Chapter 5-Audit Risk and Materiality

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.
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.


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.
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.
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.
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 toactively 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.

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?
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?

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?
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.