Auditing chapter 9
Acceptable audit risk
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.
Which of the following is a correct statement regarding performance materiality? A) Determining performance materiality is necessary because auditors accumulate evidence by segments. B) The level of performance materiality does not affect the amount of evidence needed. C) Performance materiality cannot vary for different classes of transactions. D) Performance materiality is required for public companies, but not for private companies.
Answer: A A) Determining performance materiality is necessary because auditors accumulate evidence by segments.
To what extent do auditors typically rely on internal controls of their public company clients? A) Extensively B) Only very little C) Infrequently D) Never
Answer: A A) Extensively
When dealing with audit risk: A) auditors accept some level of risk in performing the audit function. B) most risks that auditors encounter are relatively easy to measure. C) the audit risk model is only used for classes of transactions. D) most audit firms prefer to use a quantitative assessment for risk.
Answer: A A) auditors accept some level of risk in performing the audit function.
If planned detection risk is reduced, the amount of evidence the auditor accumulates will: A) increase. B) decrease. C) remain unchanged. D) be indeterminate.
Answer: A A) increase.
Using your knowledge of the relationships among acceptable audit risk, inherent risk, control risk, planned detection risk, performance materiality, 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. 1. An increase in acceptable audit risk.________. 2. An increase in inherent risk. ________. 3. A decrease in control risk. ________. 4. An increase in planned detection risk. ________. 5. An increase in performance materiality. ________.
1. Decrease 2. Increase 3. Decrease 4. Decrease 5. Decrease
Planned detection risk
A measure of the risk that audit evidence for a segment will fail to detect misstatements exceeding the performance materiality amount, should such misstatements exist
Audit standards require the auditor to consider materiality early in the audit. Which statement (s) regarding preliminary materiality are true? I. Preliminary materiality may change during the engagement. II. Preliminary materiality is the maximum amount by which the auditor believes the financials could be misstated and still not affect the decisions of reasonable users. A) I only B) II only C) both I and II D) neither are true
C) both I and II
Determining materiality requires professional judgment. A) True B) False
A. true
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 likely: A) be reduced. B) be increased. C) remain the same. D) be calculated using a computerized statistical package.
Answer: A A) be reduced.
Inherent risk is often high for an account such as: A) inventory. B) land. C) capital stock. D) notes payable.
Answer: A A) inventory.
Auditors are ________ to document the known and likely misstatements in the financial statements under audit. A) permitted B) required C) not allowed D) strongly encouraged
Answer: B B) required
________ misstatements are those where the auditor can determine the amount of the misstatement in the account. A) Potential B) Likely C) Known D) Projected
Answer: C C) Known
An auditor who audits a business cycle that has low inherent risk should: A) increase the amount of audit evidence gathered. B) assign more experienced staff to that area. C) increase the performance materiality level for the area. D) expand planning procedures.
Answer: C C) increase the performance materiality level for the area
When allocating performance materiality: A) it is easy to predict in advance which accounts are mot likely to be misstated. B) only overstatements need to be considered. C) professional judgment is critical. D) the sum of all the performance materiality levels cannot exceed the preliminary judgment about materiality.
Answer: C C) professional judgment is critical.
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) strongly encourage
Answer: C C) require
For a private company client, auditors are required to test any internal controls they believe have not been operating effectively during the period under audit. A) True B) False
B
Most practitioners allocate the preliminary judgment about materiality to both the balance sheet and income statement accounts. A) True B) False
B
Net assets are the most often used base for deciding materiality. A) True B) False
B
The most important element of the audit risk model is control risk. A) True B) False
B
Which of the following audit risk components may be assessed in non-quantitative terms? (yes or no) a.Control Risk b. Inherent Risk c. Detection Risk
a. yes b. yes c. yes
If acceptable audit risk is low, and inherent risk and control risk are both low, then planned detection risk should be high. A) True B) False
A
If an auditor assigns a tolerable misstatement of $1,000 to 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
A
There is a direct relationship between acceptable audit risk and planned detection risk. A) True B) False
A
Total estimated misstatements include known misstatements and projected misstatements plus a sampling error. A) True B) False
A
Control risk
A measure of the auditor's assessment of the likelihood that misstatements exceeding a performance materiality in a segment will not be prevented or detected by the client's internal controls.
Acceptable audit risk and the amount of substantive evidence required are inversely related. A) True B) False
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
A
As control risk increases, the amount of substantive evidence the auditor plans to accumulate should increase. A) True B) False
A
CPA firms can establish policy guidelines to help their auditors determine materiality. A) True B) False
A
Planned detection risk I. determines the amount of substantive evidence the auditor plans to accumulate. II. is dependent on inherent risk and business risk. A) I only B) II only C) I and II D) None of the above
A) I only
If it is probable that the judgment of a reasonable person will be changed or influenced by the omission or misstatement of information, then that information is, by definition of FASB Statement No. 2: A) material. B) insignificant. C) significant. D) relevant.
A) material.
The preliminary judgment on materiality is compared to the total estimated misstatement amount to determine if an account balance is materially misstated. A) True B) False
Answer: A
Lewis Corporation has a few large accounts receivable that total one million dollars whereas Clark Corporation has many small accounts receivable that total one million dollars. Misstatement in any one account is more significant for Lewis corporation because of the concept of: A) materiality. B) audit risk. C) reasonable assurance. D) comparative analysis.
Answer: A A) materiality.
A high detection risk equates to a low amount of audit evidence needed. A) True B) False
B
The five steps in applying materiality are listed below in random order. 1. Estimate the combined misstatement. 2. Estimate the total misstatement in the segment. 3. Set materiality for the financial statements as a whole. 4. Determine performance materiality. 5. Compare combined estimate with preliminary judgment about materiality. The first three steps in correct sequence would be: A) 1, 2, 5 B) 3, 4, 2 C) 2, 1, 5 D) 3, 2, 4
B) 3, 4, 2
Which of the following statements is false? A) Either an overstatement of an asset account or an understatement of a liability account 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 an overstatement of an asset account or an overstatement of a liability account would have the same effect on the income statement. D) Either an understatement of an asset account or an overstatement of a liability account would have the same effect on the income statement.
C) Either an overstatement of an asset account or an overstatement of a liability account would have the same effect on the income statement.
Qualitative factors can affect an auditor's assessment of materiality. Which of the following statements is true? I. Misstatements that are otherwise immaterial may be material if they affect earnings trends. II. Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations. A) I only B) II only C) I and II D) neither I nor II
C) I and II
Why do auditors use the audit risk model when planning an audit?
The audit risk model is used primarily for planning purposes in deciding how much evidence to accumulate in each cycle. The auditor sets an acceptable level of audit risk, (AAR) assesses inherent risk (IR) and control risk (CR), and then uses the following audit risk model to determine an appropriate level of planned detection risk (PDR): PCR ~ (AAR) / (IR x CR)
Inherent risk
A measure of the auditor's assessment of the likelihood that there are material misstatements before considering the effectiveness of internal control.
Explain why it is necessary to allocate the preliminary judgment about materiality to individual accounts (segments) in the financial statements. Also explain why allocating to balance sheet accounts is more common than allocating to income statement accounts.
Allocating the preliminary judgment about materiality to individual accounts (segments) is necessary because evidence is accumulated for accounts (segments) rather than for the financial statements as a whole. Allocating to accounts (segments) establishes a tolerable misstatement amount for 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 most income statement misstatements have an equal effect on the balance sheet due to the nature of double-entry accounting. Because there are fewer balance sheet accounts than income statement accounts in most audits, and because most audit procedures focus on balance sheet accounts, materiality should be allocated only to balance sheet accounts
Which of the following statements is not true? A) Inherent risk is inversely related to the amount of audit evidence whereas detection risk is directly related to the amount of audit evidence required. B) Inherent risk is directly related to evidence whereas detection risk is inversely related to the amount of audit evidence required. C) Inherent risk is the susceptibility of the financial statements to material error, assuming no internal controls. D) Inherent risk and control risk are assessed by the auditor and function independently of the financial statement audit.
Answer: A A) Inherent risk is inversely related to the amount of audit evidence whereas detection risk is directly related to the amount of audit evidence required.
When setting a preliminary judgment about materiality: A) more evidence is required for a low dollar amount than for a high dollar amount. B) less evidence is required for a low dollar amount than for a high dollar amount. C) the same amount of evidence is required for either low or high dollar amounts. D) there is no relationship between it and the dollar amount of evidence needed.
Answer: A A) more evidence is required for a low dollar amount than for a high dollar amount.
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) increase inherent risk and control risk. D) increase acceptable audit risk and reduce inherent risk.
Answer: A A) reduce acceptable audit risk and increase inherent risk.
Auditors generally allocate the preliminary judgment about materiality to the: A) balance sheet only. B) income statement only. C) income statement and balance sheet. D) statement of cash flows.
Answer: A A) balance sheet only
Which of the following is an incorrect 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 expect to identify overstatements as well as understatements in the accounts. D) Relative audit costs affect the allocation.
Answer: B B) The allocation has virtually no effect on audit costs because the auditor must collect sufficient appropriate audit evidence.
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) Qualitative factors as well as quantitative factors affect materiality. D) Given equal dollar amounts, frauds are usually considered more important than errors.
Answer: B B) The most important base used as the criterion for deciding materiality is total assets.
If an auditor establishes a relatively high level for materiality, then the auditor will: A) accumulate more evidence than if a lower level had been set. B) accumulate less evidence than if a lower level had been set. C) accumulate approximately the same evidence as would be the case were materiality lower. D) accumulate an undetermined amount of evidence.
Answer: B B) accumulate less evidence than if a lower level had been set.
Inherent risk and control risk: A) are inversely related to each other. B) are inversely related to detection risk. C) are directly related to detection risk. D) are directly related to audit risk.
Answer: B B) are inversely related to detection risk.
Based on audit evidence gathered and evaluated, an auditor decides to increase the assessed level of control risk from that originally planned. To achieve an overall audit risk level that is substantially the same as the planned audit risk level, the auditor would: A) increase materiality levels. B) decrease detection risk. C) decrease substantive testing. D) increase inherent risk.
Answer: B B) decrease detection risk.
As the risk of material misstatement increases, detection risk should: A) medium increase. B) decrease. C) stay the same. D) Is indeterminate.
Answer: B B) decrease.
When evaluating the audit findings, the auditor should be satisfied that the: A) amount of known misstatement is documented in the management representation letter. B) estimate of the total known and likely misstatements is less than a material amount. C) estimate of the total likely misstatement includes sample error. D) amount of known misstatement is acknowledged and recorded by the client.
Answer: B B) estimate of the total known and likely misstatements is less than a material amount.
The measurement of the auditor's assessment of the likelihood that there are material misstatements due to error or fraud in a segment before considering the effectiveness of internal controls is defined as: A) audit risk. B) inherent risk. C) sampling risk. D) detection risk.
Answer: B B) inherent risk.
Auditors typically rely on internal controls of their private company clients: A) only as needed to complete the audit and satisfy Sarbanes-Oxley requirements. B) only if the controls are determined to be effective. C) only if the client asks an auditor to test controls. D) only if the controls are sufficient to increase Control Risk to an acceptable level.
Answer: B B) only if the controls are determined to be effective.
When allocating materiality, most practitioners choose to allocate to: A) the income statement accounts because they are more important. B) the balance sheet accounts because most audits focus on the balance sheet. C) both balance sheet and income statement accounts because there could be errors on either. D) all of the financial statements because it is required by GAAS.
Answer: B B) the balance sheet accounts because most audits focus on the balance sheet.
Which is a true statement about audit risk? A) Audit risk measures the risk that a material misstatement could occur and not be detected by internal control. B) When auditors decide on a higher acceptable audit risk, they want to be more certain that the financial statements are not materially misstated. C) Audit assurance is the complement of acceptable audit risk. D) There is an inverse relationship between acceptable audit risk and planned detection risk.
Answer: C C) Audit assurance is the complement of acceptable audit risk.
Which of the following is the primary basis used to decide materiality for a for-profit entity? A) Net sales B) Net assets C) Net income before tax D) All of the above
Answer: C C) Net income before tax
The scope paragraph of the standard unqualified auditor's report states that "... the standards require that we plan and perform the audit to obtain ________ assurance about whether the financial statements are free of material misstatement. "What type of assurance is given? A) Immediate B) Limited C) Reasonable D) Absolute
Answer: C C) Reasonable
Why do auditors establish a preliminary judgment about materiality? A) To determine the appropriate level of staff to assign to the audit B) So that the client can know what records to make available to the auditor C) To help plan the appropriate evidence to accumulate D) To finalize the control risk assessment
Answer: C C) To help plan the appropriate evidence to accumulate
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) acceptable audit risk D) inherent risk
Answer: C C) acceptable audit risk
When assessing risk, it is important to remember that: A) for acceptable audit risk, the SEC decides the risk the CPA firm should take for public clients. B) inherent risk can be changed by the auditor. C) detection risk can only be determined after audit risk, inherent risk, and control risk are determined. D) control risk is determined by company management since they are responsible for internal control.
Answer: C C) detection risk can only be determined after audit risk, inherent risk, and control risk are determined.
The risk of material misstatement refers to: A) control risk and acceptable audit risk. B) inherent risk. C) the combination of inherent risk and control risk. D) inherent risk and audit risk.
Answer: C C) the combination of inherent risk and control risk.
The preliminary judgment about materiality and the amount of audit evidence accumulated are ________ Related. A) directly B) indirectly C) not D) inversely
Answer: D D) Inversely
In a financial statement audit, inherent risk is evaluated to help an auditor asses which of the following? A) The internal audit department's objectivity in reporting a material misstatement of a financial statement assertion it detects to the audit committee B) The risk the internal control system will not detect a material misstatement of a financial statement assertion C) The risk that the audit procedures implemented will not detect a material misstatement of a financial statement assertion D) The susceptibility of a financial statement assertion to a material misstatement assuming there are no related controls
Answer: D D) The susceptibility of a financial statement assertion to a material misstatement assuming there are no related controls
When the auditor is attempting to determine the extent to which external users rely on a client's financial statements, they may consider several factors except for: A) client size. B) concentration of ownership. C) nature and amounts of liabilities. D) assessment of detection risk.
Answer: D D) assessment of detection risk.
Inherent risk is ________ related to detection risk and ________ related to the amount of audit evidence. A) directly, inversely B) directly, directly C) inversely, inversely D) inversely, directly
Answer: D D) inversely, directly
The risk that audit evidence for a segment will fail to detect misstatements exceeding performance materiality levels is: A) audit risk. B) control risk. C) inherent risk. D) planned detection risk.
Answer: D D) planned detection risk.
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) the client shareholders. D) the client.
Answer: D D) the client.
Amounts involving fraud are usually considered ________ important than unintentional errors of equal dollar amounts. A) less B) no less C) no more D) more
Answer: D More
Which of the following statements is true concerning the allocation of preliminary materiality? A) It is necessary to allocate preliminary materiality to financial statements as a whole rather than by segments. B) Preliminary materiality should be allocated to income statement accounts only. C) Preliminary materiality is required by the SEC. D) The PCAOB term used when preliminary materiality is allocated to segments is tolerable misstatement.
Answer: D D) The PCAOB term used when preliminary materiality is allocated to segments is tolerable misstatement.
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) tolerable materiality. D) performance materiality.
Answer: D D) performance materiality.
Amounts involving fraud are not usually considered qualitative factors affecting the preliminary materiality judgment. A) True B) False
B
Audit assurance is the complement of planned detection risk, that is, one minus planned detection risk. A) True B) False
B
If the total misstatement of an account is known, a sampling error still needs to be determined. A) True B) False
B
Inherent risk and control risk are directly related. A) True B) False
B
Net income before tax is the normal base used to determine materiality in a not-for-profit company. A) True B) False
B
Sampling error represents the minimum misstatement amount that exists in all accounts subjected to sampling. A) True B) False
B
Statements on Auditing Standards provide detailed, objective guidance on how auditors are to establish a preliminary materiality level, thus eliminating the need for subjective auditor judgment in this task. A) True B) False
B
The audit risk model that must be used for planning audit procedures and evaluating audit results is: (DR) / (IRxCR) = AAR True or False
False
Auditor's allocate the preliminary judgment about materiality to financial statement segments rather than by financial statements as a whole. What is the term for the auditor's allocation of preliminary misstatement to account balances? What are three difficulties auditor's face when allocating materiality to balance sheet accounts?
Performance materiality is the term for the auditor's allocation of the preliminary judgment of materiality to any given account balance. The three difficulties auditors face when allocating the preliminary materiality to account balances are: 1. Auditors expect certain accounts to have more misstatement than others. 2. Both overstatements and understatements must be considered. 3. Audit costs can affect the allocation.
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
Qualitative factors that affect an auditor's materiality judgment include: • Amounts involving fraud. Amounts involving fraud are usually considered more important than unintentional errors of equal dollar amounts because 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 of the same amount. • Misstatements affecting contractual obligations. Misstatements that are 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. • Amounts affecting a trend in earnings. Amounts that are otherwise immaterial may be material if they affect a trend in earnings. An example is if reported income has increased 3 percent annually for the past five years but income for the current year has declined 1 percent, that change may be material. Similarly, a misstatement that would cause a loss to be reported as a profit may be of concern.
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.
Step 1. Set preliminary judgment about 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 performance materiality. This allocation is performed in the audit planning stage. Step 3. Estimate total 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 account are added, along with total sampling error, to calculate the combined 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.
Performance materiality level
The materiality allocated to any given account balance.
Preliminary judgment about materiality
The maximum amount by which the auditor believes that the statements could be misstated and still not affect the decisions of reasonable users.
Likely misstatements can result from : a. (yes or no) Computation of the sampling error for the cash account b. (yes or no) Differences between management's and an auditor's judgment about account balances c. (yes or no) Projections of misstatements based on an auditor's tests of a sample from a population
a. no b. yes c. yes
Which of the following are major difficulties auditors face when allocating materiality to balance sheet accounts? a. (yes or no) Certain accounts contain more misstatements than others b. (yes or no) Only overstatements need be considered c. (yes or no) Audit costs can affect allocation
a. yes b. no c. yes
Auditors may assess inherent risk and control risk: (yes or no) a. Jointly to determine the risk of material misstatement b. Separately and combine their effects in the audit risk model
a. yes b. yes
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. (yes or no) Amounts involving frauds are considered more important than errors of equal amount b. (yes or no) Misstatements that are otherwise immaterial may be material if they affect a trend in earnings
a. yes b. yes
Audit standards require the auditor to consider the combined amount of misstatement early in the audit. This is known as preliminary materiality judgment. List and discuss the three main factors that affect an auditor's preliminary judgment about materiality.
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 given size might be material for a small company, whereas the same dollar misstatement could be immaterial for a larger one. • Benchmarks are needed for evaluating materiality. Because materiality is relative, it is necessary to have benchmarks for establishing whether misstatements are material. Net income before taxes is normally the most commonly used benchmark, but other possible benchmarks 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
Materiality
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.
Audit assurance
This term is synonymous with acceptable audit risk
Both overstatements and understatements must be considered when allocating materiality to balance sheet accounts. A) True B) False
A
If the audit assurance rate is 95%, then the level of acceptable audit risk is 5%. A) True B) False
A
If the auditor approaches the audit of the accounts in s sequential manner, the findings of the audit of accounts audited earlier can be used to revise the performance materiality established for accounts audited later. A) True B) False
A
If the preliminary judgment of materiality increases, the amount of audit evidence required will decrease. A) True B) False
A
Preliminary judgments about materiality are often changed during the course of the engagement. A) True B) False
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
A
The primary purpose of allocating the preliminary judgment about materiality to financial statement accounts is to help the auditor decide the appropriate evidence to accumulate. A) True B) False
A
To maximize audit efficiency, the auditor should allocate less tolerable misstatement 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
A
The lower the dollar amount of the preliminary judgement the more audit evidence is required. A) True B) False
A (Page 8)
