Chapter Audit Planning: Assessment of Inherent Risk and Materiality 58 Audit Risk and Materiality MULTIPLE CHOICE: 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: 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: D A 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 59 Chapter Audit Planning: Assessment of Inherent Risk and Materiality 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: 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: A 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: D How can the audit program best be described at the beginning of the audit process? a Tentative b Conclusive c Comprehensive d Optional ANSWER: D A Experience has shown that certain conditions in an organization are symptoms of possible management fraud Chapter Audit Planning: Assessment of Inherent Risk and Materiality 60 Which of the following conditions would not be considered an indicator of possible fraud? a Managers regularly assuming subordinates' duties b Managers dealing in matters outside their profit center's scope c Managers not complying with corporate directives and procedures d Managers subject to formal performance reviews on a regular basis ANSWER: 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: 10 A Which of the following is not a purpose served by the application of analytical procedures? a b c d As part of audit planning to assist in locating significant changes in revenues and expenses To provide a basis for lowering materiality thresholds where significant earnings inflation is indicated To determine the economic substance of related party transactions As part of audit review to determine that all significant abnormalities have been resolved to the auditor's satisfaction ANSWER: 11 D C 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 61 12 Chapter Audit Planning: Assessment of Inherent Risk and Materiality 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: 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 d which equals the current market rate Lends to the corporation at a rate of interest, which equals the current market rate ANSWER: 14 B 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 and (2) the industry average ratio of cost of goods sold to sales is d A cross-sectional analysis of common size statements discloses: (1) the firm's ratio of cost of goods sold to sales is and (2) the industry average ratio of cost of goods sold to sales is ANSWER: 15 B A An auditor judged an item to be immaterial when planning an audit However, the auditor may still include the item if it is subsequently determined that: a Sufficient staff is available Chapter Audit Planning: Assessment of Inherent Risk and Materiality b c d Adverse effects related to the item are likely to occur Related evidence is reliable Miscellaneous income is affected ANSWER: 16 the D 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: 18 B 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 audit with an attitude of a Professional responsiveness b Conservative advocacy c Objective judgment d Professional skepticism ANSWER: 17 62 A 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 63 19 Chapter Audit Planning: Assessment of Inherent Risk and Materiality ANSWER: B 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: 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: 21 B A 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: 23 D Which of the following conditions supports an increase in detection risk? a Internal control over cash receipts is excellent Chapter Audit Planning: Assessment of Inherent Risk and Materiality b c d Application of analytical procedures reveals a significant increase in sales revenue in December, the last month of the fiscal year Internal control over shipping, billing, and recording of sales revenue is weak Study of the business reveals that the client recently acquired a new company in an unrelated industry ANSWER: 24 In B 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 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: 26 A 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: 25 64 A An abnormal fluctuation in gross profit that might suggest the need for extended audit procedures for sales and 65 Chapter Audit Planning: Assessment of Inherent Risk and Materiality planning a b c d inventories would most likely be identified in the phase of the audit by the use of Tests of transactions and balances A preliminary review of internal control Specialized audit programs Analytical procedures ANSWER: 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: 28 are B The understanding between the client and the auditor as to the degree of responsibilities to be assumed by each normally set forth in a(an) a Representation letter b Engagement letter c Management letter d Comfort letter ANSWER: 29 D B The element of the audit planning process most likely to be agreed upon with the client before implementation of the audit strategy is the determination of the a Methods of statistical sampling to be used in confirming accounts receivable b Pending legal matters to be included in the inquiry of the client's attorney c Evidence to be gathered to provide a sufficient basis for the auditor's opinion Chapter Audit Planning: Assessment of Inherent Risk and Materiality d Schedules and analyses to be prepared by the client's staff ANSWER: 30 66 D 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: 32 B 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 67 33 Chapter Audit Planning: Assessment of Inherent Risk and Materiality 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: 34 B Which of the following audit risk components may be assessed in non-quantitative terms? Inherent Control Detection risk risk risk a b c d ANSWER: 35 Yes No Yes Yes No Yes Yes Yes D 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: 36 Yes Yes No Yes B In evaluating the effectiveness of a company's credit and collection policies, the ratio most likely to be used by an auditor is a Quick ratio b Accounts receivable turnover c Working capital turnover Chapter Audit Planning: Assessment of Inherent Risk and Materiality d 68 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: 39 B 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 69 Chapter Audit Planning: Assessment of Inherent Risk and Materiality ANSWER: 40 A 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: 42 A preliminary expectation of few errors, followed by subsequent discovery of numerous errors should lead to a in the aggregate materiality threshold ANSWER: 43 the DECREASE (LOWERING, REDUCTION) High inherent risk, combined with high control risk, should lead the auditor to the aggregate materiality threshold ANSWER: 44 DOCUMENT LOWER (DECREASE, REDUCE) A scheme perpetrated by top management to inflate reported earnings and net assets for the purpose of maximizing 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 Chapter Audit Planning: Assessment of Inherent Risk and Materiality ANSWER: 46 PERMANENT FILE INDIVIDUAL ITEM, AGGREGATE An audit approach that allocates proportionately more audit resources to areas of high audit risk is referred to as a audit ANSWER: 53 INTEGRITY 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: 52 DETECTION In a recurring audit, the best source of business and industry information may be found in the ANSWER: 51 risk is the The auditor’s primary goal in considering the client acceptance decision is to avoid associating with clients whose managements lack ANSWER: 50 LOW In the audit risk equation, controllable variable ANSWER: 49 INHERENT RISK, CONTROL RISK Inasmuch as its complement forms the basis for the audit opinion, overall audit risk should be set ANSWER: 48 INTENT The two factors that contribute to the probability that unaudited financial statements contain material errors or fraud are and ANSWER: 47 70 RISK-DRIVEN 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 71 Chapter Audit Planning: Assessment of Inherent Risk and Materiality ANSWER: 54 The is an effective device for planning and controlling audit field work ANSWER: 55 PRE-AUDIT CONFERENCE TIME BUDGET 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 The auditor assesses control risk at a high level and suspects earnings inflation in the form of premature revenue recognition 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 The auditor perceives internal control over sales and cash receipts as excellent; but internal control over purchases, inventory, and cash payments is considered weak 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 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 Chapter Audit Planning: Assessment of Inherent Risk and Materiality 72 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 b c d e f g the h Lower the individual item materiality threshold Raise the individual item materiality threshold Lower the aggregate materiality threshold Raise the aggregate materiality threshold Increase reliance on external evidence Consider internal evidence as possessing enhanced reliability Rely on external evidence for the expenditure cycle, while accepting internal evidence as reliable for revenue cycle Rely on external evidence for the revenue cycle, while accepting internal evidence as reliable for the expenditure cycle SOLUTION: a,c,e a,f c,g a a b,c,e 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 73 Chapter Audit Planning: Assessment of Inherent Risk and Materiality Required: a b 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%? 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 Chapter Audit Planning: Assessment of Inherent Risk and Materiality 74 on internal evidence and suggest specific kinds of audit evidence you would recommend in the circumstances 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 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 not reveal any apparent abnormalities SOLUTION: 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 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 75 Chapter Audit Planning: Assessment of Inherent Risk and Materiality 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  ... Chapter Audit Planning: Assessment of Inherent Risk and Materiality Having evaluated inherent risk and control risk, the auditor determines detection risk a As the complement of overall audit risk. .. 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, ... exist is referred to as a Prevention risk b Inherent risk c Control risk d Detection risk ANSWER: D 61 12 Chapter Audit Planning: Assessment of Inherent Risk and Materiality Which of the following