Chapter 3

Chapter 3 Risks and Materiality

(I) Multiple Choice Questions

1. Which of the following is least likely to indicate a material misstatement in the

financial statements?

A A material provision for a lawsuit was omitted from the accounting record.

B Production overhead, which is less than 50% of the total production costs,

were misclassified as distribution expenses during the accounting process.

C Notes to the accounts had not included the details of a finance lease

agreement signed during the current year.

D The company did not write off a significant amount of inventory after

discovering that it had been stolen.

2. Inherent risk and control risk differ from detection risk in that they

A can be changed at the auditor’s discretion.

B may be stressed in either quantitative or non-quantitative terms.

C exist independently of the financial statement audit.

D may give rise when there are misapplications of auditing procedures.

3. Which of the following can be controlled by the auditor?

A Inherent risk

B Detection risk

C Control risk

D Both detection and control risk

4. If the auditor assesses control and inherent risk as low, what would you expect

the auditor to do?

A Perform no substantive procedures.

B Perform no tests of control because of the low level of control risk.

C Perform a relatively small number of substantive procedures.

D Re-evaluate his or her acceptable level of audit risk.

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5. Inherent risk would be considered to be high where:

A the company’s profit for the year is the same as last year.

B the chief accountant has been with the company for 15 years.

C the newly appointed finance director was previously the marketing

manager.

D the company has decided to set up an internal audit department.

6. Which of the following statements best describes the audit approach to

materiality?

A Materiality is a matter for professional judgement.

B Materiality is only relevant when planning the audit.

C Materiality relates to the relative size of items within the financial

statements.

D Materiality is determined by reference to the professional standards.

7. In determining the level of planning materiality for an audit, what should not be

considered?

A Prior years’ errors.

B Trends in the industry within which the company operates.

C The cost of the audit.

D The users of the financial statements.

8. Which of the following audit risk components may be assessed in non-

quantitative terms?

Control risk Detection risk Inherent risk

A Yes Yes No

B Yes No Yes

C Yes Yes Yes

D No Yes Yes

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9. Relationship between control risk and detection risk is ordinarily

A Parallel.

B Inverse

C Direct

D Equal

10. In considering materiality for planning purposes, an auditor believes that

misstatements aggregating $10,000 would have a material effect on an entity’s

income statement , but that misstatements would have to aggregate $20,000 to

materially affect the balance sheet. Ordinarily, it would be appropriate to design

auditing procedures that would be expected to detect misstatements that

aggregate:

A $10,000

B $15,000

C $20,000

D $30,000

11. The risk that financial statements are likely to be misstated materially without

regard to the effectiveness of internal control is which type of risk?

A inherent risk

B audit risk

C client risk

D control risk

12. Which of the following industries is usually considered high risk by audit firms?

A High technology companies such as Internet firms.

B Manufacturing companies such as toy producers.

C Legal services such as attorney firms.

D Non-profit companies such as trade associations.

13. Which of the following factors is not a component of the audit risk model?

A inherent risk.

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B statistical risk.

C detection risk.

D control risk.

14. In the audit risk model, which of the risk components may only be assessed by

the auditor?

A Inherent risk

B Control risk

C Detection risk

D Both A and B

15. In the audit risk model, its risk components are either determined, assessed, or

manipulated. Which of the following risks are controllable by the auditor?

A Audit risk

B Control risk

C Detection risk

D Both A and C

16. The risk-based audit approach requires the auditor to identify

A account balances or related disclosures that might be materially misstated.

B potential causes of the misstatement.

C important processes that may affect one of more account balances.

D all of the above.

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(II) Examination Style Questions

Question 1

Grand Ltd and Petit Ltd are garments manufacturing companies, both of them are the

audit clients of King & Kong. Both audit teams have identified overstatements in

debtor balances from the testing results.

Grand Ltd Petit Ltd

Tolerable misstatement for debtors $40,000 $40,000

Expected misstatement $16,000 $16,000

Book value of total debtors $1,600,000 $1,600,000

Book values of samples $896,000 $258,000

Audit value of samples $890,000 $252,000

Required:

(a) What is “materiality” in the context of financial statements as a whole?

(2 marks)

(b) List THREE factors affecting the auditors’ judgement on materiality. (3 marks)

(c) Define audit risk and its three components. (7 marks)

(d) What are the relationship among the three audit risk components and their

impact on auditors? (3 marks)

(e) Calculate the projected misstatements for Grand Ltd and Petit Ltd respectively.

Based on the projected misstatements, draw conclusions on the debtor balances

of Grand Ltd and Petit Ltd. (5 marks)

(Total 20 marks)

(HKIAAT Paper 8 Auditing December 2004 Q.B6)

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Question 2

Auditors should consider materiality and its relationship with audit risk when

conducting an audit. Furthermore, they should consider materiality when determining

the nature, timing and extent of audit procedures and evaluating the effect of

misstatements.

In evaluating whether the financial statements are prepared, in all material respects, in

accordance with an applicable financial reporting framework, auditors should assess

whether the aggregate of uncorrected misstatements that have been identified during

the audit is material.

REQUIRED:

(a) In the context of financial statements, what is the meaning of materiality?

(1 mark)

(b) State the determining factors on materiality. (2 marks)

(c) State the relationship between materiality and audit risk. (2 marks)

(d) The results of the tests of control may have effect on the original amount of

audit risk. What should auditors do in order to control audit risk at an acceptably

low level? (2 marks)

(e) Name two components forming the aggregate of uncorrected misstatements.

(2 marks)

(f) What should the auditors do if the aggregate of uncorrected misstatements

identified are considered material to the financial statements to ensure the audit

risk can be maintained at a low level? (3 marks)

(g) What is sampling risk? State TWO methods of controlling sampling risk.

(4 marks)

(h) What is non-sampling risk? State TWO causes of non-sampling risk. (4 marks)

(Total 20 marks)

(HKIAAT Paper 8 Auditing December 2007 Q.B1)

Question 3

(a) State the determining factors on materiality. (2 marks)

(b) List and explain the three components of audit risk. (6 marks)

(HKIAAT Paper 8 Pilot Paper 2008 C1(g)&(h))

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