Auditing The Art And Science Of Assurance Engagements, Canadian 12th Edition By Arens – Test Bank

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Auditing The Art And Science Of Assurance Engagements, Canadian 12th Edition By Arens – Test Bank

Auditing, 12e (Arens)

Chapter 6   Client Risk Profile and Documentation

 

6.1   Explain the importance of an adequate audit planning process

 

1) An effective audit is one that

  1. A) reduces the audit risk to the targeted level.
  2. B) ensures that there are no errors contained in the financial statements.
  3. C) does not contain errors of a dollar amount higher than 5% of the net income of the company.
  4. D) is completed on time and within budget.

Answer:  A

Diff: 1     Type: MC     Page Ref: 156

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

2) When the auditor has properly planned and performed the audit to reduce risk to an acceptably low level that is consistent with the objective of the audit, this means that the auditor has conducted enough work to

  1. A) reduce inherent risks to an acceptable level.
  2. B) increase detection risk to a satisfactory level.
  3. C) detect errors in internal controls so that control risk can be set higher.
  4. D) detect material misstatements to the targeted level of assurance.

Answer:  D

Diff: 3     Type: MC     Page Ref: 156

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

3) The audit plan includes the nature, timing and extent of audit procedures for the purposes of risk assessment, including those that are linked to the individual audit assertions, as well as any other audit procedures that are considered necessary. At what point in the audit process is the audit plan finalized? When

  1. A) the auditor has finished documenting internal controls.
  2. B) the client risk profile has been completed.
  3. C) risk assessments are complete.
  4. D) inherent risk information has been gathered.

Answer:  C

Diff: 3     Type: MC     Page Ref: 157

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

4) An important reason for adequately planning the audit engagement is to

  1. A) help decide whether the engagement should be accepted.
  2. B) enable the auditor to obtain sufficient appropriate audit evidence.
  3. C) properly design the contents of the engagement letter.
  4. D) keep audit risk as low as possible.

Answer:  B

Diff: 3     Type: MC     Page Ref: 157

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

5) 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 is the

  1. A) inherent risk.
  2. B) audit risk.
  3. C) statistical risk.
  4. D) financial risk.

Answer:  B

Diff: 2     Type: MC     Page Ref: 157

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

6) One of the purposes of developing a client risk profile is to assist the auditor in

  1. A) developing the pertinent audit procedures for tests of internal controls.
  2. B) assessing the client’s business risk.
  3. C) locating related parties that need to be disclosed.
  4. D) deciding whether fraud or illegal acts have taken place.

Answer:  B

Diff: 2     Type: MC     Page Ref: 157

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

7) A thorough understanding of the client’s business and industry and knowledge about the company’s operations are essential for doing an adequate audit. Why do auditors need greater knowledge about major customers and suppliers and related risks?

  1. A) information technology connects these organizations, so that they affect each other
  2. B) information technology provides rapid information about organizations
  3. C) there is increased importance of human capital and other intangible assets
  4. D) joint ventures and strategic alliances affect client business risks

Answer:  A

Diff: 3     Type: MC     Page Ref: 157

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

8) Risks associated with specific industries may affect the auditor’s assessment of client business risk and acceptable audit risk, and even influence client acceptance decisions. Which of the following business would be the most risky for the auditor to accept as a new client? A client that

  1. A) is a small manufacturer of metal and plastic parts, with steady profits, in business for 15 years.
  2. B) is developing a computer game, expected to be ready in three years, and has no other products.
  3. C) has fifteen retail outlets in the clothing industry, with mid-range pricing, appealing to a large population sector.
  4. D) consists of a partnership of ten lawyers, operating out of three different cities in one province.

Answer:  B

Diff: 3     Type: MC     Page Ref: 159

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

9) It is important for the auditor to obtain a good understanding of the industry of the client to develop a client risk profile. If the auditor is looking at a client in the fashion clothing industry, a risk specific to the industry would be

  1. A) the high risk of poor governance and management oversight.
  2. B) the high risk of defective products.
  3. C) the high risk of obsolescence of their inventory.
  4. D) the volatility in the stock market with regards to common stock.

Answer:  C

Diff: 2     Type: MC     Page Ref: 159

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

10) An important reason for auditors to obtain a good knowledge of a client’s industry is that

  1. A) payroll processing functions could differ from client to client.
  2. B) control risks will vary from zero to 100% and can be better assessed in context.
  3. C) detection risk must be set in accordance with the needs of the industry as well as of the individual client.
  4. D) organizations like city governments have unique accounting requirements that could be complex.

Answer:  D

Diff: 2     Type: MC     Page Ref: 159

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

11) How is lack of understanding of a client’s knowledge and industry linked to the auditor’s business risk?

  1. A) sales and collection processes need to be carefully documented so that the auditor can assess the value of accounts receivable
  2. B) failure to fully understand the nature of the client’s transactions could result in litigation should the client fail
  3. C) the auditor may not be adequately trained to understand the nature of the client’s business, conducting a poor quality audit
  4. D) there may not be sufficient expertise assigned to the audit engagement, resulting in a lack of understanding of complex issues

Answer:  B

Diff: 3     Type: MC     Page Ref: 159

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

12) There are many types of analytical procedures that the auditor can conduct during the planning stage of the financial statement audit. What is the purpose of calculating key ratios for the client’s business and comparing them with industry averages?

  1. A) understand the client’s industry and business
  2. B) assess going concern
  3. C) indicate possible misstatements
  4. D) reduce detailed tests

Answer:  A

Diff: 2     Type: MC     Page Ref: 160

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

13) In order to assess if a company is a going concern, the auditor can calculate which of the following ratios during the audit planning and compare with previous years and successful companies in the industry?

  1. A) debt to equity ratio
  2. B) accounts receivable turnover ratio
  3. C) percent of interest expense to sales
  4. D) inventory turnover ratio

Answer:  A

Diff: 2     Type: MC     Page Ref: 160

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

14) There are many types of analytical procedures that the auditor can conduct during the planning stage of the financial statement audit. What is the purpose of comparing the gross margin with those of prior years, looking for large fluctuations?

  1. A) understand the client’s industry and business
  2. B) assess going concern
  3. C) indicate possible misstatements
  4. D) reduce detailed tests

Answer:  C

Diff: 2     Type: MC     Page Ref: 160

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

15) There are many types of analytical procedures that the auditor can conduct during the planning stage of the financial statement audit. What is the purpose of comparing prepaid expenses and related expense accounts with those of prior years?

  1. A) understand the client’s industry and business
  2. B) assess going concern
  3. C) indicate possible misstatements
  4. D) reduce tests of controls

Answer:  C

Diff: 2     Type: MC     Page Ref: 160

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

16) The existence of advanced automated systems affects the audit process. Which of the following characteristics is an indicator of the presence of an advanced automated information system?

  1. A) custom-designed operational or strategic information systems
  2. B) use of packaged software to process sales both locally and across Canada
  3. C) use of customer relationship management systems to manage sales information
  4. D) numerically-controlled equipment used in the manufacturing process

Answer:  A

Diff: 3     Type: MC     Page Ref: 160

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

 

17) The existence of advanced automated systems affects the audit process. Which of the following characteristics is an indicator of the presence of an advanced automated information system?

  1. A) use of data communications (such as the Internet) to transfer transaction data
  2. B) use of packaged software to process sales both locally and across Canada
  3. C) use of customer relationship management systems to manage sales information
  4. D) numerically-controlled equipment used in the manufacturing process

Answer:  A

Diff: 3     Type: MC     Page Ref: 160

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

18) The existence of advanced automated systems affects the audit process. Which of the following characteristics is an indicator of the presence of an advanced automated information system?

  1. A) electronic data interchange systems for purchase orders, sales invoices and payments
  2. B) use of packaged software to process sales both locally and across Canada
  3. C) use of customer relationship management systems to manage sales information
  4. D) numerically-controlled equipment used in the manufacturing process

Answer:  A

Diff: 3     Type: MC     Page Ref: 161

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

19) Mario, the owner of Clayton’s ice cream, is giving Steve, the manager of the audit, a private tour of the production facilities. By doing the tour, Steve will

  1. A) be better able to identify control risks.
  2. B) understand the client’s business and operations better.
  3. C) be able to gather audit evidence on operational efficiencies.
  4. D) Steve should not be taking a tour alone with the owner as this could compromise his independence.

Answer:  B

Diff: 1     Type: MC     Page Ref: 161

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

20) Simon owns a clothing store, Simonello. Simonello recently purchased a material amount fabrics from Simonique Inc., a textile company also owned by Simon. With regards to this transaction, the auditors should

  1. A) request a confirmation from Simonique that the transaction took place.
  2. B) inspect the textile received in the warehouse to ensure that the amount sent equals the amount ordered.
  3. C) qualify the audit report as this puts into question management’s integrity.
  4. D) verify that the business relationship is disclosed in the financial statements.

Answer:  D

Diff: 3     Type: MC     Page Ref: 161

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

 

21) Jibbery Company has numerous transactions with related parties. For example, it has borrowed money from shareholders, purchases raw materials from a subsidiary company, and sells finished goods to its parent company. Which of the following describes one of the impacts upon risk assessment of these transactions?

  1. A) inherent risk would be set as low
  2. B) inherent risk would be set as high
  3. C) control risk would be set as low
  4. D) audit risk would be decreased

Answer:  B

Diff: 3     Type: MC     Page Ref: 161

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

22) Brandon is working on the audit of Michum Inc. In accordance with CAS 550 (related parties), Brandon had obtained a management confirmation of all related-party transactions. When auditing the purchasing cycle of Michum, Brandon found that the company had purchased over $500,000 of merchandise from Elite Crust Inc., a company that is owned by the CEO’s brother. The $500,000 purchase is a material amount and it was not included in the confirmation provided by Michum. Brandon should

  1. A) inform the audit committee.
  2. B) qualify the audit report.
  3. C) discuss this issue with the management of Michum.
  4. D) reduce materiality to increase the likelihood of discovering other undisclosed related party transactions.

Answer:  A

Diff: 3     Type: MC     Page Ref: 161-162

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

23) Michum Inc. has related parties with a company owned by the CEO’s brother that comprise about $500,000. There are also related party transactions with the owner (about $250) and with two of the officers ($750 and $1,000) respectively. Which related parties should be identified and included in audit documentation?

  1. A) those with material transactions only
  2. B) those that had transactions in the current year only
  3. C) all related parties
  4. D) only those that could lead to a conflict of interest

Answer:  C

Diff: 3     Type: MC     Page Ref: 161

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

 

24) An effective board of directors helps ensure that the company takes only appropriate risks. The audit committee can

  1. A) reduce the likelihood of fraud and financial statement errors through oversight of the entity level controls.
  2. B) reduce the likelihood of financial statement errors by helping management of the company with complex financial reporting issues.
  3. C) reduce the likelihood of financial statement errors by helping management in the preparation of the financial statements and related notes.
  4. D) reduce the likelihood of overly aggressive accounting through oversight of financial reporting.

Answer:  D

Diff: 2     Type: MC     Page Ref: 162

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

25) The auditor will obtain a copy of the client’s articles of incorporation (if applicable) and retain a copy in the permanent file. Important information in the articles of incorporation includes

  1. A) the interest rates currently being paid for bonds that have been issued.
  2. B) voting rights of each class of shares issued by the company.
  3. C) which shares have been redeemed by the company in the current year.
  4. D) the interest rates that are being received on long term notes invested.

Answer:  B

Diff: 3     Type: MC     Page Ref: 162

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

26) Which of the following would you expect to find in a corporation’s bylaws? The

  1. A) kinds and amounts of capital stock authorized.
  2. B) date of incorporation.
  3. C) rules and procedures adopted by the shareholders of the corporation.
  4. D) types of business activities that the corporation is authorized to conduct.

Answer:  C

Diff: 2     Type: MC     Page Ref: 163

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

27) A code of ethics is an important document for organizational conduct. In response to the Sarbanes-Oxley Act in the U.S., the SEC requires which of the following actions for organizations that have not adopted a code of ethics?

  1. A) explanation of why it has not done so
  2. B) disclosure of actions undertaken to prevent and detect fraud
  3. C) disclosure of all related parties in management and discussion documents
  4. D) a cost-benefit analysis for immediate implementation of one

Answer:  A

Diff: 2     Type: MC     Page Ref: 163

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

 

28) Which of the following is an important purpose of an organizational code of ethics and the associated processes to ensure adherence?

  1. A) make sure that there are no fraudulent or illegal transactions at the company
  2. B) train employees in acceptable conduct at the organization
  3. C) keep unethical employees from acting out unacceptable behaviour
  4. D) provide a powerful signal of acceptable organizational conduct

Answer:  D

Diff: 2     Type: MC     Page Ref: 163

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

29) The official record of the meetings of the board of directors and shareholders is contained in the corporate

  1. A) bylaws.
  2. B) charter.
  3. C) minutes.
  4. D) license.

Answer:  C

Diff: 1     Type: MC     Page Ref: 163

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

30) When reading the corporate minutes, the auditor extracted the approved annual salary for the President, the Chief Executive Officer and other senior executives. What audit step would the auditor likely conduct with this information?

  1. A) trace the payroll amount to each individual officer’s payroll record
  2. B) check that the payroll has been recorded into the correct bank account
  3. C) verify that payroll cheques have two signatures for all large amounts
  4. D) ensure that all overtime is approved and adequately documented

Answer:  A

Diff: 3     Type: MC     Page Ref: 163

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

31) When reading the corporate minutes, the auditor obtained information regarding the loans that were authorized for borrowing. What audit step would the auditor likely conduct with this information?

  1. A) trace the authorized amounts to the bank statements
  2. B) verify that notes payable have been recorded
  3. C) calculate interest payable as of the end of the year
  4. D) contact a credit rating agency to determine the rating of the lender

Answer:  B

Diff: 2     Type: MC     Page Ref: 163

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

 

32) Frontenac Construction, your audit client, is a construction company. In the initial planning phase of the audit, you identified that it has many contracts with severe non-performance clauses if any of the current constructions are not completed on the dates set in the contracts over the next three years. As the auditor, you would set the inherent risk for sales and penalties as

  1. A) high.
  2. B) moderate.
  3. C) low.
  4. D) cannot be determined until more procedures are performed.

Answer:  A

Diff: 3     Type: MC     Page Ref: 164

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

33) It is important that the policies, procedures and key decisions of senior management, board of directors and audit committee be considered when developing a client risk profile because

  1. A) they have a pervasive effect on the company.
  2. B) they influence the most important decisions for the company.
  3. C) it is required by accounting and auditing standards.
  4. D) they have the effect of increasing client business risks.

Answer:  A

Diff: 3     Type: MC     Page Ref: 164

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

34) In addition to direct impacts upon the financial statements, the auditor also needs to consider indirect effects. An assessment of client objectives and strategies can reveal issues that could lower income or cause contingent liabilities. Which of the following could cause lost sales, increases in warranty expenses and product liability claims?

  1. A) poor product quality
  2. B) excessive advertising
  3. C) ineffective projections
  4. D) inaccurate budgets

Answer:  A

Diff: 2     Type: MC     Page Ref: 164

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

35) Organizations with a good control environment are able to document their positive “tone at the top” with a clear code of ethics. How would the auditor include the presence of such a code of ethics in the risk assessment process?

  1. A) increase inherent risks associated with violations of laws and regulations
  2. B) lower inherent risks associated with violations of laws and regulations
  3. C) increase control risks associated with violations of laws and regulations
  4. D) lower control risks associated with violations of laws and regulations

Answer:  B

Diff: 3     Type: MC     Page Ref: 164

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

 

36) A client’s performance measurement system includes key performance indicators that management uses to

  1. A) measure its profitability.
  2. B) compare its performance with prior periods.
  3. C) prepare the financial statements.
  4. D) measure progress toward its objectives.

Answer:  D

Diff: 1     Type: MC     Page Ref: 164

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

37) If the client has set unreasonable objectives or if the performance measurement system encourages aggressive accounting, the auditor will

  1. A) increase inherent risk of financial statement misstatements.
  2. B) lower inherent risk of financial statement misstatements.
  3. C) increase control risk of financial statement misstatements.
  4. D) lower control risk of financial statement misstatements.

Answer:  A

Diff: 3     Type: MC     Page Ref: 165

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

38) If management and salespeople are compensated on the basis of achieving high sales targets, there is increased incentive to record sales before they have been earned. In such a situation, the auditor will increase the extent of testing for which of the following transaction-related audit objectives for sales?

  1. A) cutoff and classification
  2. B) classification and occurrence
  3. C) occurrence and cutoff
  4. D) completeness and cutoff

Answer:  C

Diff: 3     Type: MC     Page Ref: 165

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

39) Your client, Macilbink Ltd., manufactures calendars, books and magazines. The printing presses that they use are only three years old, yet new technology has been developed that would result in cuts in ink and electricity costs by over 20%, while simplifying the set up process (the new equipment can read in PDF files directly), making lower production runs more feasible. Macilbink Ltd. is facing lowered demand for its products, and will need to change direction or innovate to stay in business. The effect of the new printing technology has resulted in the following risk assessment changes by Macilbink Ltd.’s auditors:

  1. A) decrease control risk
  2. B) increase control risk
  3. C) decrease client business risk
  4. D) increase client business risk

Answer:  D

Diff: 3     Type: MC     Page Ref: 165

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

40) Vanovo Ltd. is a company that has purchased several companies in the retail sector. Recently, Vanovo Ltd. purchased both a coffee and donut chain that also owned bakeries and a submarine sandwich chain. Unfortunately, the planned synergies between these two retail chains did not arise. What effect would this have on the financial statements of Vanovo Ltd., the parent company?

  1. A) the financial statements will be incorrectly calculated, and should be checked
  2. B) the fixed assets and goodwill recorded at acquisition could be impaired
  3. C) risk of material misstatement for payroll expenses will increase
  4. D) costs of goods sold will likely be overstated for both of the new chains

Answer:  B

Diff: 3     Type: MC     Page Ref: 165

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

41) The Sarbanes-Oxley Act requires management to certify that it has informed the auditor and audit committee of any

  1. A) related party transactions.
  2. B) significant deficiencies in business practices.
  3. C) significant deficiencies in internal controls.
  4. D) specific business or industry risk.

Answer:  C

Diff: 2     Type: MC     Page Ref: 166

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

42) The Canadian Auditing Standards state the the auditor must develop an audit plan. List and explain the components that must be included in the auditor’s plan.

Answer:

– the nature, timing, and extent of audit procedures for the purpose of risk assessment.

– the nature, timing, and extent of additional audit procedures, linked to the individual audit assertions.

– any other audit procedures that are needed for the audit to be conducted in accordance with CASs.

Diff: 2     Type: ES     Page Ref: 156-157

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

43) What is the purpose of developing a client risk profile? List the steps involved in developing a client risk profile.

Answer:  The client risk profile allows the auditor to assess the client’s business risk, and provides the information needed to effectively plan the audit.

 

The steps involved in developing the client risk profile are:

∙ obtain knowledge of industry and external business environment

∙ obtain knowledge of client’s business operations and processes

∙ assess control environment, management’s philosophies and corporate governance process

∙ understand client objectives and strategies

∙ understand the client’s performance measurement system

∙ assess client business risk

– address any carry forward issues from the previous year

Diff: 2     Type: ES     Page Ref: 157-166

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

44) Black Rock Limited is a marble and tile outlet that has a large outdoor area as well as an indoor showroom for a variety of rock, tile and marble. It is July and your firm has just been appointed auditors for the September year end audit. The previous firm of auditors had conducted review engagements. The company’s bank has asked for audited financial statements for the current year end.

Required:

  1. A) What is the purpose of obtaining knowledge of the client’s industry and business environment? Identify at least three procedures that you could undertake in this area.
  2. B) What is the purpose of obtaining knowledge of the client’s business? Identify at least three procedures that you could undertake in this area.

Answer:

  1. A) The three main reasons for obtaining a good understanding of the client’s industry are:
  • to identify any unique industry accounting requirements
  • to identify risks in the industry that may affect the assessment of audit risk for the client
  • to identify inherent risks that are typically common to all clients in this industry

Methods of obtaining an understanding of the industry and business environment include:

  • discussions with the previous auditor
  • discussions with client personnel and internal auditor (if present)
  • review of industry database at the accounting firm
  • review of industry trade magazines
  1. B) Knowledge about the client that differentiates it from the industry will help the auditor more effectively assess audit risk, inherent risk, and be useful in designing analytical procedures.

Methods of gathering knowledge of the client’s business include:

  • review of permanent files
  • tour of the client’s facilities
  • review of prior financial statements and annual reports
  • review of information with respect to related party transactions
  • review of articles of incorporation, bylaws, and corporate minutes

Diff: 2     Type: ES     Page Ref: 159-160

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

45) Knowledge of the client’s industry and external environment can be obtained in different ways. Discuss some of the ways that this knowledge can be obtained.

Answer:

– discussion with the auditor who was in charge of the audit in the prior year.

– discuss with other auditors in the firm who currently work on similar engagement.

– conferences with the client’s personnel, including internal auditors.

– consult with an industry specialist.

– consult the practice advisory service of your professional body

– refer to industry audit guidelines, textbooks and technical magazines

– subscribe to specialized journals

– participate actively in industry associations and training programs

Diff: 2     Type: ES     Page Ref: 159

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

 

46) Juniper Berry is a private company, operating in the fruits and vegetable industry, located in the Niagara region. In its main St-Catharines plant, it receives the picked berries and proceeds to sort, package and also make some related products such as jams, cookies and pies. Your firm has recently been hired as the auditor of Juniper Berry. The partner in charge of the audit has asked you to write a memo explaining why it is important to gain understanding of the business operations and processes of Juniper Berry and also to list some suggested procedures to be performed in the process of understanding the business operations and processes.

 

To assist you with your memo, the partner provided you with some notes he took at a recent meeting with the management of Juniper Berry.

 

Juniper Berry (JB) sells and manufactures a wide range of products. From fresh to frozen berries, to jam, cookies and pies. Fresh and Frozen berries make up most of the revenues of JB.

– JB sells mostly to grocery stores directly. Its frozen berries however are packaged with the Mondo Grocers logo as they have an exclusive contract to sell all of their frozen berry production to Mondo.

– In 2011, JB installed a high tech scale system where the berries received from the various farms are weighed when they are delivered and the amount to be paid to the farmer is calculated and recorded immediately. The system automatically records the inventory and the central system also issues an electronic payment for the amount calculated by the scale. JB is proud to be technologically advanced as it allowed the company to cut some jobs and be more cost efficient.

– Given that most of the packaging and processing of berries into derived products is automated, capital assets represent a significant portion of the balance sheet and also required JB to obtain large bank loan in 2011 when the plant upgrade took place.

Answer:  Knowledge about the client’s business is important since it will help the auditor more effectively assess audit risk and inherent risk, and will also be useful in designing analytical procedures.

 

The following are suggested procedures that could be done at JB to gain an understanding of the business operations and processes. Note that the student’s answer could be different and still be valid.

 

– perform an analysis of the sales breakdown by product to understand which product is more significant to JB. The audit procedures should be more extensive for the line of products that are more important.

– perform an analysis of the total sales to Mondo compared to total sales. Evaluate if there is a dependence on Mondo as a customer and how this impacts the business risk.

– perform a tour of the plant to observe the scale and how the fruits are weighted to better understand the process and see if there are any signs of impairment or defective assets. Also evaluate there is segregation of duties between receiving the fruit and weighing it.

– Since JB has highly automated process that affect the financial statements (purchases and cash disbursements are automatically calculated), discuss the process with management and review documentation with regards to the system and its implementation.

Diff: 3     Type: ES     Page Ref: 157-160

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

47) Your preliminary discussion with European Real Estate Management (EREM) Corporation indicated that the company was owned by three Swedish individuals who sold limited liability partnerships of shopping malls, office buildings and large residential apartment buildings to European investors. Often, a single shopping mall was broken up into several limited liability partnerships to make the ownership pieces small enough to sell easily.

In some cases, these partnership units were sold to European companies, who diversified and bought units in several buildings. Other units were purchased by individuals. If a property looked particularly promising, the owners of EREM occasionally purchased units or advised their wives and family members to purchase units.

Required:

Explain why it is important for the auditor to identify related party transactions. Why are related party transactions a high risk area for the EREM audit?

Answer:  It is assumed that all transactions in the financial statements take place at arms length. If they do not take place at arms length, then it is critical that the related party transactions be disclosed in the notes to the financial statements so that the user can take this into account when reviewing the financial statements. If disclosure did not occur, then management could manipulate net income when related parties are involved and the user of the financial statements could make poor decisions due to biased information.

 

Transactions with related parties must be disclosed in the financial statements if they are material.

 

This is a high risk area for the EREM audit, because it appears that there are a variety of potentially complex transactions among many individuals and corporations that are related. This relationship may be familial (i.e. among family members) or based upon being able to exert influence.

 

The auditor will need to carefully audit this area, and request management to provide a detailed breakdown of common ownership, including the ownership of the foreign companies, to see if the foreign companies are also related parties.

Diff: 3     Type: ES     Page Ref: 161

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

48) A) One step in the planning phase of an audit is to obtain information about the client’s legal obligations. Identify the types of legal documents and records that auditors examine to obtain this information.

 

  1. B) Discuss the audit-relevant information contained in each of these three types of documents that an auditor should be aware of early in the audit.

 

Answer:

  1. A) Documents and records that auditors examine to obtain information about the client’s legal obligations include:
  • the client’s articles of incorporation and bylaws
  • code of ethics
  • minutes of meetings of the board of directors and shareholders
  • contracts and agreements with vendors, banks and other creditors
  1. B)

Articles of incorporation and bylaws. This includes the amounts of capital stock the corporation is authorized to issue, preferences and conditions for dividends, and information concerning voting rights of each class of stock. The bylaws specify such things as the fiscal year of the corporation, the frequency of shareholder meetings, the method of voting for directors, and the duties and powers of the corporate officers.

Code of ethics. Some laws require such codes (such as the Sarbanes-Oxley Act), so the auditor would be evaluating compliance with the legislation. Also, such a code signals that the organization required ethical behavior from its management and employees, an important component of internal control and of high-quality corporate governance.

Minutes of meetings. There are two categories of audit-relevant information contained in minutes: authorizations and discussions by the board of directors affecting inherent risk. Common authorizations in the minutes include compensation of officers, new contacts and agreements, acquisitions of property, loans, and dividend payments.

Contracts/agreements. The auditor should examine contracts/agreements early in the engagement to gain a better perspective of the organization and to become familiar with potential problem areas. Contracts/agreements will also be examined during the tests of individual audit areas.

Diff: 3     Type: ES     Page Ref: 162-164

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

49) White Top Telephones is the largest telephone distributor in the province, distributing wired and wireless phones, as well as cellular phones. Management always seems to be in a rush, and difficult to approach. Unfortunately, this attitude has permeated down to all of the staff, and everyone seems to be hurrying about, doing what needs to be done. Sometimes, it seems as if they don’t even have time for the customers, moving on to the next task.

Yet everything seems to get done. The company’s web site has a lengthy privacy policy statement indicating that customers are number one, and that all data are kept secure.

Required:

Explain the importance of the control environment and corporate governance structure. During what phases of the risk assessment and planning process would the control environment and corporate governance structure be documented and assessed?

Answer:  In a well run business with a corporate code of ethics that is demonstrated and enforced by management, the auditor will conclude that inherent and control risks are reduced. Where management does not pay attention to the ethical environment of the business, or even condones poor business practices, the risks are increased.

 

Corporate governance processes would be assessed initially in the preplanning phase, as part of the assessment of management integrity. It would also be considered when gathering knowledge of the client’s business. Specific documentation of the formal control environment and corporate governance processes, such as extent of involvement of the Board of Directors and the Audit Committee also take place.

 

The governance processes are also considered when the auditor assesses risks of fraud, audit risk, inherent risk and control risk. Throughout the audit, the auditor would also monitor discussions with the client and the results of audit tests to determine whether the governance processes are effective.

Diff: 3     Type: ES     Page Ref: 164

Learning Obj.:   6-1  Explain the importance of an adequate audit planning process

 

 

6.2   Describe the type of evidence that the auditor collects when developing the client risk profile and assessing client business risk

 

1) During discussion and inquiry with management, the auditor determined that the company has started a new line of business, requiring a substantial investment in manufacturing equipment. The company has also implemented wireless scanning for its warehouse and inventory. Which of the following techniques will the auditor likely use to corroborate these statements?

  1. A) further inquiry of the accounting personnel
  2. B) inspection of recent sales invoices for types of sales
  3. C) use of analytical procedures, comparing last year to this year
  4. D) observation during the plant tour

Answer:  D

Diff: 2     Type: MC     Page Ref: 166

Learning Obj.:   6-2  Describe the type of evidence that the auditor collects when developing the client risk profile and assessing client business risk

2) Anna performed a trend analysis of accounts receivable (AR) balances and computed the days to collect AR ratio. When she compared the results of her analysis with the industry averages, she found the results were unusually low compared to the industry norm. Anna can conclude that

  1. A) the accounts receivable balance is wrong.
  2. B) the accounts receivable has an increased risk of misstatement.
  3. C) the integrity of the company’s management is questionable.
  4. D) she will not be able to rely on internal controls for accounts receivable for audit purposes.

Answer:  B

Diff: 3     Type: MC     Page Ref: 166

Learning Obj.:   6-2  Describe the type of evidence that the auditor collects when developing the client risk profile and assessing client business risk

 

 

6.3   Determine what working papers the auditor retains to document the financial statement audit

 

1) During the course of an audit engagement an auditor prepares and accumulates audit working papers. The primary purpose of the audit working papers is to

  1. A) aid the auditor in adequately planning the work.
  2. B) provide a point of reference for future audit engagements.
  3. C) support the underlying concepts included in the preparation of the basic financial statements.
  4. D) support the auditor’s report.

Answer:  D

Diff: 2     Type: MC     Page Ref: 168

Learning Obj.:   6-3  Determine what working papers the auditor retains to document the financial statement audit

 

2) The working papers are

  1. A) the property of client.
  2. B) prepared by the client’s internal auditors.
  3. C) the primary means of documenting that an adequate audit was conducted in accordance with GAAS.
  4. D) used primarily as a basis for the partners to review and reward the work of the managers, seniors, and staff.

Answer:  C

Diff: 2     Type: MC     Page Ref: 168

Learning Obj.:   6-3  Determine what working papers the auditor retains to document the financial statement audit

 

3) The new Canadian Auditing Standards require the auditor to complete the audit working papers within how many days of the audit report date?

  1. A) 45
  2. B) 60
  3. C) 90
  4. D) 183

Answer:  B

Diff: 2     Type: MC     Page Ref: 168

Learning Obj.:   6-3  Determine what working papers the auditor retains to document the financial statement audit

4) The audit working papers serve as a record of the evidence accumulated and the results of the audit tests. This helps to demonstrate that the audit was

  1. A) properly kept confidential; information was held secure.
  2. B) completed using Canadian generally accepted accounting principles.
  3. C) organized effectively with no mistakes in calculations.
  4. D) conducted in accordance with Canadian generally accepted auditing standards.

Answer:  D

Diff: 3     Type: MC     Page Ref: 168

Learning Obj.:   6-3  Determine what working papers the auditor retains to document the financial statement audit

 

5) The working papers contain data useful for evaluating the adequacy of the audit scope and the fairness of the financial statements. This data helps the auditor to conclude whether

  1. A) control risks were accurately identified and tested.
  2. B) inherent risks were set as low as possible.
  3. C) an unqualified audit report can be issued.
  4. D) the current files properly contain copies of client contracts and agreements.

Answer:  C

Diff: 3     Type: MC     Page Ref: 168

Learning Obj.:   6-3  Determine what working papers the auditor retains to document the financial statement audit

 

6) The audit of Simcoe Transports Inc. was completed three months ago so the PA firm proceeded to the file archive stage in accordance with Canadian Audit Standards. If the audit firm receives additional information related to the audit but the information does not affect the audit conclusions, the information should be

  1. A) disregarded as it the file archive was already done.
  2. B) added to the audit file in the section to which it pertains.
  3. C) separately identified and added at the front of the audit file.
  4. D) added to the audit file and request that the reviewing partner reviews the new information.

Answer:  C

Diff: 2     Type: MC     Page Ref: 169

Learning Obj.:   6-3  Determine what working papers the auditor retains to document the financial statement audit

 

7) With the use of electronic working papers, each team member should have a unique access identification code and a password to access the working papers. Once a working paper is completed, what type of access should the staff auditor who prepared the working paper file have?

  1. A) edit capability
  2. B) update for current information
  3. C) read only
  4. D) change based upon review

Answer:  C

Diff: 2     Type: MC     Page Ref: 170-171

Learning Obj.:   6-3  Determine what working papers the auditor retains to document the financial statement audit

 

8) In addition to including on each working paper the name of the client, the period covered, the date of preparation and an index code, each working paper should clearly include

  1. A) the name of the preparer and a description of the contents.
  2. B) symbols used and a reconciliation to the general ledger balance.
  3. C) audit working paper steps that were completed.
  4. D) the nature of the transaction-based risk that is being audited.

Answer:  A

Diff: 1     Type: MC     Page Ref: 171

Learning Obj.:   6-3  Determine what working papers the auditor retains to document the financial statement audit

 

9) To facilitate the working paper preparation process, defaults can be established to automatically insert client name, period covered, and preparer. This can best be done using

  1. A) the junior staff assigned to the engagement.
  2. B) an old-fashioned rubber stamp on each printed page.
  3. C) cut and paste from word processing or spreadsheet software.
  4. D) automated working paper software.

Answer:  D

Diff: 1     Type: MC     Page Ref: 171

Learning Obj.:   6-3  Determine what working papers the auditor retains to document the financial statement audit

 

10) Renaldo compared shipping reports to sales documents, checking to see that the sales invoice date matched the shipping date, and that quantities invoiced matched quantities shipped. On his working paper, he said that he vouched invoices. What else should his working paper include with respect to the audit procedure conducted?

  1. A) details of tests conducted, with results
  2. B) results of analytical review procedures on the aging of accounts receivable
  3. C) employee number and wage rate of the employees he spoke to
  4. D) a statement that the information will be held confidential

Answer:  A

Diff: 2     Type: MC     Page Ref: 171

Learning Obj.:   6-3  Determine what working papers the auditor retains to document the financial statement audit

 

11) Each working paper should include enough information to fulfill the objectives for which it was designed. For example, if a working paper is designed to list the detail and show the verification of support of a balance sheet account such as prepaid insurance, it is essential that the detail on the working paper

  1. A) reconcile the change in costs from last year to this year.
  2. B) use analytical review to consider the reasonableness of the account.
  3. C) reconcile with the associated general ledger account.
  4. D) use observation to identify controls in place over the transactions.

Answer:  C

Diff: 3     Type: MC     Page Ref: 171

Learning Obj.:   6-3  Determine what working papers the auditor retains to document the financial statement audit

12) The working papers prepared during the engagement are the property of the

  1. A) auditor, but do not include the working papers prepared by the client for the auditor.
  2. B) auditor, even including those prepared by the client for the auditor.
  3. C) client, who will provide copies to the auditor.
  4. D) auditor and client jointly.

Answer:  B

Diff: 2     Type: MC     Page Ref: 171

Learning Obj.:   6-3  Determine what working papers the auditor retains to document the financial statement audit

 

13) Ordinarily, the working papers can be provided to someone else only with the express permission of the client. This is the case even if the papers are

  1. A) subpoenaed by a court.
  2. B) used as a part of a provincial institute practice inspection.
  3. C) requested as evidence in a provincial institute disciplinary hearing.
  4. D) transferred as a result of a public accountant selling his/her practice to another public accounting firm.

Answer:  D

Diff: 2     Type: MC     Page Ref: 172

Learning Obj.:   6-3  Determine what working papers the auditor retains to document the financial statement audit

 

14) Identify the characteristics that working papers should have. For each characteristic, briefly explain why it is important.

Answer:

properly identified: to clearly reference what the audit paper pertains to, prepared by and date completed. This is helpful in the process of file review.

indexed and cross-referenced: helps in organizing and filling. Also indicates where is the source or support for a given item.

indicate the audit work performed: serves as evidence and support that work was performed by the auditor.

include sufficient information: serves as evidence and support that work was performed by the auditor. Could also be helpful if the procedure had to be re-done as part of a file review.

conclusions should be plainly stated: states the auditor’s conclusion for the given procedure or segment. Serves as support and evidence.

Diff: 3     Type: ES     Page Ref: 171

Learning Obj.:   6-3  Determine what working papers the auditor retains to document the financial statement audit

 

15) At the first day of work at a PA firm, staff are given their own laptop computer for use in working with clients and other data.

Required:

  1. A) What is the typical structure of client working paper files?
  2. B) How is client data protected from unauthorized change?

 

Answer:

  1. A) Client files are organized into folders, with each folder containing relevant files. Folders are grouped for the following purposes:

–           knowledge of business

–           audit planning

–           supporting schedules by section, separated into current year and multi-year

  1. B) Data is password-protected so only team members can access the file. Once a document is marked as “complete,” it is locked so no further changes can be made. Documents are archived and access is logged to track which changes were made by staff, supervisors, managers or partners.

Diff: 2     Type: ES     Page Ref: 169-171

Learning Obj.:   6-3  Determine what working papers the auditor retains to document the financial statement audit

 

Auditing, 12e (Arens)

Chapter 7   Materiality and Risk

 

7.1   State the components of the audit risk model and describe the process used to assess audit risk

 

1) Risk in auditing means that the auditor accepts some level of uncertainty in performing the audit function. An effective auditor will

  1. A) take any means available to reduce the risk to the lowest possible level.
  2. B) set the risk level between 5% and 10%.
  3. C) perform the audit procedures first and quantitatively set the risk level before forming an opinion and writing the report.
  4. D) recognize that risks exist and deal with those risks in an appropriate manner.

Answer:  D

Diff: 1     Type: MC     Page Ref: 182

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

2) If the auditor assessed the detection risk as high, the extent of evidence the auditor plans to accumulate is

  1. A) low.
  2. B) high.
  3. C) medium.
  4. D) need more information to conclude.

Answer:  A

Diff: 2     Type: MC     Page Ref: 182, 185

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

3) As the effectiveness of internal control increases, what happens to control risk? It

  1. A) stays the same.
  2. B) increases.
  3. C) changes based upon the audit procedures conducted.
  4. D) decreases.

Answer:  D

Diff: 3     Type: MC     Page Ref: 184

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

 

4) The audit risk model is used primarily

  1. A) for planning purposes in determining how much evidence to accumulate.
  2. B) while doing tests of controls.
  3. C) to determine the type of opinion to express.
  4. D) to evaluate the evidence which has been gathered.

Answer:  A

Diff: 1     Type: MC     Page Ref: 184

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

5) Audit risk is a measure of

  1. A) the auditor’s assessment of the likelihood that a material misstatement might occur in the first place.
  2. B) the probability that the financial statements contain errors.
  3. C) how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed.
  4. D) the probability that errors in the financial statements that were not detected by the internal controls of the firm are not detected by the auditor.

Answer:  C

Diff: 2     Type: MC     Page Ref: 184

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

6) PA has set audit risk at 2% and determined that inherent risk is 60%. What is the level of targeted audit assurance?

  1. A) 2%
  2. B) 40%
  3. C) 98%
  4. D) 60%

Answer:  C

Diff: 2     Type: MC     Page Ref: 184

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

7) How much control does the auditor have over inherent risk? The auditor

  1. A) adjusts the controls that are considered – high levels of control.
  2. B) considers inherent risk for the business as a whole – some control.
  3. C) assesses the factors that make up inherent risk – no control.
  4. D) calculates inherent risk values as a residual – no control.

Answer:  C

Diff: 3     Type: MC     Page Ref: 185

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

 

8) What is the role of internal controls during the assessment of inherent risk?

  1. A) Internal controls are considered separately, so they are ignored during the assessment of inherent risk.
  2. B) As the quality of internal controls increases, inherent risk decreases.
  3. C) As the quality of internal controls improves, inherent risk increases.
  4. D) There is a direct relationship between the quality of internal controls and inherent risk.

Answer:  A

Diff: 3     Type: MC     Page Ref: 185

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

9) In addition to representing an assessment of whether a client’s internal control is effective for preventing or detecting misstatements, control risk also represents the

  1. A) reliability of management in preventing or detecting fraud.
  2. B) auditor’s intention to rely on internal controls.
  3. C) likelihood that the auditor will detect illegal acts.
  4. D) possibility of collusion occurring between two employees.

Answer:  B

Diff: 2     Type: MC     Page Ref: 185

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

10) Using the audit risk model, audit risk describes targeted assurance, while control risk and inherent risk are assessed based upon a variety of factors. Of the components of the audit risk model, which is most likely to be set to 100%?

  1. A) audit risk
  2. B) control risk
  3. C) detection risk
  4. D) inherent risk

Answer:  B

Diff: 3     Type: MC     Page Ref: 185

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

11) Assessing design effectiveness and conducting tests of controls are required when the auditor

  1. A) chooses to set control risk below 100 percent and relies on the controls.
  2. B) chooses to set control risk below 100 percent even it there is no reliance placed on controls.
  3. C) is planning the audit.
  4. D) should always test the design effectiveness.

Answer:  A

Diff: 2     Type: MC     Page Ref: 185

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

 

12) The risk that an auditor’s procedures will lead to the conclusion that a material error does not exist in an account balance when, in fact, such error does exist is referred to as

  1. A) audit risk.
  2. B) inherent risk.
  3. C) control risk.
  4. D) planned detection risk.

Answer:  D

Diff: 1     Type: MC     Page Ref: 185

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

13) If audit risk is increased, what happens to detection risk? It

  1. A) stays the same.
  2. B) increases.
  3. C) changes based upon the audit procedures conducted.
  4. D) decreases.

Answer:  D

Diff: 3     Type: MC     Page Ref: 185

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

14) If detection risk is reduced, the amount of evidence the auditor accumulates will

  1. A) increase.
  2. B) decrease.
  3. C) remain unchanged.
  4. D) be indeterminate.

Answer:  A

Diff: 2     Type: MC     Page Ref: 185

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

15) An inherent risk (IR) of 40% and a control risk (CR) of 60% affect detection risk and planned evidence differently than an

  1. A) IR of 60% and CR of 40%.
  2. B) IR of 100% and CR of 24%.
  3. C) IR of 80% and CR of 30%.
  4. D) IR of 70% and CR of 30%.

Answer:  D

Diff: 1     Type: MC     Page Ref: 186

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

 

16) The auditor set audit risk at 5%, inherent risk at 100%, and control risk at 50%, and determined a detection risk of 10%. If control risk had been 80%, detection risk would be about

  1. A) 16%.
  2. B) 10%.
  3. C) 6%.
  4. D) 5%.

Answer:  C

Diff: 1     Type: MC     Page Ref: 186

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

17) All other factors held constant, if the auditor decreases audit risk then

  1. A) there will be less documentation in the audit file.
  2. B) total audit evidence and audit costs will increase.
  3. C) it will also be necessary to decrease either control risk or inherent risk.
  4. D) less supervision will be required of the audit team.

Answer:  B

Diff: 3     Type: MC     Page Ref: 186

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

18) When inherent risk is assessed as higher (i.e. more material errors are likely to exist) and control risk is assessed the same from one year to the next, what is the likely effect on detection risk? Detection risk will

  1. A) increase.
  2. B) decrease.
  3. C) stay the same.
  4. D) need less documentation.

Answer:  B

Diff: 2     Type: MC     Page Ref: 186

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

19) If from last year to the current year’s audit, inherent risk has stayed constant, but control risk is higher (it is more likely that controls do not detect material errors), what is the likely effect on detection risk? Detection risk will

  1. A) increase.
  2. B) decrease.
  3. C) stay the same.
  4. D) need less documentation.

Answer:  B

Diff: 2     Type: MC     Page Ref: 186

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

 

20) With respect to clients, business risk increases when conditions, events, circumstances or inactions

  1. A) adversely affect the entity’s ability to achieve its objectives.
  2. B) cause employees to not do their job properly.
  3. C) result in the company continuing profitable operations.
  4. D) result in an assessment of poor internal controls.

Answer:  A

Diff: 3     Type: MC     Page Ref: 186

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

21) A PA firm can experience high levels of business risk if the audit firm

  1. A) does a poor job on preparing client risk profiles.
  2. B) pays its employees wages that are not in line with the market.
  3. C) has clients that do not pay their bills, or experiences significant litigation.
  4. D) has a generous vacation policy for its staff.

Answer:  C

Diff: 2     Type: MC     Page Ref: 186

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

22) When external users place heavy reliance on the financial statements it is appropriate that

  1. A) audit risk be increased.
  2. B) inherent risk be decreased.
  3. C) inherent risk be increased.
  4. D) audit risk be decreased.

Answer:  D

Diff: 3     Type: MC     Page Ref: 187

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

23) PA recently finished the audit of a family-owned business. Now, she is working on a large client with about 50 times the assets and 30 times total revenue. For the larger client, PA will likely have

  1. A) no effect on the audit risk model.
  2. B) higher control risk.
  3. C) higher audit risk.
  4. D) lower audit risk.

Answer:  D

Diff: 2     Type: MC     Page Ref: 187

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

 

24) PA is working on the audit of a publicly held corporation. At what level will the auditor likely set audit risk?

  1. A) low
  2. B) medium
  3. C) high
  4. D) very high

Answer:  A

Diff: 2     Type: MC     Page Ref: 187

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

25) PA is comparing the liabilities section of ABC Ltd. from last year to this year. Last year, ABC Ltd. had large loans due to major shareholders and officers and to one bank. This year, the debt has been reorganized, so there are now two different banks used for loans. Instead of having debt to shareholders and officers, the company now owes notes to 25 different foreign investors, who are entitled to convert the debt to shares if interest is not paid or if principal instalments are not paid on time. For this year’s audit, how will the change in debt structure affect the audit risk model?

  1. A) no effect on the audit risk model
  2. B) higher control risk
  3. C) lower audit risk
  4. D) higher audit risk

Answer:  C

Diff: 2     Type: MC     Page Ref: 187

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

26) Which one of the following would be a signal as to possible problems with management integrity?

  1. A) reliance on debt rather than equity for financing permanent assets
  2. B) rotation of holidays in the supervisory area over a period of months
  3. C) rapidly declining profits or increasing losses over a period of years
  4. D) frequent disagreements with regulators and the Canada Revenue Agency

Answer:  D

Diff: 3     Type: MC     Page Ref: 189

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

 

27) A) Explain how auditors use the audit risk model when planning an audit.

 

  1. B) Describe the audit risk model and each of its components.

 

Answer:

  1. A) 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 detection risk, so as not to provide an unqualified opinion when material errors do in fact exist in the financial statements:

 

PDR =

 

  1. B) The planning form of the audit risk model is stated as follows:

 

PDR =

 

where:

PDR = planned detection risk

AR = audit risk

IR = inherent risk

CR = control risk

 

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. Detection risk determines the amount of substantive evidence that the auditor plans to accumulate.

 

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 auditor’s evaluation of management’s integrity.

 

Inherent risk is a measure of the auditor’s 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 auditor’s assessment of the likelihood that misstatements exceeding a tolerable amount in an account will not be prevented or detected by the client’s internal controls.

Diff: 2     Type: ES     Page Ref: 184-186

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

 

28) Discuss three factors that affect client business risk, and therefore audit risk.

Answer:  Business risk and audit risk are affected by:

  • The degree to which external users will rely on the statements. For large, publicly-held clients, client business risk is greater, and audit risk will be less, than for small, privately held clients.
  • The likelihood that a client will have financial difficulties after the audit report is issued. Client business risk is greater, and audit risk will be lower, when the client is experiencing financial difficulties.
  • The auditor’s evaluation of management’s integrity. Client business risk is greater, and audit risk will be lower, when the client’s management has questionable integrity.

Diff: 2     Type: ES     Page Ref: 187-190

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

29) 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.

 

SITUATION

 1  2  3  4
Audit risk  1%  10%  10%  5%
Inherent risk  100%  100%  50%  20%
Control risk  100%  100%  40%  30%
Detection risk  ________  ________  ________  ________

 

Answer:  1. 1%; 2. 10%; 3. 50%; 4. 83.3%

Diff: 1     Type: ES     Page Ref: 186

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

30) In practice, auditors rarely assign numerical probabilities to inherent risk, control risk, or 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 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
Audit risk  Low  Low  High  High
Inherent risk  High  Low  Low  Low
Control risk  High  Low  Medium  Low
Detection risk  ________  ________  ________  ________
Planned

evidence

 ________  ________  ________  ________

 

Answer:

  1. low, high
  2. medium, medium
  3. medium, medium
  4. high, low

Diff: 2     Type: ES     Page Ref: 186

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

31) Your firm has been appointed as the auditor of Bush Mining Inc. (BMI), a company that runs small mining operations in remote areas of northern Canada, primarily in surface mines. You have been assigned the job of audit senior for BMI.

BMI’s operations are subject to provincial and federal laws and regulations. These laws and regulations have become stricter in recent years and some of BMI’s older mines may be in violation of environmental laws.

 

Surface mining produces tailings (toxic wastes that are dangerous to animal and plant life). These tailings are either further processed and buried or retained in tailings ponds. BMI is required to restore the mining property to a safe condition after a mine is exhausted. BMI has programs in place to monitor and control pollutants that are released to the air and to local waterways.

 

Required:

 

  1. A) What factors would affect the client business risk of BMI? Based upon your assessment of BMI’s client business risk, would you adjust audit risk? Why or why not?

 

  1. B) What is your preliminary assessment of audit risk? Justify your answer.

 

Answer:

  1. A) The factors that affect business risk also affect audit risk. Each factor is discussed in turn:

Reliance on statements by external users: BMI likely has shareholders, financial institution and regulatory agencies (such as environmental agencies and Canada Revenue Agency) using the financial statements.

Likelihood of financial failure: The company probably has fluctuating profits, depending upon metal commodity prices. Also, if there are heavy fines or environmental problems, this increases the risk of financial failure.

Management’s integrity: There are no indicators of management integrity problems. However, management probably has a bias towards not disclosing environmental violations.

Based upon the above factors, I would lower audit risk because of the likely volatility of the business and the potential for exposure with respect to environmental matters.

  1. B) I would assess audit risk as low, due to factors discussed in (a).

Diff: 3     Type: ES     Page Ref: 187-190

Learning Obj.:   7-1  State the components of the audit risk model and describe the process used to assess audit risk

 

 

32) Mugsy Brights Limited (MBL) is a private company in Winnipeg that sells mugs, jars and bottles in a variety of colours, sizes and materials. MBL is owned by four equal owners since inception. The owners have different skills – creative design, marketing, finance and information systems. The company attributes much of its success to the use of materials that can be easily shipped without breaking, and unique designs that appeal to a variety of buyers, particularly commercial buyers who purchase for restaurants, or for businesses who choose to advertise their business by giving away or selling regular or travel mugs.

 

The owners meet formally every month, and have informal meetings two or three times per week to discuss particular clients or new approaches. About a quarter of the sales are via the company’s secure web site, while the remainder are by telephone or purchase order. MBL works with distributors of kitchenware, selling wholesale to hundreds of outlets in Canada. Most of these sales are done via the telephone, although a salesperson does spend some time in major cities across the country visiting some of the large customers, helping with shelf layout and marketing to the ultimate consumers for larger distributors. These efforts have resulted in gradually increasing market share for the company.

 

All sales are recorded in the accounting software package used by the company. The accounting manager reports directly to one of the owners, and there are two other employees in the accounting department. Password controls are used to limit functions that are accessible by employees. For example, only the controller can implement wage rate increases or product price increases (which are reviewed and approved by the owner responsible for marketing). Two owners are required to sign cheques, and do so with source documents attached. Similarly, two owners are required to approve new employees.

 

All manufacturing is outsourced to local producers who work with different materials. For example, a different supplier handles steel mugs versus plastics or glass. Ceramics is rarely used as it is quite breakable, whereas some forms of glass are very durable. MBL does not hold any inventory, as manufacturing is all done to order. However, as there have been some collection problems from customers, the company has had to go to the maximum of its line of credit, and has no additional borrowing capacity available. It is waiting for the results of the audited financial statements to approach the bank for an increase in its line of credit.

 

Internet sales are prepared (via credit card), while sales to distributors are net thirty. The company has an April year end.

 

 

Following are extracts from the annual financial statements:

 

2012 2011 2010
Cash $99,000 $110,000 $124,000
Accounts receivable $320,000 $220,000 $150,000
Fixed assets (net) $15,000 $20,000 $25,000
Accounts payable $270,000 $180,000 $150,000
Bank indebtedness $100,000 $25,000 $0
Share capital $200,000 $200,000 $200,000
Revenue $625,310 $538,120 $507,380
Cost of sales $406,452 $333,634 $304,428
Administration expenses $89,000 $57,000 $58,000
Sales expenses $31,266 $21,525 $20,295
Amortization $5,000 $5,000 $5,000

 

Required:

  1. A) What audit risk would you assign to the company? Why? [Tip: Do some calculations and consider client business risk.]
  2. B) Calculate preliminary materiality. Justify your decision of materiality base and choice of materiality.

Answer:

  1. A)
2012 2011 2010
cost of sales percent 65 62 60
sales expenses percent 5 4 4
net income $93,593 $120,961 $119,657

 

Client business risk should be set at high, because:

– Net income has declined substantially in the current year (supported by dollar calculations), which may indicate that the company is facing declining profitability

– Cost of sales seems to be steadily declining (see calculations), the company may not be able to pass cost increases on to its customers

– there has been a large increase in accounts receivable (so there may be a collection problem)

– a large accounts receivable write-off could substantially reduce or eliminate the net income for the year

– this would reduce the ability of the company to borrow money from the bank

– there has been a large increase in accounts payable (so they may be holding funds to conserve cash)

– the company is at the edge of its line of credit, and may not be able to borrow additional funds:

– if so, there could be a going concern problem if the owners cannot contribute additional capital

 

Client business risk is reduced by:

– the fact that manufacturing is outsourced and there is no inventory, reducing financial exposure for unsold items

Audit risk could be argued to be any of low/med/high depending upon the emphasis given to the points raised above.

– primary users are the owners and the bank, which is a limited number of owners, which increases audit risk

– however, as the company is intending to borrow additional funds, the bank may be paying closer attention to the financial statements, which reduces audit risk

 

  1. B) Several potential methods for calculating materiality:

(1) five to ten percent of net income before taxes:

Net income: $93,593

low end of range: 5% = $4,680

high end of range: 10% = $9,359

(2) ½ to 5 percent of gross profit:

Gross profit: $218,859

low end of range: 1/2% = $1,094

high end of range: 5% = $10,943

(3) ½ to 1 percent of revenue:

Revenue: $625,310

low end of range: 1/2% = $3,127

high end of range: 1% = $6,253

Note: Base cannot be calculated using total assets or shareholders equity. If students state the assumption that they have all of the assets, or show the amounts that they have included in the calculation, then they could do a calculation based upon total assets, shown below, but they do not have retained earnings so could not do a base using shareholders equity.

(4) ½ to 1 percent of total assets:

Total assets: $434,000

low end of range: 1/2% = $ 2,170

high end of range: 1% = $ 4,340

 

Discussion:

– it is difficult to choose among bases, as revenue is increasing while net income is declining

– may be suitable to use an average of more than one base

– since revenue may be incorrect (due to potential problems with accounts receivable and accounts payable), it may be more suitable to do an average of one or more bases

Diff: 3     Type: ES     Page Ref: 184-190, 193-200

Learning Obj.:  7-1  State the components of the audit risk model and describe the process used to assess audit risk (for A); 7-3  Examine how materiality is used to assess the amount of work conducted during an audit engagement (for B)

 

 

7.2   Describe the factors the auditor considers when assessing inherent risk

 

1) An important role of inherent risk assessment during the audit process is the need to

  1. A) document the quality of the disaster recovery plan.
  2. B) attempt to predict where misstatements are most and least likely in the financial statement segments.
  3. C) train the audit staff to assess the integrity of management.
  4. D) increase the level of analytical review.

Answer:  B

Diff: 3     Type: MC     Page Ref: 190

Learning Obj.:   7-2  Describe the factors the auditor considers when assessing inherent risk

 

2) Which of the following describes the components of the audit risk model that are used to describe the risk of material misstatement (RMM)?

  1. A) AR / DR
  2. B) IR × CR
  3. C) IR × DR
  4. D) CR × DR

Answer:  B

Diff: 2     Type: MC     Page Ref: 190

Learning Obj.:   7-2  Describe the factors the auditor considers when assessing inherent risk

 

3) The inherent risk of programming errors (and thus processing errors for the affected application systems) increases when

  1. A) programs are customized by an external software house.
  2. B) the company uses an internet-based applications service provider.
  3. C) standard software packages are used for processing transactions.
  4. D) programs are customized by an understaffed information system group.

Answer:  D

Diff: 3     Type: MC     Page Ref: 191

Learning Obj.:   7-2  Describe the factors the auditor considers when assessing inherent risk

 

4) The inherent risks of programming errors with resulting data loss increases when

  1. A) packaged software is used that has to be updated every year.
  2. B) complex configurations such as ERP at multiple locations are used.
  3. C) functional systems are used (such as separate systems for sales and payroll).
  4. D) sequential file systems are used rather than database management systems.

Answer:  B

Diff: 3     Type: MC     Page Ref: 191

Learning Obj.:   7-2  Describe the factors the auditor considers when assessing inherent risk

 

5) The inherent risks of data compromise (such as privacy violations) or data loss increase when

  1. A) documents are sent by regular mail to confirm contract details.
  2. B) information is encrypted using public key technology.
  3. C) organizations use web sites to process sales transactions.
  4. D) packaged software is used to process sales transactions.

Answer:  C

Diff: 3     Type: MC     Page Ref: 191

Learning Obj.:   7-2  Describe the factors the auditor considers when assessing inherent risk

 

6) Use of electronic funds transfers (such as electronic data interchange and online banking) has which of the following effects on the audit risk model?

  1. A) decreases control risks associated with cash
  2. B) increases control risks associated with cash
  3. C) decreases inherent risks associated with cash
  4. D) increases inherent risks associated with cash

Answer:  D

Diff: 3     Type: MC     Page Ref: 191

Learning Obj.:   7-2  Describe the factors the auditor considers when assessing inherent risk

 

7) You generally consider your audit client’s management to be honest. However, they do have a bias towards wanting to understate their income to lower income taxes. How would this bias be implemented in the audit risk model?

  1. A) reduce audit risk and reduce inherent risk
  2. B) increase audit risk and reduce inherent risk
  3. C) reduce audit risk and increase inherent risk
  4. D) increase audit risk and increase inherent risk

Answer:  C

Diff: 3     Type: MC     Page Ref: 191

Learning Obj.:   7-2  Describe the factors the auditor considers when assessing inherent risk

 

8) Senior management of Mega Corp. is entitled to receive large bonuses if they achieve earnings targets. What is the effect of this on the risks associated with recording of revenue? It increases

  1. A) inherent risks associated with revenue cutoff and existence assertions.
  2. B) inherent risks associated with revenue cutoff and completeness assertions.
  3. C) control risks associated with revenue cutoff and existence assertions.
  4. D) control risks associated with revenue cutoff and completeness assertions.

Answer:  A

Diff: 3     Type: MC     Page Ref: 191

Learning Obj.:   7-2  Describe the factors the auditor considers when assessing inherent risk

 

 

9) PA is auditing a client where the accounts receivable are in worse shape than last year: many accounts are significantly overdue. How would this fact be dealt with in the audit risk model?

  1. A) increase inherent risk for accounts receivable
  2. B) decrease inherent risk for accounts receivable
  3. C) increase control risk for accounts receivable
  4. D) decrease control risk for accounts receivable

Answer:  A

Diff: 3     Type: MC     Page Ref: 191

Learning Obj.:   7-2  Describe the factors the auditor considers when assessing inherent risk

10) If inherent risk is considered at the assertion level, why does the nature of the client’s business affect inherent risk?

  1. A) Certain accounts, such as inventory, are affected by the nature of the client’s business.
  2. B) If the client has really basic manufacturing processes, inherent risk is low.
  3. C) When there is a risk of technological obsolescence, a specialist must be used during the engagement.
  4. D) Accounts such as cash, notes and mortgages payable vary depending upon the type of business.

Answer:  A

Diff: 3     Type: MC     Page Ref: 192

Learning Obj.:   7-2  Describe the factors the auditor considers when assessing inherent risk

 

11) 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 considered to be

  1. A) significant.
  2. B) insignificant.
  3. C) material.
  4. D) relevant.

Answer:  C

Diff: 1     Type: MC     Page Ref: 192

Learning Obj.:   7-2  Describe the factors the auditor considers when assessing inherent risk

 

12) CAS 320 (Materiality in planning and performing an audit) defines materiality in terms of three key concepts. The first and second concepts are that a material misstatement should be considered in the context of knowledgeable users and the effect on decision making and that material is relative to circumstances surrounding the decision and nature of the information. The third concept is

  1. A) that the auditor should consider users of financial statements as a group.
  2. B) that the auditor should consider users of financial statements individually.
  3. C) that the users should be informed and approve of the materiality used by the auditor.
  4. D) that the auditor should be conservative in setting the materiality level.

Answer:  A

Diff: 3     Type: MC     Page Ref: 192

Learning Obj.:   7-2  Describe the factors the auditor considers when assessing inherent risk

 

13) GreenGrow Limited is a local landscaping company that does household and commercial landscaping. Primarily, it helps businesses select plants and manage the plants. It also has regular maintenance contracts such as watering, weeding, and mowing. In the winter, it has some contracts for managing the indoor plants of shopping malls, and does snow clearing to help boost that low income season.

 

Joey, the majority shareholder of GreenGrow is ecstatic. He has managed to come in as the low bidder for a new type of contract. He bid on the construction of a track for the track and field area of a local university. A piece of land on the north end of the university is being cleared and GreenGrow will be leveling the land and placing a bed of crushed stone for the track. Joey has just the right person to be in charge. Jack has previous experience working as an assistant on a road crew and knows how to use the surveying equipment needed to keep the track level. This is a big contract, and will increase revenues by one third!

 

Required:

Assess inherent risk for revenue for GreenGrow Limited.

Answer:  I would assess inherent risk for revenue for GreenGrow Limited as high.

Reasons:

  • Income in the winter season is volatile, depending upon snowfall.
  • There is a new contract for a track which is expected to comprise 30% of income. GreenGrow has never done this kind of work before, and may not be able to complete the contract in a timely manner.
  • The above is a non-routine transaction which may be recorded incorrectly; we will need to determine that the costs and revenues are properly matched in this contract, which will require different accounting methods than maintenance and landscaping revenues.

– the company is relying heavily on Jack’s previous experience working as an assistant on a road crew which may not be sufficient experience to fulfill the contract.

Diff: 3     Type: ES     Page Ref: 190-192

Learning Obj.:   7-2  Describe the factors the auditor considers when assessing inherent risk

 

14) Big Box Distribution Company has an in-house information systems department of 50 people. The company generally does its own programming, although some software was acquired as a software package.

 

In addition, a software package was purchased for customer relationship management, which will be modified by the programming staff.

 

Procedures for implementing programs vary by department. All major changes are approved by the Management Information Systems steering committee. The committee is also given a list of the maintenance changes that are planned in the coming year. Some departments request that the data processing department handle testing, while other users are rather picky and want to do their own testing.

 

Requirements are generally prepared in writing, although small maintenance changes may be handled verbally.

 

Required:

Assess inherent risk associated with program changes at Big Box.

Answer:  Inherent risks for programming errors are high. This means that there could be incorrect or unauthorized program changes, particularly for those departments where the information systems department handles all of the testing.

 

Reasoning:

The following behaviours increase the risks of unauthorized or incorrect program changes:

  • Maintenance changes do not require independent approval (this means that anyone can initiate a program change).
  • Maintenance changes may be made without a written request or may not be documented (same as above, it also means that program change may be made without being documented or tested).
  • Customized systems are in use; customized systems are used by only one business, i.e. Big Box, and tend to have less testing and documentation than package systems, meaning that there is a greater likelihood of program error.

Diff: 3     Type: ES     Page Ref: 190-192

Learning Obj.:   7-2  Describe the factors the auditor considers when assessing inherent risk

 

 

7.3   Examine how materiality is used to assess the amount of work conducted during an audit engagement

 

1) Silka is in the process of performing an audit. During the audit, Silka decided to change materiality. A valid reason for this would be

  1. A) a new user of the financial statements was identified.
  2. B) a fraud was discovered in the accounts payable section.
  3. C) materiality required the auditors to perform too many tests.
  4. D) too many errors were found during testing.

Answer:  A

Diff: 3     Type: MC     Page Ref: 192

Learning Obj.:   7-3  Examine how materiality is used to assess the amount of work conducted during an audit engagement

2) Which of the following types of misstatements has the highest level of certainty?

  1. A) identified misstatements
  2. B) likely misstatements
  3. C) likely aggregate misstatements
  4. D) further possible misstatements

Answer:  A

Diff: 3     Type: MC     Page Ref: 193

Learning Obj.:   7-3  Examine how materiality is used to assess the amount of work conducted during an audit engagement

 

3) Further possible misstatement considers

  1. A) possible presence of management fraud.
  2. B) possible lack of knowledge of the audit team.
  3. C) imprecision in the sampling process.
  4. D) imprecision in the audit procedures.

Answer:  C

Diff: 2     Type: MC     Page Ref: 193

Learning Obj.:   7-3  Examine how materiality is used to assess the amount of work conducted during an audit engagement

 

4) The first step in applying materiality is

  1. A) estimating the misstatement in a segment, for each functional cycle.
  2. B) setting a judgment about materiality for the financial statements as a whole.
  3. C) estimating the combined effects of errors.
  4. D) comparing the error estimate with the materiality levels.

Answer:  B

Diff: 3     Type: MC     Page Ref: 193

Learning Obj.:   7-3  Examine how materiality is used to assess the amount of work conducted during an audit engagement

 

 

5) If the auditor sets a low dollar amount as materiality,

  1. A) more evidence is required than for a high amount.
  2. B) less evidence is required than for a high amount.
  3. C) the same amount of evidence is required as for a high dollar amount.
  4. D) it has no effect on the amount of evidence required.

Answer:  A

Diff: 3     Type: MC     Page Ref: 194

Learning Obj.:   7-3  Examine how materiality is used to assess the amount of work conducted during an audit engagement

 

6) Since materiality is relative, it is necessary to have bases for establishing whether misstatements are material. Normally, the most important base for deciding what is material, because it is regarded as a critical item of current period information for users, is

  1. A) total assets.
  2. B) net income.
  3. C) net working capital.
  4. D) net income before taxes.

Answer:  D

Diff: 2     Type: MC     Page Ref: 195

Learning Obj.:   7-3  Examine how materiality is used to assess the amount of work conducted during an audit engagement

7) The auditors have decided upon a materiality level of $100,000 for their audit of ABC Manufacturing. Which one of the following errors would be considered more important by the auditors? An

  1. A) error in accounts receivable cut-off of $50,000.
  2. B) overstatement of accounts payable by $15,000.
  3. C) error in allocation between accounts receivable and accounts payable by $75,000.
  4. D) illegal payment of $15,000.

Answer:  D

Diff: 3     Type: MC     Page Ref: 195

Learning Obj.:   7-3  Examine how materiality is used to assess the amount of work conducted during an audit engagement

 

8) The materiality for Holloy Company is $75,000. There are carryforward misstatements of $25,000 from the previous year. Current year anticipated misstatements are $15,000, with anticipated corrections of $10,000. What is the performance materiality?

  1. A) $45,000
  2. B) $50,000
  3. C) $55,000
  4. D) $90,000

Answer:  A

Diff: 3     Type: MC     Page Ref: 197

Learning Obj.:   7-3  Examine how materiality is used to assess the amount of work conducted during an audit engagement

 

 

9) Materiality should be adjusted for the effect of net anticipated misstatements to determine performance materiality available for

  1. A) identified misstatements.
  2. B) likely misstatements.
  3. C) unanticipated misstatements.
  4. D) further possible misstatements.

Answer:  C

Diff: 3     Type: MC     Page Ref: 197

Learning Obj.:   7-3  Examine how materiality is used to assess the amount of work conducted during an audit engagement

 

10) When an auditor allocates materiality to segments, then the materiality amount for different accounts under audit will

  1. A) potentially differ from each other.
  2. B) require the same level of unanticipated misstatements.
  3. C) require the same amount of audit work.
  4. D) be the same for each account audited.

Answer:  A

Diff: 3     Type: MC     Page Ref: 198

Learning Obj.:   7-3  Examine how materiality is used to assess the amount of work conducted during an audit engagement

11) The purpose of allocating planning materiality to balance sheet accounts is to

  1. A) assess the appropriate evidence to accumulate for each account on the balance sheet.
  2. B) assess the appropriate evidence to accumulate for each account on both the balance sheet and income statement.
  3. C) reduce the amount of procedures done in the course of the audit.
  4. D) increase the possibility that fraud or illegal activities would be detected by audit procedures.

Answer:  B

Diff: 3     Type: MC     Page Ref: 198

Learning Obj.:   7-3  Examine how materiality is used to assess the amount of work conducted during an audit engagement

 

12) If an auditor were to calculate an estimate of the errors by direct projection from the sample to the population, and found $7,000 of net overstatement errors in a sample of $100,000 out of a total population of $900,000, the estimate of errors in the population is

  1. A) $6,300.
  2. B) $778.
  3. C) $63,000.
  4. D) $77,778.

Answer:  C

Diff: 2     Type: MC     Page Ref: 199

Learning Obj.:   7-3  Examine how materiality is used to assess the amount of work conducted during an audit engagement

 

 

13) A) Discuss each of the six steps in applying materiality in an audit, and identify the audit phase(s) in which each step is performed.

 

  1. B) Discuss the three main factors that affect an auditor’s preliminary judgment about materiality.

 

Answer:

  1. A)

Step 1. Set 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. Establish performance materiality. Materiality is adjusted for the effect of net anticipated misstatements to determine materiality available for unanticipated misstatements. This is done during the planning stage.

Step 3. Allocate planning materiality to segments (not commonly done). In this step, some auditors allocate the preliminary judgment about materiality to the balance sheet accounts. This allocation is performed in the audit planning stage.

Step 4. 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 5. 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 6. Compare combined estimated misstatement with materiality. If the combined estimated misstatement is less than or equal to 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.

  1. B) 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 total assets, revenue, gross profit, 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 irregularities.

Diff: 3     Type: ES     Page Ref: 194-200

Learning Obj.:   7-3  Examine how materiality is used to assess the amount of work conducted during an audit engagement

 

 

14) Lauralye Leasing Limited (LLL) provides lease financing to companies and individuals for equipment other than automobiles. Leases on commercial signs make up 50% of total leases, computer and telecommunications equipment are 30% and restaurant equipment makes up most of the remainder. LLL’s customers arrange to buy new equipment from equipment dealers, then contact LLL to arrange lease financing.

 

LLL was founded over thirty years ago by Laura and Al Ye. It is now run by Mr. and Mrs. Ye’s daughter, Betsy, who is the President of LLL. LLL owns a small building downtown, where the offices of the business are located. Unused office space is rented out to other commercial tenants.

Betsy was a classmate of yours at York University, and you have kept loosely in touch over the years. This year, she moved the audit to your firm (a local firm with five partners), deciding that the firm her parents had hired many years ago did not really understand her business’ needs.

 

LLL has a small loan that is used to cover blips in working capital. The company has two salespeople. Most loans are received from stores throughout the city, with whom LLL has standing agreements. If customers require financing, they fill in an application at the store, which is faxed to LLL for approval. LLL will reply within two business days.

 

The company has been profitable for many years. There are no extraordinary items in the current year’s financial statements.

 

Selected financial information is as follows:

 

Current assets                   $9,910,000

Long term assets             $46,500,000

Short term liabilities        $30,700,000

Shareholders’ equity        $25,710,000

Revenue                          $10,200,000

Expenses                           $5,600,000

Income before tax             $4,600,000

(and before bonus)

 

Required:

  1. A) Which base would you use to calculate materiality? Why?
  2. B) Calculate materiality. Choose a specific number, and explain why you chose that amount.

 

Answer:

  1. A) Normally, net income before income taxes and bonus would be used to calculate materiality. The company has been profitable for many years, and there is no need to consider other bases. Gross profit applies more to companies that sell products or have direct costs associated with products. Total assets, equity and revenue are used as bases if net income fluctuates or if the company is experiencing losses.

 

  1. B) The range applied to net income is 5% to 10%, which would result in a materiality range of $230,000 to $460,000. The company is a private company, with the shareholders and the bank as users. Due to the few users, we would likely go towards the larger end of this range, i.e. $460,000.

Diff: 3     Type: ES     Page Ref: 195

Learning Obj.:   7-3  Examine how materiality is used to assess the amount of work conducted during an audit engagement

 

7.4   Relate the components of the audit risk model to the amount of evidence that should be collected during an audit

 

1) When a different extent of evidence is needed for the various cycles, the difference is caused by

  1. A) errors in the client’s accounting system.
  2. B) the client’s need to achieve an unqualified opinion.
  3. C) the auditor’s need to follow GAAS.
  4. D) the auditor’s expectations of errors and assessment of internal control.

Answer:  D

Diff: 2     Type: MC     Page Ref: 201

Learning Obj.:   7-4  Relate the components of the audit risk model to the amount of evidence that should be collected during an audit

 

2) Audit risk is ordinarily set by the auditor during planning and

  1. A) held constant for each major cycle and account.
  2. B) held constant for each major cycle but varies by account.
  3. C) varies by each major cycle and by each account.
  4. D) varies by each major cycle but is constant by account.

Answer:  A

Diff: 2     Type: MC     Page Ref: 201

Learning Obj.:   7-4  Relate the components of the audit risk model to the amount of evidence that should be collected during an audit

 

3) Because control risk and inherent risk vary from cycle to cycle, account to account, or objective to objective,

  1. A) audit risk must also change.
  2. B) planned detection risk and required audit evidence will also vary.
  3. C) planned detection risk will vary but audit evidence will remain constant.
  4. D) planned detection risk will remain constant but audit evidence will vary.

Answer:  B

Diff: 2     Type: MC     Page Ref: 202

Learning Obj.:   7-4  Relate the components of the audit risk model to the amount of evidence that should be collected during an audit

 

4) 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,

  1. A) the same amount of evidence will be gathered for each cycle.
  2. B) a different extent of evidence is needed for various cycles.
  3. C) he/she has not followed generally accepted auditing standards.
  4. D) the level for each cycle must be no more than 2% so that the entire audit does not exceed 10%.

Answer:  B

Diff: 3     Type: MC     Page Ref: 202

Learning Obj.:   7-4  Relate the components of the audit risk model to the amount of evidence that should be collected during an audit

 

5) The audit risk model is

  1. A) a planning, testing, and evaluation model.
  2. B) useful in planning but of limited value in evaluating results.
  3. C) useful in evaluating results but of limited use in planning.
  4. D) useful when performing the tests of balances, but of little value in either the planning or evaluation stages.

Answer:  B

Diff: 3     Type: MC     Page Ref: 204

Learning Obj.:   7-4  Relate the components of the audit risk model to the amount of evidence that should be collected during an audit