivable able for for a finance finance compa company ny are less less likely likely to be collec collectibl tiblee than those those of a bank. d. Audits with larger larger sample sizes are less less risky than those with smaller smaller sample sizes. sizes.
57. challenging d
Tolerable misstatement as set by the auditor: a. decreases acceptable audit risk. b. increases inherent risk and control risk. c. affe affect ctss plan planne ned d dete detect ctio ion n risk risk.. d. does does not not aff affec ectt any any of the the fou fourr ris risks ks..
58. challenging a
Which of the following underlies the application of generally accepted auditing standards, particularly the standards of fieldwork and reporting? a. The elements of materiality and relative risk. b. The element of internal control. c. The The ele eleme ment nt of of cor corro robo bora ratin ting g evi evide denc nce. e. d. The The ele eleme ment nt of of rea reaso sona nable ble assu assura ranc nce. e.
Essay Questions 59. medium
Discuss the three main factors that affect an auditor’s preliminary judgment about materiality. Answer: The three main factors that affect an auditor’s judgment about materiality are: Materiality is a relative rather than an absolute concept . A misstatement of a • give given n size size might might be mate materi rial al for for a sm smal alll comp company any,, wher wherea eass the the same same dolla dollar r misstatement could be immaterial for a larger one. Bases are needed for evaluating materiality. Since materiality is relative, it is necessary necessary to have bases for establishing establishing whether whether misstatement misstatementss are material. Net income before taxes is normally the most commonly used base, but other possible bases include current assets, total assets, current liabilities, and owners’ equity. •
Qualitative factors also affect materiality . Certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same, such as misstatements involving frauds.
•
Arens/Elder/Beasley Arens/Elder/Beasley
Arens/Elder/Beasley Arens/Elder/Beasley
60. medium
Due to qualitative factors, certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same. Identify two qualitative factors that might significantly affect an auditor’s materiality judgment, and give an example of each. Answer: Qualitative factors that affect an auditor’s materiality judgment include: Amounts involving fraud. Amounts involving fraud are usually considered more important than unintentional unintentional errors errors of equal dollar amounts because because fraud fraud reflects on the honesty and reliability of the management or other personnel involved. For example, an intentional misstatement of inventory would be more important to users than a clerical error in inventory i nventory of the same amount.
•
Missta tate teme ment ntss that that are are Misstatements Misstatements affecting contractual obligations. Miss otherwise minor may be material if there are possible consequences arising from contractual obligations. For example, if a misstatement causes a required minimum account balance to exceed the minimum, when the correct balance is less than the minimum, this misstatement likely would be important to users.
•
Profit vs. loss. Misstatements that cause a loss to be reported as a profit or misstatements that affect trends in earnings are likely to be important to users.
•
61. medium
Explain why it is necessary to allocate the preliminary judgment about materiality to individual accounts accounts (segments) (segments) in the financial statements. statements. Also explain explain why allocating to balance balance sheet sheet accounts is more common than allocating to income statement accounts. Answer: Allocating the preliminary judgment about materiality to individual accounts is necessary because evidence is accumulated for accounts rather than for the financial statements as a whole. whole. Alloca Allocating ting to accou accounts nts establ establish ishes es a tolera tolerable ble missta misstatem tement ent amount amount for each each account, which helps the auditor decide the appropriate audit evidence to accumulate for each account. Most practitioners allocate materiality to balance sheet accounts rather than income statement accounts because there are fewer balance sheet than income statement accounts.
62. medium
Why do most practitioners allocate the preliminary judgment about materiality to balance sheet accounts? Answer: Most income statement misstatements have an equal effect on the balance sheet because of the double-entry bookkeeping system. Because there are fewer balance sheet accounts than income statement accounts in most audits and most audit procedures focus on balance sheet accounts, allocating materiality to balance sheet accounts is the most appropriate alternative.
63. medium
Discuss how auditors use the audit risk model when planning an audit. Answer: The audit audit risk risk mod model el is used used primar primarily ily for planning planning purposes purposes in decidin deciding g how much evidence to accumulate in each cycle. The auditor decides an acceptable level of audit risk, assesses inherent risk and control risk, and then uses the relationship depicted in the following model to determine an appropriate level for planned detection risk: PDR
Arens/Elder/Beasley Arens/Elder/Beasley
=
A AR IR x CR
64. medium
Describe the audit risk model and each of its components. Answer: The planning form of the audit risk model is stated as follows: PDR
where:
=
PDR A AR IR CR
A AR IR x CR = = = =
planned detection risk acceptable audit risk inherent risk control risk
Planned detection risk is a measure of the risk that audit evidence for an account will fail to detect misstatements exceeding a tolerable amount, should such misstatements exist. Planned detection risk determines the amount of substantive evidence that the auditor plans to accumulate. Acceptable audit risk is a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued. It is influenced influenced primarily primarily by the degree to which external external users will rely on the statements, the likelihood that a client will have financial difficulties after the audit report is issued, and the auditor’s evaluation of management’s integrity. Inherent risk is a measure of the auditor’s assessment of the likelihood that there are material material misstatements misstatements in an account account before before considering considering the effectiven effectiveness ess of internal control. Control risk is a measure of the auditor’s assessment of the likelihood that misstatements exceeding a tolerable amount in an account will not be prevented or detected by the client’s internal controls.
65. medium
There are several factors that affect an audit firm’s business risk and, therefore, acceptable audit risk. Discuss three of these factors. Answer: Business risk and acceptable audit risk are affected by: The degree to which external users will rely on the statements . For large, publicly held clients, business risk is greater, and acceptable audit risk will be less, than for small, privately held clients, all things being equal. •
The likelihood that a client will have financial difficulties after the audit report is issued . Business risk is greater, and acceptable audit risk will be lower, when the client is experiencing financial difficulties. •
The auditor’s evaluation of management’s integrity . Business risk is greater • and and acce accepta ptable ble audit audit risk risk will will be lowe lowerr when when the the clien client’ t’ss mana manage geme ment nt has has questionable integrity.
Arens/Elder/Beasley Arens/Elder/Beasley
66. challenging
Discuss each of the five steps in applying materiality in an audit, and identify the audit phase(s) in which each step is performed. List these steps in the order in which they occur. Answer: Step 1. Set preliminar preliminaryy judgment judgment about materiality materiality. This is the combined amount of misstatements in the financial statements that would be considered material. This decision is made in the planning stage of the audit. Step 2. Allocate preliminary judgment about materiality to segments . In this step, the auditor normally allocates the preliminary judgment about materiality to the balance sheet accounts. The amount of materiality allocated to an account is referred to as that account’s tolerable misstatement. This allocation is performed in the audit planning stage. Step 3. Estimate total misstatement misstatement in segment . In this step, the auditor projects the sample results to the population. An allowance for sampling risk is also calculated. This would be performed after the substantive tests for each account are completed. Step 4. Estimate the combined misstatement . In this step, the projected errors for each acco accoun untt are are adde added, d, alon along g with with tota totall samp samplin ling g erro error, r, to calc calcula ulate te the combi combine ned d misstatement. This would be performed after all substantive tests have been completed. Step 5. Compare combined estimated misstatement with preliminary or revised judgment about materiality. If the combined estimated misstatement is less than or equal to the judgment about materiality, then the auditor concludes the financial statements are fairly presented. This would be performed after all substantive tests have been completed, in the final review stage of the audit.
Other Objective Answer Format Questions 67. easy
Below are four situations that involve the audit risk model as it is used for planning audit evidence requirements in the audit of inventory. For each situation, calculate planned detection risk. SITUATION 1
2
3
4
1%
10%
10%
5%
Inherent risk
100%
100%
50%
20%
Control risk
100%
100%
40%
30%
Planned detection risk
______
_ _ __ _ _
______
Acceptable audit risk
Answer: 1. 1%;
Arens/Elder/Beasley Arens/Elder/Beasley
2. 10%;
3. 50%;
4. 83.3%
______
68. easy
Using your knowledge of the relationships among acceptable audit risk, inherent risk, control risk, planned detection risk, tolerable misstatement, and planned evidence, state the effect on planned evidence (increase or decrease) of changing each of the following factors, while the other factors remain unchanged.
decrease increase decrease decrease decrease
1. 2. 3. 4. 5.
69. medium
Match nine of the terms (a-i) with the definitions provided below (1-9): a. b. c. d. e. f. g. h. i.
An increase in acceptable audit risk. An increase in inherent risk. A decrease in control risk. An increase in planned detection risk. An increase in tolerable misstatement.
. . . . .
Business risk Preliminary judgment about materiality Inherent risk Plan Planne ned d de detect tectio ion n ris risk k Audit assurance Acceptab table audit risk isk Tole Tolerrable able mis missstate tateme ment nt Control ri risk Materiality
d
1.
A measure of the risk that audit evidence for a segment will fail to detect misstatements exceeding a tolerable amount, should such misstatements exist.
a
2.
The risk that the auditor or audit firm will suffer harm because of a client relationship, even though the audit report rendered for the client was correct.
h
3.
A measure of the auditor’s assessment of the likelihood that misstatements exceeding a tolerable amount in a segment will not be prevented or detected by the client’s internal controls.
f
4.
A measure of how much risk the auditor is willing to take that the financial statements may be materially misstated after the audit is completed and an unqualified audit opinion has been issued. i ssued.
g
5.
The materiality allocated to any given account balance.
b
6.
The maximum amount by which the auditor believes that the statements could be misstated and still not affect the decisions of reasonable users.
e
7.
This term is synonymous with acceptable audit risk.
i
8.
The magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person would have been changed.
c
9.
A measure of the auditor’s assessment of the likelihood that there are material misstatements before considering the effectiveness of internal control.
Arens/Elder/Beasley Arens/Elder/Beasley
70. medium
In practice, auditors rarely assign numerical numerical probabilitie probabilitiess to inherent risk, control control risk, or acceptable audit risk. It is more common to assess these risks as high, medium, or low. For each of the four situations below, fill in the blanks for planned detection risk and the amount of evidence you would plan to gather (“planned evidence”) using the terms high, medium, or low. SITUATION 1
2
3
4
Acceptable audit risk
Low
Low
High
High
Inherent risk
High
Low
Low
Low
Control risk
High
Low
Medium
Low
Planned detection risk
______
_ _ __ _ _
______
______
Planned evidence
______
_ _ _ __ _
______
______
Answer: Answer: 1. 2. 3. 4.
low, high medium, medium medium, medium high, low
71. easy a
The auditor’s preliminary judgment about materiality is the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of reasonable users. a. True b. False
72. easy a
There is no precise definition of materiality in the professional literature. a. True b. False
73. easy b
The FASB definition of materiality focuses on potential users of financial statements. a. True b. False
74. easy a
Net income before taxes is normally the most important base for deciding materiality. a. True b. False
75. easy b
Most practitioners allocate the preliminary judgment about materiality to income statement accounts. a. True b. False
76. easy a
The primary purpose of allocating allocating the preliminary preliminary judgment about materiality to financial financial statement accounts is to help the auditor decide the appropriate evidence to accumulate. a. True b. False
Arens/Elder/Beasley Arens/Elder/Beasley
77. easy b
Auditors Auditors cannot cannot use prior year financial financial statement balances balances to establish establish their preliminary preliminary judgment about materiality in planning the current year’s audit. a. True b. False
78. easy b
If acceptable audit risk is low, and inherent risk and control risk are both high, then planned detection risk should be high. a. True b. False
79. easy a
Inherent risk and planned detection risk are inversely related; i.e., as inherent risk increases, planned detection risk should decrease, ceteris paribus. a. True b. False
80. easy b
Acceptable audit risk and planned detection risk are inversely related; i.e., as acceptable audit risk increases, planned detection risk should decrease, ceteris paribus. a. True b. False
81. easy b
The most important element of the audit risk model is control risk. a. True b. False
82. easy b
For a private company client, auditors are required to test any internal controls they believe have not been operating effectively during t he period under audit. a. True b. False
83. easy a
If an auditor believes the client will have financial difficulties after the audit report is issued, and external users will be relying heavily on the financial statements, the auditor will probably set acceptable audit risk as low. a. True b. False
84. medium b
Achieved detection risk can be reduced only by accumulating more audit evidence. a. True b. False
85. medium a
Auditors Auditors have difficulty difficulty applying applying the concept of materiality materiality in practice practice because they often do not know who the users of the financial statements are or what decisions will be made. a. True b. False
86. medium b
The audit risk model that must be used for planning audit procedures and evaluating audit results is: AcAR = IR x CR x AcDR. a. True b. False
Arens/Elder/Beasley Arens/Elder/Beasley
87. medium b
Statements on Auditing Standards provide detailed, objective guidance on how auditors are to establ establish ish a prelimi preliminar nary y materia materiality lity level, level, thus elimina eliminating ting the need need for sub subjec jective tive auditor auditor judgment in this task. a. True b. False
88. medium b
If the preliminary judgment of materiality increases, the amount of audit evidence required will also increase. a. True b. False
89. medium b
Insert risk and control risk are normally assessed for the overall audit. a. True b. False
90. medium b
Tolerable misstatement is the maximum combined total of all misstatements in the financial statements statements that the auditor is willing to allow, or tolerate, tolerate, when issuing a standard standard unqualified unqualified opinion. a. True b. False
91. medium a
If an auditor auditor assigns a tolerable tolerable misstatement misstatement of $1,000 to accounts accounts payable, he or she would need to obtain more audit evidence for that account than if $100,000 had been assigned. a. True b. False
92. medium a
To maximiz maximizee audit audit effic efficien iency cy,, the auditor auditor sho should uld allocat allocatee less less tolera tolerable ble misstate misstatemen mentt to accounts that can be verified by using low-cost audit procedures, such as analytical procedures, than to accounts that are more costly to audit. a. True b. False
93. medium b
To maximize audit effectiveness, the auditor should establish a high preliminary judgment about materiality and allocate most of the amount to balance sheet accounts. a. True b. False
94. medium a
Acceptable audit risk and the amount of substantive evidence required are inversely related. a. True b. False
95. medium a
As control risk increases, increases, the amount amount of substantive evidence evidence the auditor plans to accumulate accumulate should increase. a. True b. False
96. medium b
Inherent risk and control risk are directly related. a. True b. False
Arens/Elder/Beasley Arens/Elder/Beasley
97. medium a
An acceptable audit risk assessment of low indicates a risky client requiring more extensive evidence, assignment of more experienced personnel, and/or a more extensive review of audit files. a. True b. False
98. medium a
Engagement risk is effectively the audit firm’s business risk. a. True b. False
99. medium b
Audit Audit assura assurance nce is the comple complemen mentt of planne planned d detect detection ion risk, risk, that that is, one minus planne planned d detection risk. a. True b. False
Arens/Elder/Beasley Arens/Elder/Beasley