Auditing: A Risk Based Approach to Conducting a Quality Audit, 10e
Solutions for Chapter 7
True/False Questions
7-2 T
7-4 T
7-6 F
7-8 F
7-10 F
7-12 T
7-14 T
Multiple-Choice Questions
7-16 A
7-18 E
7-20 C
7-22 E
7-24 E
7-26 B
7-28 C
7-2
Review and Short Case Questions
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A misstatement is an error, either intentional or unintentional, that exists in a transaction or
financial statement account balance. Characteristics that would make a misstatement material
include:
• The misstatement makes it probable that the judgment of a reasonable person relying on
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The advantage of the more quantitative approach is that it (a) promotes consistency across audit
engagements; (b) ensures that important items are addressed in the audit engagement; and (c)
presents an initial basis from which an auditor can adjust the preliminary materiality assessment.
The advantage of the individual auditor approach is that the auditor is in the best position to
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a. Performance materiality refers to the amount or amounts set by the auditor at less than the
materiality level for the financial statements as a whole or for particular classes of transactions,
account balances, or disclosures. The term is used with respect to assessing risks of material
misstatement and determining the nature, timing, and extent of further audit procedures.
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The qualitative aspect of materiality recognizes that some items, because of their very nature,
may be quite significant to users – even if the dollar magnitude is less than most quantitative
measures of materiality. As an example, a company may be developing a new line of business
with very high expected growth. A decline in the rate of growth may be very significant to the
stock market even if the dollar amounts are not material to the overall financial statements.
Auditors understand this concept and will increasingly be called upon to implement it in the
preparation of financial statement audits. Thus, when planning the audit, the auditor’s materiality
assessment has to incorporate these qualitative factors which may cause the materiality amount
to be lower than if it were based solely on quantitative factors.
The SEC provides guidance on situations in which a quantitatively small misstatement may still
be considered material because of qualitative reasons. These include:
• the misstatement hides a failure to meet analysts’ consensus expectations for the company
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a. Using the maximum thresholds for net income, net sales, and total assets, and the 10%
clearly trivial threshold yields the following amounts:
Common
Benchmarks
Maximum Overall
Materiality Threshold
Clearly Trivial Threshold (10%)
% of Net Income
5%=$2,872,800
10% X (2,872,800) = $287,280
% of Net Sales
1%=$10,666,910
10% X (10,666,910) =
$1,066,691
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b. The difficulty that the different materiality amounts poses for the auditor is that it is
challenging to choose among the alternatives. In practice, consistency with past decisions is
important, so the auditor will likely use the prior year’s benchmark, i.e., if % of net income was
used last year it makes sense to use that benchmark again unless conditions have changed. The
qualitative factors that the auditor should consider in this case are:
o There have been misstatements in the past in accounts receivable, so it is
possible that the posting threshold should be even lower than 10% for this
account.
c. Because the problem provides no information on the benchmark used in the past, any of the
three benchmarks is a reasonable answer to the question. Students may decide on total assets as
d. The fact that misstatements have occurred in this account in the past suggests that a clearly
trivial threshold even lower than 10% might be appropriate. So, for example, students might
decide on a 5% clearly trivial threshold to reflect the qualitative risks noted in the problem. In
that case, the clearly trivial thresholds would be:
Maximum Overall
Materiality
Threshold
Clearly Trivial Threshold
(5%)
5%=$2,872,800
5% X (2,872,800) = $143,640
1%=$10,666,910
5% X (10,666,910) = $533,346
1%=$6,987,520
5% X (6,987,520) = $349,376
7-34
a. There is an inverse relationship between client riskiness and materiality thresholds. Thus, a
riskier client will require a smaller threshold. In this case, the materiality threshold for Client A
should be less than that for Client B. Further, the auditor will need to collect more audit evidence
to obtain the same level of assurance for Client A compared to Client B.
7-5
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a. The FASB defines materiality as the “magnitude of an omission or misstatement of
accounting information that, in light of surrounding circumstances, makes it probable that the
judgment of a reasonable person relying on the information would have been changed or
influenced by the omission or misstatement.” The Supreme Court of the United States offers a
likely needs and expectations in order to make appropriate materiality judgments.
b. Examples of items for each dimension might be these:
Dollar Magnitude:
Something that is over 5% of net income or a 5% misstatement of an account balance.
Nature of Item under Consideration:
A misstatement of an account that significantly changes a trend in earnings or reflects on
the integrity of management (such as an intentional misstatement).
c. Yes, the auditor’s assessment of materiality can, and likely will, change during the course
of the audit. As the auditor acquires additional information about the client and the likely audited
net income, the auditor’s assessment of any further undetected misstatement may change and the
auditor’s assessment of materiality for the client may change as more qualitative factors are
considered.
7-6
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• Inherent Risk—the susceptibility of an assertion about a class of transaction, account
balance, or disclosure to a misstatement that could be material, either individually or
when aggregated with other misstatements, before consideration of any related
controls.
See Exhibit 7.1 for a graphical depiction of how these risks relate to each other. The risk of
material misstatement exists at the overall financial statement level and at the account and
assertion levels; within these levels, risk can be categorized as involving inherent risk and
control risk. These risks originate with the client, are controllable by the client, and are related to
characteristics of the client organization, environment, and internal control. After assessing
inherent and control risks, the auditor then determines the appropriate level of audit risk to
Upon determining the level of acceptable audit risk, the auditor should determine detection risk.
Detection risk is under the control of the auditor, and the level of audit effort that the auditor will
expend on the engagement depends on the level of detection risk. When the risk of material
misstatement is higher, detection risk is lower, in order to reduce audit risk to an acceptable
level. The auditor reduces detection risk through the nature, timing, and extent of substantive
7-7
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Controls exist to address the inherent risks of material misstatement. Therefore, it would be
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As the risk of material misstatement increase, the auditor will accept less audit risk, and
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Audit risk and materiality are intertwined concepts. Audit risk is defined in materiality terms, i.e.
it is the likelihood that the financial statements are materially misstated. The auditor must design
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The following is a list of factors that would lead the auditor to assess inherent risk at the
assertion level at a higher level:
• the account balance represents an asset that is relatively easily stolen, e.g., cash
• the account balance is made up of complex transactions
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• Operations in regions that are economically unstable, e.g., countries with significant
currency devaluation or highly inflationary economies (a)
• Operations exposed to volatile markets, e.g., futures trading (a)
• Entities or business segments likely to be sold (a)
• The existence of complex alliances and joint ventures (a)
• Use of off balance sheet financing, special-purpose entities, and other complex
financing arrangements (b)
7-42
Pfizer discloses a variety of interesting risks relating to inherent risk at the financial statement
level. These include:
• Increasing pricing pressures related to governmental regulations
• The Company’s growing reliance on selling specialty pharmaceuticals, and the pricing
pressure that governments are making as those governments seek cost-containment
strategies
7-9
7-43
• Management inquiries
• Review of client’s budget
• Tour of client’s plant and operations
7-44
a. Management integrity is defined as the general honesty of management and its
motivation for truthfulness (or lack thereof) in financial reporting. It is a reflection of the extent
to which management shows good business practice and to which the auditor believes that
management’s representations are likely to be honest.
If the auditor questions management’s integrity, the nature of the audit evidence to be gathered
and the evaluation of that evidence will be affected as follows:
• The auditor will not be able to rely on management’s representations without
significant corroboration.
b. Sources of evidence pertaining to management integrity might include
• The predecessor auditor, if applicable
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c. Analysis of Management Scenarios:
i. This is a frequent business practice and is not considered to reflect negatively on
management’s integrity. Many members of management believe that it is their obligation to
minimize their overall tax burden.
ii. This is a common business trait and seems to be widely accepted. However, it is also an
indication of a potential problem when a member of management is so domineering that he or
she can intimidate other members of the organization to achieve their objectives, no matter how
achieved. There have been many instances of major financial statement fraud by top
management who intimidated lower level managers.
iii. As in the previous scenarios, this is not an uncommon trait. In the author’s view, this is an
unfortunate statement about the status of accounting principles in the United States. Two factors
in this scenario should raise the auditor’s skepticism: the manager (1) has a very short-term
orientation and (2) has shown a tendency to change jobs after achieving the short-run objectives.
iv. Ostensibly the manager is a pillar of the business community. However, two factors are
unsettling: (1) the previous conviction on tax evasion and (2) the current manipulation among
controlled corporations to avoid tax. Although this latter practice is common, the auditor must
7-11
determine whether such manipulation violates the federal income tax provisions. However, most
auditors would consider this to be a high risk situation.
v. The scenario reflects poorly on management’s integrity. The attitude is that it will do
something only after being “caught.” Such an attitude raises questions about management’s
openness with the auditor in disclosing transactions or questionable accounting.
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a. Brainstorming usually occurs during the planning/risk assessment phase of the audit, but on
occasion sessions are repeated if actual fraud is detected or at the end of the audit to ensure that
all ideas generated during brainstorming have been addressed during the conduct of the audit.
d. The guidelines are:
• Suspension of criticism. Participants are requested to refrain from criticizing or making
value judgments during the session.
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e. The steps are:
(1) review prior year client information, (2) consider client information, particularly with respect
7-46
The following is a list of factors that would lead the auditor to assess control risk at a higher
level:
• poor controls in specific countries or locations
• it is difficult for the auditor to determine or gain access to the organization or individuals
who own and/or control the entity
To have an appropriate level of understanding of the client’s internal controls, the auditor needs
to understand the controls management has designed and implemented to mitigate identified
risks of material misstatement. For entity-wide controls, auditors will typically review relevant
documentation prepared by management and interview appropriate individuals. As an example,
consider the risk assessment procedures that auditors might perform related to one component of
internal controls—management’s risk assessment. To obtain this understanding, the auditor
typically uses some or all of the following risk assessment procedures:
• Interview relevant parties to develop an understanding of the processes used by the board
of directors and management to evaluate and manage risks
• Review the risk-based approach used by the internal audit function with the director of
the internal audit function and with the audit committee
7-13
7-47
Ratio and industry trend analysis can be useful in pointing out significant trends in the industry
or changes in individual account balances. Ratio analysis can indicate whether the client is
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7-49
a. Identification of risk areas for Jones Manufacturing:
Potential Risk Indicator Risk Analysis
Inventory increase There is a substantial increase in inventory, both in
dollar terms and as a percentage of sales, which
could indicate potential problems with new
7-14
Cost of goods sold decrease COGS has decreased to 55 percent of sales at the
same time inventory has increased. One explanation
is that COGS has not been booked for some
significant sales. There may also be a change in
Inventory turnover Inventory turnover has decreased by 33 percent.
This points to and confirms the problems identified
by the increase in inventory and decrease in cost of
Average number of days
to collect This ratio has increased by 23 percent over the
previous year and is 33 percent above the industry
average. The increase in the ratio could represent a
number of problems:
o Less stringent credit standards.
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Employee turnover This is more difficult to interpret, but there is a 60
percent increase over previous years to a rate that is
double that of the industry. This might indicate
problems with morale, quality control, or other
dissatisfaction with the manner in which the
company is being run.
Debt/Equity ratio This ratio has increased substantially and is double
the industry average. The company has become
highly leveraged. The increased leverage has three
implications the auditor ought to address:
o The existence of new debt covenants
that ought to be addressed as part of the
audit.
One important use of analytical procedures is to point to potential problem areas that may
affect the audit. The implication is that the auditor should consider specifically how the
identified risk areas might reflect material misstatements in the financial statements. The
risk areas identified above should lead the auditor to plan specific audit tests including,
but not limited to, the following:
• Expanded tests of inventory, pricing, returns, warranties, and the accounting
procedures for recognizing product returns.
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b. One ratio above that might cause the auditor to increase professional skepticism is the Return
on Investments. This ratio is better than expected and better than industry. When the client’s
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a. Risks include:
• There is a significant trend toward a declining current and quick ratio, which would
indicate liquidity problems for the company, often relating to operating problems.
• Interest coverage has decreased significantly and is substantially below the industry
7-17
• The number of day’s sales in inventory has been steadily increasing. This is the same
problem as the decreasing inventory turnover identified above. Some people find that this
ratio better visualizes the problem.
• Indianola has steadily decreased its investment in R&D, to a current level that is less than
• The significant decrease in earnings per share hampers the company’s ability to raise new
capital. Also, the significant decrease that has taken place in the past three years may
cause investors to question current management’s ability. Potential suits may be brought
against management if there are signs of mismanagement. The amount and extent of
personal bonuses or potential misuse of corporate funds become important and heighten
profitability and operations of the company, there may be substantial valuation problems
associated with these intangible assets.
• Sales growth has increased but less than the industry average. It is also evident that the
increase has come with poorer credit.
The preceding analysis points out a number of areas on which audit attention ought to be
focused. The company is publicly traded and SEC reports are required. The dependence on one
major product with a patent about to expire, decreased research and development, and decreased
operating performance all point to potential realization problems. The audit work will likely be
modified as follows:
• Audit risk will be set at a low level, reflecting the increased risk associated with the
client.
b. Other information that might be gathered as part of this audit engagement would include:
• Analysis of industry product trends including the identification of competitor products
and other new product developments (obtained from industry journals).
• The status of client’s drugs submitted for approval by the Food and Drug Administration,
c. Actions that took place in the preceding year would likely have included:
• A major issuance of debt reflected in the debt/equity ratio.
• The acquisition of another company or of other intangible assets reflected in the decrease
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a. There are a number of potential hypotheses that may explain the changes in the financial data
that has taken place. The task for the auditor is to determine which of the potential explanations
either (a) best explains all the changes, or (b) best reflects the economic reality of the situation.
The following are possible hypotheses:
• The company is more efficient because of its computerized processing.
• The company has embarked on a program that has led to better customer relations, but it
has come at the cost of deferred receivables.