978-0134065823 Chapter 9 Solution Manual Part 1

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Chapter 9

Assessing the Risk of Material Misstatement

 Concept Checks

P. 268

1. The risk of material misstatement exists at two levels: the overall financial

to plan the audit in response to those assessed risks.

2. To obtain an understanding of the entity and its environment, including the

entity’s internal controls, the auditor performs risk assessment procedures to

identify and assess the risk of material misstatement, whether due to fraud or

error. Risk assessment procedures include the following:

 Inquiries of management and others within the entity

P. 284

1. The audit risk model is as follows:

PDR = AARR

IR x CR

Where PDR = Planned detection risk

AAR = Acceptable audit risk

IR = Inherent risk

CR = Control risk

should such misstatements exist.

Acceptable audit risk A measure of how willing the auditor is to accept that

the financial statements may be materially misstated after the audit is

effectiveness of internal control.

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Concept Check, P. 284 (continued)

Auditing standards note that the combination of inherent risk and control risk

2. An increase in planned detection risk may be caused by an increase in

acceptable audit risk or a decrease in either control risk or inherent risk. A

 Review Questions

significant risks, including fraud risks), part six (assess inherent risk), and part

seven (control risk).

9–2 The risk of material misstatement at the overall financial statement level

9–3 A number of overarching factors may increase the risks of material

misstatement at the overall financial statement level. For example, deficiencies in

management’s integrity or competence, ineffective oversight by the board of

directors, or inadequate accounting systems and records increase the likelihood

statement level.

9–4 Concern about the client potentially recording revenues that did not occur

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9–5 The auditor performs risks assessment procedures to identify and assess

the risk of material misstatement, whether due to fraud or error. Risk assessment

procedures include the following:

1. Inquiries of management and others within the entity: Because

number of inquiries of these individuals to understand the entity and its

2. Analytical procedures: As noted in Chapter 8, auditors are required to

3. Observation and inspection: Auditors observe the entity’s operations

organizes key business functions and leaders in the oversight of day–

to-day operations.

4. Discussion among engagement team members: Auditing standards

about the susceptibility of the client’s financial statements to fraud, in

5. Other risk assessment procedures: The auditor may perform other

9–6 In addition to making inquiries of individuals involved in financial reporting

positions, auditors benefit from obtaining information or different perspectives

through inquiries of others within the entity and other employees with different

levels of authority. Additionally, inquiries of those charged with governance, such

as the board of directors or audit committee, may provide important insights

9-7 Auditing standards require the engagement partner and other key

engagement team members to discuss the susceptibility of the client’s financial

statements to material misstatement. Discussion among the engagement partner

and other key members of the engagement team provides an opportunity for

more experienced team members, including the engagement partner, to share

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9-7 (continued)

engagement partner, all members of the engagement team become better

informed about the potential for material misstatement of the financial statements

misstatement due to fraud, this can be held concurrently with the discussion

about the susceptibility of the financial statements to material misstatement due

to error. These discussions should include an exchange of ideas or brainstorming

9–9 While auditors perform risk assessment procedures to assess the risk of

material misstatement due to fraud or error, auditing standards require the

auditor to explicitly consider fraud risk because the risk of not detecting a

auditor, and they may try to conceal the transaction through collusion with others.

As a result, explicitly focusing on the risks of material misstatements due to fraud

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9-10 (continued)

conclusion in the working papers.

9-11 Auditing standards require the auditor to inquire of management about

their assessment of the risk that the financial statements may be materially

misstated due to fraud. As part of those inquiries, the auditor should ask

management has communicated any information about fraud risks to those

charged with governance.

9-12 A significant risk represents an identified and assessed risk of material

9-13 Three types of characteristics of transactions and balances that might

1. Nonroutine Transactions: Significant risks often relate to significant

nonroutine transactions, which represent transactions that are unusual,

collection and processing, and they can involve complex calculations

or unusual accounting principles not subject to effective internal

considered significant risks.

2. Matters Requiring Significant Judgment: Significant risks also

relate to matters that require significant judgment because they include

on assumptions about future events. As a result, those types of

transactions or balances frequently are identified as significant risks.

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9-13 (continued)

3. Fraud Risk: Because fraud generally involves concealment, detecting

material misstatements due to fraud is difficult. As a result, when

9-14 Inherent risk and control risk relate to the risk of material misstatement at

the assertion level. Inherent risk measures the auditor’s assessment of the

susceptibility of an assertion to material misstatement, before considering the

9–15 An increase in planned detection risk may be caused by an increase in

acceptable audit risk or a decrease in either control risk or inherent risk. A

9–16 Inherent risk is a measure of the auditor’s assessment of the

Factors affecting assessment of inherent risk include:

 Nature of the client’s business

 Results of previous audits

 Initial vs. repeat engagement

 Related parties

9–17 Inherent risk is set for audit objectives for segments rather than for the

overall audit because misstatements occur at the objective level within a

those segments.

When inherent risk is increased from medium to high, the auditor should

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9–18 Extensive misstatements in the prior year’s audit would cause inherent

risk to be set at a high level (maybe even 100%). An increase in inherent risk

would lead to a decrease in planned detection risk, which would require that the

auditor increase the level of planned audit evidence.

9–19 Acceptable audit risk is a measure of how willing the auditor is to accept

that the financial statements may be materially misstated after the audit is

9–20 When the auditor is in a situation where he or she believes that there is a

high exposure to legal liability, the acceptable audit risk would be set lower than

amount of inventory tested and/or the number of audit procedures performed.

9–22 Exact quantification of all components of the audit risk model is not

required to use the model in a meaningful way. An understanding of the

9–23 The auditor should revise the components of the audit risk model

when the evidence accumulated during the audit indicates that the auditor’s

original assessments of inherent risk or control risk are too low or too high or

the original assessment of acceptable audit risk is too low or too high.

9–24 Audit risk is a measure of how willing the auditor is to accept that the

financial statements may be materially misstated after the audit is completed

and an unmodified opinion has been issued. An auditor cannot assess the risk

of material misstatement without first deciding the size of misstatements that

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 Multiple Choice Questions From CPA Examinations

9–25 a. (2) b. (1) c (4)

9–28 a. (2) b. (2) c. (1)

 Discussion Questions And Problems

professional judgment:

 Preliminary judgment about materiality

 Control risk

 Risk of fraud

judgment:

 Estimated total misstatement in a segment

 Estimate of the combined misstatement

 Known misstatement

95% completed. For example, the performance materiality or

acceptable audit risk would not be raised at the end of the audit

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9–30 a. PCAOB Auditing Standard No. 12 (paragraph .07) notes that the

auditor, when obtaining an understanding of the company and its

environment, should obtain an understanding of the following:

1. Relevant industry, regulatory, and other external factors,

including the competitiveness of the environment, technological

organizational structure, management personnel, sources of

3. The company’s selection and application of accounting

principles, including related disclosures, including an evaluation

of whether they are appropriate for its business and consistent

In obtaining an understanding of the company, the auditor

should evaluate whether significant changes in the company from

b. Paragraph .17 of PCAOB Auditing Standard No. 12 provides two

examples of performance measures that create incentives or

pressures for management to manipulate certain accounts or

action, including the correction of misstatements.

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9–30 (continued)

be done either as part of the discussion regarding risks of material

misstatement due to error or separately. Communication about

significant matters affecting the risks of material misstatement should

continue throughout the audit.

environment that enables management to rationalize committing

fraud. The team should also discuss the potential for management

override of controls.

d. When determining whether an identified and assessed risk is a

factors should be considered:

 The effect of the quantitative and qualitative risk factors on the

likelihood and potential magnitude of misstatements

 Whether the risk is a fraud risk (i.e., a fraud risk is a significant

risk)

 The degree of complexity or judgment in the recognition or

uncertainty, and

 Whether the risk involves significant unusual transactions

e. Paragraph .74 of PCAOB Auditing Standard No. 12 notes that the

auditor’s assessment of the risks of material misstatement, including