Chap003 (1)

Chapter 03Risk Assessment and Materiality

True / False Questions

1. Audit risk is the auditor's exposure to loss or injury of his or her reputation from events arising in connection with financial statements audited. True False

2. Engagement risk is the auditor's exposure to loss or injury of his or her reputation from events arising in connection with financial statements audited. True False

3. The components of the audit risk model include inherent risk, control risk, and detection risk. True False

4. Inherent risk is the susceptibility of an assertion to material misstatement, assuming no related controls. True False

5. Professional judgment must be used when evaluating business risk. True False

6. Audit risk and materiality significantly impact the auditor's decisions about how much and what kind of evidence to gather. True False

7. The risk of a material misstatement includes inherent risk and sampling risk. True False

8. The combination of inherent risk and control risk is referred to as client risk. True False

9. Inherent risk includes sampling risk and nonsampling risk. True False

10. Materiality is based on a quantitative analysis of the financial statements only. True False

Multiple Choice Questions

11. Engagement risk is: A. The risk of issuing an incorrect audit opinionB. The auditor's risk of loss from events arising in connection with financial statements audited and reported uponC. The overall risk of material misstatementD. The risk of the client's financial failure

12. Client risk as defined in the text is A. The auditor's risk of loss from events arising in connection with financial statements audited and reported uponB. The overall risk of material misstatementC. The risk that audit procedures will fail to detect material misstatementsD. The risk of the client's financial failure

13. Under Statements on Auditing Standards, which of the following would be classified as an error? A. Misappropriation of assets for the benefit of managementB. Misinterpretation by management of facts that existed when the financial statements were preparedC. Preparation of records by employees to cover a fraudulent schemeD. Intentional omission of the recording of a transaction to benefit a third party

14. When assessing the risk of material misstatement, auditors evaluate the reasonableness of an entity's accounting estimates. An auditor normally would be concerned about assumptions that are A. Susceptible to biasB. Consistent with prior periodsC. Insensitive to variationsD. Similar to industry guidelines

15. Which of the following characteristics most likely would heighten an auditor's concern about the risk of intentional manipulation of financial statements? A. Turnover of senior accounting personnel is lowB. Insiders recently purchased additional shares of the entity's stockC. Management places substantial emphasis on meeting earnings projectionsD. The rate of change in the entity's industry is slow

16. Which of the following is a known misstatement? A. A management estimate that is outside the range of reasonable outcomes determined by the auditorB. A fixed asset being recorded at the incorrect costC. A projected misstatement resulting from errors found during samplingD. Difference in judgment between the auditor and management

17. Tolerable misstatement is A. Materiality allocated to an assertionB. Materiality for the balance sheet as a wholeC. Materiality for the income statement as a wholeD. Materiality allocated to a specific account

18. Which of the following would an auditor most likely use in determining the auditor's planning materiality? A. The anticipated sample size for planned substantive proceduresB. The entity's annualized interim (i.e. quarterly) financial statementsC. The results of the internal control questionnaireD. The contents of the management representation letter

19. Which of the following is not a qualitative factor that may affect an auditor's establishment of materiality? A. Potential for fraudB. The company is close to violating loan covenantsC. Firm policy sets materiality at 4% of pretax incomeD. A small misstatement would interrupt an earnings trend

20. Which of the following is not a concern as to whether a misstatement is qualitatively material? A. The misstatement hides a failure to meet analysts' expectationsB. The misstatement is less than 5% of pretax incomeC. The misstatement increases management's compensationD. The misstatement changes a small amount of profit to a small reported loss

21. Engagement risk can be eliminated by A. Establishing policies for client acceptance and continuanceB. Lowering audit riskC. Lowering materialityD. Engagement risk cannot be eliminated

22. The achieved (actual) level of audit risk A. Can always be accurately assessed by the auditorB. Should be greater than or equal to acceptable audit riskC. Can never be known with certaintyD. Is the same for all audit clients

23. An auditor knows that an audit client operating in an industry in which common stock is valued based on the price-earnings ratio will soon make an initial public offering. All of the following are true except: A. Materiality should be reducedB. Risk of material misstatement should increaseC. Detection risk should increaseD. Audit risk should increase

24. The risk that an auditor will conclude, based on substantive procedures, that a material error does not exist in an account balance when, in fact, such error does exist is referred to as A. Sampling riskB. Detection riskC. Nonsampling riskD. Inherent risk

25. The risk of material misstatement differs from detection risk in that it A. Arises from the misapplication of auditing proceduresB. May be assessed in either quantitative or qualitative termsC. Exists independently of the actions of the auditorD. Can be changed at the auditor's discretion

26. All of the following are inherent risk factors that are pervasive to the financial statements except A. Highly complex significant transactionsB. Non-routine transactionsC. Classes of transactions are not processed systematicallyD. Supplies inventory is difficult to count

27. When an auditor increases the assessed level of risk of material misstatement because certain control procedures were determined to be ineffective, the auditor would most likely increase the A. Extent of tests of controlsB. Level of detection riskC. Extent of substantive testsD. Level of inherent risk

28. On the basis of audit evidence gathered and evaluated, an auditor decides to increase the assessed level of risk of material misstatement from that originally planned. To achieve an overall audit risk level that is substantially the same as the planned audit risk level, the auditor would A. Decrease amount of substantive testingB. Decrease detection riskC. Increase detection riskD. Increase materiality levels

29. The risk of material misstatement includes which of the following: A. Detection riskB. Audit riskC. Inherent riskD. Nonsampling risk

30. An auditor learns that a client employee in control of inventory gets divorced and is responsible for paying a large amount of child support. All of the following for the audit of inventory likely are true except: A. Fraud risk increasesB. The risk of misappropriation of assets increasesC. Risk of material misstatement increasesD. Detection risk increases

31. Which of the following audit risk components may be assessed in qualitative terms? A. Risk of material misstatementB. Detection riskC. Neither risk of material misstatement nor detection riskD. Both risk of material misstatement and detection risk

32. When an entity moves into a significant new line of business, all of the following increase except A. Client riskB. Acceptable audit riskC. Risk of material misstatementD. Entity business risk

33. Which of the following procedures would not be used to obtain an understanding of the entity and its environment? A. Observe entity operationsB. Reperform entity processesC. Verify proper valuation of inventory subject to technological obsolescenceD. Review prior year's audit documentation

34. Which of the following is not an important consideration in an auditor's evaluation of an entity's business risk? A. The specific business risks an entity faces that may result in financial statement errors and fraudB. Business risk factors that impact the ability of the entity to be profitable and surviveC. Audit standards include many entity business risk factors that identify circumstances that increase the likelihood of material misstatementsD. Audit standards require the auditor to evaluate the entity's business risk in order to provide suggestions to improve the entity's profitability

35. Which of the following relatively small misstatements most likely would have a material effect on an entity's financial statements? A. An illegal payment to a foreign official that was not recordedB. A piece of obsolete office equipment that was not retiredC. A petty cash fund disbursement that was not properly authorizedD. An uncollectible account receivable that was not written off

36. Which of the following is a source of detection risk? A. Unstable business environmentB. Poor client controlsC. A non-representative sampleD. Inherent risk assessed too high

37. In general, material frauds perpetrated by which of the following are most difficult to detect? A. Internal auditorB. Keypunch operatorC. CashierD. Controller

38. Which of the following circumstances most likely would cause an auditor to believe that material misstatements may exist in an entity's financial statements? A. Accounts receivable confirmation requests yield significantly fewer responses than expectedB. Audit trails of computer-generated transactions exist only for a short timeC. The chief financial officer does not sign the management representation letter until the last day of the auditor's fieldworkD. Management consults with other accountants about significant accounting matters

39. The primary responsibility for preventing fraud in an organization lies with A. The audit committee of the board of directorsB. The internal audit staffC. The external auditorD. The organization's management

40. Which of the following is not a misstatement of the financial statements? A. The client uses different inventory accounting methods for internal and external reportingB. A departure from GAAPC. The footnote for pensions is omittedD. A clerk incorrectly based the allowance for doubtful accounts on 31% of sales as opposed to 13% of sales as determined by the controller

41. All of the following represent an increased opportunity to commit fraud except: A. Significant related party transactionsB. The auditor's relationship with management is strainedC. Management is dominated by a single personD. The financial statements included highly subjective estimates

42. The auditor can respond to an increased risk of fraud by doing all of the following except A. Heavily emphasizing the importance of professional skepticismB. Assigning more experienced personnel to the auditC. Increasing detection riskD. Taking steps to obtain more reliable evidence

43. An auditor discovers a likely fraud during an audit but concludes that the overall effect of the fraud is not sufficiently material to affect the audit opinion. The auditor should probably A. Disclose the fraud to the appropriate level of the client's managementB. Disclose the fraud to appropriate authorities external to the clientC. Discuss with the client the additional audit procedures that will be needed to identify the exact amount of the fraudD. Modify the audit program to include tests specifically designed to identify the fraud and its impact on the financial statements

44. Which of the following is the most important qualitative factor that auditors should consider when making materiality judgments? A. A misstatement exceeded five percent of net incomeB. The auditor also provides consulting services to the audit clientC. The misstatement will cause the client to fail to meet an earnings forecastD. The audit committee is not well educated about the accounting principle in question

45. The acceptable level of detection risk is inversely related to the A. Extent of the substantive proceduresB. Risk of misapplying auditing proceduresC. Planning materialityD. Risk of failing to discover material misstatements

46. As the acceptable level of detection risk decreases, an auditor may change the A. Timing of tests of controls by performing them at an interim date rather than at year-endB. Nature of substantive procedures from less effective to more effective proceduresC. Timing of tests of controls by performing them at several dates rather than at one timeD. Assessed level of risk of material misstatement to a higher amount

47. As the acceptable level of detection risk decreases, the assurance directly provided from A. Substantive procedures should increaseB. Substantive procedures should decreaseC. Tests of controls should increaseD. Tests of controls should decrease

48. Increased fraud risk could also result in all of the following except A. Lower detection riskB. Higher inherent riskC. Lower control riskD. Higher client risk

49. The objectives of the engagement partner's communication with the audit team include A. Maintaining an adversarial atmosphere between the auditor and managementB. Complying with SEC rulesC. Complying with FASB rulesD. Emphasizing the importance of professional skepticism

50. The auditor is most likely to presume that a high risk of a fraud exists if A. The entity is a multinational company that does business in numerous foreign countriesB. The entity does business with several related partiesC. Inadequate segregation of duties places an employee in a position to perpetrate and conceal theftD. Inadequate employee training results in lengthy EDP exception reports each month

51. Which of the following factors most likely would heighten an auditor's concern about the risk of fraudulent financial reporting? A. Inability to generate cash flows from operations while reporting substantial earnings growthB. Management's lack of interest in increasing the entity's earnings trendC. Large amounts of liquid assets that are easily converted into cashD. Inability to borrow necessary capital without granting debt covenants

52. A properly planned and performed audit may fail to detect a material misstatement resulting from fraud because A. Audit procedures that are otherwise effective may be ineffective for fraud that is concealed through collusionB. An audit is planned and performed to provide reasonable assurance of detecting material misstatements caused by errors but not by fraudC. The factors considered in assessing control risk indicated an increased risk of error but only a low risk of fraud in the financial statementsD. The auditor did not consider factors influencing audit risk for account balances that have effects pervasive to the financial statements taken as a whole

53. Which of the following is correct concerning required auditor communications about fraud? A. Fraud that involves senior management should be reported directly by the auditor to the audit committee regardless of the amount involvedB. Fraud with a material effect on the financial statements should be reported directly by the auditor to the Securities and Exchange CommissionC. Any requirement to disclose fraud outside the entity is the responsibility of management and not that of the auditorD. The professional standards provide no requirements related to the communication of fraud, but the auditor should use professional judgment in determining communication responsibilities

54. Which element(s) is/are pervasive to the application of generally accepted auditing standards, particularly the standards of fieldwork and reporting? A. The elements of materiality and audit riskB. The element of internal controlC. The element of corroborating evidenceD. The element of reasonable assurance

55. Which of the following statements is not correct about materiality? A. The concept of materiality recognizes that some matters are important for fair presentation of financial statements in conformity with GAAP, while other matters are not importantB. An auditor considers materiality for the aggregate level of misstatements that could be material to any one of the financial statements individuallyC. Materiality judgments are made in light of surrounding circumstances and necessarily involve both quantitative and qualitative judgmentsD. An auditor's consideration of materiality is influenced by the auditor's perception of the needs of a reasonable person who will rely on the financial statements

Short Answer Questions

56. Using the audit risk model, identify the relationship between the following elements. For each of the items below circle whether the two elements have an inverse relationship, a direct relationship or no relationship. When considering each item, assume that the other components of the risk model remain constant.

57. What is the difference between audit risk and engagement risk?

58. You are teaching a class of new hires at your international accounting firm. Explain the audit risk model using a mathematical formula.

59. Stacey, the partner in charge of the audit of RIF Enterprises, sets the planned level of audit risk for the audit of accounts payable at .06. The risk of material misstatement is assessed at .65. What is the detection risk for this audit.

60. Your classmate asserts, "Accountants shouldn't need to take business courses besides accounting, because they are only interested in the financial statements of a company." Defend or refute this statement.

61. You are the senior on an audit of Two Be Gone, a large publicly held company. The company recently completed an acquisition of its fifth largest competitor. What risks might this present? How will you, the auditor, respond to these risks (i.e. what actions should you take)?

62. Define misstatements arising from fraudulent financial reporting and misstatements arising from misappropriation of assets in one sentence each.

63. DATRIX, Inc, a Fortune 500 company, has been experiencing poor performance. Industry analysts have been issuing negative reports and the company's stock price has been steadily declining. As an auditor, what would concern you about the audit engagement of DATRIX, Inc.

64. During the course of the audit of FF Financial, you find that some accounting entries have been altered. You believe this may be the result of management fraud and you have determined that the effect of this could be material to the financial statements. What are appropriate steps to take?

65. Often in an audit, total combined tolerable misstatement is greater than overall materiality. Why is this the case?

66. Assume that you are the new audit senior on the LV Drug Corporation (LVD) engagement. LVD is a pharmaceutical company that has three successful drugs and a number of drugs in progress in their research and development pipeline. You are considering your audit plan and it is important to identify the inherent risks that LVD has and how they relate to the planning process. Required:For each of the following factors, indicate whether it will tend to increase, decrease, or have no effect on inherent risk, and the reasoning for your answer.a. Dr Jones is the major shareholder of LVD and its CEO.b. Your firm has audited LVD for the last four years.c. There has been high turnover of key accounting personnel during the last two years.d. The internal audit function reports to the audit committee.e. LVD has been the subject of lawsuits by users of Framadon who claim that the drug affects their liver functions. LVD is confident that there are no such side effects from the use of Framadon.

Chapter 03 Risk Assessment and Materiality Answer Key

True / False Questions

1. Audit risk is the auditor's exposure to loss or injury of his or her reputation from events arising in connection with financial statements audited. FALSE

AACSB: CommunicationsAICPA BB: LegalAICPA FN: Risk AnalysisBloom's: KnowledgeDifficulty: EasyLearning Objective: 1

2. Engagement risk is the auditor's exposure to loss or injury of his or her reputation from events arising in connection with financial statements audited. TRUE


3. The components of the audit risk model include inherent risk, control risk, and detection risk. TRUE


4. Inherent risk is the susceptibility of an assertion to material misstatement, assuming no related controls. TRUE


5. Professional judgment must be used when evaluating business risk. TRUE

AACSB: CommunicationsAICPA BB: LegalAICPA FN: Risk AnalysisBloom's: ComprehensionDifficulty: EasyLearning Objective: 2

6. Audit risk and materiality significantly impact the auditor's decisions about how much and what kind of evidence to gather. TRUE

AACSB: CommunicationsAICPA BB: LegalAICPA FN: Risk AnalysisBloom's: ComprehensionDifficulty: EasyLearning Objective: 11Learning Objective: 2

7. The risk of a material misstatement includes inherent risk and sampling risk. FALSE


8. The combination of inherent risk and control risk is referred to as client risk. TRUE


9. Inherent risk includes sampling risk and nonsampling risk. FALSE


10. Materiality is based on a quantitative analysis of the financial statements only. FALSE


Multiple Choice Questions

11. Engagement risk is: A. The risk of issuing an incorrect audit opinionB. The auditor's risk of loss from events arising in connection with financial statements audited and reported uponC. The overall risk of material misstatementD. The risk of the client's financial failure


12. Client risk as defined in the text is A. The auditor's risk of loss from events arising in connection with financial statements audited and reported uponB. The overall risk of material misstatementC. The risk that audit procedures will fail to detect material misstatementsD. The risk of the client's financial failure


13. Under Statements on Auditing Standards, which of the following would be classified as an error? A. Misappropriation of assets for the benefit of managementB. Misinterpretation by management of facts that existed when the financial statements were preparedC. Preparation of records by employees to cover a fraudulent schemeD. Intentional omission of the recording of a transaction to benefit a third party

AACSB: EthicsAICPA BB: LegalAICPA FN: Decision MakingBloom's: ApplicationDifficulty: EasyLearning Objective: 6

14. When assessing the risk of material misstatement, auditors evaluate the reasonableness of an entity's accounting estimates. An auditor normally would be concerned about assumptions that are A. Susceptible to biasB. Consistent with prior periodsC. Insensitive to variationsD. Similar to industry guidelines

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: ApplicationDifficulty: EasyLearning Objective: 5

15. Which of the following characteristics most likely would heighten an auditor's concern about the risk of intentional manipulation of financial statements? A. Turnover of senior accounting personnel is lowB. Insiders recently purchased additional shares of the entity's stockC. Management places substantial emphasis on meeting earnings projectionsD. The rate of change in the entity's industry is slow

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: ApplicationDifficulty: EasyLearning Objective: 6

16. Which of the following is a known misstatement? A. A management estimate that is outside the range of reasonable outcomes determined by the auditorB. A fixed asset being recorded at the incorrect costC. A projected misstatement resulting from errors found during samplingD. Difference in judgment between the auditor and management

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: MeasurementBloom's: KnowledgeDifficulty: ModerateLearning Objective: 6

17. Tolerable misstatement is A. Materiality allocated to an assertionB. Materiality for the balance sheet as a wholeC. Materiality for the income statement as a wholeD. Materiality allocated to a specific account

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: MeasurementBloom's: ComprehensionDifficulty: EasyLearning Objective: 11

18. Which of the following would an auditor most likely use in determining the auditor's planning materiality? A. The anticipated sample size for planned substantive proceduresB. The entity's annualized interim (i.e. quarterly) financial statementsC. The results of the internal control questionnaireD. The contents of the management representation letter

AACSB: AnalyticAICPA BB: IndustryAICPA FN: Risk AnalysisBloom's: ComprehensionDifficulty: EasyLearning Objective: 11Learning Objective: 12

19. Which of the following is not a qualitative factor that may affect an auditor's establishment of materiality? A. Potential for fraudB. The company is close to violating loan covenantsC. Firm policy sets materiality at 4% of pretax incomeD. A small misstatement would interrupt an earnings trend

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: KnowledgeDifficulty: EasyLearning Objective: 11

20. Which of the following is not a concern as to whether a misstatement is qualitatively material? A. The misstatement hides a failure to meet analysts' expectationsB. The misstatement is less than 5% of pretax incomeC. The misstatement increases management's compensationD. The misstatement changes a small amount of profit to a small reported loss

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: ComprehensionDifficulty: ModerateLearning Objective: 11

21. Engagement risk can be eliminated by A. Establishing policies for client acceptance and continuanceB. Lowering audit riskC. Lowering materialityD. Engagement risk cannot be eliminated

AACSB: CommunicationsAICPA BB: LegalAICPA FN: Risk AnalysisBloom's: AnalysisDifficulty: ModerateLearning Objective: 1

22. The achieved (actual) level of audit risk A. Can always be accurately assessed by the auditorB. Should be greater than or equal to acceptable audit riskC. Can never be known with certaintyD. Is the same for all audit clients

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: ComprehensionDifficulty: ModerateLearning Objective: 2

23. An auditor knows that an audit client operating in an industry in which common stock is valued based on the price-earnings ratio will soon make an initial public offering. All of the following are true except: A. Materiality should be reducedB. Risk of material misstatement should increaseC. Detection risk should increaseD. Audit risk should increase

AACSB: AnalyticAICPA BB: IndustryAICPA FN: Risk AnalysisBloom's: AnalysisDifficulty: HardLearning Objective: 11Learning Objective: 2Learning Objective: 3Learning Objective: 6

24. The risk that an auditor will conclude, based on substantive procedures, that a material error does not exist in an account balance when, in fact, such error does exist is referred to as A. Sampling riskB. Detection riskC. Nonsampling riskD. Inherent risk

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: ComprehensionDifficulty: ModerateLearning Objective: 2Learning Objective: 3

25. The risk of material misstatement differs from detection risk in that it A. Arises from the misapplication of auditing proceduresB. May be assessed in either quantitative or qualitative termsC. Exists independently of the actions of the auditorD. Can be changed at the auditor's discretion


26. All of the following are inherent risk factors that are pervasive to the financial statements except A. Highly complex significant transactionsB. Non-routine transactionsC. Classes of transactions are not processed systematicallyD. Supplies inventory is difficult to count

AACSB: AnalyticAICPA BB: IndustryAICPA FN: Risk AnalysisBloom's: AnalysisDifficulty: ModerateLearning Objective: 2Learning Objective: 3

27. When an auditor increases the assessed level of risk of material misstatement because certain control procedures were determined to be ineffective, the auditor would most likely increase the A. Extent of tests of controlsB. Level of detection riskC. Extent of substantive testsD. Level of inherent risk

AACSB: AnalyticAICPA BB: IndustryAICPA FN: Risk AnalysisBloom's: AnalysisDifficulty: HardLearning Objective: 2Learning Objective: 3

28. On the basis of audit evidence gathered and evaluated, an auditor decides to increase the assessed level of risk of material misstatement from that originally planned. To achieve an overall audit risk level that is substantially the same as the planned audit risk level, the auditor would A. Decrease amount of substantive testingB. Decrease detection riskC. Increase detection riskD. Increase materiality levels

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: AnalysisDifficulty: HardLearning Objective: 2Learning Objective: 3

29. The risk of material misstatement includes which of the following: A. Detection riskB. Audit riskC. Inherent riskD. Nonsampling risk


30. An auditor learns that a client employee in control of inventory gets divorced and is responsible for paying a large amount of child support. All of the following for the audit of inventory likely are true except: A. Fraud risk increasesB. The risk of misappropriation of assets increasesC. Risk of material misstatement increasesD. Detection risk increases

AACSB: AnalyticAICPA BB: IndustryAICPA FN: Risk AnalysisBloom's: ApplicationDifficulty: ModerateLearning Objective: 2Learning Objective: 3Learning Objective: 6

31. Which of the following audit risk components may be assessed in qualitative terms? A. Risk of material misstatementB. Detection riskC. Neither risk of material misstatement nor detection riskD. Both risk of material misstatement and detection risk

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: KnowledgeDifficulty: ModerateLearning Objective: 3

32. When an entity moves into a significant new line of business, all of the following increase except A. Client riskB. Acceptable audit riskC. Risk of material misstatementD. Entity business risk

AACSB: AnalyticAICPA BB: IndustryAICPA FN: Risk AnalysisBloom's: ApplicationDifficulty: ModerateLearning Objective: 2Learning Objective: 5

33. Which of the following procedures would not be used to obtain an understanding of the entity and its environment? A. Observe entity operationsB. Reperform entity processesC. Verify proper valuation of inventory subject to technological obsolescenceD. Review prior year's audit documentation

AACSB: CommunicationsAICPA BB: IndustryAICPA FN: Decision MakingBloom's: ComprehensionDifficulty: ModerateLearning Objective: 5

34. Which of the following is not an important consideration in an auditor's evaluation of an entity's business risk? A. The specific business risks an entity faces that may result in financial statement errors and fraudB. Business risk factors that impact the ability of the entity to be profitable and surviveC. Audit standards include many entity business risk factors that identify circumstances that increase the likelihood of material misstatementsD. Audit standards require the auditor to evaluate the entity's business risk in order to provide suggestions to improve the entity's profitability


35. Which of the following relatively small misstatements most likely would have a material effect on an entity's financial statements? A. An illegal payment to a foreign official that was not recordedB. A piece of obsolete office equipment that was not retiredC. A petty cash fund disbursement that was not properly authorizedD. An uncollectible account receivable that was not written off

AACSB: AnalyticAICPA BB: LegalAICPA FN: Risk AnalysisBloom's: ApplicationDifficulty: ModerateLearning Objective: 11

36. Which of the following is a source of detection risk? A. Unstable business environmentB. Poor client controlsC. A non-representative sampleD. Inherent risk assessed too high

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: AnalysisDifficulty: ModerateLearning Objective: 2

37. In general, material frauds perpetrated by which of the following are most difficult to detect? A. Internal auditorB. Keypunch operatorC. CashierD. Controller

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: ApplicationDifficulty: ModerateLearning Objective: 6

38. Which of the following circumstances most likely would cause an auditor to believe that material misstatements may exist in an entity's financial statements? A. Accounts receivable confirmation requests yield significantly fewer responses than expectedB. Audit trails of computer-generated transactions exist only for a short timeC. The chief financial officer does not sign the management representation letter until the last day of the auditor's fieldworkD. Management consults with other accountants about significant accounting matters

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: AnalysisDifficulty: HardLearning Objective: 6Learning Objective: 7Learning Objective: 8

39. The primary responsibility for preventing fraud in an organization lies with A. The audit committee of the board of directorsB. The internal audit staffC. The external auditorD. The organization's management

AACSB: CommunicationsAICPA BB: IndustryAICPA FN: Decision MakingBloom's: ComprehensionDifficulty: ModerateLearning Objective: 5Learning Objective: 6

40. Which of the following is not a misstatement of the financial statements? A. The client uses different inventory accounting methods for internal and external reportingB. A departure from GAAPC. The footnote for pensions is omittedD. A clerk incorrectly based the allowance for doubtful accounts on 31% of sales as opposed to 13% of sales as determined by the controller

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Decision MakingBloom's: AnalysisDifficulty: ModerateLearning Objective: 6Learning Objective: 7

41. All of the following represent an increased opportunity to commit fraud except: A. Significant related party transactionsB. The auditor's relationship with management is strainedC. Management is dominated by a single personD. The financial statements included highly subjective estimates

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: ApplicationDifficulty: ModerateLearning Objective: 6Learning Objective: 7

42. The auditor can respond to an increased risk of fraud by doing all of the following except A. Heavily emphasizing the importance of professional skepticismB. Assigning more experienced personnel to the auditC. Increasing detection riskD. Taking steps to obtain more reliable evidence

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: ApplicationDifficulty: ModerateLearning Objective: 2Learning Objective: 7

43. An auditor discovers a likely fraud during an audit but concludes that the overall effect of the fraud is not sufficiently material to affect the audit opinion. The auditor should probably A. Disclose the fraud to the appropriate level of the client's managementB. Disclose the fraud to appropriate authorities external to the clientC. Discuss with the client the additional audit procedures that will be needed to identify the exact amount of the fraudD. Modify the audit program to include tests specifically designed to identify the fraud and its impact on the financial statements

AACSB: CommunicationsAICPA BB: Critical ThinkingAICPA FN: Decision MakingBloom's: AnalysisDifficulty: HardLearning Objective: 8

44. Which of the following is the most important qualitative factor that auditors should consider when making materiality judgments? A. A misstatement exceeded five percent of net incomeB. The auditor also provides consulting services to the audit clientC. The misstatement will cause the client to fail to meet an earnings forecastD. The audit committee is not well educated about the accounting principle in question

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: AnalysisDifficulty: ModerateLearning Objective: 11

45. The acceptable level of detection risk is inversely related to the A. Extent of the substantive proceduresB. Risk of misapplying auditing proceduresC. Planning materialityD. Risk of failing to discover material misstatements


46. As the acceptable level of detection risk decreases, an auditor may change the A. Timing of tests of controls by performing them at an interim date rather than at year-endB. Nature of substantive procedures from less effective to more effective proceduresC. Timing of tests of controls by performing them at several dates rather than at one timeD. Assessed level of risk of material misstatement to a higher amount


47. As the acceptable level of detection risk decreases, the assurance directly provided from A. Substantive procedures should increaseB. Substantive procedures should decreaseC. Tests of controls should increaseD. Tests of controls should decrease


48. Increased fraud risk could also result in all of the following except A. Lower detection riskB. Higher inherent riskC. Lower control riskD. Higher client risk

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: SynthesisDifficulty: HardLearning Objective: 2Learning Objective: 6

49. The objectives of the engagement partner's communication with the audit team include A. Maintaining an adversarial atmosphere between the auditor and managementB. Complying with SEC rulesC. Complying with FASB rulesD. Emphasizing the importance of professional skepticism

AACSB: CommunicationsAICPA BB: Resource ManagementAICPA FN: Decision MakingBloom's: ApplicationDifficulty: ModerateLearning Objective: 6

50. The auditor is most likely to presume that a high risk of a fraud exists if A. The entity is a multinational company that does business in numerous foreign countriesB. The entity does business with several related partiesC. Inadequate segregation of duties places an employee in a position to perpetrate and conceal theftD. Inadequate employee training results in lengthy EDP exception reports each month

AACSB: AnalyticAICPA BB: IndustryAICPA FN: Risk AnalysisBloom's: AnalysisDifficulty: ModerateLearning Objective: 6

51. Which of the following factors most likely would heighten an auditor's concern about the risk of fraudulent financial reporting? A. Inability to generate cash flows from operations while reporting substantial earnings growthB. Management's lack of interest in increasing the entity's earnings trendC. Large amounts of liquid assets that are easily converted into cashD. Inability to borrow necessary capital without granting debt covenants

AACSB: AnalyticAICPA BB: IndustryAICPA FN: Risk AnalysisBloom's: SynthesisDifficulty: HardLearning Objective: 6Learning Objective: 7Learning Objective: 8

52. A properly planned and performed audit may fail to detect a material misstatement resulting from fraud because A. Audit procedures that are otherwise effective may be ineffective for fraud that is concealed through collusionB. An audit is planned and performed to provide reasonable assurance of detecting material misstatements caused by errors but not by fraudC. The factors considered in assessing control risk indicated an increased risk of error but only a low risk of fraud in the financial statementsD. The auditor did not consider factors influencing audit risk for account balances that have effects pervasive to the financial statements taken as a whole


53. Which of the following is correct concerning required auditor communications about fraud? A. Fraud that involves senior management should be reported directly by the auditor to the audit committee regardless of the amount involvedB. Fraud with a material effect on the financial statements should be reported directly by the auditor to the Securities and Exchange CommissionC. Any requirement to disclose fraud outside the entity is the responsibility of management and not that of the auditorD. The professional standards provide no requirements related to the communication of fraud, but the auditor should use professional judgment in determining communication responsibilities

AACSB: CommunicationsAICPA BB: IndustryAICPA FN: Risk AnalysisBloom's: ComprehensionDifficulty: ModerateLearning Objective: 10

54. Which element(s) is/are pervasive to the application of generally accepted auditing standards, particularly the standards of fieldwork and reporting? A. The elements of materiality and audit riskB. The element of internal controlC. The element of corroborating evidenceD. The element of reasonable assurance

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Decision MakingBloom's: ComprehensionDifficulty: HardLearning Objective: 11

55. Which of the following statements is not correct about materiality? A. The concept of materiality recognizes that some matters are important for fair presentation of financial statements in conformity with GAAP, while other matters are not importantB. An auditor considers materiality for the aggregate level of misstatements that could be material to any one of the financial statements individuallyC. Materiality judgments are made in light of surrounding circumstances and necessarily involve both quantitative and qualitative judgmentsD. An auditor's consideration of materiality is influenced by the auditor's perception of the needs of a reasonable person who will rely on the financial statements


Short Answer Questions

56. Using the audit risk model, identify the relationship between the following elements. For each of the items below circle whether the two elements have an inverse relationship, a direct relationship or no relationship. When considering each item, assume that the other components of the risk model remain constant.


57. What is the difference between audit risk and engagement risk?

Audit risk is the risk that the auditor may unknowingly fail to appropriately modify the opinion on financial statements that are materially misstated. It can be directly controlled by the scope of the auditor's test procedures. Engagement risk, on the other hand is the auditor's exposure to loss or injury to professional practice from litigation, adverse publicity, or other events arising in connection with financial statements audited and reported on. It cannot be directly controlled by the auditor, but some control can be exercised through the careful acceptance and continuance of clients.


58. You are teaching a class of new hires at your international accounting firm. Explain the audit risk model using a mathematical formula.

AR = RMM X DRAR = Audit riskRMM = Risk of material misstatementDR = Detection riskAudit risk consists of1) The risk that the balance or class and related assertions contain misstatements that could be material to the financial statements when aggregated with misstatements in other balances or classes. These risks exist independently of the audit.2) The risk that the auditor will not detect such misstatements (detection risk). This risk can be controlled by the auditor through the scope of the audit procedures performed.

AACSB: CommunicationsAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: ComprehensionDifficulty: EasyLearning Objective: 2Learning Objective: 3

59. Stacey, the partner in charge of the audit of RIF Enterprises, sets the planned level of audit risk for the audit of accounts payable at .06. The risk of material misstatement is assessed at .65. What is the detection risk for this audit.

Substituting the values into the audit risk model, the detection risk is around 9%.DR = AR/(RMM)DR = .06/.65DR = 9.2%

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: ApplicationDifficulty: EasyLearning Objective: 2Learning Objective: 3

60. Your classmate asserts, "Accountants shouldn't need to take business courses besides accounting, because they are only interested in the financial statements of a company." Defend or refute this statement.

The classmate is misguided. Auditors need to develop a deep understanding of business. Most business concepts and risks have the potential to affect the financial statements either immediately or in the long run. In addition, a thorough understanding of business risks increases the likelihood of identifying material misstatements in the financial statements. Therefore, an auditor should be familiar with a client's business environment for numerous reasons, including evaluating the going concern assertion.

AACSB: CommunicationsAICPA BB: IndustryAICPA FN: Risk AnalysisBloom's: ApplicationDifficulty: ModerateLearning Objective: 5Learning Objective: 6

61. You are the senior on an audit of Two Be Gone, a large publicly held company. The company recently completed an acquisition of its fifth largest competitor. What risks might this present? How will you, the auditor, respond to these risks (i.e. what actions should you take)?

Student answers for the first question will vary. After identifying possible risks, the auditor should determine which ones may result in material misstatements in the financial statements. Once those are identified, the auditor should evaluate how those risk may impact financial reporting and then design the audit to obtain evidence that addresses whether those risk have adversely impacted financial reporting. If the entity does not respond adequately to business risks that may affect financial reporting, the auditor will have to expand audit tests to determine if any misstatements are present in the related account balances or class of transactions.


62. Define misstatements arising from fraudulent financial reporting and misstatements arising from misappropriation of assets in one sentence each.

Misstatements arising from fraudulent financial reporting are intentional misstatements or omissions of amounts or disclosures in financial statements intended to deceive financial statement users. Misstatements arising from misappropriation of assets involve the theft of an entity's assets where the theft causes the financial statements to be misstated.

AACSB: CommunicationsAICPA BB: Critical ThinkingAICPA FN: Risk AnalysisBloom's: KnowledgeDifficulty: EasyLearning Objective: 6

63. DATRIX, Inc, a Fortune 500 company, has been experiencing poor performance. Industry analysts have been issuing negative reports and the company's stock price has been steadily declining. As an auditor, what would concern you about the audit engagement of DATRIX, Inc.

An auditor should be concerned because of the apparent incentive the management of DATRIX may have to commit financial statement fraud. For instance, the company's management may be tempted to change accounting estimates or use other means to falsely increase the company's book profits. The auditor should exercise professional skepticism in this engagement and addresses carefully the risk of financial statement fraud.

AACSB: AnalyticAICPA BB: IndustryAICPA FN: Risk AnalysisBloom's: AnalysisDifficulty: ModerateLearning Objective: 6

64. During the course of the audit of FF Financial, you find that some accounting entries have been altered. You believe this may be the result of management fraud and you have determined that the effect of this could be material to the financial statements. What are appropriate steps to take?

In this situation, the auditor should attempt to obtain audit evidence to determine whether material fraud has occurred and, if so, its effect. The auditor should consider the implications for other aspects of the audit. If fraud is found in one account, there are chances the auditor will find fraud in other accounts, as well. The auditor needs to discuss the matter and the approach to further investigation with an appropriate level of management that is at least one level above those involved in committing the fraud and with senior managements. If appropriate, the auditor could suggest that the client consult with legal counsel. If the results of the audit tests indicate a significant risk of fraud, the auditor should consider withdrawing from the engagement and communicating the reasons for withdrawal to the audit committee or others with equivalent authority and responsibility.

AACSB: CommunicationsAICPA BB: IndustryAICPA FN: Decision MakingBloom's: ApplicationDifficulty: ModerateLearning Objective: 8Learning Objective: 9

65. Often in an audit, total combined tolerable misstatement is greater than overall materiality. Why is this the case?

Answers may vary, but could include:1. Not all accounts will be misstated by the full amount of their tolerable misstatement allocation.2. Audits of the individual accounts are conducted simultaneously. If accounts were audited sequentially, unadjusted misstatements observed during testing would count against materiality and theoretically the auditor could carry the unused portion of materiality to the next account and so forth.3. When control weaknesses or misstatements are identified in an account, the auditors typically perform additional procedures in that and related, accounts. Thus, the actual testing will often achieve a much smaller margin for misstatement than planned tolerable misstatement.4. Overall financial statement materiality serves as a "safety net." If individual misstatements in accounts are below their tolerable misstatement, but the aggregate of the misstatements is greater than materiality, an adjustment will need to be made.

AACSB: AnalyticAICPA BB: Critical ThinkingAICPA FN: MeasurementBloom's: ComprehensionDifficulty: HardLearning Objective: 11Learning Objective: 12

66. Assume that you are the new audit senior on the LV Drug Corporation (LVD) engagement. LVD is a pharmaceutical company that has three successful drugs and a number of drugs in progress in their research and development pipeline. You are considering your audit plan and it is important to identify the inherent risks that LVD has and how they relate to the planning process. Required:For each of the following factors, indicate whether it will tend to increase, decrease, or have no effect on inherent risk, and the reasoning for your answer.a. Dr Jones is the major shareholder of LVD and its CEO.b. Your firm has audited LVD for the last four years.c. There has been high turnover of key accounting personnel during the last two years.d. The internal audit function reports to the audit committee.e. LVD has been the subject of lawsuits by users of Framadon who claim that the drug affects their liver functions. LVD is confident that there are no such side effects from the use of Framadon.

a. Increase: The CEO, as the major shareholder, has additional incentive to "manage" earningsb. No effect: The history that the auditor has with the client has no effect on the inherent risks of the business. However, the auditor will be able to use their past experience in designing tests that are efficient and effective.c. Increase: The turnover in personnel may indicate issues in the management of the company. At a minimum, the fact that many key personnel are new and do not know the company well will increase risk.d. No effect: The reporting structure of the internal audit group is a control system issue, not an inherent risk factor.e. Increase: The mere presence of an ongoing lawsuit presents increased business/inherent risk, even if the company is confident that they will prevail.


Chapter 03 - Risk Assessment and Materiality

3- PAGE 43

Chap003 (1)

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