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

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 client's 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. 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
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.

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

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.

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 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.

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

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.

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

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

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 auditor's 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.

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 auditor's 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
year's rate, based on unaudited sales and commissions data, is 3%. Internal control

over sales and cash receipts is strong.

____ 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 company's 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

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 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 Jayco's internal controls to be effective in all transaction cycles. Analytical procedures revealed
that Jayco's 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 Bresky's 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 Jayco's 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 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 year's 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 auditor's 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.