Deck 9: Materiality and Risk

Question 1

The auditor's preliminary judgment about materiality is the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of reasonable users.

Answer 1

True

Question 2

The scope paragraph of the standard unqualified auditor's report states that "… the standards require that we plan and perform the audit to obtain ________ assurance about whether the financial statements are free of material misstatement". What type of assurance is given?

A) immediate
B) limited
C) reasonable
D) absolute

Answer 2

C

Question 3

Audit standards require the auditor to consider materiality early in the audit. Which statement(s) regarding preliminary materiality are true?
I) Preliminary materiality may change during the engagement.
II) Preliminary materiality is the maximum amount the auditor by which the auditor believes the financials could be misstated and still not affect the decisions of reasonable users.

A) I only
B) II only
C) both I and II
D) neither are true

Answer 3

C

Question 4

Which of the following statements is not correct?

A) Materiality is a relative rather than an absolute concept.
B) The most important base used as the criterion for deciding materiality is total assets.
C) Qualitative factors as well as quantitative factors affect materiality.
D) Given equal dollar amounts, frauds are usually considered more important than errors.

Question 5

Qualitative factors can affect an auditor's assessment of materiality. Which of the following qualitative factors could influence the assessment of materiality?
I) Misstatements that are otherwise immaterial may be material if they affect earnings trends.
II) Minor misstatements resulting from the consequences of contractual obligations.

A) I only
B) II only
C) I and II
D) neither I nor II

Question 6

Auditors are responsible for determining whether financial statements are materially misstated, so upon discovering a material misstatement they must bring it to the attention of:

A) regulators.
B) the audit firm's managing partner.
C) the client shareholders.
D) the client's management.

Question 7

Lewis Corporation has a few large accounts receivable that total one million dollars whereas
Clark Corporation has many small accounts receivable that total one million dollars. Misstatement in any one account is more significant for Lewis corporation because of the concept of:

A) Materiality.
B) Audit risk.
C) Reasonable assurance.
D) Comparative analysis.

Question 8

The preliminary judgment about materiality and the amount of audit evidence accumulated are ________ related.

A) directly
B) indirectly
C) not
D) inversely

Question 9

Due to qualitative factors, certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same. Identify two qualitative factors that might significantly affect an auditor's materiality judgment, and give an example of each.

Question 10

If an auditor establishes a relatively high level for materiality, then the auditor will:

A) accumulate more evidence than if a lower level had been set.
B) accumulate less evidence than if a lower level had been set.
C) accumulate approximately the same evidence as would be the case were materiality lower.
D) accumulate an undetermined amount of evidence.

Question 11

The FASB definition of materiality focuses on potential users of financial statements.

Question 12

The five steps in applying materiality are listed below in random order.
1) Estimate the combined misstatement.
2) Estimate the total misstatement in the segment.
3) Set preliminary judgment about materiality.
4) Allocate preliminary judgment about materiality to segments.
5) Compare combined estimate with preliminary judgment about materiality.
The first three steps in correct sequence would be:

A) 1, 2, 5
B) 3, 4, 2
C) 2, 1, 5
D) 3, 2, 4

Question 13

Certain types of misstatements are likely to be more important than other types to users, even if the dollar amounts are the same. Which of the following demonstrates this?

A)
B)
C)
D)

Question 14

Why do auditors establish a preliminary judgment about materiality?

A) To determine the appropriate level of staff to assign to the audit.
B) So that the client can know what records to make available to the auditor.
C) To plan the appropriate audit evidence to accumulate and develop an overall audit strategy.
D) To finalize the control risk assessment.

Question 15

Auditing standards ________ that the basis used to determine the preliminary judgment about materiality be documented in the audit files.

A) permit
B) do not allow
C) require
D) strongly encourage

Question 16

When setting a preliminary judgment about materiality:

A) more evidence is required for a low dollar amount than for a high dollar amount.
B) less evidence is required for a low dollar amount than for a high dollar amount.
C) the same amount of evidence is required for either low or high dollar amounts.
D) there is no relationship between it and the dollar amount of evidence needed.

Question 17

If it is probable that the judgment of a reasonable person will be changed or influenced by the omission or misstatement of information, then that information is, by definition of FASB Statement No. 2:

A) material.
B) insignificant.
C) significant.
D) relevant.

Question 18

Amounts involving fraud are usually considered ________ important than unintentional errors of equal dollar amounts.

A) less
B) no less
C) no more
D) more

Question 19

Material misstatement is the magnitude of misstatement that makes a reasonable person either change their mind or be influenced by the misstatement. Audit standards require the auditor to consider the combined amount of misstatement early in the audit. This is known as preliminary materiality judgment. List and discuss the three main factors that affect an auditor's preliminary judgment about materiality.

Question 20

Which of the following is the primary basis used to decide materiality for a for-profit entity?

A) net sales
B) net assets
C) net income before tax
D) all of the above

Question 21

Net assets are the most often used base for deciding materiality.

Question 22

When tolerable misstatement is exceeded by ________ the auditor should request the client to adjust their account balance.
I) Known misstatements
II) Projected misstatement

A) I only
B) II only
C) I and II
D) None of the above

Question 23

Which of the following statements is false?

A) Either an overstatement of an asset account or an understatement of a liability account would have the same effect on the income statement.
B) A misclassification in the balance sheet will have no effect on operating income.
C) Either an overstatement of an asset account or an overstatement of a liability account would have the same effect on the income statement.
D) Either an understatement of an asset account or an overstatement of a liability account would have the same effect on the income statement.

Question 24

Amounts involving fraud are not usually considered qualitative factors affecting the preliminary materiality judgment.

Question 25

Which of the following are major difficulties auditors face when allocating materiality to balance sheet accounts?

A)
B)
C)
D)

Question 26

When allocating materiality, most practitioners choose to allocate to:

A) the income statement accounts because they are more important.
B) the balance sheet accounts because there are fewer.
C) both balance sheet and income statement accounts because there could be errors on either.
D) all of the financial statements because it is required by GAAS.

Question 27

Auditor's allocate the preliminary judgment about materiality to financial statement segments rather than by financial statements as a whole. What is the term for the auditor's allocation of preliminary misstatement to account balances? What are three difficulties auditor's face when allocating materiality to balance sheet accounts?

Question 28

Which of the following statements is true concerning the allocation of preliminary materiality?

A) It is necessary to allocate preliminary materiality to financial statements as a whole rather than by segments.
B) Preliminary materiality should be allocated to income statement accounts only.
C) It is required by the SEC.
D) When preliminary materiality is allocated to segments it is termed tolerable misstatement.

Question 29

Which of the following is an incorrect statement regarding the allocation of the preliminary judgment about materiality to balance sheet accounts?

A) Auditors expect certain accounts to have more misstatements than others.
B) The allocation has virtually no effect on audit costs because the auditor must collect sufficient appropriate audit evidence.
C) Auditors expect to identify overstatements as well as understatements in the accounts.
D) Relative audit costs affect the allocation.

Question 30

When auditors allocate the preliminary judgment about materiality to account balances, the materiality allocated to any given account balance is referred to as:

A) the materiality range.
B) the error range.
C) tolerable materiality.
D) tolerable misstatement.

Question 31

Tolerable misstatement as set by the auditor:

A) decreases acceptable audit risk.
B) increases inherent risk and control risk.
C) affects planned detection risk.
D) does not affect any of the four risks.

Question 32

Auditors have difficulty applying the concept of materiality in practice because they often do not know who the users of the financial statements are or what decisions will be made.

Question 33

Net income before tax is the normal base used to determine materiality in a non-for-profit company.

Question 34

Preliminary judgments about materiality are often changed during the course of the engagement.

Question 35

If the preliminary judgment of materiality increases, the amount of audit evidence required will decrease.

Question 36

Auditors generally allocate the preliminary judgment about materiality to the:

A) balance sheet only.
B) income statement only.
C) income statement and balance sheet.
D) statement of cash flows.

Question 37

Statements on Auditing Standards provide detailed, objective guidance on how auditors are to establish a preliminary materiality level, thus eliminating the need for subjective auditor judgment in this task.

Question 38

Explain why it is necessary to allocate the preliminary judgment about materiality to individual accounts (segments) in the financial statements. Also explain why allocating to balance sheet accounts is more common than allocating to income statement accounts.

Question 39

Most practitioners allocate the preliminary judgment about materiality to balance sheet accounts.

Question 40

The lower the dollar amount of the preliminary judgment the more audit evidence is required.

Question 41

________ misstatements are those where the auditor can determine the amount of the misstatement in the account.

A) Potential
B) Likely
C) Known
D) Projected

Question 42

Auditors are ________ to document the known and likely misstatements in the financial statements under audit.

A) permitted
B) required
C) not allowed
D) strongly encouraged

Question 43

The primary purpose of allocating the preliminary judgment about materiality to financial statement accounts is to help the auditor decide the appropriate evidence to accumulate.

Question 44

Both overstatements and understatements must be considered when allocating materiality to balance sheet accounts.

Question 45

Discuss each of the five steps in applying materiality in an audit, and identify the audit phase(s) in which each step is performed. List these steps in the order in which they occur.

Question 46

The most important element of the audit risk model is control risk.

Question 47

Based on audit evidence gathered and evaluated, an auditor decides to increase the assessed level of control risk 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) increase materiality levels.
B) decrease detection risk.
C) decrease substantive testing.
D) increase inherent risk.

Question 48

To maximize audit efficiency, the auditor should allocate less tolerable misstatement to accounts that can be verified by using low-cost audit procedures, such as analytical procedures, than to accounts that are more costly to audit.

Question 49

Using your knowledge of the relationships among acceptable audit risk, inherent risk, control risk, planned detection risk, tolerable misstatement, and planned evidence, state the effect on planned evidence (increase or decrease) of changing each of the following factors, while the other factors remain unchanged.
1. An increase in acceptable audit risk.________.
2. An increase in inherent risk. ________.
3. A decrease in control risk. ________.
4. An increase in planned detection risk. ________.
5. An increase in tolerable misstatement. ________.

Question 50

The audit risk model that must be used for planning audit procedures and evaluating audit results is:
DR
IR × CR = AAR.

Question 51

Why do auditors use the audit risk model when planning an audit?

Question 52

Total estimated misstatements include known misstatements and projected misstatements plus a sampling error.

Question 53

When expressing an unqualified opinion, the auditor who evaluates the audit findings should be satisfied that the:

A) amount of known misstatement is documented in the management representation letter.
B) estimate of the total known and likely misstatements is less than a material amount.
C) estimate of the total likely misstatement includes sample error.
D) amount of known misstatement is acknowledged and recorded by the client.

Question 54

Which of the following audit risk components may be assessesed in non-quantitative terms?

A)
B)
C)
D)

Question 55

The risk of material misstatement is a combination of two client controlled factors: inherent risk and control risk. What is inherent risk, why is it important and give examples of inherent risk factors.

Question 56

The preliminary judgment on materiality is compared to an estimated total misstatements to determine if an account balance is materially misstated.

Question 57

If an auditor assigns a tolerable misstatement of $1,000 to accounts payable, he or she would need to obtain more audit evidence for that account than if $100,000 had been assigned.

Question 58

Which of the following underlies the application of generally accepted auditing standards?

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

Question 59

An auditor who audits a business cycle that has low inherent risk should:

A) increase the amount of audit evidence gathered.
B) assign more experienced staff to that area.
C) increase the tolerable misstatement for the area.
D) expand planning procedures.

Question 60

Likely misstatements can result from:

A)
B)
C)
D)

Question 61

Inherent risk is often high for an account such as:

A) inventory.
B) land.
C) cash.
D) notes payable.

Question 62

To what extent do auditors typically rely on internal controls of their public company clients?

A) extensively
B) only very little
C) infrequently
D) never

Question 63

Auditors typically rely on internal controls of their private company clients:

A) only as needed to complete the audit and satisfy Sarbanes-Oxley requirements.
B) only if the controls are determined to be effective.
C) only if the client asks an auditor to test controls.
D) only if the controls are sufficient to increase Control Risk to an acceptable level.

Question 64

Inherent risk is ________ related to detection risk and ________ related to the amount of audit evidence.

A) directly, inversely
B) directly, directly
C) inversely, inversely
D) inversely, directly

Question 65

Which of the following statements is not true?

A) Inherent risk is inversely related to the amount of audit evidence whereas detection risk is directly related to the amount of audit evidence required.
B) Inherent risk is directly related to evidence whereas detection risk is inversely related to the amount of audit evidence required.
C) Inherent risk is the susceptibility of the financial statements to material error, assuming no internal controls.
D) Inherent risk and control risk are assessed by the auditor and function independently of the financial statement audit.

Question 66

Planned detection risk
I) determines the amount of substantive evidence the auditor plans to accumulate.
II) is dependent on inherent risk and control risk.

A) I only
B) II only
C) I and II
D) None of the above

Question 67

The risk of material misstatement differs from detection risk in that it:

A) arises because audit procedures have been misapplied.
B) can be controlled and changed by the auditor.
C) can be assessed in quantitative and non-quantitative terms.
D) is controllable by the client.

Question 68

Acceptable audit risk is ordinarily set by the auditor during planning and:

A) held constant for each major cycle and account.
B) held constant for each major cycle but varies by account.
C) varies by each major cycle and by each account.
D) varies by each major cycle but is constant by account.

Question 69

Tolerable misstatement does not affect audit risk, inherent risk, control risk, or planned detection risk yet the combination of the tolerable misstatement and the four risks will determine the amount of planned audit evidence.

Question 70

If acceptable audit risk is low, and inherent risk and control risk are both low, then planned detection risk should be high.

Question 71

Auditors frequently refer to the terms audit assurance, overall assurance, and level of assurance to refer to ________.

A) detection risk
B) audit report risk
C) acceptable audit risk
D) inherent risk

Question 72

If planned detection risk is reduced, the amount of evidence the auditor accumulates will:

A) increase.
B) decrease.
C) remain unchanged.
D) be indeterminate.

Question 73

As the risk of material misstatement increases, detection risk should:

A) medium increase.
B) decrease.
C) stay the same.
D) Is indeterminate.

Question 74

The measurement of the auditor's assessment of the likelihood that there are material misstatements due to error or fraud in a segment before considering the effectiveness of internal controls is defined as:

A) Audit risk.
B) Inherent risk.
C) Sampling risk.
D) Detection risk.

Question 75

Inherent risk and control risk:

A) are inversely related to each other.
B) are inversely related to detection risk.
C) are directly related to detection risk.
D) are directly related to audit risk.

Question 76

The risk that audit evidence for a segment will fail to detect misstatements exceeding tolerable misstatement is:

A) Audit risk.
B) Control risk.
C) Inherent risk.
D) Planned detection risk.

Question 77

Auditors may assess inherent risk and control risk:

A)
B)
C)
D)

Question 78

The risk of material misstatement refers to:

A) control risk and acceptable audit risk.
B) inherent risk.
C) the combination of inherent risk and control risk.
D) inherent risk and audit risk.

Question 79

Match nine of the terms (a-i) with the definitions provided below (1-9):
a. Business risk
b. Preliminary judgment about materiality
c. Inherent risk
d. Planned detection risk
e. Audit assurance
f. Acceptable audit risk
g. Tolerable misstatement
h. Control risk
i. Materiality
________ 1. A measure of the risk that audit evidence for a segment will fail to detect misstatements exceeding a tolerable amount, should such misstatements exist.
________ 2. The risk that the auditor or audit firm will suffer harm because of a client relationship, even though the audit report rendered for the client was correct.
________ 3. A measure of the auditor's assessment of the likelihood that misstatements exceeding a tolerable amount in a segment will not be prevented or detected by the client's internal controls.
________ 4. A measure of how much risk the auditor is willing to take that the financial statements may be materially misstated after the audit is completed and an unqualified audit opinion has been issued.
________ 5. The materiality allocated to any given account balance.
________ 6. The maximum amount by which the auditor believes that the statements could be misstated and still not affect the decisions of reasonable users.
________ 7. This term is synonymous with acceptable audit risk.
________ 8. The magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person would have been changed.
________ 9. A measure of the auditor's assessment of the likelihood that there are material misstatements before considering the effectiveness of internal control.

Question 80

In a financial statement audit, inherent risk is evaluated to help an auditor asses which of the following?

A) The internal audit department's objectivity in reporting a material misstatement of a financial statement assertion it detects to the audit committee.
B) The risk the internal control system will not detect a material misstatement of a financial statement assertion.
C) The risk that the audit procedures implemented will not detect a material misstatement of a financial statement assertion.
D) The susceptibility of a financial statement assertion to a material misstatement assuming there are no related controls.