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7.2 Describe the factors the auditor considers when assessing inherent risk
1) 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.
2) 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
3) The inherent risk of programming errors (and thus processing errors for the affected
application systems) increases when
A) programs are customized by an external software house.
B) the company uses an internet-based applications service provider.
C) standard software packages are used for processing transactions.
D) programs are customized by an understaffed information system group.
4) The inherent risks of programming errors with resulting data loss increases when
A) packaged software is used that has to be updated every year.
B) complex configurations such as ERP at multiple locations are used.
C) functional systems are used (such as separate systems for sales and payroll).
D) sequential file systems are used rather than database management systems.
5) The inherent risks of data compromise (such as privacy violations) or data loss increase when
A) documents are sent by regular mail to confirm contract details.
B) information is encrypted using public key technology.
C) organizations use web sites to process sales transactions.
D) packaged software is used to process sales transactions.
6) Use of electronic funds transfers (such as electronic data interchange and online banking) has
which of the following effects on the audit risk model?
A) decreases control risks associated with cash
B) increases control risks associated with cash
C) decreases inherent risks associated with cash
D) increases inherent risks associated with cash
7) 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
8) Senior management of Mega Corp. is entitled to receive large bonuses if they achieve earnings
targets. What is the effect of this on the risks associated with recording of revenue? It increases
A) inherent risks associated with revenue cutoff and existence assertions.
B) inherent risks associated with revenue cutoff and completeness assertions.
C) control risks associated with revenue cutoff and existence assertions.
D) control risks associated with revenue cutoff and completeness assertions.
9) PA is auditing a client where the accounts receivable are in worse shape than last year: many
accounts are significantly overdue. How would this fact be dealt with in the audit risk model?
A) increase inherent risk for accounts receivable
B) decrease inherent risk for accounts receivable
C) increase control risk for accounts receivable
D) decrease control risk for accounts receivable
10) If inherent risk is considered at the assertion level, why does the nature of the client’s
business affect inherent risk?
A) Certain accounts, such as inventory, are affected by the nature of the client’s business.
B) If the client has really basic manufacturing processes, inherent risk is low.
C) When there is a risk of technological obsolescence, a specialist must be used during the
engagement.
D) Accounts such as cash, notes and mortgages payable vary depending upon the type of
business.
11) If it is probable that the judgment of a reasonable person would have been changed or
influenced by the omission or misstatement of information, then that information is considered to
be
A) significant.
B) insignificant.
C) material.
D) relevant.
12) CAS 320 (Materiality in planning and performing an audit) defines materiality in terms of
three key concepts. The first and second concepts are that a material misstatement should be
considered in the context of knowledgeable users and the effect on decision making and that
material is relative to circumstances surrounding the decision and nature of the information. The
third concept is
A) that the auditor should consider users of financial statements as a group.
B) that the auditor should consider users of financial statements individually.
C) that the users should be informed and approve of the materiality used by the auditor.
D) that the auditor should be conservative in setting the materiality level.
13) GreenGrow Limited is a local landscaping company that does household and commercial
landscaping. Primarily, it helps businesses select plants and manage the plants. It also has regular
maintenance contracts such as watering, weeding, and mowing. In the winter, it has some
contracts for managing the indoor plants of shopping malls, and does snow clearing to help boost
that low income season.
Joey, the majority shareholder of GreenGrow is ecstatic. He has managed to come in as the low
bidder for a new type of contract. He bid on the construction of a track for the track and field
area of a local university. A piece of land on the north end of the university is being cleared and
GreenGrow will be leveling the land and placing a bed of crushed stone for the track. Joey has
just the right person to be in charge. Jack has previous experience working as an assistant on a
road crew and knows how to use the surveying equipment needed to keep the track level. This is
a big contract, and will increase revenues by one third!
Required:
Assess inherent risk for revenue for GreenGrow Limited.
14) Big Box Distribution Company has an in-house information systems department of 50
people. The company generally does its own programming, although some software was
acquired as a software package.
In addition, a software package was purchased for customer relationship management, which
will be modified by the programming staff.
Procedures for implementing programs vary by department. All major changes are approved by
the Management Information Systems steering committee. The committee is also given a list of
the maintenance changes that are planned in the coming year. Some departments request that the
data processing department handle testing, while other users are rather picky and want to do their
own testing.
Requirements are generally prepared in writing, although small maintenance changes may be
handled verbally.
Required:
Assess inherent risk associated with program changes at Big Box.
7.3 Examine how materiality is used to assess the amount of work conducted during an audit
engagement
1) Silka is in the process of performing an audit. During the audit, Silka decided to change
materiality. A valid reason for this would be
A) a new user of the financial statements was identified.
B) a fraud was discovered in the accounts payable section.
C) materiality required the auditors to perform too many tests.
D) too many errors were found during testing.
2) Which of the following types of misstatements has the highest level of certainty?
A) identified misstatements
B) likely misstatements
C) likely aggregate misstatements
D) further possible misstatements
3) Further possible misstatement considers
A) possible presence of management fraud.
B) possible lack of knowledge of the audit team.
C) imprecision in the sampling process.
D) imprecision in the audit procedures.
4) The first step in applying materiality is
A) estimating the misstatement in a segment, for each functional cycle.
B) setting a judgment about materiality for the financial statements as a whole.
C) estimating the combined effects of errors.
D) comparing the error estimate with the materiality levels.
5) If the auditor sets a low dollar amount as materiality,
A) more evidence is required than for a high amount.
B) less evidence is required than for a high amount.
C) the same amount of evidence is required as for a high dollar amount.
D) it has no effect on the amount of evidence required.
6) Since materiality is relative, it is necessary to have bases for establishing whether
misstatements are material. Normally, the most important base for deciding what is material,
because it is regarded as a critical item of current period information for users, is
A) total assets.
B) net income.
C) net working capital.
D) net income before taxes.
7) The auditors have decided upon a materiality level of $100,000 for their audit of ABC
Manufacturing. Which one of the following errors would be considered more important by the
auditors? An
A) error in accounts receivable cut-off of $50,000.
B) overstatement of accounts payable by $15,000.
C) error in allocation between accounts receivable and accounts payable by $75,000.
D) illegal payment of $15,000.
8) The materiality for Holloy Company is $75,000. There are carryforward misstatements of
$25,000 from the previous year. Current year anticipated misstatements are $15,000, with
anticipated corrections of $10,000. What is the performance materiality?
A) $45,000
B) $50,000
C) $55,000
D) $90,000
9) Materiality should be adjusted for the effect of net anticipated misstatements to determine
performance materiality available for
A) identified misstatements.
B) likely misstatements.
C) unanticipated misstatements.
D) further possible misstatements.
10) When an auditor allocates materiality to segments, then the materiality amount for different
accounts under audit will
A) potentially differ from each other.
B) require the same level of unanticipated misstatements.
C) require the same amount of audit work.
D) be the same for each account audited.
11) The purpose of allocating planning materiality to balance sheet accounts is to
A) assess the appropriate evidence to accumulate for each account on the balance sheet.
B) assess the appropriate evidence to accumulate for each account on both the balance sheet and
income statement.
C) reduce the amount of procedures done in the course of the audit.
D) increase the possibility that fraud or illegal activities would be detected by audit procedures.
12) If an auditor were to calculate an estimate of the errors by direct projection from the sample
to the population, and found $7,000 of net overstatement errors in a sample of $100,000 out of a
total population of $900,000, the estimate of errors in the population is
A) $6,300.
B) $778.
C) $63,000.
D) $77,778.
13) A) Discuss each of the six steps in applying materiality in an audit, and identify the audit
phase(s) in which each step is performed.
B) Discuss the three main factors that affect an auditor’s preliminary judgment about materiality.
14) Lauralye Leasing Limited (LLL) provides lease financing to companies and individuals for
equipment other than automobiles. Leases on commercial signs make up 50% of total leases,
computer and telecommunications equipment are 30% and restaurant equipment makes up most
of the remainder. LLL’s customers arrange to buy new equipment from equipment dealers, then
contact LLL to arrange lease financing.
LLL was founded over thirty years ago by Laura and Al Ye. It is now run by Mr. and Mrs. Ye’s
daughter, Betsy, who is the President of LLL. LLL owns a small building downtown, where the
offices of the business are located. Unused office space is rented out to other commercial tenants.
Betsy was a classmate of yours at York University, and you have kept loosely in touch over the
years. This year, she moved the audit to your firm (a local firm with five partners), deciding that
the firm her parents had hired many years ago did not really understand her business’ needs.
LLL has a small loan that is used to cover blips in working capital. The company has two
salespeople. Most loans are received from stores throughout the city, with whom LLL has
standing agreements. If customers require financing, they fill in an application at the store, which
is faxed to LLL for approval. LLL will reply within two business days.
The company has been profitable for many years. There are no extraordinary items in the current
year’s financial statements.
Selected financial information is as follows:
Current assets $9,910,000
Long term assets $46,500,000
Short term liabilities $30,700,000
Shareholders’ equity $25,710,000
Revenue $10,200,000
Expenses $5,600,000
Income before tax $4,600,000
(and before bonus)
Required:
A) Which base would you use to calculate materiality? Why?
B) Calculate materiality. Choose a specific number, and explain why you chose that amount.
7.4 Relate the components of the audit risk model to the amount of evidence that should be
collected during an audit
1) When a different extent of evidence is needed for the various cycles, the difference is caused
by
A) errors in the client’s accounting system.
B) the client’s need to achieve an unqualified opinion.
C) the auditor’s need to follow GAAS.
D) the auditor’s expectations of errors and assessment of internal control.
2) 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.
3) Because control risk and inherent risk vary from cycle to cycle, account to account, or
objective to objective,
A) audit risk must also change.
B) planned detection risk and required audit evidence will also vary.
C) planned detection risk will vary but audit evidence will remain constant.
D) planned detection risk will remain constant but audit evidence will vary.
4) When the auditor has the same level of willingness to risk that material errors will exist after
the audit is finished for all five cycles,
A) the same amount of evidence will be gathered for each cycle.
B) a different extent of evidence is needed for various cycles.
C) he/she has not followed generally accepted auditing standards.
D) the level for each cycle must be no more than 2% so that the entire audit does not exceed
10%.
5) The audit risk model is
A) a planning, testing, and evaluation model.
B) useful in planning but of limited value in evaluating results.
C) useful in evaluating results but of limited use in planning.
D) useful when performing the tests of balances, but of little value in either the planning or
evaluation stages.