Auditing, 12e (Arens)
Chapter 7 Materiality and Risk
7.1 State the components of the audit risk model and describe the process used to assess audit
risk
1) Risk in auditing means that the auditor accepts some level of uncertainty in performing the
audit function. An effective auditor will
A) take any means available to reduce the risk to the lowest possible level.
B) set the risk level between 5% and 10%.
C) perform the audit procedures first and quantitatively set the risk level before forming an
opinion and writing the report.
D) recognize that risks exist and deal with those risks in an appropriate manner.
2) If the auditor assessed the detection risk as high, the extent of evidence the auditor plans to
accumulate is
A) low.
B) high.
C) medium.
D) need more information to conclude.
3) As the effectiveness of internal control increases, what happens to control risk? It
A) stays the same.
B) increases.
C) changes based upon the audit procedures conducted.
D) decreases.
4) The audit risk model is used primarily
A) for planning purposes in determining how much evidence to accumulate.
B) while doing tests of controls.
C) to determine the type of opinion to express.
D) to evaluate the evidence which has been gathered.
5) Audit risk is a measure of
A) the auditor’s assessment of the likelihood that a material misstatement might occur in the first
place.
B) the probability that the financial statements contain errors.
C) how willing the auditor is to accept that the financial statements may be materially misstated
after the audit is completed.
D) the probability that errors in the financial statements that were not detected by the internal
controls of the firm are not detected by the auditor.
6) PA has set audit risk at 2% and determined that inherent risk is 60%. What is the level of
targeted audit assurance?
A) 2%
B) 40%
C) 98%
D) 60%
7) How much control does the auditor have over inherent risk? The auditor
A) adjusts the controls that are considered – high levels of control.
B) considers inherent risk for the business as a whole – some control.
C) assesses the factors that make up inherent risk – no control.
D) calculates inherent risk values as a residual – no control.
8) What is the role of internal controls during the assessment of inherent risk?
A) Internal controls are considered separately, so they are ignored during the assessment of
inherent risk.
B) As the quality of internal controls increases, inherent risk decreases.
C) As the quality of internal controls improves, inherent risk increases.
D) There is a direct relationship between the quality of internal controls and inherent risk.
9) In addition to representing an assessment of whether a client’s internal control is effective for
preventing or detecting misstatements, control risk also represents the
A) reliability of management in preventing or detecting fraud.
B) auditor’s intention to rely on internal controls.
C) likelihood that the auditor will detect illegal acts.
D) possibility of collusion occurring between two employees.
10) Using the audit risk model, audit risk describes targeted assurance, while control risk and
inherent risk are assessed based upon a variety of factors. Of the components of the audit risk
model, which is most likely to be set to 100%?
A) audit risk
B) control risk
C) detection risk
D) inherent risk
11) Assessing design effectiveness and conducting tests of controls are required when the auditor
A) chooses to set control risk below 100 percent and relies on the controls.
B) chooses to set control risk below 100 percent even it there is no reliance placed on controls.
C) is planning the audit.
D) should always test the design effectiveness.
12) The risk that an auditor’s procedures will lead 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) audit risk.
B) inherent risk.
C) control risk.
D) planned detection risk.
13) If audit risk is increased, what happens to detection risk? It
A) stays the same.
B) increases.
C) changes based upon the audit procedures conducted.
D) decreases.
14) If detection risk is reduced, the amount of evidence the auditor accumulates will
A) increase.
B) decrease.
C) remain unchanged.
D) be indeterminate.
15) 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%.
16) 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%.
17) 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 will be required of the audit team.
18) When inherent risk is assessed as higher (i.e. more material errors are likely to exist) and
control risk is assessed the same from one year to the next, what is the likely effect on detection
risk? Detection risk will
A) increase.
B) decrease.
C) stay the same.
D) need less documentation.
19) If from last year to the current year’s audit, inherent risk has stayed constant, but control risk
is higher (it is more likely that controls do not detect material errors), what is the likely effect on
detection risk? Detection risk will
A) increase.
B) decrease.
C) stay the same.
D) need less documentation.
20) With respect to clients, business risk increases when conditions, events, circumstances or
inactions
A) adversely affect the entity’s ability to achieve its objectives.
B) cause employees to not do their job properly.
C) result in the company continuing profitable operations.
D) result in an assessment of poor internal controls.
21) A PA firm can experience high levels of business risk if the audit firm
A) does a poor job on preparing client risk profiles.
B) pays its employees wages that are not in line with the market.
C) has clients that do not pay their bills, or experiences significant litigation.
D) has a generous vacation policy for its staff.
22) 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.
23) 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, PA will
likely have
A) no effect on the audit risk model.
B) higher control risk.
C) higher audit risk.
D) lower audit risk.
24) 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
25) 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 instalments 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
26) Which one of the following would be a signal as to 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
27) A) Explain how auditors use the audit risk model when planning an audit.
B) Describe the audit risk model and each of its components.
28) Discuss three factors that affect client business risk, and therefore audit risk.
29) 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
1
2
3
4
Audit risk
1%
10%
10%
5%
Inherent risk
100%
100%
50%
20%
Control risk
100%
100%
40%
30%
Detection risk
________
________
________
________
30) 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
1
2
3
4
Audit risk
Low
Low
High
High
Inherent risk
High
Low
Low
Low
Control risk
High
Low
Medium
Low
Detection risk
________
________
________
________
Planned
evidence
________
________
________
________
31) Your firm has been appointed as the auditor of Bush Mining Inc. (BMI), a company that runs
small mining operations in remote areas of northern Canada, primarily in surface mines. You
have been assigned the job of audit senior for BMI.
BMI’s operations are subject to provincial and federal laws and regulations. These laws and
regulations have become stricter in recent years and some of BMI‘s older mines may be in
violation of environmental laws.
Surface mining produces tailings (toxic wastes that are dangerous to animal and plant life).
These tailings are either further processed and buried or retained in tailings ponds. BMI is
required to restore the mining property to a safe condition after a mine is exhausted. BMI has
programs in place to monitor and control pollutants that are released to the air and to local
waterways.
Required:
A) What factors would affect the client business risk of BMI? Based upon your assessment of
BMI’s client business risk, would you adjust audit risk? Why or why not?
B) What is your preliminary assessment of audit risk? Justify your answer.
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32) 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 is owned by four equal owners since
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 sales are via the
company’s secure web site, 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 via the telephone, although a salesperson does spend some time in major
cities across the country visiting some of the large customers, 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 is rarely used
as it is 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 the 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:
2012
2011
2010
Cash
$99,000
$110,000
$124,000
Accounts receivable
$320,000
$220,000
$150,000
Fixed assets (net)
$15,000
$20,000
$25,000
Accounts payable
$270,000
$180,000
$150,000
Bank indebtedness
$100,000
$25,000
$0
Share capital
$200,000
$200,000
$200,000
Revenue
$625,310
$538,120
$507,380
Cost of sales
$406,452
$333,634
$304,428
Administration expenses
$89,000
$57,000
$58,000
Sales expenses
$31,266
$21,525
$20,295
Amortization
$5,000
$5,000
$5,000
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.
2012
2011
2010
cost of sales percent
65
62
60
sales expenses percent
5
4
4
net income
$93,593
$120,961
$119,657