Review Questions chapter 9

Explain why inherent risk is set for audit objectives for segments (classes of transactions, balances, and presentation and disclosure) rather than for the overall audit. What is the effect on the amount of evidence the auditor must accumulate when inherent risk is increased from medium to high for an audit objective.

Inherent risk is set for audit objectives for segments rather than for the overall audit because misstatements occur at the objective level within a segment. By identifying expectations of misstatements in segments, the auditor is thereby able to modify audit evidence by searching for misstatements in those segments. When inherent risk is increased from medium to high, the auditor should increase the audit evidence accumulated to determine whether the expected misstatement actually occurred.

Define the meaning of the term materiality as it used in accounting and auditing. What is the relationship between materiality and the phrase obtain reasonable assurance used in the auditor's report?

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

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 the financial statements. The auditor must therefore make an assessment of the likely users and the decisions they will make. Materiality is also difficult to apply because it is a relative concept. Auditing standards offer little specific guidance regarding the application of materiality. The auditor must, therefore, exercise considerable professional judgment in the application of materiality.

Explain why there is an inverse relationship between planned detection risk and the amount model. How is it possible to use the model in a meaningful way without a precise way of measuring the risk?

Planned detection risk is the risk that audit evidence for a segment will fail to detect misstatements that could be material, should such misstatements exist. In order to reduce this risk, the auditor would increase the amount of evidence they collect for a 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.

Define the audit risk model and explain each term in the model. Also describe which two factors of the model when combined reflect the risk of material misstatments.

The audit risk model is as follows: PDR = AARR IR x CR Where PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk Planned detection risk A measure of the risk that audit evidence for a segment will fail to detect misstatements that could be material, should such misstatements exist. Acceptable audit risk 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. Inherent risk A measure of the auditor's assessment of the susceptibility of an assertion to material misstatement before considering the effectiveness of internal control. Control risk 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 by the client's internal controls. Auditing standards note that the combination of inherent risk and control risk reflect the risk of material misstatement.

Explain the circumstances when the auditor should revise the components of the audit risk model and the effect of the revisions on planned detection risk and planned evidence.

The auditor should revise the components of the audit risk model when the evidence accumulated during the audit indicates that the auditor's original assessments of inherent risk or control risk are too low or too high or the original assessment of acceptable audit risk is too low or too high. The auditor should exercise care in determining the additional amount of evidence that will be required. This should be done without the use of the audit risk model. If the audit risk model is used to determine a revised planned detection risk, there is a danger of not increasing the evidence sufficiently.

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

The following qualitative factors are likely to be considered in evaluating materiality: a. Amounts involving fraud are usually considered more important than unintentional errors of equal dollar amounts. b. Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations. c. Misstatements that are otherwise immaterial may be material if they affect a trend in earnings.

chapter 8 introduced the eight parts of the planning phase of an audit. Which part is the evaluation of materialiy and risk?

The parts of planning are: accept client and perform initial planning, understand the client's business and industry, assess client business risk, perform preliminary analytical procedures, set materiality and assess acceptable audit risk and inherent risk, understand internal control and assess control risk, gather information to assess fraud risk, and develop overall audit strategy and audit program. Evaluation of materiality is in the fifth part of planning. Risk assessment is in part three (client business risk), part five (acceptable audit risk and inherent risk), part six (control risk), and part seven (fraud risk).

What is meant by setting a preliminary judgment about materiality? Identify the most important factors affecting the preliminary judgment.

The 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. Several factors affect the preliminary judgment about materiality and are as follows: 1. Materiality is a relative rather than an absolute concept. 2. Benchmarks are needed for evaluating materiality. 3. Qualitative factors affect materiality decisions. 4. Expected distribution of the financial statements will affect the preliminary judgment of materiality. If the financial statements are widely distributed to users, the preliminary judgment of materiality will probably be set lower than if the financial statements are not expected to be widely distributed. 5. The level of acceptable audit risk will also affect the preliminary judgment of materiality.

Assume a company with the following balance sheet accounts: Cash $10,000 fixed assets $ 60,000 longterm loans $30,000 M. Johnson, proprietor $40,000 you are concerned only about overstatements of owner's equity. Set performance materiality for the three relevant accounts such that preliminary judgment about materiality does not exceed $5000. Justify your answer.

There are several possible answers to the question. One example is: Cash $ 500 Overstatement Fixed assets $3,000 Overstatement Long-term loans $1,500 Understatement Note: Cash and fixed assets are tested for overstatement and long-term loans for understatement because the auditor's objective in this case is to test for overstatements of owner's equity. The least amount of performance materiality was allocated to cash and long-term loans because they are relatively easy to audit. The majority of the total allocation was to fixed assets because there is a greater likelihood of misstatement of fixed assets in a typical audit.

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.

When allocating the preliminary judgment about materiality for the financial statements as a whole to individual segments, the auditor considers both efficiency and effectiveness of the audit. An auditor might set a lower level of performance materiality for a particular account balance if it is easy to audit and no misstatements are expected (e.g., notes payable), 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).

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 lower 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 minimum acceptable audit risk that should be met.

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 segment of the audit, or 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.

Explain what is meant by term acceptable audit risk. What is its relevance to evidence accumulation?

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

Explain the causes of an increased or decreased 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. A decrease in planned detection risk is caused by the opposite: a decrease in acceptable audit risk or an increase in control risk or inherent risk.

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

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. 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 meant by using benchmarks for setting a preliminary judgment about materiality? How will those benchmarks differ for the audit of a manufacturing company and a government unit such as school district?

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

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 relationships among model components and the effect that changes in the components have on the amount of evidence needed 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 audit risk, planned detection risk and planned audit evidence

Extensive misstatements in the prior year's audit would cause inherent risk to be set at a high level (maybe even 100%). An increase in inherent risk would lead to a decrease in planned detection risk, which would require that the auditor increase the level of planned audit evidence.

how will the conduct of an audit of a medium-sized company be affected by the company's being a small part of of a large conglomerate as compared with it being a separate entity?

If an audit is being performed on a medium-sized company that is part of a conglomerate, the auditor must make a materiality judgment based upon the conglomerate. Materiality may be larger 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 would be lower than for the audit of a conglomerate.

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?

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. 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 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

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

Inherent risk is a measure of the auditor's assessment of the susceptibility of an assertion to material misstatements before considering the effectiveness of internal control. Factors affecting assessment of inherent risk include: Nature of the client's business Results of previous audits Initial vs. repeat engagement Related parties Complex or nonroutine transactions Judgment required to correctly record transactions Makeup of the population Factors related to fraudulent financial reporting Factors related to misappropriation of assets