Question 1

The auditor set audit risk at 5%, inherent risk at 100%, and control risk at 50%, and determined a detection risk of 10%. If control risk had been 80%, detection risk would be about
A) 16%.
B) 10%.
C) 6%.
D) 5%.

Accepted Answer

The formula for audit risk is: 
Audit risk = Inherent risk x Control risk x Detection risk 
If audit risk is set at 5%, inherent risk is 100%, and control risk is 50%, then detection risk must be: 
5% = 100% x 50% x Detection risk 
Detection risk = 5% / (100% x 50%) = 0.1 or 10%.

If control risk had been 80%, then the new formula for detection risk would be: 
5% = 100% x 80% x Detection risk 
Detection risk = 5% / (100% x 80%) = 0.0625 or 6.25%. 
Rounding to the nearest whole number gives us a detection risk of 6%, which is closest to Choice C.

Question 2

An inherent risk (IR) of 40% and a control risk (CR) of 60% affect detection risk and planned evidence differently than an
A) IR of 60% and CR of 40%.
B) IR of 100% and CR of 24%.
C) IR of 80% and CR of 30%.
D) IR of 70% and CR of 30%.

Accepted Answer

The answer of An inherent risk (IR) of 40% and...

Question 3

How much control does the auditor have over inherent risk?
A) The auditor adjusts the controls that are considered (high level of control).
B) The auditor considers inherent risk for the business as a whole (some control).
C) The auditor assesses the factors that make up inherent risk (no control).
D) The auditor calculates inherent risk values as a residual (no control).

Accepted Answer

The auditor assesses the factors that make up inherent risk but does not have control over them. Inherent risk is determined by factors such as industry, financial stability of the client, and complexity of transactions, which are outside the control of the auditor. The auditor can only evaluate and assess the inherent risk based on the information available.

Question 4

A) Explain how auditors use the audit risk model when planning an audit.
B) Describe the audit risk model and each of its components.

Accepted Answer

The answer of A) Explain how auditors use the audit...

Question 5

When external users place heavy reliance on the financial statements it is appropriate that
A) audit risk be increased.
B) inherent risk be decreased.
C) inherent risk be increased.
D) audit risk be decreased.

Accepted Answer

When external users heavily rely on the financial statements, the auditor should decrease audit risk by gathering sufficient and appropriate evidence to ensure that the financial statements are free from material misstatement. Inherent risk, which is the risk of material misstatement before considering the effectiveness of internal controls, may or may not be decreased depending on the assessed level of inherent risk. However, the auditor's primary focus should be on reducing audit risk to an acceptably low level. Therefore, option D is the best choice.

Question 6

In practice, auditors rarely assign numerical probabilities to inherent risk, control risk, or audit risk. It is more common to assess these risks as high, medium, or low. For each of the four situations below, fill in the blanks for detection risk and the amount of evidence you would plan to gather ("planned evidence") using the terms high, medium, or low.
SITUATION

Accepted Answer

The answer of In practice, auditors rarely assign numerical probabilities...

Question 7

Mugsy Brights Limited (MBL) is a private company in Winnipeg that sells mugs, jars, and bottles in a variety of colours, sizes, and materials. MBL has been owned by four equal owners since its inception. The owners have different skills-creative design, marketing, finance, and information systems. The company attributes much of its success to the use of materials that can be easily shipped without breaking, and unique designs that appeal to a variety of buyers, particularly commercial buyers who purchase for restaurants, or for businesses who choose to advertise their business by giving away or selling regular or travel mugs.
The owners meet formally every month and have informal meetings two or three times per week to discuss particular clients or new approaches. About a quarter of the company's sales are completed via the company's secure website, while the remainder are by telephone or purchase order. MBL works with distributors of kitchenware, selling wholesale to hundreds of outlets in Canada. Most of these sales are done over the phone, although a salesperson does spend some time in major cities across the country visiting some of the large customers and helping with shelf layout and marketing to the ultimate consumers for larger distributors. These efforts have resulted in gradually increasing market share for the company.
All sales are recorded in the accounting software package used by the company. The accounting manager reports directly to one of the owners, and there are two other employees in the accounting department. Password controls are used to limit functions that are accessible by employees. For example, only the controller can implement wage rate increases or product price increases (which are reviewed and approved by the owner responsible for marketing). Two owners are required to sign cheques, and do so with source documents attached. Similarly, two owners are required to approve new employees.
All manufacturing is outsourced to local producers who work with different materials. For example, a different supplier handles steel mugs versus plastics or glass. Ceramics are rarely used as they are quite breakable, whereas some forms of glass are very durable. MBL does not hold any inventory, as manufacturing is all done to order. However, as there have been some collection problems from customers, the company has had to go to the maximum of its line of credit and has no additional borrowing capacity available. It is waiting for the results of the audited financial statements to approach its bank for an increase in its line of credit.
Internet sales are prepared (via credit card), while sales to distributors are net thirty. The company has an April year end. Following are extracts from the annual financial statements.
  
Required: 
A) What audit risk would you assign to the company? Why? [Tip: Do some calculations and consider client business risk.]
B) Calculate preliminary materiality. Justify your decision of materiality base and choice of materiality.

Accepted Answer

The answer of Mugsy Brights Limited (MBL) is a private...

Question 8

A PA is working on the audit of a publicly held corporation. At what level will the auditor likely set audit risk?
A) low
B) medium
C) high
D) very high

Accepted Answer

The answer of A PA is working on the audit...

Question 9

If audit risk is increased, what happens to detection risk?
A) It stays the same.
B) It increases.
C) It changes based upon the audit procedures conducted.
D) It decreases.

Accepted Answer

Detection risk is inversely related to audit risk. If audit risk increases, it means that the overall risk of material misstatement has increased and detection risk must decrease in order to maintain an acceptable level of overall risk. Therefore, the correct answer is D, detection risk decreases.

Question 10

You generally consider your audit client's management to be honest. However, they do have a bias towards wanting to understate their income to lower income taxes. How would this bias be implemented in the audit risk model?
A) reduce audit risk and reduce inherent risk
B) increase audit risk and reduce inherent risk
C) reduce audit risk and increase inherent risk
D) increase audit risk and increase inherent risk

Accepted Answer

The answer of You generally consider your audit client's management...

Question 11

Below are four situations that involve the audit risk model as it is used for planning audit evidence requirements in the audit of inventory. For each situation, calculate planned detection risk.
SITUATION

Accepted Answer

The answer of Below are four situations that involve the...

Question 12

A PA firm can experience high levels of business risk if the audit firm
A) does a poor job preparing client risk profiles.
B) pays its employees wages that are not in line with the market.
C) experiences significant litigation or has clients that do not pay their bills.
D) has a generous vacation policy for its staff.

Accepted Answer

If the audit firm has significant litigation or clients who do not pay their bills, it can create a high level of business risk for the PA firm. This can result in financial losses and damage to the firm's reputation. Poor client risk profiles, wages, and vacation policies may affect the efficiency of the firm, but they do not necessarily create high levels of business risk.

Question 13

Which of the following would be a signal of possible problems with management integrity?
A) reliance on debt rather than equity for financing permanent assets
B) rotation of holidays in the supervisory area over a period of months
C) rapidly declining profits or increasing losses over a period of years
D) frequent disagreements with regulators and the Canada Revenue Agency

Accepted Answer

Frequent disagreements with regulators and the Canada Revenue Agency may signal that management is not operating in compliance with laws and regulations, which could reflect a lack of integrity. Choices A, B, and C do not necessarily relate to management integrity.

Question 14

PA has set audit risk at 5% and determined that inherent risk and control risk is at 100%. What is the detection risk?
A) 5%
B) 50%
C) 95%
D) 20%

Accepted Answer

The answer of PA has set audit risk at 5%...

Question 15

If detection risk is reduced, the amount of evidence the auditor accumulates will
A) increase.
B) decrease.
C) remain unchanged.
D) be indeterminate.

Accepted Answer

If detection risk is reduced, the auditor will need to accumulate more evidence to achieve a lower acceptable level of audit risk. This means the amount of evidence will increase.

Question 16

Which of the following describes the components of the audit risk model that are used to describe the risk of material misstatement (RMM)?
A) AR / DR
B) IR × CR
C) IR × DR
D) CR × DR

Accepted Answer

The components of the audit risk model that are used to describe the risk of material misstatement (RMM) are inherent risk (IR) and control risk (CR) which are multiplied together. Therefore, the correct formula for computing RMM is IR x CR. The other options (A, C, and D) are not correct formulas for calculating RMM.

Question 17

A PA recently finished the audit of a family-owned business. Now she is working on a large client with about 50 times the assets and 30 times total revenue. For the larger client, the PA will likely have
A) no changes to the audit risk model.
B) higher control risk.
C) higher audit risk.
D) lower audit risk.

Accepted Answer

The answer of A PA recently finished the audit of...

Question 18

An important role of inherent risk assessment during the audit process is the need to
A) document the quality of the disaster recovery plan.
B) attempt to predict where misstatements are most and least likely in the financial statement segments.
C) train the audit staff to assess the integrity of management.
D) increase the level of analytical review.

Accepted Answer

Inherent risk assessment helps auditors identify areas of the financial statements where misstatements are more likely to occur, allowing them to focus their auditing efforts and increase the effectiveness of the audit. The other options listed are not the primary purpose of inherent risk assessment.

Question 19

PA is comparing the liabilities section of ABC Ltd. from last year to this year. Last year, ABC Ltd. had large loans due to major shareholders and officers and to one bank. This year, the debt has been reorganized so there are now two different banks used for loans. Instead of having debt to shareholders and officers, the company now owes notes to 25 different foreign investors, who are entitled to convert the debt to shares if interest is not paid or if principal installments are not paid on time. For this year's audit, how will the change in debt structure affect the audit risk model?
A) no effect on the audit risk model
B) higher control risk
C) lower audit risk
D) higher audit risk

Accepted Answer

The answer of PA is comparing the liabilities section of...

Question 20

All other factors held constant, if the auditor decreases audit risk then
A) there will be less documentation in the audit file.
B) total audit evidence and audit costs will increase.
C) it will also be necessary to decrease either control risk or inherent risk.
D) less supervision of the audit team will be required.

Accepted Answer

Decreasing audit risk means the auditor is willing to accept less risk of material misstatement. As a result, the auditor will need to gather more audit evidence to reduce that risk. This means that total audit evidence and audit costs will increase. All other factors held constant, there is no indication that less documentation or less supervision of the audit team will be required. It is not necessary to decrease either control risk or inherent risk, but the auditor may choose to do so in order to decrease audit risk.

Quiz 7: Materiality and Risk

The auditor set audit risk at 5%, inherent risk at 100%, and control risk at 50%, and determined a detection risk of 10%. If control risk had been 80%, detection risk would be about

An inherent risk (IR) of 40% and a control risk (CR) of 60% affect detection risk and planned evidence differently than an

How much control does the auditor have over inherent risk?

A) Explain how auditors use the audit risk model when planning an audit. B) Describe the audit risk model and each of its components.

When external users place heavy reliance on the financial statements it is appropriate that

A PA is working on the audit of a publicly held corporation. At what level will the auditor likely set audit risk?

If audit risk is increased, what happens to detection risk?

You generally consider your audit client's management to be honest. However, they do have a bias towards wanting to understate their income to lower income taxes. How would this bias be implemented in the audit risk model?

Below are four situations that involve the audit risk model as it is used for planning audit evidence requirements in the audit of inventory. For each situation, calculate planned detection risk. SITUATION

A PA firm can experience high levels of business risk if the audit firm

Which of the following would be a signal of possible problems with management integrity?

PA has set audit risk at 5% and determined that inherent risk and control risk is at 100%. What is the detection risk?

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

Which of the following describes the components of the audit risk model that are used to describe the risk of material misstatement (RMM) ?

A PA recently finished the audit of a family-owned business. Now she is working on a large client with about 50 times the assets and 30 times total revenue. For the larger client, the PA will likely have

An important role of inherent risk assessment during the audit process is the need to

All other factors held constant, if the auditor decreases audit risk then