Chapter 12 – Multiple Choice Questions

12.2 If the acceptable level of detection risk decreases, the assurance directly provided from:

A. Substantive procedures should increase.

B. Substantive procedures should decrease.

C. Tests of controls should increase.

D. Tests of controls should decrease.

12.3 The auditor assesses control risk because:

A. It includes the aspects of non-sampling risk that are controllable.

B. It indicates where inherent risk may be the greatest.

C. It affects the level of detection risk the auditor may accept.

D. It needs to be reported on in the auditor's report.

12.4 Which of these is not considered a substantive procedure?

A. Analytical procedures.

B. Tests of controls.

C. Tests of details of transactions.

D. Tests of details of balances.

12.5 Which of these would not be considered to be a test of details of balances?

A. Accounts receivable confirmations.

B. Observing the entities stocktake.

C. Tracing an invoice to the sales journal.

D. Inspecting plant assets.

12.6 Which of these is not compatible with a high level of inherent and control risk?

A. Detection risk is low.

B. A larger sample should be used.

C. Year-end tests are preferable.

D. Substantive procedures are less effective.

12.7 The audit program is basically a list of:

A. Audit procedures to be performed.

B. Detailed audit objectives.

C. Account balances and their related assertions.

D. Control policies and procedures to be tested.

12.8 Extensive tests of details for an income statement account are least likely to be required when:

A. Analytical procedures reveal some unexpected fluctuations.

B. Inherent risk is high.

C. Detection risk is high.

D. Control risk is high.

12.9 What financial statement assertion is most often tested by CAATs?

A. Valuation.

B. Rights and obligations.

C. Measurement.

D. Disclosure.

12.10 Why are related party transactions a risk area for auditors?

A. They have minimal disclosure requirements.

B. They have a higher than average risk of irregularities.

C. They have a direct impact on profit.

D. They are difficult to assess.

Chapter 12 REVIEW questions

12.11 Which components of the audit risk model can be controlled by the auditor? Discuss the
interrelationships.

Detention risk (DR) – is the risk that auditor’s subsumptive procedures will not detect a material
misstatement.

Inherent Risk (IR) – Susceptibility of control balance or class of transactions to material misstatement
given inherent and environmental characteristics, but without regard to inherent control.

Control Risk (CR) – is the risk of material misstatement in the financial misstatement arising due to
absence or failure in the operation of relevant controls of the entity.

The risks vary inversely from one another. The less inherent or control risk the auditor believes exists,
the greater the acceptable detection risk. Conversely, the greater the inherent or control risk the
auditor believes to exists the less the acceptable detection risk.

In terms of which components can be controlled by the auditor, the only part would be detection risk
(ASA 200). This is varied based on the assessment of inherent risk and control risk. Inherent risk is
given for particular client, the auditor access it but cannot change it. Similarly, control risk is given for
a particular client, however if control risk is medium or low the auditor may choose to rely on controls
and will therefore have to perform some compliance testing. Audit risk is specified for the auditor, but
it probably constant for the majority of the clients of audit firm.

12.12 Identify and explain the three steps in assessing the risk of material misstatement.

Step 1 Evaluate the type of potential misstatements that may occur

The auditor needs to recognise risk factors and then like those risk factors to accretion that are likely
to be misstated. Some risk may have a pervasive effect on the financial statements and may influence
multiple account balances and assertions while other risk factors will be asserted specific.

Step 2 Evaluate the magnitude of potential misstatement

Some potential misstatements are more significant than others so the auditor needs to consider their
magnitude. For example, the existence of inventory is more significant for a manufacturer than for a
hotel. Auditor will need to allocate more audit attention to the assertions that can have a potential
material effect, individually or in aggregate, on the financial statements.

Step 3 Evaluate the likelihood or material misstatement

The auditor must also determine how likely a possible material misstatement is. Once the auditor has
identified the various risks that might affect the financial statements they should then access the
adequacy of the system of internal controls. The greater the effectiveness of internal controls, the less
the likelihood of material misstatement.

12.13 Give three reasons why the predominantly substantive approach can be more suitable to
smaller entities.

 Small clients may not have adequate resources to implement all appropriate controls.
 Controls may not be as effective due to the lack of resources (e.g. due to a lack of segregation
of duties).
 The size of the entity may make it inefficient for the auditor to rely on controls in performing
the audit.

12.14 Identify the three types of substantive procedures and discuss the effectiveness of each.

The three types of substantive procedures are;

Analytical procedures - consist of the study and comparison of relationships among data. These
procedures have proven quite effective in detecting large misstatements in the financial reports and
tend to be least costly of substantive procedures.

Test of details of transactions - primarily involve tracing and vouching the individual debt and credit
entries in the account. When these procedures involve highly appropriate evidence such as externally
generated documents, they can be quite effective. They tend to be more costly than analytical
procedures, but less costly than tests of details of balance.

Test of details of balances - verify the ending account balances directly, without any explicit reference
to the individual debit and credit entries. These procedures tend to be most effective and costly since
they often involve the most competent forms of evidence such as auditor observation and
confirmation from outsiders.

12.15 Why are cut-off tests a special category of tests of details of transactions?

Cut off tests – are a special category of test of details of transactions that are related more to the
closing balance than to transactions.

- It is much more important at the end of the reporting period to ensure that transactions are
recorded on the correct date, given the impact on the financial statements.

The purpose of cut-off tests is to ensure:

1. Completeness (in that all transactions occurring before the end of the reporting period are
recorded), and

2. Existence (in that transactions occurring after the end of the reporting periods are recorded
and excluded).

Test of details of balances

 Test of details of balances focus on obtaining evidence directly about an ending account
balance.
 An example would be verifying amounts owed by an individual customer recorded in the
accounts receivable ledger, by confirming the balance directly with the customer.
 Extend of the testing is dependent on the outcome of tests of controls and tests of details of
transactions.

The auditor may also inspect plant assets, observe the entities stocktake and perform pricing test of
the closing inventory.
The effectiveness of these tests also depends on the procedure performed and the type of evidence
obtained.

Tests of details of balances are the main ways of collecting evidence for the balances that make up
the balance sheet.

From an audit point of view, it is very important that profit is not overstated which means ensuring
that assets are not overstated and liabilities are not understand.

Many of these tests are of ending balances and are essential to the conduct of the audit because the
evidence is obtained from a source independent of the client and is thus considered to be highly
reliable.

Assertions (Test of controls)

Assertions about classes of transactions
- Occurrence
- Completeness
- Accuracy
- Cut-off
- Classification
Assertions about account balances
- Existence
- Completeness
- Rights and obligations
- Valuation and allocation
- Classification

12.16 Explain why there is an increased audit risk from conducting procedures before the end of the
reporting period and identify two ways in which this increased risk is controlled.

12.17 Why may an auditor decide to perform tests of details on income statement accounts rather
than relying on analytical review?
12.18 How can generalised software be used to assist in performing substantive procedures during
the audit?

12.19 What steps may the auditor perform in evaluating the reasonableness of accounting
estimates?

12.20 Why is the audit of related party transactions a particular risk area for auditors?