Audit Chapter 9

Provide two examples of when an auditor might set a lower level of performance materiality for a particular class of​ transactions, account​ balance, or disclosure.

An auditor might set a lower level of performance materiality for a particular account balance if it is harder to audit and no material misstatements are expected​ (e.g. payroll​ expenses) or or if the auditor expects that a misstatement of a lower amount in a particular account or transaction might influence an investor​ (e.g. disclosure of a related party​ transaction). This is because performance materiality is inversely related to the amount of evidence an auditor will accumulate.

Begin by explaining the causes of an increased planned detection risk.

An increase in planned detection risk may be caused by an increase in acceptable audit risk or a decrease in either control risk or inherent risk.

Explain how audit risk and materiality are related and why they need to be considered together in planning an audit.

Audit risk is a measure of the​ auditor's assessment of the risk that a material misstatement could occur in an assertion and not be prevented or detected on a timely basis by the​ client's internal controls. An auditor cannot assess the risk of material misstatement without first deciding the size of misstatements that will be considered material. Materiality and audit risk are considered together in planning the nature and extent of risk assessment procedures to be​ performed, identifying and assessing the risks of material​ misstatement, determining the​ nature, timing and extent of audit​ procedures, and evaluating audit findings.

What is the relationship between materiality and the phrase obtain reasonable assurance used in the​ auditor's report?

"Obtain reasonable​ assurance," as used in the audit​ report, means that the auditor does not guarantee or ensure the fair presentation of the financial statements. There is some risk that the financial statements contain a material misstatement.

There are eight parts of the planning phase of an audit. Which​ part(s) include(s) the evaluation of​ risk?

- Assess client business risk - Set materiality and assess acceptable audit risk and inherent risk - Understand internal control and assess control risk - Gather information to assess fraud risks

Identify the most important factors affecting the preliminary judgment about materiality.

- Qualitative factors affect materiality decisions. - Benchmarks are needed for evaluating materiality. - Materiality is a relative rather than an absolute concept.

Identify four factors that make for high inherent risk in audits.

-Nature of the​ client's business -Results of previous audits -Related parties -Initial versus repeat engagement

Next explain the causes of a decreased planned detection risk.

A decrease in planned detection risk is caused by a decrease in acceptable audit risk or an increase in control risk or inherent risk.

Distinguish between the terms performance materiality and preliminary judgment about materiality. How are they related to each​ other?

A preliminary judgment about materiality is set for the financial statements as a whole. Performance materiality is the maximum amount of misstatement that would be considered material for an individual account balance. The amount of performance materiality for any given segment or account is dependent upon the preliminary judgment about materiality. ​Ordinarily, performance materiality for any given segment or account would have to be lower than the preliminary judgment about materiality. In many​ cases, it will be considerably lower because of the possibility of misstatements in different accounts​ that, in​ total, cannot exceed the preliminary judgment about materiality.

What is the relevance of acceptable audit risk to evidence​ accumulation?

Acceptable audit risk has an inverse relationship to evidence. If acceptable audit risk is​ reduced, planned evidence should increase.

Explain what is meant by the term acceptable audit risk.

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.

What is meant by using benchmarks for setting a preliminary judgment about​ materiality?

Because materiality is relative rather than​ absolute, it is necessary to have benchmarks for establishing whether misstatements are material.

Auditors have not been successful in measuring the components of the audit risk model. How is it possible to use the model in a meaningful way without a precise way of measuring the​ risk?

Exact quantification of all components of the audit risk model is not required to use the model in a meaningful way. An understanding of the control risk within the audit risk model and the effect it has on the amount of evidence needed is the only necessary component. This will allow practitioners to use the audit risk model in a meaningful way.

Explain the effect of extensive misstatements found in the prior​ year's audit on inherent​ risk, planned detection​ risk, and planned audit evidence.

Extensive misstatements in the prior​ year's audit would cause no change in inherent​ risk, planned detection​ risk, or the level of planned audit evidence because most misstatements are not systematic in nature.

How will those benchmarks used for setting a preliminary judgement about materiality differ for the audit of a manufacturing company and a government unit such as a school​ district?

In the audit of a manufacturing​ company, the auditor might use as​ benchmarks: net income before​ taxes, total​ assets, current​ assets, and working capital. For a governmental​ unit, such as a school​ district, there is no net income before​ taxes, and therefore that would not be an available benchmark.​ Instead, the primary benchmarks would likely be fund​ balances, total​ assets, and perhaps total revenue.

Define what is meant by inherent risk. Identify four factors that make for high inherent risk in audits. Define what is meant by inherent risk.

Inherent risk is a measure of​ 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.

Explain why inherent risk is set audit objectives for segments rather than for the overall audit.

Inherent risk is set for audit objectives for segments rather than for the overall audit because the auditor cannot rely on the internal controls. By identifying how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and issued an unqualified audit​ opinion, the auditor will be able to reissue a new audit report.

Which one of the following statements is correct concerning the concept of​ materiality? In considering materiality for planning​ purposes, an auditor believes that misstatements aggregating​ $10,000 will have a material effect on an​ entity's income​ statement, but that misstatements will have to aggregate​ $20,000 to materially affect the balance sheet.​ Ordinarily, it is appropriate to design audit procedures that are expected to detect misstatements that aggregate A client decides not to record an​ auditor's proposed adjustments that collectively are not material and wants the auditor to issue the report based on the unadjusted numbers. Which of the following statements is correct regarding the financial statement​ presentation?

Materiality is a matter of professional judgment. $10,000 The financial statements are free from material​ misstatement, and no disclosure is required in the notes to the financial statements.

Which one of the following statements is correct concerning the concept of​ materiality? In considering materiality for planning​ purposes, an auditor believes that misstatements aggregating​ $10,000 will have a material effect on an​ entity's income​ statement, but that misstatements will have to aggregate​ $20,000 to materially affect the balance sheet.​ Ordinarily, it is appropriate to design audit procedures that are expected to detect misstatements that aggregate A client decides not to record an​ auditor's proposed adjustments that collectively are not material and wants the auditor to issue the report based on the unadjusted numbers. Which of the following statements is correct regarding the financial statement​ presentation?

Materiality is a matter of professional judgment. $10,000. The financial statements are free from material​ misstatement, and no disclosure is required in the notes to the financial statements.

Explain why materiality is important but difficult to apply in practice.

Materiality is important because if financial statements are materially misstated, users' decisions may be affected, and thereby cause financial loss to them. It is difficult to apply because there are often many different users of financial statements.

Define the meaning of the term materiality as it is used in accounting and auditing.

Materiality is the magnitude of an omission or misstatement of accounting information​ that, in light of the surrounding​ circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.

How will the conduct of an audit of a​ mediumsized company be affected by the​ company's being a small part of a large conglomerate as compared with it being a separate​ entity?

Materiality would be lower for a company that is part of a conglomerate because even though the financial statements of the​ medium-sized company may be​ misstated, the financial statements of the large conglomerate might still be fairly stated.​ If, however, the auditor is giving a separate opinion on the​ medium-sized company, the materiality may be larger than for the audit of a conglomerate.

Assume that Rosanne​ Madden, CPA, is using​ 5% of net income before​ taxes, current​ assets, or current liabilities as her major guidelines for evaluating materiality. What qualitative factors should she also consider in deciding whether misstatements may be​ material?

Misstatements that are otherwise immaterial may be material if they affect a trend in earnings. Auditors expect no more than two misstatements in any one account. Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations.

Define the audit risk model. Explain each term in the model. Also describe which two factors of the model when combined reflect the risk of material misstatements.

PDR = AAR/IR x CR Control risk is 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. 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. Planned detection risk is a measure of the risk that audit evidence for a segment will fail to detect misstatements exceeding a tolerable​ amount, should such misstatements exist. Inherent risk is a measure of the​ auditor's assessment of the likelihood that there are material misstatements in a segment before considering the effectiveness of internal control. (Abbreviation used: PDR​ = Planned detection​ risk; AAR​ = Acceptable audit​ risk; IR​ = Inherent​ risk; CR​ = Control​ risk.) -Control risk -Inherent risk

Explain why there is an inverse relationship between planned detection risk and the amount of evidence an auditor collects for a specific audit objective.

Planned detection risk is a measure of the​ auditor's assessment of the risk that a material misstatement could occur in an assertion and not be prevented or detected on a timely basis by the​ client's internal controls. In order to reduce this​ risk, the auditor would increase the amount of performance materiality and collection of evidence for specific audit objective. For​ example, if the auditor wanted a low level of risk that audit procedures designed to test the existence of inventory fail to detect a material​ misstatement, they would increase the amount of inventory tested​ and/or the number of audit procedures performed.

There are eight parts of the planning phase of an audit. Which​ part(s) include(s) the evaluation of​ materiality?

Set materiality and assess acceptable audit risk and inherent risk

Explain the circumstances when the auditor should revise the components of the audit risk model.

The auditor should never revise the components of the audit risk model.

What is meant by setting a preliminary judgment about​ materiality?

The preliminary judgement 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.

Assume materiality for the financial statements as a whole is​ $100,000 and performance materiality for accounts receivable is set at​ $40,000. If the auditor finds one receivable that is overstated by​ $55,000, what should the auditor​ do?

The​ $55,000 overstatement is an example of a known misstatement. The auditor could request the client make an adjustment to correct the overstatement or make a note of the overstatement for​ follow-up at a later point in the audit. If performance materiality for accounts receivable is​ $40,000 and the auditor finds a​ $55,000 overstatement of a receivable​ balance, the auditor would document the misstatement and evaluate results of the remaining audit procedures in accounts receivable. If accounts receivable testing was performed using sampling​ techniques, the auditor would also project total known misstatements to the population and may perform additional tests depending on the outcome.

Explain the effect of the revisions on planned detection risk and planned evidence.

To determine the additional amount of evidence that will be​ required, it should be done without the use of the audit risk model. When the audit risk model is used to determine a revised planned detection​ risk, there is a chance of not increasing the evidence sufficiently.

Explain the relationship between acceptable audit risk and the legal liability of auditors.

When the auditor is in a situation where he or she believes that there is a high exposure to legal​ liability, the acceptable audit risk would be set higher than when there is little exposure to liability. Even when the auditor believes that there is little exposure to legal​ liability, there is still a maximum acceptable audit risk that should be met.

What is the effect on the amount of evidence the auditor must accumulate when inherent risk is increased from medium to high for a​ segment? When inherent risk is increased from medium to​ high, the auditor should ______________ the audit evidence accumulated _________________________________________________

increase, to determine whether the expected misstatement actually occurred.