Accounting, Financial, Taxation

Problem:
8. Which of the following would an auditor most likely use in determining the auditor’s preliminary judgment about materiality?
a. The anticipated sample size of the planned substantive tests.
b. The entity’s annualized interim financial statements.
c. The results of the internal control questionnaire.
d. The contents of the management representation letter.

Answer & Explaination:
8. (b) The requirement is to identify the information that an auditor would most likely use in determining a preliminary judgment about materiality. Answer (b) is correct because many materiality measures relate to an annual figure (e.g., net income, sales). Answer (a) is incorrect because the preliminary judgment about materiality is a factor used in determining the anticipated sample size, not the reverse as suggested by the reply. Answers (c) and (d) are incorrect because materiality will not normally be affected by the results of the internal control questionnaire or the contents of the management representation letters.

Problem:
9. Which of the following statements is not correct about materiality?
a. The concept of materiality recognizes that some matters are important for fair presentation of financial statements in conformity with GAAP, while other matters are not important.
b. An auditor considers materiality for planning purposes in terms of the largest aggregate level of misstatements that could be material to any one of the financial statements.
c. Materiality judgments are made in light of surrounding circumstances and necessarily involve both quantitative and qualitative judgments.
d. An auditor’s consideration of materiality is influenced by the auditor’s perception of the needs of a reasonable person who will rely on the financial statements.

Answer & Explaination:
9. (b) The requirement is to identify the statement that is not correct concerning materiality. Answer (b) is the proper reply because the auditor considers materiality for planning purposes in terms of the smallest, not the largest, aggregate amount of misstatement that could be material to any one of the financial statements. Answers (a), (c), and (d) all represent correct statements about materiality.

Problem:
10. Which of the following elements underlies the application of generally accepted auditing standards, particularly the standards of fieldwork and reporting?
a. Internal control.
b. Corroborating evidence.
c. Quality control.
d. Materiality and relative risk.

Answer & Explaination:
10. (d) The requirement is to identify the elements which underlie the application of generally accepted auditing standards, particularly the standards of fieldwork and reporting. Answer (d) is correct because AU 150 states that materiality and relative risk underlie the application of all the standards. Answer (a) is incorrect because a consideration of internal control is one of the field standards, not an element underlying the standards. Answer (b) is incorrect because the second fieldwork standard, on evidence, relates most directly to corroborating evidence. Answer (c) is incorrect because while it is accurate that quality control standards encompass the firm’s policies and procedures to provide reasonable assurance of conforming with professional standards, the standards are not related more directly to the fieldwork and reporting standards than to the general group of generally accepted auditing standards.

Problem:
11. In considering materiality for planning purposes, an auditor believes that misstatements aggregating $10,000 would have a material effect on an entity’s income statement, but that misstatements would have to aggregate $20,000 to materially affect the balance sheet. Ordinarily, it would be appropriate to design auditing procedures that would be expected to detect misstatements that aggregate
a. $10,000
b. $15,000
c. $20,000
d. $30,000

Answer & Explaination:
11. (a) The requirement is to determine the appropriate level of materiality for planning purposes when $10,000 would have a material effect on an entity’s income statement, but $20,000 would materially affect the balance sheet. AU 312 states that the audit should be designed to obtain reasonable assurance about whether the financial statements are free of material misstatement. Because it will ordinarily be difficult to anticipate during the planning stage of an audit whether all misstatements will affect only one financial statement, the auditor is generally required to use the lower financial statement figure for most portions of planning. Therefore, answer (a), $10,000, is correct. Answers (b), (c), and (d) are all incorrect because they are dollar amounts which exceed the lowest level of materiality.

Problem:
12. Which of the following would an auditor most likely use in determining the auditor’s preliminary judgment about materiality?
a. The results of the initial assessment of control risk.
b. The anticipated sample size for planned substantive tests.
c. The entity’s financial statements of the prior year.
d. The assertions that are embodied in the financial statements.

Answer & Explaination:
12. (c) The requirement is to identify the information that an auditor would be most likely to use in making a preliminary judgment about materiality. Answer (c) is correct because auditors often choose to use a measure relating to the prior year’s financial statements (e.g., a percentage of total assets, net income, or revenue) to arrive at a preliminary judgment about materiality. Answer (a) is incorrect because materiality is based on the magnitude of an omission or misstatement and not on the initial assessment of control risk. Answer (b) is incorrect because while an auditor’s materiality judgment will affect the anticipated sample size for planned substantive tests, sample size does not affect the materiality judgment. Answer (d) is incorrect because the assertions embodied in the financial statements remain the same from one audit to another. See AU 312 for information on materiality and AU 326 for information on financial statement assertions.

Problem:
13. Holding other planning considerations equal, a decrease in the amount of misstatement in a class of transactions that an auditor could tolerate most likely would cause the auditor to
a. Apply the planned substantive tests prior to the balance sheet date.
b. Perform the planned auditing procedures closer to the balance sheet date.
c. Increase the assessed level of control risk for relevant financial statement assertions.
d. Decrease the extent of auditing procedures to be applied to the class of transactions.

Answer & Explaination:
13. (b) The requirement is to identify the most likely effect of a decrease in the tolerable amount of misstatement (tolerable misstatement) in a class of transactions. Answer (b) is correct because AU 312 states that decreasing the tolerable amount of misstatement will require the auditor to do one or more of the following: (1) perform auditing procedures closer to the balance sheet date (answer [b]); (2) select a more effective auditing procedure; or (3) increase the extent of a particular auditing procedure. Answer (a) is incorrect because in such a circumstance substantive tests are more likely to be performed at or after the balance sheet date than prior to the balance sheet date. Answer (c) is incorrect because decreasing the tolerable amount of misstatement will not necessarily lead to an increase in the assessed level of control risk. Answer (d) is incorrect because the extent of auditing procedures will be increased, not decreased.

Problem:
14. When issuing an unqualified opinion, the auditor who evaluates the audit findings should be satisfied that the
a. Amount of known misstatement is documented in the management representation letter.
b. Estimate of the total likely misstatement is less than a material amount.
c. Amount of known misstatement is acknowledged and recorded by the client.
d. Estimate of the total likely misstatement includes the adjusting entries already recorded by the client.

Answer & Explaination:
14. (b) The requirement is to identify the necessary condition for an auditor to be able to issue an unqualified opinion. Answer (b) is correct because if the estimate of likely misstatement is equal to or greater than a material amount a material departure from generally accepted accounting principles exists and thus AU 508 requires either a qualified or adverse opinion in such circumstances. Answer (a) is incorrect because the amount of known misstatement (if any) need not be documented in the management representation letter. Answer (c) is incorrect because it ordinarily is not necessary for the client to acknowledge and record immaterial known misstatements. Answer (d) is incorrect because the total likely misstatement need not include the adjusting entries already recorded by the client. See AU 312 for guidance on the evaluation of audit findings involving misstatements.

AUDIT RISK
Problem:
1. As the acceptable level of detection risk decreases, an auditor may
a. Reduce substantive testing by relying on the assessments of inherent risk and control risk.
b. Postpone the planned timing of substantive tests from interim dates to the year-end.
c. Eliminate the assessed level of inherent risk from consideration as a planning factor.
d. Lower the assessed level of control risk from the maximum level to below the maximum.

Answer & Explaination:
1. (b) The requirement is to determine a likely auditor reaction to a decreased acceptable level of detection risk. Answer (b) is correct because postponement of interim substantive tests to year-end decreases detection risk by reducing the risk for the period subsequent to the performance of those tests; other approaches to decreasing detection risk include changing to more effective substantive tests and increasing their extent. Answer (a) is incorrect because increased, not reduced, substantive testing is required. Answer (c) is incorrect because inherent risk must be considered in planning, either by itself or in combination with control risk. Answer (d) is incorrect because tests of controls must be performed to reduce the assessed level of control risk.

Problem:
2. The risk that an auditor will conclude, based on substantive tests, that a material misstatement does not exist in an account balance when, in fact, such misstatement does exist is referred to as
a. Sampling risk.
b. Detection risk.
c. Nonsampling risk.
d. Inherent risk.

Answer & Explaination:
2. (b) The requirement is to identify the risk that an auditor will conclude, based on substantive tests, that a material error does not exist in an account balance when, infact, such error does exist. Answer (b) is correct because detection risk is the risk that the auditor will not detect a material misstatement that exists in an assertion. Detection risk may be viewed in terms of two components (1) the risk that analytical procedures and other relevant substantive tests would fail to detect misstatements equal to tolerablemisstatement, and (2) the allowable risk of incorrect acceptance for the substantive tests of details. Answer (a) is incorrect because sampling risk arises from the possibility that, when a test of controls or a substantive test is restricted to a sample, the auditor’s conclusions may be different from the conclusions he or she would reach if the tests were applied in the same way to all items in the account balance or class of transactions. When related to substantive tests sampling risk is only a part of the risk that the auditor’s substantive tests will not detect a material misstatement. Answer (c) is incorrect because nonsampling risk includes only those aspects of audit risk that are not due to sampling. Answer (d) is incorrect because inherent risk is the susceptibilityof an assertion to a material misstatement, assuming that there are no related controls.

Problem:
3. As the acceptable level of detection risk decreases, the assurance directly provided from
a. Substantive tests should increase.
b. Substantive tests should decrease.
c. Tests of controls should increase.
d. Tests of controls should decrease.

Answer & Explaination:
3. (a) The requirement is to identify an effect of a decrease in the acceptable level of detection risk. Answer (a) is correct because as the acceptable level of detection risk decreases, the assurance provided from substantive tests should increase. To gain this increased assurance the auditors may (1) change the nature of substantive tests to more effective procedures (e.g., use independent parties outside the entity rather than those within the entity), (2) change the timing of substantive tests (e.g., perform them at year-end rather than at an interim date), and (3) change the extent of substantive tests (e.g., take a larger sample). Answer (b) is incorrect because the assurance provided from substantive tests increases, it does not decrease. Answers (c) and (d) are incorrect because the acceptable level of detection risk is based largely on the assessed levels of control risk and inherent risk. Accordingly, any tests of controls will already have been performed.

Problem:
5. Inherent risk and control risk differ from detection risk in that they
a. Arise from the misapplication of auditing procedures.
b. May be assessed in either quantitative or nonquantitative terms.
c. Exist independently of the financial statement audit.
d. Can be changed at the auditor’s discretion.

Answer & Explaination:
5. (c) The requirement is to determine a manner in which inherent risk and control risk differ from detection risk. Answer (c) is correct because inherent risk and control risk exist independently of the audit of the financial statements as functions of the client and its environment, whereas detection risk relates to the auditor’s procedures and can be changed at his or her discretion. Answer (a) is incorrect because inherent risk and control risk are functions of the client and its environment and do not arise from misapplication of auditing procedures. Answer (b) is incorrect because inherent risk, control risk and detection risk may each be assessed in either quantitative or nonquantitative terms. Answer (d) is incorrect because inherent risk and control risk are functions of the client and its environment, they cannot be changed at the auditor’s discretion. However, the assessed levels of inherent and control risk (not addressed in this question) may be affected by auditor decisions relating to the cost of gathering evidence to substantiate assessed levels below the maximum.

Problem:
6. On the basis of the audit evidence gathered and evaluated, an auditor decides to increase the assessed level of control risk from that originally planned. To achieve an overall audit risk level that is substantially the same as the planned audit risk level, the auditor would
a. Decrease substantive testing.
b. Decrease detection risk.
c. Increase inherent risk.
d. Increase materiality levels.

Answer & Explaination:
6. (b) The requirement is to determine the best way for an auditor to achieve an overall audit risk level when the audit evidence relating to control risk indicates the need to increase its assessed level. Answer (b) is correct because a decrease in detection risk will allow the auditor achieve an overall audit risk level substantially the same as planned. Answer (a) is incorrect because a decrease in substantive testing will increase, not decrease, detection risk and thereby increase audit risk. Answer (c) is incorrect because an increase in inherent risk will also increase audit risk. Answer (d) is incorrect because there appears to be no justification for increasing materiality levels beyond those used in planning the audit.

Problem:
7. Relationship between control risk and detection risk is ordinarily
a. Parallel.
b. Inverse.
c. Direct.
d. Equal.

Answer & Explaination:
7. (b) The requirement is to determine the relationship between control risk and detection risk. Inverse is correct because as control risk increases (decreases) detection risk must decrease (increase).