58

Audit Risk and Materiality

MULTIPLE CHOICE:
1. An auditor compares 2002 revenues and expenses with those
of the prior year and investigates all changes exceeding
10%. By this procedure the auditor would be most likely to
learn that
a. An increase in property tax rates has not been
recognized in the client's accrual.
b. The 2002 provision for uncollectible accounts is
inadequate, because of worsening economic conditions.
c. Fourth quarter payroll taxes were not paid.
d. The client changed its capitalization policy for small
tools in 2002.
ANSWER: D
2. The element of the audit planning process most likely to be
agreed upon with the client before implementation of the
audit strategy is the determination of the
a. Timing of inventory observation procedures to be
performed.
b. Evidence to be gathered to provide a sufficient basis
for the auditor's opinion.
c. Procedures to be undertaken to discover litigation,
claims, and assessments.
d. Pending legal matters to be included in the inquiry of
the client's attorney.
ANSWER: A
3. When a CPA is approached to perform an audit for the first
time, the CPA should make inquiries of the predecessor
auditor. This is a necessary procedure because the
predecessor may be able to provide the successor with
information that will assist the successor in determining
a. Whether the predecessor's work should be utilized.
b. Whether the company follows the policy of rotating its
auditors.
c. Whether, in the predecessor's opinion, internal
control of the company has been satisfactory.
d. Whether the engagement should be accepted.
ANSWER: D
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59
4. Having evaluated inherent risk and control risk, the
auditor determines detection risk
a. As the complement of overall audit risk.
b. By performing substantive audit tests.
c. As a product of further study of the business and
industry and application of analytical procedures.
d. At a level that equates the joint probability of
inherent risk, control risk, and detection risk with
overall audit risk.
ANSWER: D
5. Which of the following is not a factor that affects the
auditor's judgment, during audit planning, as to the
quantity, type, and content of working papers?
a. The auditor's preliminary assessment of control risk.
b. The auditor's preliminary evaluation of inherent risk
based on discussions with the client.
c. The nature of the clients business.
d. The type of report to be issued by the auditor.
ANSWER: D
6. How can the audit program best be described at the
beginning of the audit process?
a. Tentative.
b. Conclusive.
c. Comprehensive.
d. Optional.
ANSWER: A
7. The auditor's analytical procedures will be facilitated if
the client
a. Uses a standard cost system that produces variance
reports.
b. Segregates obsolete inventory before the physical
inventory count.
c. Corrects material weaknesses in internal control
before the beginning of the audit.
d. Reduces inventory balances to the lower of cost or
market.
ANSWER: A
8. Experience has shown that certain conditions in an
organization are symptoms of possible management fraud.
Chapter 5 Audit Planning: Assessment of Inherent Risk and Materiality
60
Which of the following conditions would not be considered
an indicator of possible fraud?
a. Managers regularly assuming subordinates' duties.
b. Managers dealing in matters outside their profit
center's scope.
c. Managers not complying with corporate directives and
procedures.
d. Managers subject to formal performance reviews on a
regular basis.
ANSWER: D
9. Which of the following underlies the application of
generally accepted auditing standards, particularly the
standards of field work and reporting?
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.
ANSWER: A
10. Which of the following is not a purpose served by the
application of analytical procedures?
a. As part of audit planning to assist in locating
significant changes in revenues and expenses.
b. To provide a basis for lowering materiality thresholds
where significant earnings inflation is indicated.
c. To determine the economic substance of related party
transactions.
d. As part of audit review to determine that all
significant abnormalities have been resolved to the
auditor's satisfaction.
ANSWER: C
11. The probability of an auditor's procedures leading to the
conclusion that a material error does not exist in an
account balance when, in fact, such error does exist is
referred to as
a. Prevention risk.
b. Inherent risk.
c. Control risk.
d. Detection risk.
ANSWER: D
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12. Which of the following concepts is most useful in assessing
the scope of an auditor's program relating to various
accounts?
a. Attribute sampling.
b. Materiality.
c. The reliability of information.
d. Management fraud.
ANSWER: B
13. The existence of a related party transaction may be
indicated when another entity
a. Sells real estate to the corporation at a price that
is comparable to its appraised value.
b. Absorbs expenses of the corporation.
c. Borrows from the corporation at a rate of interest
which equals the current market rate.
d. Lends to the corporation at a rate of interest, which
equals the current market rate.
ANSWER: B
14. Which of the following is an indicator of possible
fraudulent financial reporting for the purpose of inflating
earnings?
a. A trend analysis discloses: (1) sales increases of
50 percent and (2) cost of goods sold increases of
25 percent.
b. A ratio analysis discloses: (1) sales of $50 million
and (2) cost of goods sold of $25 million.
c. A cross-sectional analysis of common size statements
discloses: (1) the firm's ratio of cost of goods sold
to sales is .4 and (2) the industry average ratio of
cost of goods sold to sales is .5.
d. A cross-sectional analysis of common size statements
discloses: (1) the firm's ratio of cost of goods sold
to sales is .5 and (2) the industry average ratio of
cost of goods sold to sales is .4.
ANSWER: A
15. An auditor judged an item to be immaterial when planning an
audit. However, the auditor may still include the item if
it is subsequently determined that:
a. Sufficient staff is available.
Chapter 5 Audit Planning: Assessment of Inherent Risk and Materiality
62
b. Adverse effects related to the item are likely to
occur.
c. Related evidence is reliable.
d. Miscellaneous income is affected.
ANSWER: B
16. Given that an audit in accordance with generally accepted
auditing standards is influenced by the possibility of
material errors and fraud, the auditor should conduct the
audit with an attitude of
a. Professional responsiveness.
b. Conservative advocacy.
c. Objective judgment.
d. Professional skepticism.
ANSWER: D
17. Warning signs that cause the auditor to question management
integrity must be taken seriously and pursued vigorously.
Which of the following may lead the auditor to suspect
management dishonesty?
a. The president and chief executive officer of the
client corporation has held numerous meetings with the
controller for the purpose of discussing accounting
practices that will maximize reported profits.
b. The client has been named as a defendant in a product
liability suit.
c. The client has experienced a decrease in revenue from
increased import competition.
d. A new federal regulation making customer licenses more
difficult to obtain may adversely affect the client's
operations.
ANSWER: A
18. Auditors sometimes use comparison of ratios as audit
evidence. For example, an unexplained decrease in the ratio
of gross profit to sales may suggest which of the
following possibilities?
a. Unrecorded purchases.
b. Unrecorded sales.
c. Merchandise purchases being charged to selling and
general expense.
d. Fictitious sales.
ANSWER: B
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19. In applying analytical procedures, the auditor discovered
that gross profit as a percent of sales declined sharply
during the current year. A possible cause might be
a. The client has significant amounts of obsolete
inventory carried at full cost.
b. A significant quantity of finished goods located in a
distant warehouse was inadvertently omitted from the
ending inventory.
c. Recorded sales included goods that were shipped the
following year.
d. Depreciation of office equipment was overstated.
ANSWER: B
20. Which of the following is not a component of audit
planning?
a. Observing the client's annual physical inventory
taking and making test counts of selected items.
b. Making arrangements with the client concerning the
timing of audit field work and use of the client's
staff in completing certain phases of the examination.
c. Obtaining an understanding of the business.
d. Developing audit programs.
ANSWER: A
21. Audit risk consists of all but the following components:
a. Inherent risk.
b. Detection risk.
c. Substantive risk.
d. Control risk.
ANSWER: C
22. Significant unexpected fluctuations identified by
analytical procedures will usually necessitate a(an)
a. Consistency qualification.
b. Review of internal control.
c. Explanation in the representation letter.
d. Auditor investigation.
ANSWER: D
23. Which of the following conditions supports an increase in
detection risk?
a. Internal control over cash receipts is excellent.
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b. Application of analytical procedures reveals a
significant increase in sales revenue in December, the
last month of the fiscal year.
c. Internal control over shipping, billing, and recording
of sales revenue is weak.
d. Study of the business reveals that the client recently
acquired a new company in an unrelated industry.
ANSWER: A
24. Which of the following statements best describes the
auditor's responsibility regarding the detection of fraud?
a. The auditor is responsible for the failure to detect
fraud only when such failure clearly results from
nonperformance of audit procedures specifically
described in the engagement letter.
b. The auditor should design audit procedures that will
provide reasonable assurance that the financial
statements are free from material misstatement due to
errors and/or fraud.
c. The auditor must extend auditing procedures to
actively search for evidence of fraud where the
examination indicates that fraud may exist.
d. The auditor is responsible for the failure to detect
fraud only when an unqualified opinion is issued.
ANSWER: B
25. An independent auditor observed that only one of the
company's ten divisions had a large number of material
sales transactions close to the end of the fiscal year. In
terms of risk analysis, this would most likely lead the
auditor to conclude that:
a. There is a relatively higher risk of overstatement of
revenues for this division than for other divisions.
b. Risks associated with auditing this division are not
affected by this information.
c. There is a high risk that liabilities of this division
are understated.
d. There is a high risk that the other nine divisions
have understated revenues.
ANSWER: A
26. An abnormal fluctuation in gross profit that might suggest
the need for extended audit procedures for sales and
Chapter 5 Audit Planning: Assessment of Inherent Risk and Materiality
65
inventories would most likely be identified in the planning
phase of the audit by the use of
a. Tests of transactions and balances.
b. A preliminary review of internal control.
c. Specialized audit programs.
d. Analytical procedures.
ANSWER: D
27. Inherent risk is defined as the susceptibility of an
account balance or class of transactions to error that
could be material assuming that there were no related
internal controls. Of the following conditions, which one
does not increase inherent risk?
a. The client has entered into numerous related party
transactions during the year under audit.
b. Internal control over shipping, billing, and recording
of sales revenue is weak.
c. The client has lost a major customer accounting for
approximately 30% of annual revenue.
d. The board of directors approved a substantial bonus
for the president and chief executive officer, and
also approved an attractive stock option plan for
themselves.
ANSWER: B
28. The understanding between the client and the auditor as to
the degree of responsibilities to be assumed by each are
normally set forth in a(an)
a. Representation letter.
b. Engagement letter.
c. Management letter.
d. Comfort letter.
ANSWER: B
29. The element of the audit planning process most likely to be
agreed upon with the client before implementation of the
audit strategy is the determination of the
a. Methods of statistical sampling to be used in
confirming accounts receivable.
b. Pending legal matters to be included in the inquiry of
the client's attorney.
c. Evidence to be gathered to provide a sufficient basis
for the auditor's opinion.
Chapter 5 Audit Planning: Assessment of Inherent Risk and Materiality
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d. Schedules and analyses to be prepared by the client's
staff.
ANSWER: D
30. Which of the following statements concerning materiality
thresholds is incorrect?
a. Aggregate materiality thresholds are a function of the
auditor's preliminary judgments concerning audit risk.
b. In general, the more misstatements the auditor
expects, the higher should be the aggregate
materiality threshold.
c. The smallest aggregate level of errors or
fraud that could be considered material to any one of
the financial statements is referred to as a
"materiality threshold."
d. Materiality thresholds may change between the planning
and review stages of the audit. These changes may be
due to quantitative and/or qualitative factors.
ANSWER: B
31. With respect to errors and fraud, the auditor should plan
to
a. Search for errors or fraud that would have a
material effect on the financial statements.
b. Discover errors or fraud that would have a material
effect on the financial statements.
c. Search for errors that would have a material effect
and for fraud that would have either material or
immaterial effects on the financial statements.
d. Search for fraud that would have a material
effect and for errors that would have either material
or immaterial effects on the financial statements.
ANSWER: B
32. Why should the auditor plan more work on individual
accounts as lower acceptable levels of both audit risk and
materiality are established?
a. To find smaller errors.
b. To find larger errors.
c. To increase the tolerable error in the accounts.
d. To decrease the risk of overreliance.
ANSWER: A
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33. The auditor notices significant fluctuations in key
elements of the company's financial statements. If
management is unable to provide an acceptable explanation,
the auditor should
a. Consider the matter a scope limitation.
b. Perform additional audit procedures to investigate the
matter further.
c. Intensify the examination with the expectation of
detecting management fraud.
d. Withdraw from the engagement.
ANSWER: B
34. Which of the following audit risk components may be
assessed in non-quantitative terms?
Inherent Control Detection
risk risk risk
a. Yes Yes No
b. Yes No Yes
c. No Yes Yes
d. Yes Yes Yes
ANSWER: D
35. Which of the following statements is true with regard to
the relationship among audit risk, audit evidence, and
materiality?
a. The lower the inherent risk and control risk, the
lower the aggregate materiality threshold.
b. Under conditions of high inherent and control risk,
the auditor should place more emphasis on obtaining
external evidence and should reduce reliance on
internal evidence.
c. Where inherent risk is high and control risk is low,
the auditor may safely ignore inherent risk.
d. Aggregate materiality thresholds should not change
under conditions of changing risk levels.
ANSWER: B
36. In evaluating the effectiveness of a company's credit and
collection policies, the ratio most likely to be used by an
auditor is
a. Quick ratio.
b. Accounts receivable turnover.
c. Working capital turnover.
Chapter 5 Audit Planning: Assessment of Inherent Risk and Materiality
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d. Return on sales.
ANSWER: B
37. Which of the following models expresses the general
relationship of risks associated with the auditor's
evaluation of internal control (CR), study of the business
and application of analytical procedures (IR), and overall
audit risk (AR), that would lead the auditor to conclude
that additional substantive tests of details of an account
balance are not necessary?
IR CR AR
a. 20% 40% 10%
b. 20% 60% 5%
c. 10% 70% 4.5%
d. 30% 40% 5.5%
ANSWER: A
38. Of the following procedures, which is the most important
that an auditor should use when performing an analytical
review of the income statement?
a. Select sales and expense items and trace amounts to
related supporting documents.
b. Compare actual revenues and expenses with the
corresponding figures of the previous year and
investigate significant differences.
c. Obtain from the proper client representatives,
inventory certificates for the beginning and ending
inventory amounts that were used to determine cost of
sales.
d. Ascertain that the net income amount in the statement
of changes in financial position (statement of cash
flows) agrees with the net income amount in the income
statement.
ANSWER: B
39. The risk of fraudulent financial reporting increases in the
presence of
a. Incentive systems based on operating income.
b. Improved control systems.
c. Substantial increases in sales.
d. Frequent changes in suppliers.
ANSWER: A
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40. Which of the following might be considered a "red flag"
indicating possible fraud in a large manufacturing company
with several subsidiaries?
a. The existence of a financial subsidiary.
b. A consistent record of above average return on
investment for all subsidiaries.
c. Complex sales transactions and transfers of funds
between affiliated companies.
d. Use of separate bank accounts for payrolls by each
subsidiary.
ANSWER: C
COMPLETION:
41. In satisfying the requirements of SAS 82, the auditor must
assess the risk of material misstatement due to fraud,
develop an appropriate audit response, and ___________ the
response.
ANSWER: DOCUMENT
42. A preliminary expectation of few errors, followed by
subsequent discovery of numerous errors should lead to a
in the aggregate materiality threshold.
ANSWER: DECREASE (LOWERING, REDUCTION)
43. High inherent risk, combined with high control risk, should
lead the auditor to the aggregate materiality
threshold.
ANSWER: LOWER (DECREASE, REDUCE)
44. A scheme perpetrated by top management to inflate reported
earnings and net assets for the purpose of maximizing the
value of stock options and/or bonuses is an example of
_____________.
ANSWER: FRAUDULENT FINANCIAL REPORTING
45. The main factor that distinguishes errors from fraud is
.
ANSWER: INTENT
Chapter 5 Audit Planning: Assessment of Inherent Risk and Materiality
70
46. The two factors that contribute to the probability that
unaudited financial statements contain material errors or
fraud are and .
ANSWER: INHERENT RISK, CONTROL RISK
47. Inasmuch as its complement forms the basis for the audit
opinion, overall audit risk should be set .
ANSWER: LOW
48. In the audit risk equation, risk is the
controllable variable.
ANSWER: DETECTION
49. The auditors primary goal in considering the client
acceptance decision is to avoid associating with clients
whose managements lack .
ANSWER: INTEGRITY
50. In a recurring audit, the best source of business and
industry information may be found in the
.
ANSWER: PERMANENT FILE
51. The financial statement impact of a single error is
referred to as materiality, whereas the
total effect of a series of errors is termed
materiality.
ANSWER: INDIVIDUAL ITEM, AGGREGATE
52. An audit approach that allocates proportionately more audit
resources to areas of high audit risk is referred to as a
audit.
ANSWER: RISK-DRIVEN
53. The , in addition to the permanent
file, is an effective means for familiarizing members of
the audit team with the nature of the client's business and
for highlighting those areas presenting the highest audit
risk.
Chapter 5 Audit Planning: Assessment of Inherent Risk and Materiality
71
ANSWER: PRE-AUDIT CONFERENCE
54. The is an effective device for planning
and controlling audit field work.
ANSWER: TIME BUDGET
55. Illegal payments, fraud detected during the audit, and
contingencies are examples of _____________ aspects of
materiality.
ANSWER: QUALITATIVE
MATCHING
56. Indicate by letter the appropriate auditors response to
each of the listed audit environments. More than one response
may be applicable to each environment.
____ 1. The auditor assesses control risk at a high level and
suspects earnings inflation in the form of premature
revenue recognition.
____ 2. Although the auditor has found internal control to be
highly effective, analytical procedures suggest that
repairs and maintenance expenses may have been
debited to plant asset accounts, thereby materially
overstating net income.
____ 3. The auditor perceives internal control over sales and
cash receipts as excellent; but internal control over
purchases, inventory, and cash payments is considered
weak.
____ 4. Debits to the account, Construction in Progress
have increased dramatically during the year under
audit; during the same period, however, Repairs and
Maintenance Expense, as well as Research and
Development have experienced significant declines.
Internal control is considered good in all areas.
____ 5. Although salespersons are granted 5% commissions on
all sales, the current years rate, based on unaudited
sales and commissions data, is 3%. Internal control
over sales and cash receipts is strong.
Chapter 5 Audit Planning: Assessment of Inherent Risk and Materiality
72
____ 6. Based on past experience and analytical procedures
applied to unaudited data, the auditor suspects that
the controller has understated net income to reduce
the companys tax liability. Internal control for the
company is weak in all areas.
____ 7.Tests of internal control revealed it to be much more
effective than the auditor had perceived during the
preliminary planning stages.
a. Lower the individual item materiality threshold
b. Raise the individual item materiality threshold
c. Lower the aggregate materiality threshold
d. Raise the aggregate materiality threshold
e. Increase reliance on external evidence
f. Consider internal evidence as possessing enhanced
reliability
g. Rely on external evidence for the expenditure cycle,
while accepting internal evidence as reliable for the
revenue cycle
h. Rely on external evidence for the revenue cycle, while
accepting internal evidence as reliable for the
expenditure cycle
SOLUTION:
1. a,c,e
2. a,f
3. c,g
4. a
5. a
6. b,c,e
7. d,f
PROBLEM/ESSAY
57. Louis Hernandez set the following materiality thresholds
for the Sanders Wholesale audit:
Individual item materiality - income statement:
$30,000 (5% of unaudited net income, $600,000)
Individual item materiality - balance sheet:
(2% of unaudited net assets, $3,500,000)$70,000
Aggregate materiality (20% of individual item)
Income statement $6,000
Balance sheet $14,000
Chapter 5 Audit Planning: Assessment of Inherent Risk and Materiality
73
Required:
a. What factors should Hernandez have considered in
setting the above thresholds? Why is the aggregate
threshold set at 20% rather than, say 10% or 5%?
b. In the process of testing Sanders internal controls,
Hernandez discovered significant weaknesses that, in
his opinion, may have materially impacted the
financial statements. Moreover, the application of
analytical procedures revealed the likelihood of a
material overstatement of unaudited net income and net
assets. What effect should these findings have on the
materiality thresholds?
SOLUTION:
a. In setting the individual item thresholds, Hernandez
should have considered the impact that a single misstatement
would have on the decisions of a reasonably informed investor.
The income statement threshold determines whether proposed audit
adjustments will be drafted, while the balance sheet threshold
relates to audit reclassifications. In setting the aggregate
thresholds, Hernandez should have considered the quality of
Sanders existing internal control. In this case, the high
percentage means that Hernandez believed Sanders internal
control to be effective for the year under audit. The stronger
the internal control is perceived to be, the fewer the expected
errors, and the higher the aggregate threshold.
b. The internal control weaknesses suggest that Hernandez
should lower the aggregate materiality threshold percentage from
20% to a much lower figure. Weak internal control increases the
probability that numerous small errors have occurred and, in the
aggregate, have materially impacted the financial statements.
The high probability of material overstatement of net
income and net assets suggests a lowering of the individual item
thresholds. When materiality is related to a lower monetary
base, the minimum dollar amount that impacts decisions is also
reduced. The threshold may be lowered by reducing the
percentages, or by lowering the income and asset bases to which
the percentages are applied.
58. For each of the listed scenarios, determine whether
inherent risk or control risk or both should be assessed at a
high level. Then describe an appropriate audit approach. In
developing your approach, consider whether the auditor should
decrease reliance on internal evidence and suggest specific
Chapter 5 Audit Planning: Assessment of Inherent Risk and Materiality
74
kinds of audit evidence you would recommend in the
circumstances.
1. In planning the audit of Jayco Corporation, Charles
Lawson, the in-charge senior auditor found Jaycos internal
controls to be effective in all transaction cycles. Analytical
procedures revealed that Jaycos operating income declined 30%
in 2000, based on unaudited data. Increased competition from
imports, combined with more stringent emission requirements,
contributed to the decline. Lawson is concerned, however, that
Jayco reported operating income while its nearest competitors
reported losses. He notes that Jayco is not showing a capacity
loss notwithstanding a significant decrease in production and
fixed overhead absorption. Ending inventories seem high
relative to cost of goods sold for the year.
2. Although the internal controls for Montrose, Inc., a
local cable broadcasting company, are effective for the revenue
cycle, they are lacking in the expenditure cycle. Of particular
concern to Eva Bresky, the in-charge auditor, is the absence of
internal control over the processing of invoices from and
payments to network providers. The Montrose engagement is an
initial audit for Breskys firm and a first audit for Montrose.
Analytical procedures do not reveal any apparent abnormalities.
SOLUTION:
1. Given the effectiveness of internal control, Lawson
may assess control risk at a low level and should plan to rely
on internal evidence in most areas of the audit. The results of
applying analytical procedures suggests a high level of inherent
risk. Although operating income declined in 2000 relative to
the preceding year, Lawson, in light of the competition and the
absence of a capacity loss, should consider the probability of a
material income overstatement. Increased emphasis on auditing
Jaycos ending inventories, including a careful analysis of
overhead application, is indicated.
2. Given weaknesses in internal control over
expenditures, Bresky should assess control risk at a high level
for the expenditure cycle and rely on external evidence ( e.g.,
confirmations of charges and payments with network providers)
over internal evidence. A lower assessment of control risk and
greater reliance on internal evidence may be appropriate for the
revenue cycle (but see below).
Notwithstanding the failure of analytical procedures to
produce any abnormalities, inherent risk should be assessed at
Chapter 5 Audit Planning: Assessment of Inherent Risk and Materiality
75
100%. The fact that this is a first-time audit for Montrose,
suggests that prior years data, as well as the current year,
may be materially misstated. Physical evidence, mathematical
evidence, and confirmation evidence should be emphasized over
analytical evidence, documentary evidence, and hearsay evidence,
at least for this years audit. Assuming that Montrose is a
relatively small client, and given that this is a first-time
audit for the company, Bresky should probably perform a
primarily substantive audit.
59. In assessing the probability of fraud, the auditor
considers two types. Identify and define these two types of
fraud. What is the auditors responsibility for detecting
fraud?
SOLUTION:
The two types of fraud considered by the auditor in
assessing the probability of fraud are misappropriation and
fraudulent financial reporting. Misappropriation is the
fraudulent transfer of assets from the firm to one or more
dishonest employees, either preceded or followed by some form of
concealment. Fraudulent financial reporting consists of
deliberate attempts by management to misstate the financial
statements to deceive financial statement users.
AICPA Professional Standards assign the auditor
responsibility for designing the audit to provide reasonable
assurance of detecting misstatements (errors or fraud) that are
material to the financial statements.