CHAPTER 9

Multiple-Choice Questions
1.
easy
a

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, by
definition of FASB Statement No. 2,
a. material.
b. insignificant.
c. significant.
d. relevant.

2.
easy
b

The preliminary judgment about materiality is the

amount by which the auditor
believes the statements could be misstated and still not affect the decisions of reasonable users.
a. minimum
b. maximum
c. mean average
d. median average

3.
easy
d

When auditors allocate the preliminary judgment about materiality to account balances, the
materiality allocated to any given account balance is referred to in SAS No. 39 as
a. the materiality range.
b. the error range.
c. tolerable materiality.
d. tolerable misstatement.

4.
easy
a

Why do auditors establish a preliminary judgment about materiality?

a. To help the auditor plan the appropriate evidence to accumulate.
b. So that the client can know what records to make available to the auditor.
c. To determine what level of staffing (i.e., work experience) is required for the audit.
d. None of the above.

5.
easy
a

If an auditor establishes a relatively low level for materiality, then the auditor will
a. accumulate more evidence than if a higher level had been set.
b. accumulate less evidence than if a higher level had been set.
c. accumulate approximately the same evidence as would be the case were a higher level set.
d. accumulate an undetermined amount of evidence.

6.
easy
d

After the preliminary judgment about materiality has been established, auditors may
a. not adjust it.
b. adjust it downward only.
c. adjust it upward only.
d. adjust it either downward or upward.

7.
easy
d

In an audit area that has a higher inherent risk, it would be prudent to

a. increase the amount of audit evidence gathered.
b. assign more experienced staff to that area.
c. review the completed audit files more thoroughly.
d. do all of the above.

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8.
easy
d

Which of the following is least likely to be appropriate as the basis for determining the
preliminary judgment about materiality in the audit of a set of financial statements?
a. Net income before taxes.
b. Current assets.
c. Owners equity.
d. Inventory.

9.
easy
a

Which of the following might not be a signal of a lack of integrity in management?

a. Prior criminal conviction of an assembly line foreman.
b. Frequent turnover of key internal audit personnel.
c. Frequent disagreements with previous auditors.
d. Frequent turnover of key financial personnel.

10.
easy
d

Which of the following qualitative factors may significantly influence whether an item is
deemed to be material?
a. Misstatements that are otherwise minor may be material if there are possible
consequences arising from contractual obligations.
b. Misstatements that are otherwise immaterial may be material if they affect a trend in
earnings.
c. Amounts involving fraud are usually considered more important than unintentional
errors of equal dollar amounts.
d. All of the above may influence materiality.

11.
easy
a

Auditors generally allocate the preliminary judgment about materiality to

a. the balance sheet only.
b. the income statement only.
c. the income statement and balance sheet.
d. the statement of cash flows.

12.
easy
c

Which of the following statements regarding inherent risk is correct?

a. The inherent risk assigned in the audit risk model is unaffected by the auditors
experience with clients organization.
b. Most auditors set a low inherent risk in the first year of an audit and increase it if
experience shows that it was incorrect.
c. Most auditors set a high inherent risk in the first year of an audit and reduce it in
subsequent years as they gain experience, even when there is inherent risk.
d. The inherent risk assigned in the audit risk model is dependent upon the strengths in
clients internal control system.

13.
easy
a

Auditors begin their assessments of inherent risk during the planning phase. Which of the
following would not be a topic of the planning phase that would also help to assess inherent
risk?
a. Obtaining clients agreement on the engagement letter.
b. Obtaining knowledge about the clients business and industry.
c. Touring the clients plant and offices.
d. Identifying related parties.

14.
medium
d

Which of the following is not a difficulty associated with allocating the preliminary judgment
about materiality to balance sheet accounts?
a. Auditors expect certain accounts to have more misstatements than others.
b. The allocation can have a significant effect on audit costs.
c. The auditor can expect to identify overstatements as well as understatements in the
accounts.
d. All of the above are difficulties associated with the allocation of materiality.

15.
medium
b

What is the primary means of dealing with risk in planning audit evidence?
a. Selection of more effective tests of details of balances.
b. Application of the audit risk model.

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c.
d.

Establish a lower preliminary judgment about materiality.

All of the above.

16.
medium
a

The opinion paragraph in auditors reports includes two important phrases that are directly
related to materiality and risk. The phrases are
a. in our opinion and in all material respects.
b. presents fairly and in all material respects.
c. in our opinion and presents fairly.
d. in all material respects and reasonable assurance.

17.
medium
d

The phrase in our opinion in the auditors report is intended to inform users that auditors
a. guarantee fair presentation of the financial statements.
b. act as insurers of the accuracy of the statements.
c. certify the material presented in the statements by management.
d. base their conclusions about the statements on professional judgment.

18.
medium
d

Inherent risk is _______ related to detection risk and _______ related to the amount of audit
evidence.
a. directly, inversely.
b. directly, directly.
c. inversely, inversely.
d. inversely, directly.

19.
medium
b

The five steps in applying materiality are listed below in random order.
1. Estimate the combined misstatement.
2. Estimate the total misstatement in the segment.
3. Set preliminary judgment about materiality.
4. Allocate preliminary judgment about materiality to segments.
5. Compare combined estimate with preliminary judgment about materiality.
The correct sequence from start to finish would be
a. 1 2 5 4 3.
b. 3 4 2 1 5.
c. 4 3 1 5 2.
d. 5 1 3 2 4.

20.
medium
a

SAS No. 47 defines the preliminary judgment about materiality as the combined amount of
misstatements in the financial statements that would be considered material. This judgment
a. need not be quantified.
b. must be quantified.
c. must be quantified in terms of dollars.
d. must be quantified in terms of both dollars and of a percentage of sales.

21.
medium
b

Which of the following statements is not correct?

a. Materiality is a relative rather than an absolute concept.
b. Normally, the most important base used as the criterion for deciding materiality is total
assets.
c. Qualitative factors as well as quantitative factors affect materiality.
d. Given equal dollar amounts, frauds are usually considered more important than errors.

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22.
medium
a

Since materiality is relative, it is necessary to have bases for establishing whether

misstatements are material. Normally, the most common base for deciding what is material is
a. net income before taxes.
b. net working capital.
c. net income after taxes.
d. total assets.

23.
medium
d

Certain types of misstatements are likely to be more important than other types to users, even if
the dollar amounts are the same. Which of the following does not demonstrate this?
a. Amounts involving frauds are considered more important than errors of equal amount.
b. Misstatements that are otherwise minor may be considered material if there are possible
consequences arising from contractual obligations.
c. Misstatements that are otherwise immaterial may be material if they affect a trend in
earnings.
d. Each of the above demonstrates this concept.

24.
medium
b

The more effective the internal controls, the lower the risk factor that ______ assigned to
control risk.
a. should be.
b. could be.
c. is.
d. must be.

25.
medium
b

Allocating the preliminary judgment about materiality to segments of the financial statements
is necessary because
a. evidence is accumulated for the financial statements as a whole so the materiality doesnt
apply to them.
b. evidence is accumulated by segments rather than for the financial statements as a whole.
c. it is required by the AICPAs Code of Professional Conduct.
d. it is required by the SEC.

26.
medium
c

Which of the following statements is not correct?

a. Either an overstatement of an asset account or an understatement of a liability account
would have the same effect on the income statement.
b. A misclassification in the balance sheet will have no effect on operating income.
c. Either an overstatement of an asset account or an overstatement of a liability account
would have the same effect on the income statement.
d. Either an understatement of an asset account or an overstatement of a liability account
would have the same effect on the income statement.

27.
medium

Regardless of how the allocation of the preliminary judgment about materiality was done,
when the audit is complete the auditor must be confident that the combined errors in all
accounts are
a. less than the preliminary judgment.
b. equal to the preliminary judgment.
c. more than the preliminary judgment.
d. less than or equal to the preliminary judgment.

28.
medium
c

Auditors frequently refer to the terms audit assurance, overall assurance, and level of assurance
to refer to ________.
a. detection risk.
b. audit report risk.
c. acceptable audit risk.
d. none of the above.

29.
medium

When a different extent of evidence is needed for the various cycles, the difference is caused by
a. errors in the clients accounting system.

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b.
c.
d.

30.

If planned detection risk is reduced, the amount of substantive evidence the auditor
accumulates will
a. increase.
b. decrease.
c. remain unchanged.
d. be indeterminate.

medium
a

clients need to achieve an unqualified opinion.

the auditors need to follow GAAS.
the auditors expectations of errors and assessment of the control structure.

31.
medium
b

When discussing control risk (CR) and the audit risk model, which of the following statements
is not true?
a. CR is a measure of the auditors assessment of the likelihood that misstatements
exceeding a tolerable amount will not be prevented or detected by the clients internal
controls.
b. If the auditor concludes that internal control is completely ineffective to prevent or detect
errors, he/she would assign a 0% to CR.
c. The relationship between control risk and detection risk is inverse.
d. The relationship between control risk and evidence is direct.

32.
medium
d

Which of the following is not a good indicator of the degree to which statements are relied on
by external users?
a. Clients size, as measured by total assets or total revenue.
b. Distribution of ownership among the public.
c. Nature and amount of liabilities.
d. Amount of net income or loss after taxes.

33.
medium

In situations in which the auditor believes the chance of financial failure or loss is high, and
there is a corresponding increase in client business risk for the auditor, acceptable audit risk
should
a. be reduced.
b. be increased.
c. remain the same.
d. be calculated using a computerized statistical package.

34.
medium
a

When management has an adequate level of integrity for the auditor to accept the engagement
but cannot be regarded as completely honest in all dealings, auditors normally
a. reduce acceptable audit risk and increase inherent risk.
b. reduce inherent risk and control risk.
c. increase inherent risk and control risk.
d. increase acceptable audit risk and reduce inherent risk.

35.
medium
b

Many account balances require estimates and/or a great deal of management judgment. One
area that does not require such judgment would be
a. allowance for uncollectible accounts.
b. useful life of equipment for tax purposes.
c. obsolete inventory.
d. liability for warranty payments.

36.
medium
d

Inherent risk is reduced where the likelihood of defalcations is low. This would be true for an
account such as
a. inventory.
b. marketable securities.
c. cash.
d. accounts receivable.

37.
medium

The auditor assesses control risk and inherent risk. On a typical engagement, the auditor
would be least likely to assess these for

9-5

a.
b.
c.
d.

each audit objective.

each cycle.
each account.
the overall audit.

38.
medium
a

Acceptable 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.

39.
medium
d

When the auditor is attempting to determine the extent to which external users rely on a
clients financial statements, they may consider several factors including
a. client size.
b. concentration of ownership.
c. types and amounts of liabilities.
d. all of the above.

40.
medium
b

A major limitation in the application of the audit risk model is

a. the difficulty in defining the terms of the model.
b. the difficulty in measuring the components of the model.
c. the difficulty in understanding the effect on other factors in the model when one factor is
changed.
d. the failure of the Audit Standards Board (ASB) of the AICPA to accept it and incorporate
it into the SASs.

41.
medium
a

An auditor determines that a client has not accounted for a certain material item in conformity
with generally accepted accounting principles. This fact is prominently disclosed in a footnote
to the financial statements. The CPA does not agree with this departure from GAAP and
should
a. issue a qualified the opinion because of the deviation from generally accepted accounting
principles.
b. disclaim an opinion.
c. not allow the accounting treatment for this item to affect the type of opinion because the
deviation from generally accepted accounting principles was disclosed.
d. express an unqualified opinion and insert a middle paragraph emphasizing the matter by
reference to the footnote.

42.
medium
a

In determining the type of opinion to express, an auditor assesses the nature of the reporting
qualifications and the materiality of their effects. Materiality will be the primary factory
considered in the choice between
a. an except for opinion and an adverse opinion.
b. an except for opinion and a disclaimer of opinion.
c. an adverse opinion and a disclaimer of opinion.
d. a qualified opinion and a piecemeal opinion.

43.
challenging
a

When setting a preliminary judgment about materiality,

a. more evidence is required for a low dollar amount than for a high dollar amount.
b. less evidence is required for a low dollar amount than for a high dollar amount.
c. the same amount of evidence is required for either low or high dollar amounts.
d. there is no relationship between it and the dollar amount of evidence needed.

9-6

44.
challenging
b

When allocating materiality, most practitioners choose to allocate to

a. the income statement accounts because they are more important.
b. the balance sheet accounts because there are fewer.
c. both balance sheet and income statement accounts because there could be errors on either
one.
d. all of the financial statements because there could be errors on other statements besides
the income statement and balance sheet.

45.
challenging
c

The expectation of misstatements after considering the effect of internal control is most
appropriately thought of as
a. control risk and acceptable audit risk.
b. inherent risk.
c. the combination of inherent risk and control risk.
d. none of the above.

46.
challenging
c

Which one of the following statements about the cycle approach to auditing is not correct?
a. There are differences among cycles in the frequency and size of expected errors.
b. There are differences among cycles in the effectiveness of the internal control structure.
c. There are differences among cycles on the auditors willingness that material errors exist
after the auditing is complete.
d. It is common for auditors to want an equally low likelihood of errors for each cycle after
the auditor is finished.

47.
challenging
a

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. a different extent of evidence is needed for various cycles.
b. the same amount of evidence will be gathered for each cycle.
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%.

48.
challenging
c

Which of the following factors is least likely to contribute to opportunities leading to

misappropriation of assets?
a. Inadequate controls related to segregation of duties.
b. Not requiring mandatory vacations.
c. Disregard for the need to monitor or reduce risks of misappropriating assets.
d. Presence of large sums of cash or inventory items of high value.

49.

When discussing inherent risk (IR) and the audit risk model, which of the following is not
true?
a. IR is inversely related to planned detection risk.
b. IR is inversely related to evidence.
c. IR is the susceptibility of the financial statements to material error, assuming no internal
controls.
d. IR is the auditors assessment of the likelihood that errors exceeding a tolerable amount
exist in a segment before considering the effectiveness of internal accounting controls.

challenging
b

50.
challenging
d

When discussing acceptable audit risk (AAR) and the audit risk model, which of the following
statements is true?
a. The terms audit assurance, overall assurance, or level of assurance are synonyms for
AAR.
b. AAR is objectively determined by the auditor.
c. AAR is the risk that the auditor is willing to take that the financial statements are fairly
stated after the audit is completed and an unqualified opinion has been reached.
d. When the auditor decides on a lower acceptable audit risk, it means the auditor wants to
be more certain that the financial statements are not materially misstated.

51.

Which of the following is an example of the concept of inherent risk?

9-7

challenging
c

a.
b.
c.
d.

Humans make more errors than computers; therefore, a manual accounting system is
riskier than a computerized system.
Accounting systems with vouchers have many more controls built in, so the risk that
there will be errors on the financial statements is reduced.
Loans receivable for a finance company are less likely to be collectible than those of a
bank.
Audits with larger sample sizes are less risky than those with smaller sample sizes.

52.
challenging
D

Tolerable misstatement as set by the auditor

a. decreases acceptable audit risk.
b. increases inherent risk and control risk.
c. affects planned detection risk.
d. does not affect any of the four risks.

53.
challenging
C

The audit risk model is

a. a planning, testing, and evaluation model.
b. useful in evaluating results but of limited use in planning.
c. useful in planning, but of limited value in evaluating results.
d. useful when performing the tests of balances, but of little value in either the planning or
evaluation stages.

54.
challenging
B

Research in auditing has shown that if a revised risk is used in the audit risk model to
determine a revised planned detection risk, there is a danger of
a. not decreasing the evidence sufficiently.
b. not increasing the evidence sufficiently.
c. over-auditing.
d. increased lawsuits against the auditor for failure to follow GAAS.

55.
challenging
b

The audit risk against which the auditor requires reasonable protection is a combination of two
separate risks. The first of these is that material errors will occur in the accounting process by
which the financial statements are developed, and the second is that
a. a companys system of internal control is not adequate to detect errors and frauds.
b. those errors that occur will not be detected in the auditors examination.
c. management may possess an attitude that lacks integrity.
d. evidential matter is not competent enough for the auditor to form an opinion based on
reasonable assurance.

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56.
challenging
b

For financial reporting purposes, a change from straight-line to an accelerated depreciation

method was disclosed in a note to the financial statements and has an immaterial effect on the
current financial statements. It is expected, however, that the change will have a significant
effect on future periods. The auditor should express a(n)
a. qualified opinion.
b. unqualified opinion.
c. consistency exception.
d. adverse opinion.

57.
challenging
b

An auditor is confronted with an exception considered sufficiently material to warrant some

deviation from the standard unqualified auditors report. If the exception relates to a departure
from generally accepted accounting principles, the auditor must decide between expressing
a(n)
a. adverse opinion and an unqualified opinion with an explanatory paragraph.
b. adverse opinion and an except for opinion.
c. adverse opinion and a disclaimer of opinion.
d. disclaimer of opinion and an unqualifed opinion with an explanatory paragraph.

58.
challenging
A

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.

59.
challenging
A

For a reporting entity that has participated in related-party transactions that are material,
disclosure in the financial statements should include
a. the nature of the relationship and the terms and manner of settlement.
b. details of the transactions within major classifications.
c. a statement to the effect that a transaction was consummated on terms no less favorable
than those that would have been obtained if the transaction had been with an unrelated
party.
d. a reference to deficiencies in the entitys system of internal accounting control.

Essay Questions
60.
medium

Discuss the three main factors that affect an auditors preliminary judgment about materiality.

61.
medium

Due to qualitative factors, certain types of misstatements are likely to be more important to
users than others, even if the dollar amounts are the same. Identify two qualitative factors that

Answer:
The three main factors that affect an auditors judgment about materiality are:
Materiality is a relative rather than an absolute concept. A misstatement of a given
size might be material for a small company, whereas the same dollar misstatement
could be immaterial for a larger one.
Bases are needed for evaluating materiality. Since materiality is relative, it is
necessary to have bases for establishing whether misstatements are material. Net
income before taxes is normally the most commonly used base, but other possible
bases include current assets, total assets, current liabilities, and owners equity.
Qualitative factors also affect materiality. Certain types of misstatements are likely
to be more important to users than others, even if the dollar amounts are the same,
such as misstatements involving frauds.

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might significantly affect an auditors materiality judgment, and give an example of each.
Answer:
Qualitative factors that affect an auditors materiality judgment include:
Amounts involving fraud. Amounts involving fraud are usually considered more
important than unintentional errors of equal dollar amounts because fraud reflects on
the honesty and reliability of the management or other personnel involved. For
example, an intentional misstatement of inventory would be more important to users
than a clerical error in inventory of the same amount.
Misstatements affecting contractual obligations. Misstatements that are otherwise
minor may be material if there are possible consequences arising from contractual
obligations. For example, if a misstatement causes a required minimum account
balance to exceed the minimum, when the correct balance is less than the minimum,
this misstatement likely would be important to users.
Profit vs. loss. Misstatements that cause a loss to be reported as a profit or
misstatements that affect trends in earnings are likely to be important to users.
62.
medium

Explain why it is necessary to allocate the preliminary judgment about materiality to

individual accounts (segments) in the financial statements. Also explain why allocating to
balance sheet accounts is more common than allocating to income statement accounts.
Answer:
Allocating the preliminary judgment about materiality to individual segments is
necessary because evidence is accumulated for segments rather than for the financial
statements as a whole. Allocating to segments establishes a tolerable misstatement
amount for each segments, which helps the auditor decide the appropriate audit evidence
to accumulate for each segments. Most practitioners allocate materiality to balance sheet
accounts rather than income statement accounts because there are fewer balance sheet
than income statement accounts.

63.
medium

Why do most practitioners allocate the preliminary judgment about materiality to balance sheet
accounts?
Answer:
Most income statement misstatements have an equal effect on the balance sheet because
of the double-entry bookkeeping system. Because there are fewer balance sheet accounts
than income statement accounts in most audits and most audit procedures focus on
balance sheet accounts, allocating materiality to balance sheet accounts is the most
appropriate alternative.

64.
medium

Discuss how auditors use the audit risk model when planning an audit.
Answer:
The audit risk model is used primarily for planning purposes in deciding how much
evidence to accumulate in each cycle. The auditor decides an acceptable level of audit
risk, assesses inherent risk and control risk, and then uses the relationship depicted in the
following model to determine an appropriate level for planned detection risk:
PDR

65.
medium

AAR
IR x CR

Describe the audit risk model and each of its components.

Answer:
The planning form of the audit risk model is stated as follows:

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PDR
where:

=
PDR
AAR
IR
CR

AAR
IR x CR
=
=
=
=

planned detection risk

acceptable audit risk
inherent risk
control risk

Planned detection risk is a measure of the risk that audit evidence for an account will fail
to detect misstatements exceeding a tolerable amount, should such misstatements exist.
Planned detection risk determines the amount of substantive evidence that the auditor
plans to accumulate.
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 completed and an
unqualified opinion has been issued. It is influenced primarily by the degree to which
external users will rely on the statements, the likelihood that a client will have financial
difficulties after the audit report is issued, and the auditors evaluation of managements
integrity.
Inherent risk is a measure of the auditors assessment of the likelihood that there are
material misstatements in an account before considering the effectiveness of internal
control.
Control risk is a measure of the auditors assessment of the likelihood that misstatements
exceeding a tolerable amount in an account will not be prevented or detected by the
clients internal controls.
66.
medium

There are several factors that affect acceptable audit risk. Discuss three of these factors.
Answer:
Acceptable audit risk is affected by:
The degree to which external users will rely on the statements. For large, publicly
held clients, acceptable audit risk will be less, than for small, privately held clients,
ceteris paribus.
The likelihood that a client will have financial difficulties after the audit report is
issued. Acceptable audit risk will be lower, when the client is experiencing financial
difficulties.
The auditors evaluation of managements integrity. Acceptable audit risk will be
lower, when the clients management has questionable integrity.

67.
challenging

Discuss each of the five steps in applying materiality in an audit, and identify the audit
phase(s) in which each step is performed.
Answer:
Step 1. Set preliminary judgment about materiality. This is the combined amount of
misstatements in the financial statements that would be considered material. This
decision is made in the planning stage of the audit.
Step 2. Allocate preliminary judgment about materiality to segments. In this step, the
auditor normally allocates the preliminary judgment about materiality to the balance
sheet accounts. The amount of materiality allocated to an account is referred to as that
accounts tolerable misstatement. This allocation is performed in the audit planning
stage.
Step 3. Estimate total misstatement in segment. In this step, the auditor projects the
sample results to the population. An allowance for sampling risk is also calculated. This
would be performed after the substantive tests for each account are completed.
Step 4. Estimate the combined misstatement. In this step, the projected errors for each

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account are added, along with total sampling error, to calculate the combined
misstatement. This would be performed after all substantive tests have been completed.
Step 5. Compare combined estimated misstatement with preliminary or revised judgment
about materiality. If the combined estimated misstatement is less than or equal to the
judgment about materiality, then the auditor concludes the financial statements are fairly
presented. This would be performed after all substantive tests have been completed, in the
final review stage of the audit.

Other Objective Answer Format Questions

68.
easy

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.
1

1%

Inherent risk

SITUATION

10%

10%

5%

100%

100%

50%

20%

Control risk

100%

100%

40%

30%

Planned detection risk

______

______

______

Acceptable audit risk

Answer: 1. 1%;

2. 10%;

3. 50%;

______

4. 83.3%

69.
easy

Using your knowledge of the relationships among acceptable audit risk, inherent risk, control
risk, planned detection risk, tolerable misstatement, and planned evidence, state the effect on
planned evidence (increase or decrease) of changing each of the following factors, while the
other factors remain unchanged.

decrease
increase
Increase
decrease
decrease

1.
2.
3.
4.
5.

70.
Medium

Match six of the terms (a-i) with the definitions provided below (1-6):
a.
b.
c.
d.
e.
f.
g.
h.
i.

An increase in acceptable audit risk.

An increase in inherent risk.
A decrease in control risk.
An increase in planned detection risk.
An increase in tolerable misstatement.

.
.

.
.
.

Business risk
Preliminary judgment about materiality
Inherent risk
Planned detection risk
Audit assurance
Acceptable audit risk
Tolerable misstatement
Control risk
Materiality
1.

A measure of the risk that audit evidence for a segment will fail to detect
misstatements exceeding a tolerable amount, should such misstatements exist.

9-12

2.

The risk that the client will fail to achieve its objectives.

3.

A measure of the auditors assessment of the likelihood that misstatements

exceeding a tolerable amount in a segment will not be prevented or detected by
the clients internal controls.

4.

A measure of how much risk the auditor is willing to take that the financial
statements may be materially misstated after the audit is completed and an
unqualified audit opinion has been issued.

5.

The materiality allocated to any given account balance.

6.

The maximum amount by which the auditor believes that the statements could
be misstated and still not affect the decisions of reasonable users.

71.
medium

In practice, auditors rarely assign numerical probabilities to inherent risk, control risk, or
acceptable 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 planned detection risk and the amount of
evidence you would plan to gather (planned evidence) using the terms high, medium, or low.
SITUATION
1

Acceptable audit risk

Low

Low

High

High

Inherent risk

High

Low

Low

Low

Control risk

High

Low

Medium

Low

Planned detection risk

______

______

______

______

Planned evidence

______

______

______

______

Answer: 1.
2.
3.
4.
72.
challenging

low, high
high, low
medium, medium
high, low

The following graph shows three levels of acceptable audit risk (1%, 5%, 10%), three levels of
inherent risk control risk (Low, Medium, High), nine intersections (a through i), and nine
levels of required audit evidence (1 through 9).
During a typical audit engagement in which the acceptable level of audit risk is medium
(5%) and the assessed levels of inherent risk and control risk are medium, the required amount
of audit evidence would be medium (5 in the graph). Use the graph to determine what effect
(increase, decrease, or none) a change in acceptable audit risk, inherent risk, or control risk
would have on the amount of audit evidence you would gather.

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Low
IR x CR

Acceptable
Audit
Risk

10%
5%

Medium
IR x CR

High
IR x CR

d
b

g
e

1%

1 2 3

h
f

4 5 6

7 8

Amount of Audit
Evidence Required

Example: Compared to a typical audit (e/5), a decision to reduce your acceptable level of audit
risk would change the intersection to
, causing the amount of required evidence to
.
(Answer: f, increase to 6)
f,
incr. to 6

1. Compared to (e/5), a change from auditing a privately held company to auditing a

publicly held company would change the intersection to
, causing the amount of required
evidence to _______________.

b,
decr. to 2

2. Compared to (e/5), a decision to increase reliance on internal control would change the
intersection to
, causing required evidence to ______________________.

h,
incr. to 8

3. Compared to (e/5), a large increase in an account balance from the previous year would
change the intersection to
, causing required evidence to ___________________.

d,
decr. to 4

4. You determined during the planning phase of the audit that there has been a significant
improvement in the clients financial condition relative to the previous year, in which
acceptable audit risk was 5% and assessed risk was medium. This year, you would change the
intersection to
, causing required evidence to _______________________.

b,
decr. to 2

5. This is the second-year engagement, and there were good audit results in the previous
year. Compared to (e/5), you would change the intersection this year to
, causing the
amount of required evidence to ________________________.

h,
incr. to 8

6.
About halfway through the current years audit, you discover that the client is
constructing its own building during idle periods, using factory personnel. This is the first time
they have done this, and it was done at your recommendation. Compared to (e/5), the
intersection for the audit of the fixed assets account will change to
, causing the amount
of required evidence to
.

i,
incr. to 9

7. In a discussion with the client, you learn that management is planning to sell the business
in the next few months. Because of the planned changes, several key accounting personnel quit
several months ago. Compared to (e/5), the intersection will change to
, causing the
amount of required evidence to _______________________.

b,

8.

Compared to the audit of inventory in a manufacturing company in which acceptable

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decr. to 2

audit risk was 5% and assessed risk was medium (e/5), the intersection for the audit of prepaid
expenses will change to
, causing required evidence to ________________________.

73.
easy
a

The auditors preliminary judgment about materiality is the maximum amount by which the
auditor believes the financial statements could be misstated and still not affect the decisions of
reasonable users.
a. True
b. False

74.
easy
a

There is no precise definition of materiality in the professional literature.

a. True
b. False

75.
easy
a

Net income before taxes is normally the most important base for deciding what is material.
a. True
b. False

76.
easy
a

Most practitioners allocate the preliminary judgment about materiality to balance sheet, rather
than income statement, accounts.
a. True
b. False

77.
easy
a

The primary purpose of allocating the preliminary judgment about materiality to financial
statement accounts is to help the auditor decide the appropriate evidence to accumulate for
each account.
a. True
b. False

78.
easy
a

Auditors often use prior year financial statement balances to establish their preliminary
judgment about materiality in planning the current years audit.
a. True
b. False

79.
easy
b

If acceptable audit risk is low, and inherent risk and control risk are both high, then planned
detection risk should be high.
a. True
b. False
Inherent risk and planned detection risk are inversely related; i.e., as inherent risk increases,
planned detection risk should decrease, ceteris paribus.
a. True
b. False

80.
easy
a

81.
easy
b

Acceptable audit risk and planned detection risk are inversely related; i.e., as acceptable audit
risk increases, planned detection risk should decrease, ceteris paribus.
a. True
b. False

82.
easy
b

The most important element of the audit risk model is control risk.
a. True
b. False

83.
easy
b

Auditors are required to test any internal controls they believe have not been operating
effectively during the period under audit.
a. True
b. False

84.

If an auditor believes the client will have financial difficulties after the audit report is issued,

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easy
b

and external users will be relying heavily on the financial statements, the auditor will probably
set acceptable audit risk as high.
a. True
b. False

85.
medium
a

Auditors have difficulty applying the concept of materiality in practice because they often do
not know who the users of the financial statements are or what decisions will be made.
a. True
b. False

86.
medium
b

Statements on Auditing Standards provide detailed, objective guidance on how auditors are to
establish a preliminary materiality level, thus eliminating the need for subjective auditor
judgment in this task.
a. True
b. False

87.
medium
b

If the preliminary judgment of materiality increases, the amount of audit evidence required
will also increase.
a. True
b. False

88.
medium
b

Tolerable misstatement is the maximum combined total of all misstatements in the financial
statements that the auditor is willing to allow, or tolerate, when issuing a standard unqualified
opinion.
a. True
b. False
If an auditor assigns a tolerable misstatement of $1,000 to accounts payable, he or she would
need to obtain more audit evidence for that account than if $100,000 had been assigned.
a. True
b. False
To maximize audit efficiency, the auditor should allocate less tolerable misstatement to
accounts that can be verified by using low cost audit procedures, such as analytical procedures,
than to accounts that are more costly to audit.
a. True
b. False

89.
medium
a
90.
medium
a

91.
medium
a
92.
medium
a

Acceptable audit risk and the amount of substantive evidence required are inversely related;
i.e., as acceptable audit risk increases, the amount of substantive evidence the auditor plans to
accumulate should decrease.
a. True
b. False
Control risk and the amount of substantive evidence required are directly related; i.e., as
control risk increases, the amount of substantive evidence the auditor plans to accumulate
should increase.
a. True
b. False

93.
medium
b

Inherent risk and control risk are directly related; i.e., as inherent risk increases, control risk
also increases.
a. True
b. False

94.
medium
a

An acceptable audit risk assessment of low indicates a risky client requiring more extensive
evidence, assignment of more experienced personnel, and/or a more extensive review of audit
files.
a. True
b. False

95.

Audit assurance is the complement of planned detection risk, that is, one minus planned

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challenging
b

detection risk.
a. True
b. False

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