Multiple-Choice Questions
1. If it is probable that the judgment of a reasonable person would have been changed or
easy influenced by the omission or misstatement of information, then that information is, by
a definition of FASB Statement No. 2:
a. material.
b. insignificant.
c. significant.
d. relevant.
2. The preliminary judgment about materiality is the amount by which the auditor
easy believes the statements could be misstated and still not affect the decisions of reasonable users.
b a. minimum
b. maximum
c. mean average
d. median average
3. Auditors are responsible for determining whether financial statements are materially misstated,
easy so upon discovering a material misstatement they must bring it to the attention of:
d a. regulators.
b. the audit firm’s managing partner.
c. no one in particular.
d. the client’s management.
4. The FASB definition of materiality emphasizes what class of financial statement users?
easy a. Regulators.
c b. Informed investors.
c. Reasonable persons.
d. Potential investors.
5. When auditors allocate the preliminary judgment about materiality to account balances, the
easy materiality allocated to any given account balance is referred to as:
d a. the materiality range.
b. the error range.
c. tolerable materiality.
d. tolerable misstatement.
7. Auditors are _____ to decide on the combined amount of misstatements in the financial
easy statements that they would consider material early in the audit.
b a. permitted
b. required
c. not allowed
d. strongly encouraged
8. If an auditor establishes a relatively high level for materiality, then the auditor will:
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easy a. accumulate more evidence than if a lower level had been set.
b b. accumulate less evidence than if a lower level had been set.
c. accumulate approximately the same evidence as would be the case were materiality lower.
d. accumulate an undetermined amount of evidence.
9. The preliminary judgment about materiality and the amount of audit evidence accumulated are
easy _____ related.
d a. directly
b. indirectly
c. not
d. inversely
10. After the preliminary judgment about materiality has been established, auditors may:
easy a. not adjust it.
d b. adjust it downward only.
c. adjust it upward only.
d. adjust it either downward or upward.
11. In an audit area that has a lower inherent risk, it would be prudent to:
easy a. increase the amount of audit evidence gathered.
c b. assign more experienced staff to that area.
c. increase the tolerable misstatement for the area.
d. expand planning procedures.
12. Which of the following is least likely to be appropriate as the basis for determining the
easy preliminary judgment about materiality in the audit of financial statements?
d a. Net income before taxes.
b. Current assets.
c. Owners’ equity.
d. Inventory.
13. Auditing standards _____ that the basis used to determine the preliminary judgment about
easy materiality be documented in the audit files.
c a. permit
b. do not allow
c. require
d. strongly encourage
14. Amounts involving fraud are usually considered _____ important than unintentional errors of
easy equal dollar amounts.
d a. less
b. no less
c. no more
d. more
15. Which of the following qualitative factors may significantly influence whether an item is
easy deemed to be material?
a
Misstatements that are otherwise
minor may be material if there are Misstatements that are otherwise immaterial
possible consequences arising from may be material if they affect a trend in
contractual obligations. earnings
a. Yes Yes
b. No No
c. Yes No
d. No Yes
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16. Auditors generally allocate the preliminary judgment about materiality to the:
easy a. balance sheet only.
a b. income statement only.
c. income statement and balance sheet.
d. statement of cash flows.
18. Auditors begin their assessments of inherent risk during audit planning. Which of the following
easy would not help in assessing inherent risk during the planning phase?
a a. Obtaining client’s agreement on the engagement letter.
b. Obtaining knowledge about the client’s business and industry.
c. Touring the client’s plant and offices.
d. Identifying related parties.
19. Auditors commonly allocate materiality to balance sheet accounts rather than income statement
medium accounts because most income statement misstatements have a(n) _____ effect on the balance
b sheet.
a. reduced
b. equal
c. undetermined
d. increased
20. Which of the following is not a correct statement regarding the allocation of the preliminary
medium judgment about materiality to balance sheet accounts?
b a. Auditors expect certain accounts to have more misstatements than others.
b. The allocation has virtually no effect on audit costs because the auditor must collect
sufficient appropriate audit evidence.
c. Auditors expect to identify overstatements as well as understatements in the accounts.
d. Relative audit costs affect the allocation.
21. What is the primary means of dealing with risk in planning decisions related to audit evidence?
medium a. Selection of more effective tests of details of balances.
b b. Application of the audit risk model.
c. Establishing a lower preliminary judgment about materiality.
d. Allocating materiality judgment to segments.
22. The phrase “in our opinion” in the auditor’s report is intended to inform users that auditors:
medium a. guarantee fair presentation of the financial statements.
d 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.
23. Inherent risk is _______ related to detection risk and _______ related to the amount of audit
medium evidence.
d a. directly, inversely
b. directly, directly
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c. inversely, inversely
d. inversely, directly
24. The five steps in applying materiality are listed below in random order.
medium 1. Estimate the combined misstatement.
b 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.
26. Since materiality is relative, it is necessary to have bases for establishing whether misstatements
medium are material. Normally, the most common base for deciding materiality is:
a a. net income before taxes.
b. net working capital.
c. net income after taxes.
d. total assets.
27. Certain types of misstatements are likely to be more important than other types to users, even if
medium the dollar amounts are the same. Which of the following demonstrates this?
a
Amounts involving frauds are Misstatements that are otherwise immaterial
considered more important than may be material if they affect a trend in
errors of equal amount earnings.
a. Yes Yes
b. No No
c. Yes No
d. No Yes
28. Allocating the preliminary judgment about materiality to financial statements segments is
medium necessary because:
b a. evidence is accumulated for the financial statements as a whole so materiality does not
apply to them.
b. evidence is accumulated by segments rather than for the financial statements as a whole.
c. it is required by the AICPA’s Code of Professional Conduct.
d. it is required by the SEC.
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30. Regardless of how the preliminary judgment about materiality is allocated, the auditor must be
medium confident that total combined misstatements in all accounts are:
d 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.
31. Auditors frequently refer to the terms audit assurance, overall assurance, and level of assurance
medium to refer to ________.
c a. detection risk
b. audit report risk
c. acceptable audit risk
d. inherent risk
32. _____ misstatements are those where the auditor can determine the amount of the misstatement
medium in the account.
c a. Potential
b. Likely
c. Known
d. Projected
33. When a different extent of evidence is needed for the various cycles, the difference is caused
by:
medium a. errors in the client’s accounting system.
d b. a client’s need to achieve an unqualified opinion.
c. an auditor’s need to follow auditing standards.
d. an auditor’s expectations of errors and assessment of internal control.
34. If planned detection risk is reduced, the amount of evidence the auditor accumulates will:
medium a. increase.
a b. decrease.
c. remain unchanged.
d. be indeterminate.
36. When discussing control risk (CR) and the audit risk model, which of the following is false?
medium a. CR is a measure of the auditor’s assessment of the likelihood that misstatements will not
b be prevented or detected by internal control.
b. If the auditor concludes that internal control is completely ineffective to prevent or detect
errors, he/she would assign a low value (e.g., 0%) to CR.
c. The relationship between control risk and detection risk is inverse.
d. The relationship between control risk and evidence needed to support account balances is
direct.
37. Which of the following is not a good indicator of the degree to which statements are relied on
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medium by external users?
d a. Client’s 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.
38. If an auditor believes the chance of financial failure is high and there is a corresponding
medium increase in business risk for the auditor, acceptable audit risk would likely:
a a. be reduced.
b. be increased.
c. remain the same.
d. be calculated using a computerized statistical package.
39. When management has an adequate level of integrity for the auditor to accept the engagement
medium but cannot be regarded as completely honest in all dealings, auditors normally:
a 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.
40. One accounting issue that does not require management to use significant judgments is:
medium a. the allowance for doubtful accounts.
b b. the useful life of equipment for tax purposes.
c. obsolete inventory.
d. the liability for warranty payments.
42. The auditor typically does not assess control risk and inherent risk for:
medium a. each audit objective.
d b. each cycle.
c. each account.
d. the overall audit.
43. (Public) To what extent do auditors typically rely on internal controls of their public company clients?
medium a. Extensively
a b. Only very little
c. Infrequently
d. Never
44. Auditors typically rely on internal controls of their private company clients:
medium a. Only as needed to complete the audit and satisfy Sarbanes-Oxley requirements.
b b. Only if the controls are determined to be effective.
c. Only if the client asks an auditor to test controls.
d. Only if the controls are sufficient to increase Control Risk to an acceptable level.
45. Acceptable audit risk is ordinarily set by the auditor during planning and:
medium a. held constant for each major cycle and account.
a 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.
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46. When the auditor is attempting to determine the extent to which external users rely on a client’s
medium financial statements, they may consider several factors except for:
d a. client size.
b. concentration of ownership.
c. types and amounts of liabilities.
d. assessment of detection risk.
47. A major difficulty in the application of the audit risk model is:
medium a. defining the terms of the model.
b b. measuring the components of the model.
c. understanding the effect on other factors in the model when one factor is changed.
d. the failure of the Audit Standards Board to accept it and incorporate it into standards.
medium Jointly to determine the risk of Separately and combine their effects in the
a material misstatement audit risk model
a. Yes Yes
b. No No
c. Yes No
d. No Yes
52. Which one of the following statements about the cycle approach to auditing is not correct?
challenging a. There are differences among cycles in the frequency and size of expected errors.
c b. There are differences among cycles in the effectiveness of internal controls.
c. There are differences among cycles on the auditor’s willingness to accept risk 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.
53. When the auditor has the same level of willingness to risk that material misstatements will exist
challenging after the audit is finished for all financial statement cycles:
a a. a different extent of evidence will likely be needed for various cycles.
b. the same amount of evidence will be gathered for each cycle.
c. the auditor 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%.
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54. Which of the following statements is not true?
challenging a. Inherent risk is inversely related to detection risk.
b b. Inherent risk is inversely related to evidence.
c. Inherent risk is the susceptibility of the financial statements to material error, assuming no
internal controls.
d. Inherent risk is the auditor’s assessment of the likelihood that errors exceeding a tolerable
amount exist in a segment before considering the effectiveness of internal controls.
55. Which of the following is not a primary consideration when assessing inherent risk?
challenging a. Nature of client’s business.
c b. Existence of related parties.
c. Frequency and intensity of management’s review of accounting transactions and records.
d. Susceptibility to defalcation.
58. Which of the following underlies the application of generally accepted auditing standards,
challenging particularly the standards of fieldwork and reporting?
a 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.
Essay Questions
59. Discuss the three main factors that affect an auditor’s preliminary judgment about materiality.
medium
Answer:
The three main factors that affect an auditor’s 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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60. Due to qualitative factors, certain types of misstatements are likely to be more important to
medium users than others, even if the dollar amounts are the same. Identify two qualitative factors that
might significantly affect an auditor’s materiality judgment, and give an example of each.
Answer:
Qualitative factors that affect an auditor’s 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.
61. Explain why it is necessary to allocate the preliminary judgment about materiality to individual
medium 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 accounts is necessary
because evidence is accumulated for accounts rather than for the financial statements as a
whole. Allocating to accounts establishes a tolerable misstatement amount for each
account, which helps the auditor decide the appropriate audit evidence to accumulate for
each account. Most practitioners allocate materiality to balance sheet accounts rather than
income statement accounts because there are fewer balance sheet than income statement
accounts.
62. Why do most practitioners allocate the preliminary judgment about materiality to balance sheet
medium 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.
63. Discuss how auditors use the audit risk model when planning an audit.
medium
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 = AAR
IR x CR
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64. Describe the audit risk model and each of its components.
medium
Answer:
The planning form of the audit risk model is stated as follows:
PDR = AAR
IR x CR
65. There are several factors that affect an audit firm’s business risk and, therefore, acceptable audit
medium risk. Discuss three of these factors.
Answer:
Business risk and acceptable audit risk are affected by:
The degree to which external users will rely on the statements. For large, publicly
held clients, business risk is greater, and acceptable audit risk will be less, than for
small, privately held clients, all things being equal.
The likelihood that a client will have financial difficulties after the audit report is
issued. Business risk is greater, and acceptable audit risk will be lower, when the
client is experiencing financial difficulties.
The auditor’s evaluation of management’s integrity. Business risk is greater and
acceptable audit risk will be lower when the client’s management has questionable
integrity.
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66. Discuss each of the five steps in applying materiality in an audit, and identify the audit phase(s)
challenging in which each step is performed. List these steps in the order in which they occur.
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 account’s
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
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.
67. Below are four situations that involve the audit risk model as it is used for planning audit
easy evidence requirements in the audit of inventory. For each situation, calculate planned detection
risk.
SITUATION
1 2 3 4
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68. Using your knowledge of the relationships among acceptable audit risk, inherent risk, control
easy 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.
69. Match nine of the terms (a-i) with the definitions provided below (1-9):
medium
a. Business risk
b. Preliminary judgment about materiality
c. Inherent risk
d. Planned detection risk
e. Audit assurance
f. Acceptable audit risk
g. Tolerable misstatement
h. Control risk
i. Materiality
d 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.
a 2. The risk that the auditor or audit firm will suffer harm because of a client
relationship, even though the audit report rendered for the client was correct.
f 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.
b 6. The maximum amount by which the auditor believes that the statements could
be misstated and still not affect the decisions of reasonable users.
c 9. A measure of the auditor’s assessment of the likelihood that there are material
misstatements before considering the effectiveness of internal control.
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70. In practice, auditors rarely assign numerical probabilities to inherent risk, control risk, or
medium 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 2 3 4
71. The auditor’s preliminary judgment about materiality is the maximum amount by which the
easy auditor believes the financial statements could be misstated and still not affect the decisions of
a reasonable users.
a. True
b. False
73. The FASB definition of materiality focuses on potential users of financial statements.
easy a. True
b b. False
74. Net income before taxes is normally the most important base for deciding materiality.
easy a. True
a b. False
75. Most practitioners allocate the preliminary judgment about materiality to income statement
easy accounts.
b a. True
b. False
76. The primary purpose of allocating the preliminary judgment about materiality to financial
easy statement accounts is to help the auditor decide the appropriate evidence to accumulate.
a a. True
b. False
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77. Auditors cannot use prior year financial statement balances to establish their preliminary
easy judgment about materiality in planning the current year’s audit.
b a. True
b. False
78. If acceptable audit risk is low, and inherent risk and control risk are both high, then planned
easy detection risk should be high.
b a. True
b. False
79. Inherent risk and planned detection risk are inversely related; i.e., as inherent risk increases,
easy planned detection risk should decrease, ceteris paribus.
a a. True
b. False
80. Acceptable audit risk and planned detection risk are inversely related; i.e., as acceptable audit
easy risk increases, planned detection risk should decrease, ceteris paribus.
b a. True
b. False
81. The most important element of the audit risk model is control risk.
easy a. True
b b. False
82. For a private company client, auditors are required to test any internal controls they believe
easy have not been operating effectively during the period under audit.
b a. True
b. False
83. If an auditor believes the client will have financial difficulties after the audit report is issued,
easy and external users will be relying heavily on the financial statements, the auditor will probably
a set acceptable audit risk as low.
a. True
b. False
84. Achieved detection risk can be reduced only by accumulating more audit evidence.
medium a. True
b b. False
85. Auditors have difficulty applying the concept of materiality in practice because they often do
medium not know who the users of the financial statements are or what decisions will be made.
a a. True
b. False
86. The audit risk model that must be used for planning audit procedures and evaluating audit
medium results is: AcAR = IR x CR x AcDR.
b a. True
b. False
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87. Statements on Auditing Standards provide detailed, objective guidance on how auditors are to
medium establish a preliminary materiality level, thus eliminating the need for subjective auditor
b judgment in this task.
a. True
b. False
88. If the preliminary judgment of materiality increases, the amount of audit evidence required will
medium also increase.
b a. True
b. False
89. Insert risk and control risk are normally assessed for the overall audit.
medium a. True
b b. False
90. Tolerable misstatement is the maximum combined total of all misstatements in the financial
medium statements that the auditor is willing to allow, or tolerate, when issuing a standard unqualified
b opinion.
a. True
b. False
91. If an auditor assigns a tolerable misstatement of $1,000 to accounts payable, he or she would
medium need to obtain more audit evidence for that account than if $100,000 had been assigned.
a a. True
b. False
92. To maximize audit efficiency, the auditor should allocate less tolerable misstatement to
medium accounts that can be verified by using low-cost audit procedures, such as analytical procedures,
a than to accounts that are more costly to audit.
a. True
b. False
93. To maximize audit effectiveness, the auditor should establish a high preliminary judgment
medium about materiality and allocate most of the amount to balance sheet accounts.
b a. True
b. False
94. Acceptable audit risk and the amount of substantive evidence required are inversely related.
medium a. True
a b. False
95. As control risk increases, the amount of substantive evidence the auditor plans to accumulate
medium should increase.
a a. True
b. False
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97. An acceptable audit risk assessment of low indicates a risky client requiring more extensive
medium evidence, assignment of more experienced personnel, and/or a more extensive review of audit
a files.
a. True
b. False
99. Audit assurance is the complement of planned detection risk, that is, one minus planned
medium detection risk.
b a. True
b. False
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