CHAPTER 9

Multiple-Choice Questions

1.easya

If it is probable that the judgment of a reasonable person would have been 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.

2.easy

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.

b a. minimumb. maximumc. mean averaged. median average

3.easy

When auditors allocate the preliminary judgment about materiality to account balances, the materiality allocated to any given account balance is referred to in SAS No. 39 as

d a. the materiality range.b. the error range.c. tolerable materiality.d. tolerable misstatement.

4. Why do auditors establish a preliminary judgment about materiality?easy a. To help the auditor plan the appropriate evidence to accumulate.a b. So that the client can know what records to make available to the auditor.

c. To determine what level of staffing (i.e., work experience) is required for the audit.d. None of the above.

5. If an auditor establishes a relatively low level for materiality, then the auditor will easy a. accumulate more evidence than if a higher level had been set.a b. accumulate less evidence than if a higher level had been set.

c. accumulate approximately the same evidence as would be the case were a higher level set.d. accumulate an undetermined amount of evidence.

6. After the preliminary judgment about materiality has been established, auditors mayeasy a. not adjust it.d b. adjust it downward only.

c. adjust it upward only.d. adjust it either downward or upward.

7. In an audit area that has a higher inherent risk, it would be prudent toeasy a. increase the amount of audit evidence gathered.d b. assign more experienced staff to that area.

c. review the completed audit files more thoroughly.d. do all of the above.

9-1

8.easy

Which of the following is least likely to be appropriate as the basis for determining the preliminary judgment about materiality in the audit of a set of financial statements?

d a. Net income before taxes.b. Current assets.c. Owners’ equity.d. Inventory.

9. Which of the following might not be a signal of a lack of integrity in management?easy a. Prior criminal conviction of an assembly line foreman.a b. Frequent turnover of key internal audit personnel.

c. Frequent disagreements with previous auditors.d. Frequent turnover of key financial personnel.

10.easy

Which of the following qualitative factors may significantly influence whether an item is deemed to be material?

d a. Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations.

b. Misstatements that are otherwise immaterial may be material if they affect a trend in earnings.

c. Amounts involving fraud are usually considered more important than unintentional errors of equal dollar amounts.

d. All of the above may influence materiality.

11. Auditors generally allocate the preliminary judgment about materiality to easy a. the balance sheet only.a b. the income statement only.

c. the income statement and balance sheet.d. the statement of cash flows.

12. Which of the following statements regarding inherent risk is correct?easyc

a. The inherent risk assigned in the audit risk model is unaffected by the auditor’s experience 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 auditors set a high inherent risk in the first year of an audit and reduce it in subsequent years as they gain experience, even when there is inherent risk.

d. The inherent risk assigned in the audit risk model is dependent upon the strengths in client’s internal control system.

13.easya

Auditors begin their assessments of inherent risk during the planning phase. Which of the following would not be a topic of the planning phase that would also help to assess inherent risk?a. Obtaining client’s agreement on the engagement letter.b. Obtaining knowledge about the client’s business and industry.c. Touring the client’s plant and offices.d. Identifying related parties.

14.medium

Which of the following is not a difficulty associated with allocating the preliminary judgment about materiality to balance sheet accounts?

d a. Auditors expect certain accounts to have more misstatements than others.b. The allocation can have a significant effect on audit costs.c. The auditor can expect to identify overstatements as well as understatements in the

accounts.d. All of the above are difficulties associated with the allocation of materiality.

15. What is the primary means of dealing with risk in planning audit evidence?

9-2

medium a. Selection of more effective tests of details of balances.b b. Application of the audit risk model.

c. Establish a lower preliminary judgment about materiality.d. All of the above.

16.medium

The opinion paragraph in auditors’ reports includes two important phrases that are directly related to materiality and risk. The phrases are

a a. “in our opinion” and “in all material respects.”b. “presents fairly” and “in all material respects.”c. “in our opinion” and “presents fairly.”d. “in all material respects” and “reasonable assurance.”

17. The phrase “in our opinion” in the auditor’s report is intended to inform users that auditors medium a. guarantee fair presentation of the financial statements.d b. act as insurers of the accuracy of the statements.

c. certify the material presented in the statements by management.d. base their conclusions about the statements on professional judgment.

18.medium

Inherent risk is _______ related to detection risk and _______ related to the amount of audit evidence.

d a. directly, inversely.b. directly, directly.c. inversely, inversely.d. inversely, directly.

19. The five steps in applying materiality are listed below in random order.medium 1. Estimate the combined misstatement.b 2. Estimate the total misstatement in the segment.

3. Set preliminary judgment about materiality.4. Allocate preliminary judgment about materiality to segments.5. Compare combined estimate with preliminary judgment about materiality.

The correct sequence from start to finish would bea. 1 2 5 4 3.b. 3 4 2 1 5.c. 4 3 1 5 2.d. 5 1 3 2 4.

20.medium

SAS No. 47 defines the preliminary judgment about materiality as the combined amount of misstatements in the financial statements that would be considered material. This judgment

a a. need not be quantified.b. must be quantified.c. must be quantified in terms of dollars.d. must be quantified in terms of both dollars and of a percentage of sales.

21. Which of the following statements is not correct?medium a. Materiality is a relative rather than an absolute concept.b b. Normally, 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.

9-3

22.medium

Since materiality is relative, it is necessary to have bases for establishing whether misstatements are material. Normally, the most common base for deciding what is material is

a a. net income before taxes.b. net working capital.c. net income after taxes.d. total assets.

23.medium

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 does not demonstrate this?

d a. Amounts involving frauds are considered more important than errors of equal amount.b. Misstatements that are otherwise minor may be considered 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.d. Each of the above demonstrates this concept.

24.medium

The more effective the internal controls, the lower the risk factor that ______ assigned to control risk.

b a. should be.b. could be.c. is.d. must be.

25.medium

Allocating the preliminary judgment about materiality to segments of the financial statements is necessary because

b a. evidence is accumulated for the financial statements as a whole so the materiality doesn’t apply to them.

b. evidence is accumulated by segments rather than for the financial statements as a whole.c. it is required by the AICPA’s Code of Professional Conduct.d. it is required by the SEC.

26. Which of the following statements is not correct?mediumc

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.

27.medium

Regardless of how the allocation of the preliminary judgment about materiality was done, when the audit is complete the auditor must be confident that the combined errors in all accounts are

d a. less than the preliminary judgment.b. equal to the preliminary judgment.c. more than the preliminary judgment.d. less than or equal to the preliminary judgment.

28.medium

Auditors frequently refer to the terms audit assurance, overall assurance, and level of assurance to refer to ________.

c a. detection risk.b. audit report risk.c. acceptable audit risk.d. none of the above.

9-4

29. When a different extent of evidence is needed for the various cycles, the difference is caused by

medium a. errors in the client’s accounting system.d b. client’s need to achieve an unqualified opinion.

c. the auditor’s need to follow GAAS.d. the auditor’s expectations of errors and assessment of the control structure.

30. If planned detection risk is reduced, the amount of substantive evidence the auditor accumulates will

medium a. increase.a b. decrease.

c. remain unchanged.d. be indeterminate.

31.medium

When discussing control risk (CR) and the audit risk model, which of the following statements is not true?

b a. CR is a measure of the auditor’s assessment of the likelihood that misstatements exceeding a tolerable amount will not be prevented or detected by the client’s internal controls.

b. If the auditor concludes that internal control is completely ineffective to prevent or detect errors, he/she would assign a 0% to CR.

c. The relationship between control risk and detection risk is inverse.d. The relationship between control risk and evidence is direct.

32.medium

Which of the following is not a good indicator of the degree to which statements are relied on by external users?

d a. Client’s size, as measured by total assets or total revenue.b. Distribution of ownership among the public.c. Nature and amount of liabilities.d. Amount of net income or loss after taxes.

33.medium

In situations in which the auditor believes the chance of financial failure or loss is high, and there is a corresponding increase in client business risk for the auditor, acceptable audit risk should

a a. be reduced.b. be increased.c. remain the same.d. be calculated using a computerized statistical package.

34.medium

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 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.

35.medium

Many account balances require estimates and/or a great deal of management judgment. One area that does not require such judgment would be

b a. allowance for uncollectible accounts.b. useful life of equipment for tax purposes.c. obsolete inventory.d. liability for warranty payments.

36.medium

Inherent risk is reduced where the likelihood of defalcations is low. This would be true for an account such as

d a. inventory.b. marketable securities.

9-5

c. cash.d. accounts receivable.

37.medium

The auditor assesses control risk and inherent risk. On a typical engagement, the auditor would be least likely to assess these for

d a. each audit objective.b. each cycle.c. each account.d. the overall audit.

38. Acceptable audit risk is ordinarily set by the auditor during planning andmedium a. held constant for each major cycle and account.a b. held constant for each major cycle but varies by account.

c. varies by each major cycle and by each account.d. varies by each major cycle but is constant by account.

39.medium

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 including

d a. client size.b. concentration of ownership.c. types and amounts of liabilities.d. all of the above.

40. A major limitation in the application of the audit risk model ismedium a. the difficulty in defining the terms of the model.b b. the difficulty in measuring the components of the model.

c. the difficulty in understanding the effect on other factors in the model when one factor is changed.

d. the failure of the Audit Standards Board (ASB) of the AICPA to accept it and incorporate it into the SASs.

41.mediuma

An auditor determines that a client has not accounted for a certain material item in conformity with generally accepted accounting principles. This fact is prominently disclosed in a footnote to the financial statements. The CPA does not agree with this departure from GAAP and shoulda. issue a qualified the opinion because of the deviation from generally accepted

accounting principles.b. disclaim an opinion.c. not allow the accounting treatment for this item to affect the type of opinion because the

deviation from generally accepted accounting principles was disclosed.d. express an unqualified opinion and insert a middle paragraph emphasizing the matter by

reference to the footnote.

42.mediuma

In determining the type of opinion to express, an auditor assesses the nature of the reporting qualifications and the materiality of their effects. Materiality will be the primary factory considered in the choice betweena. an “except for” opinion and an adverse opinion.b. an “except for” opinion and a disclaimer of opinion.c. an adverse opinion and a disclaimer of opinion.d. a qualified opinion and a piecemeal opinion.

43. When setting a preliminary judgment about materiality,challenging a. more evidence is required for a low dollar amount than for a high dollar amount.a 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.

9-6

44. When allocating materiality, most practitioners choose to allocate tochallenging a. the income statement accounts because they are more important.b b. the balance sheet accounts because there are fewer.

c. both balance sheet and income statement accounts because there could be errors on either one.

d. all of the financial statements because there could be errors on other statements besides the income statement and balance sheet.

45.challenging

The expectation of misstatements after considering the effect of internal control is most appropriately thought of as

c a. control risk and acceptable audit risk.b. inherent risk.c. the combination of inherent risk and control risk.d. none of the above.

46. Which one of the following statements about the cycle approach to auditing is not correct?challenging a. There are differences among cycles in the frequency and size of expected errors.c b. There are differences among cycles in the effectiveness of the internal control structure.

c. There are differences among cycles on the auditor’s willingness that material errors exist after the auditing is complete.

d. It is common for auditors to want an equally low likelihood of errors for each cycle after the auditor is finished.

47.challenging

When the auditor has the same level of willingness to risk that material errors will exist after the audit is finished for all five cycles,

a a. a different extent of evidence is needed for various cycles.b. the same amount of evidence will be gathered for each cycle.c. he/she has not followed generally accepted auditing standards.d. the level for each cycle must be no more than 2% so that the entire audit does not exceed

10%.

48.challenging

Which of the following factors is least likely to contribute to opportunities leading to misappropriation of assets?

c a. Inadequate controls related to segregation of duties.b. Not requiring mandatory vacations.c. Disregard for the need to monitor or reduce risks of misappropriating assets.d. Presence of large sums of cash or inventory items of high value.

49. When discussing inherent risk (IR) and the audit risk model, which of the following is not true?

challenging a. IR is inversely related to planned detection risk.b b. IR is inversely related to evidence.

c. IR is the susceptibility of the financial statements to material error, assuming no internal controls.

d. IR is the auditor’s assessment of the likelihood that errors exceeding a tolerable amount exist in a segment before considering the effectiveness of internal accounting controls.

50.challenging

When discussing acceptable audit risk (AAR) and the audit risk model, which of the following statements is true?

d a. The terms audit assurance, overall assurance, or level of assurance are synonyms for AAR.

b. AAR is objectively determined by the auditor.c. AAR is the risk that the auditor is willing to take that the financial statements are fairly

stated after the audit is completed and an unqualified opinion has been reached.d. When the auditor decides on a lower acceptable audit risk, it means the auditor wants to

be more certain that the financial statements are not materially misstated.

9-7

51. Which of the following is an example of the concept of inherent risk?challengingc

a. Humans make more errors than computers; therefore, a manual accounting 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 receivable for a finance company are less likely to be collectible than those of a bank.

d. Audits with larger sample sizes are less risky than those with smaller sample sizes.

52. Tolerable misstatement as set by the auditorchallenging a. decreases acceptable audit risk.D b. increases inherent risk and control risk.

c. affects planned detection risk.d. does not affect any of the four risks.

53. The audit risk model ischallenging a. a planning, testing, and evaluation model.C b. useful in evaluating results but of limited use in planning.

c. useful in planning, but of limited value in evaluating results.d. useful when performing the tests of balances, but of little value in either the planning or

evaluation stages.

54.challenging

Research in auditing has shown that if a revised risk is used in the audit risk model to determine a revised planned detection risk, there is a danger of

B a. not decreasing the evidence sufficiently.b. not increasing the evidence sufficiently.c. over-auditing.d. increased lawsuits against the auditor for failure to follow GAAS.

55.challengingb

The audit risk against which the auditor requires reasonable protection is a combination of two separate risks. The first of these is that material errors will occur in the accounting process by which the financial statements are developed, and the second is thata. a company’s system of internal control is not adequate to detect errors and frauds.b. those errors that occur will not be detected in the auditor’s examination.c. management may possess an attitude that lacks integrity.d. evidential matter is not competent enough for the auditor to form an opinion based on

reasonable assurance.

9-8

56.challengingb

For financial reporting purposes, a change from straight-line to an accelerated depreciation method was disclosed in a note to the financial statements and has an immaterial effect on the current financial statements. It is expected, however, that the change will have a significant effect on future periods. The auditor should express a(n)a. qualified opinion.b. unqualified opinion.c. consistency exception.d. adverse opinion.

57.challengingb

An auditor is confronted with an exception considered sufficiently material to warrant some deviation from the standard unqualified auditor’s report. If the exception relates to a departure from generally accepted accounting principles, the auditor must decide between expressing a(n)a. adverse opinion and an unqualified opinion with an explanatory paragraph.b. adverse opinion and an “except for” opinion.c. adverse opinion and a disclaimer of opinion.d. disclaimer of opinion and an unqualifed opinion with an explanatory paragraph.

58.challenging

Which of the following underlies the application of generally accepted auditing standards, particularly the standards of field work and reporting?

A a. The elements of materiality and relative risk.b. The element of internal control.c. The element of corroborating evidence.d. The element of reasonable assurance.

59.challenging

For a reporting entity that has participated in related-party transactions that are material, disclosure in the financial statements should include

A a. the nature of the relationship and the terms and manner of settlement.b. details of the transactions within major classifications.c. a statement to the effect that a transaction was consummated on terms no less favorable

than those that would have been obtained if the transaction had been with an unrelated party.

d. a reference to deficiencies in the entity’s system of internal accounting control.

Essay Questions

60.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 given

size might be material for a small company, whereas the same dollar misstatement could be immaterial for a larger one.

Bases are needed for evaluating materiality. Since materiality is relative, it is necessary to have bases for establishing whether misstatements 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.

9-9

61.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 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.

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.

62.medium

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.

Answer:Allocating the preliminary judgment about materiality to individual segments is necessary because evidence is accumulated for segments rather than for the financial statements as a whole. Allocating to segments establishes a tolerable misstatement amount for each segments, which helps the auditor decide the appropriate audit evidence to accumulate for each segments. Most practitioners allocate materiality to balance sheet accounts rather than income statement accounts because there are fewer balance sheet than income statement accounts.

63.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.

64.medium

Discuss how auditors use the audit risk model when planning an audit.

Answer:The audit risk model is used primarily for planning purposes in deciding 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 = AAR IR x CR

65. Describe the audit risk model and each of its components.

9-10

mediumAnswer:

The planning form of the audit risk model is stated as follows:

PDR = AAR IR x CR

where: PDR = planned detection riskAAR = acceptable audit riskIR = inherent riskCR = 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 primarily by the degree to which 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 misstatements in an account before considering the effectiveness 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.

66.medium

There are several factors that affect acceptable audit risk. Discuss three of these factors.

Answer:Acceptable audit risk is affected by: The degree to which external users will rely on the statements. For large, publicly

held clients, acceptable audit risk will be less, than for small, privately held clients, ceteris paribus.

The likelihood that a client will have financial difficulties after the audit report is issued. Acceptable audit risk will be lower, when the client is experiencing financial difficulties.

The auditor’s evaluation of management’s integrity . Acceptable audit risk will be lower, when the client’s management has questionable integrity.

67.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.

Answer: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 tolerable misstatement. This allocation is performed in the audit planning

9-11

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.

Other Objective Answer Format Questions

68.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

Acceptable audit risk 1% 10% 10% 5%

Inherent risk 100% 100% 50% 20%

Control risk 100% 100% 40% 30%

Planned detection risk ______ ______ ______ ______

Answer: 1. 1%; 2. 10%; 3. 50%; 4. 83.3%

69.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 1. An increase in acceptable audit risk. .

increase 2. An increase in inherent risk. .

Increase 3. A decrease in control risk. .

decrease 4. An increase in planned detection risk. .

decrease 5. An increase in tolerable misstatement. .

70. Match six of the terms (a-i) with the definitions provided below (1-6):Medium

a. Business risk

9-12

b. Preliminary judgment about materialityc. Inherent riskd. Planned detection riske. Audit assurancef. Acceptable audit riskg. Tolerable misstatementh. Control riski. 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 client will fail to achieve its objectives.

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.

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.

71.medium

In practice, auditors rarely assign numerical probabilities to inherent risk, 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: 1. low, high2. high, low3. medium, medium4. high, low

72.challenging

The following graph shows three levels of acceptable audit risk (1%, 5%, 10%), three levels of inherent risk control risk (Low, Medium, High), nine intersections (a through i), and nine levels of required audit evidence (1 through 9).

9-13

During a “typical” audit engagement in which the acceptable level of audit risk is medium (5%) and the assessed levels of inherent risk and control risk are medium, the required amount of audit evidence would be medium (“5” in the graph). Use the graph to determine what effect (increase, decrease, or none) a change in acceptable audit risk, inherent risk, or control risk would have on the amount of audit evidence you would gather.

a

b

c

d

e

f

g

h

i

10%

5%

1%

AcceptableAuditRisk

Low IR x CR

MediumIR x CR

HighIR x CR

Amount of AuditEvidence Required1 2 3 4 5 6 7 8 9

Example: Compared to a typical audit (e/5), a decision to reduce your acceptable level of audit risk would change the intersection to , causing the amount of required evidence to .(Answer: f, increase to 6)

f,incr. to 6

1. Compared to (e/5), a change from auditing a privately held company to auditing a publicly held company would change the intersection to , causing the amount of required evidence to _______________.

b,decr. to 2

2. Compared to (e/5), a decision to increase reliance on internal control would change the intersection to , causing required evidence to ______________________.

h,incr. to 8

3. Compared to (e/5), a large increase in an account balance from the previous year would change the intersection to , causing required evidence to ___________________.

d,decr. to 4

4. You determined during the planning phase of the audit that there has been a significant improvement in the client’s financial condition relative to the previous year, in which acceptable audit risk was 5% and assessed risk was medium. This year, you would change the intersection to , causing required evidence to _______________________.

b,decr. to 2

5. This is the second-year engagement, and there were good audit results in the previous year. Compared to (e/5), you would change the intersection this year to , causing the amount of required evidence to ________________________.

h,incr. to 8

6. About halfway through the current year’s audit, you discover that the client is constructing its own building during idle periods, using factory personnel. This is the first time they have done this, and it was done at your recommendation. Compared to (e/5), the intersection for the audit of the fixed assets account will change to , causing the amount of required evidence to .

9-14

i,incr. to 9

7. In a discussion with the client, you learn that management is planning to sell the business in the next few months. Because of the planned changes, several key accounting personnel quit several months ago. Compared to (e/5), the intersection will change to , causing the amount of required evidence to _______________________.

b,decr. to 2

8. Compared to the audit of inventory in a manufacturing company in which acceptable audit risk was 5% and assessed risk was medium (e/5), the intersection for the audit of prepaid expenses will change to , causing required evidence to ________________________.

73.easya

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. Trueb. False

74.easya

There is no precise definition of materiality in the professional literature.a. Trueb. False

75.easya

Net income before taxes is normally the most important base for deciding what is material.a. Trueb. False

76.easya

Most practitioners allocate the preliminary judgment about materiality to balance sheet, rather than income statement, accounts.a. Trueb. False

77.easya

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 for each account.a. Trueb. False

78.easya

Auditors often use prior year financial statement balances to establish their preliminary judgment about materiality in planning the current year’s audit.a. Trueb. False

79.easyb

If acceptable audit risk is low, and inherent risk and control risk are both high, then planned detection risk should be high.a. Trueb. False

80.easya

Inherent risk and planned detection risk are inversely related; i.e., as inherent risk increases, planned detection risk should decrease, ceteris paribus.a. Trueb. False

81.easyb

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. Trueb. False

82. The most important element of the audit risk model is control risk.

9-15

easyb

a. Trueb. False

83.easyb

Auditors are required to test any internal controls they believe have not been operating effectively during the period under audit.a. Trueb. False

84.easyb

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 high.a. Trueb. False

85.mediuma

Auditors have difficulty applying the concept of materiality in practice because they often do not know who the users of the financial statements are or what decisions will be made.a. Trueb. False

86.mediumb

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. Trueb. False

87.mediumb

If the preliminary judgment of materiality increases, the amount of audit evidence required will also increase.a. Trueb. False

88.mediumb

Tolerable misstatement is the maximum combined total of all misstatements in the financial statements that the auditor is willing to allow, or tolerate, when issuing a standard unqualified opinion.a. Trueb. False

89.mediuma

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. Trueb. False

90.mediuma

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. Trueb. False

91.mediuma

Acceptable audit risk and the amount of substantive evidence required are inversely related; i.e., as acceptable audit risk increases, the amount of substantive evidence the auditor plans to accumulate should decrease.a. Trueb. False

92.mediuma

Control risk and the amount of substantive evidence required are directly related; i.e., as control risk increases, the amount of substantive evidence the auditor plans to accumulate should increase.a. Trueb. False

93. Inherent risk and control risk are directly related; i.e., as inherent risk increases, control risk

9-16

mediumb

also increases.a. Trueb. False

94.mediuma

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. Trueb. False

95.challengingb

Audit assurance is the complement of planned detection risk, that is, one minus planned detection risk.a. Trueb. False

9-17