Audit Risk and Materiality

Name:

MULTIPLE CHOICE. Highlight with the color red the letter of your
choice. God Bless!

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.

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.

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.

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.

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59 Audit Planning: Assessment of Inherent Risk and Materiality

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.

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.

6. How can the audit program best be described at the

beginning of the audit process?
a. Tentative.
b. Conclusive.
c. Comprehensive.
d. Optional.

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.

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.
Audit Planning: Assessment of Inherent Risk and Materiality 60

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.

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.

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.

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.

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.

61 Audit Planning: Assessment of Inherent Risk and Materiality

d. Lends to the corporation at a rate of interest, which

equals the current market rate.

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.

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.

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.

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.
Audit Planning: Assessment of Inherent Risk and Materiality 62

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.
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.

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.

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.

21. Audit risk consists of all but the following components:

a. Inherent risk.
b. Detection risk.
c. Substantive risk.
d. Control risk.

22. Significant unexpected fluctuations identified by

analytical procedures will usually necessitate a(an)
a. Consistency qualification.
63 Audit Planning: Assessment of Inherent Risk and Materiality

b. Review of internal control.

c. Explanation in the representation letter.
d. Auditor investigation.

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.

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.

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.
Audit Planning: Assessment of Inherent Risk and Materiality 64

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.

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.

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.

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.

30. Which of the following statements concerning materiality

thresholds is incorrect?
65 Audit Planning: Assessment of Inherent Risk and Materiality

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.

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.

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.

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.

34. Which of the following audit risk components may be assessed

in non-quantitative terms?
Audit Planning: Assessment of Inherent Risk and Materiality 66

Inherent Control Detection

risk risk risk

a. Yes Yes No
b. Yes No Yes
c. No Yes Yes
d. Yes Yes Yes

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.

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.

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%

38. Of the following procedures, which is the most important

that an auditor should use when performing an
analytical
review of the income statement?
67 Audit Planning: Assessment of Inherent Risk and Materiality

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.

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.

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.

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:
Audit Planning: Assessment of Inherent Risk and Materiality 68

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?

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