CHAP 9. Materiality and Risk
CHAP 9. Materiality and Risk
CHAPTER 9
5. If an auditor establishes a relatively low level for materiality, then the auditor
will
A. Accumulate more evidence than if a higher level had been set.
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14. Which of the following is not a difficulty associated with allocating the
preliminary judgment about materiality to balance sheet accounts?
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.
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16. The opinion paragraph in auditors’ reports includes two important phrases
that are directly related to materiality and risk. The phrases are
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
A. Guarantee fair presentation of the financial statements
B. Acts 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 judgement.
18. Inherent risk is __________ related to detection risk and _______ related to
the amount of audit evidence.
A. Directly, inversely
B. Directly, directly
C. Inversely, inversely
D. Inversely, directly
19. The five steps in applying materiality are listed below in random order.
1. Estimate the combined misstatement
2. Estimate the total misstatement in the segment.
3. Set preliminary judgment about materiality to segments.
4. Allocate preliminary judgment about materiality to segments.
5. Compare combined estimate with preliminary judgment about
materiality.
A. 1, 2, 5, 4, 3 C. 4, 3, 1, 5, 2
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B. 3, 4, 2, 1, 5 D. 5, 1, 3, 2, 4
20. 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. 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
23. 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?
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.
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24. The more effective the internal controls, the lower the risk factor that
_________ assigned to control risk.
A. Should be
B. Could be
C. Is
D. Must be
28. Auditors frequently refer to the terms audit assurance, overall assurance, and
level of assurance to refer to ____________ .
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A. Detection risk
B. Audit report risk
C. Acceptable audit risk
D. None of the above
29. When a different extent of evidence is needed for the various cycles, the
difference is caused by
A. Errors in the client’s accounting system
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
A. Increase
B. Decrease
C. Remain unchanged
D. Be indeterminate
31. When discussing control risk (CR) and the audit risk model, which of the
following statements is not true?
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. Which of the following is not a good indicator of the degree to which
statements are relied on by external users?
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.
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33. 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, accessible audit risk should
A. Be reduced
B. Be increased
C. Remain the same
D. Be calculated using a computerized statistical package
34. When management has an adequate level of integrity for the auditor to accept
the engagement but cannot be regarded as completely honest in all dealings,
auditors normally
A. Reduce acceptable audit risk and increase inherent risk
B. Reduce inherent risk and control risk
C. Increase inherent risk and control risk
D. Increase acceptable audit risk and reduce inherent risk
35. Many account balances require estimates and/or a great deal of management
judgment. One area that does not require such judgment would be
A. Allowance for uncollectible accounts
B. Useful life of equipment for tax purposes
C. Obsolete inventory
D. Liability for warranty payments
36. Inherent risk is reduced where the likelihood of defalcations is low. This
would be true for an account such as
A. Inventory
B. Marketable securities
C. Cash
D. Accounts receivable
37. The auditor assesses control risk and inherent risk. On a typical engagement,
the auditor would be least likely to assess these for
A. Each audit objective
B. Each cycle
C. Each account
D. The overall audit
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38. Acceptable audit risk is ordinarily set by the auditor during planning and
A. Held constant for each major cycle and account
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. 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
A. Client size
B. Concentration of ownership
C. Types and amounts of liabilities
D. All of the above
41. 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 should
A. 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.
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42. 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 between
A. 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
46. Which one of the following statements about the cycle approach to auditing
is not correct?
A. There are differences among cycles in the frequency and size of expected
errors.
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47. 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 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%.
49. When discussing inherent risk (IR) and the audit risk model, which of the
following is not true?
A. IR is inversely related to planned detection risk
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. When discussing acceptable audit risk (AAR) and the audit risk model, which
of the following statements is true?
A. The terms audit assurance, overall assurance, or level of assurance are
synonyms for AAR.
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54. 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
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.
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55. 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 that
A. 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.
ESSAY QUESTIONS
60. Discuss the three main factors that affect an auditors 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.
ANSWER:
Qualitative factors that affect an auditors’ materiality judgment include:
Amounts involving fraud. Amounts involving fraud are usually
considered more important than unintentional errors of equal dollar
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64. Discuss how auditors use the audit risk model when planning an audit.
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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, assess 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.
ANSWER:
The planning form of the audit risk model is stated as follows:
PDR = AAR
IR x CR
66. 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. 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 accounts’ tolerable misstatement. This
allocation is performed in the audit planning stage.
Step 3. Estimate total misstatement in segment. In this step, the auditor
projects the sample results to the population. An allowance for sampling risk
is also calculated. This would be performed after the substantive tests for
each account are completed.
Step 4. Estimate the combined misstatement. In this step, the projected
errors for each account are added, along with total sampling error, to
calculate the combined misstatement. This would be performed after all
substantive tests have been completed.
Step 5. Compare combined estimated misstatement with preliminary or
revised judgment about materiality. If the combined estimated misstatement
is less than or equal to the judgment about materiality, then the auditor
concludes the financial statements are fairly presented. This would be
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performed after all substantive tests have been completed, in the final review
of the audit.
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. 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)
or changing each of the following factors, while the other factors remain
unchanged.
70. Match six of the terms (A-I) with the definitions provided below (1-6).
A. Business risk
B. Preliminary judgment about materiality
C. Inherent risk
D. Planned detection risk
E. Audit assurance
F. Acceptable audit risk
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G. Tolerable misstatement
H. Control risk
I. 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 as 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 audit 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.
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, high
2. High, low
3. Medium, Medium
4. High, low
72. The following graph shows three levels of acceptable audit risk (1%, 5%,
10%) three level of inherent risk x control risk (Low, Medium, High), nine
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1 2 3 4 5 6
(Answer: f, increase to 6)
75. Net income before taxes is normally the most important base for deciding
what is material.
A. True
B. False
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77. 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. True
B. False
78. Auditors often use prior year financial statement balances to establish their
preliminary judgment about materiality in planning the current year’s audit.
A. True
B. False
79. If acceptable audit risk is low, and inherent risk and control risk are both
high, then planned detection risk should be high.
A. True
B. False
80. Inherent risk and planned detection risk are inversely related; i.e., as inherent
risk increases, planned detection risk should decrease, ceteris paribus.
A. True
B. False
81. 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. True
B. False
82. The most important element of the audit risk model is control risk.
A. True
B. False
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83. Auditors are required to test any internal controls they believe have not been
operating effectively during the period under audit.
A. True
B. False
84. 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. True
B. False
90. To maximize audit efficiency, the auditor should allocate less tolerable
misstatement to accounts that can be verified by using low cost audit
procedures, such as analytical procedures, than to accounts that are more
costly to audit.
A. True
B. False
91. 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. True
B. False
92. 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. True
B. False
93. Inherent risk and control risk are directly related; i.e., as inherent risk
increases, control risk also increases.
A. True
B. False
94. An acceptable audit risk assessment of low indicates a risky client requiring
more extensive evidence, assignment of more experienced personnel, and/or
a more extensive review of audit files.
A. True
B. False
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95. Audit assurance is the complement of planned detection risk, that is, one
minus planned detection risk.
A. True
B. False
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