Chapter 8 Audit Planning and Analytical Procedures

8.1 Learning Objective 8-1

1) 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
A) inherent risk.
B) acceptable audit risk.
C) statistical risk.
D) financial risk.

2) The first phase in planning an audit and designing an audit approach is to

A) accept the client and perform initial audit planning.
B) set the preliminary judgment of materiality.
C) understand the client's business and industry.
D) perform preliminary audit procedures.

3) _______ is the risk that the financial statements contain a material misstatement due to fraud
or error prior to the audit.
A) Inherent risk
B) Client business risk
C) Acceptable audit risk
D) Risk of material misstatement

4) In what order should the following steps occur?

A. Set preliminary judgment of materiality and performance materiality.
B. Understand the clients business and industry.
C. Perform preliminary analytical procedures.
D. Accept the client and perform initial audit planning.
A) D, B, C, A
B) B, A, C, D
C) B, D, A, C
D) D, C, B, A

5) The auditor uses knowledge gained from the understanding of the client's business and
industry to assess
A) client business risk.
B) control risk.
C) inherent risk.
D) audit risk.

6) There are three main reasons why an auditor should properly plan audit engagements. Discuss
each of these reasons.
Answer: There are three main reasons why the auditor should properly plan engagements:
1. To enable the auditor to obtain sufficient appropriate evidence for the circumstances in
order to minimize legal liability and maintain a good reputation in the business
community.
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 2. To help keep audit costs reasonable helps the firm remain competitive.
3. To avoid misunderstandings with the client is necessary for good client relations and for
facilitating high-quality work at reasonable cost.

True – false questions

7) When an auditor sets a low acceptable audit risk, it means that he wants to be more certain
that the financial statements are not materially misstated. True
8) As acceptable audit risk is decreased, the likely cost of conducting an audit increases. True

9) Assessing acceptable audit risk, client business risk, and risk of material misstatement helps
determine the audit procedures that will be needed. True

10) A 100 % audit risk is complete certainty. False

8.2 Learning Objective 8-2

1) One of the purposes of an engagement letter is to avoid misunderstandings with the client.
This is important for
A)
Engagement objectives Engagement limitations
Yes Yes

B)
Engagement objectives Engagement limitations
No No

C)
Engagement objectives Engagement limitations
Yes No

D)
Engagement objectives Engagement limitations
No Yes

2) The auditor is likely to accumulate more evidence when the audit is for a company
A)
Which has large amounts of debt Which is to be sold in the near future
Yes Yes

B)
Which has large amounts of debt Which is to be sold in the near future
No No

C)
Which has large amounts of debt Which is to be sold in the near future
Yes No

D)
Which has large amounts of debt Which is to be sold in the near future
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 No Yes

3) Initial audit planning involves four matters. Which of the following is not one of these?
A) Develop an overall audit strategy.
B) Request that bank balances be confirmed.
C) Schedule engagement staff and audit specialists.
D) Identify the client's reason for the audit.

4) Smith, CPA, has requested permission to communicate with the predecessor auditor in order
to review certain workpapers for high risk accounts for a new audit client. The new audit client's
refusal to allow this communication to occur would impact Smith's decision concerning
A) the auditor's ability to design audit tests.
B) possible scope exception due to lack of access.
C) the desirability of accepting the prospective engagement.
D) violation of the GAAP rules concerning consistency and comparability of financial
information.

5) A successor auditor may perform which of the following for a new audit client?
A)
Speak to local attorneys, banks and other
businesses regarding the company's Speak to the predecessor auditors about
reputation disagreements they had with management
Yes Yes

B)
Speak to local attorneys, banks and other
businesses regarding the company's Speak to the predecessor auditors about
reputation disagreements they had with management
No No

C)
Speak to local attorneys, banks and other
businesses regarding the company's Speak to the predecessor auditors about
reputation disagreements they had with management
Yes No

D)
Speak to local attorneys, banks and other
businesses regarding the company's Speak to the predecessor auditors about
reputation disagreements they had with management
No Yes

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6) When dealing with audit risk,
A) audit risk should not be a factor when determining if a new client should be accepted.
B) audits with a low acceptable audit risk generally result in lower audit fees.
C) if management of a company has a reputation of integrity, but is also known to take
aggressive financial risks, the auditor should not accept the company as a new client.
D) if the auditor concludes that acceptable audit risk is low, but the client is still acceptable, the
auditor may still accept the engagement but increase the fee proposed to the client.

7) A written understanding detailing what the auditor expects from the client in performing an
audit will normally be expressed in the
A) management letter requested by the auditor.
B) engagement letter.
C) audit Plan.
D) audit Strategy for the client.

8) For public companies, the ________ is responsible for hiring the auditor as required by the
Sarbanes-Oxley Act.
A) client's management
B) client's chief executive officer
C) client's chief financial officer
D) client's audit committee

9) Which of the following statements is true regarding communications between predecessor and
successor auditors?
A) The burden of initiating the communication rests with the predecessor.
B) The predecessor's response can be limited to stating that no information will be provided.
C) The predecessor should communicate with the successor only if the client is public.
D) The predecessor auditor of a public company does not need permission from the client before
communicating with the successor auditor.

10) The purpose of an engagement letter is to

A) document the CPA firm's responsibility to external users of the audited financial statements.
B) document the terms of the engagement.
C) notify the audit staff of an upcoming engagement so that personnel scheduling can be
facilitated.
D) emphasize management's responsibility for approving the audit program.

11) The written communication stating the auditor cannot guarantee that all acts of fraud will be
discovered is found in the
A) engagement letter.
B) representation letter.
C) responsibility letter.
D) client letter.

12) Which of the following normally signs the engagement letter for an audit of a private
company?
A) management
B) board of directors representative
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C) audit committee representative
D) corporate treasurer

13) The two major factors affecting acceptable audit risk are
A) inherent risk and the intended uses of the financial statements.
B) control risk and the intended uses of the financial statements.
C) the likely statement users and their intended uses of the statements.
D) the audit firm and the intended uses of the statements

14) An engagement letter sent to a publicly held audit client usually would not include a(n)
A) reference to the auditor's responsibility for the detection of errors or irregularities.
B) estimation of the time to be spent on the audit work by audit staff and management.
C) statement that management advisory services would be made available upon request.
D) reference to management's responsibility for the financial statements.

15) The preliminary audit strategy

A) is set before the auditor understands the client's reasons for the audit.
B) guides the development of the audit plan.
C) is determined after the engagement staffing is set.
D) is the detailed steps to be followed for the substantive audit tests.

16) The purpose of the requirement in having communication between the predecessor and
successor auditors is to
A) allow the predecessor to disclose information which would otherwise be confidential.
B) help the successor auditor to evaluate whether to accept the engagement.
C) help the client by facilitating the change of auditors.
D) ensure the predecessor collects all unpaid fees prior to a change in auditor.

17) The predecessor auditor is required to respond to the request of the successor auditor for
information, but the response can be limited to stating that no information will be provided when
A) the predecessor auditor has poor relations with the successor auditor.
B) the client is dissatisfied with the predecessor's work.
C) there are actual or potential legal problems between the client and the predecessor.
D) the predecessor believes that the client lacks integrity.

18) Which of the following best expresses the understanding of the terms of the engagement that
exist between the client and the CPA firm?
A) Management asserts there are no errors, material or immaterial, in the general ledger.
B) Auditors assert that the primary audit goal is audit efficiency.
C) Auditors assert that their primary responsibility is to plan and perform the audit in order to
provide reasonable assurance as to the detection of material misstatement due to error or fraud.
D) Management asserts that they will provide the auditor with a risk assessment as to material
misstatements due to errors or fraud in the company's financial statements.

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19) When selecting staff for the audit engagement
A) only staff members who are CPAs should be assigned to the audit.
B) only managers and above need to have appropriate competence and capabilities to perform
the audit.
C) continuity of staff members from year to year should not be a factor.
D) staff assigned to the audit must be knowledgeable about the client's industry.

20) When developing the overall strategy for the audit, the auditor will
A) decide whether to accept a new client.
B) determine if any audit specialists will be required.
C) identify why the auditor needs an audit.
D) obtain an engagement letter.

21) Which is usually included in an engagement letter?

A)
Estimate of hours required to Dollar estimate of fees to be billed to
complete audit the client
Yes Yes

B)
Estimate of hours required to Dollar estimate of fees to be billed to
complete audit the client
No No

C)
Estimate of hours required to Dollar estimate of fees to be billed to
complete audit the client
Yes No

D)
Estimate of hours required to Dollar estimate of fees to be billed to
complete audit the client
No Yes

22) Which is usually included in an engagement letter?

A)
Identification of the financial
The objectives of the reporting framework used by
engagement management
Yes Yes

B)
Identification of the financial
The objectives of the reporting framework used by
engagement management
No No

C)
The objectives of the Identification of the financial
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 reporting framework used by
engagement management
Yes No

D)
Identification of the financial
The objectives of the reporting framework used by
engagement management
No Yes

23) Which is usually included in an engagement letter?

A)
The financial statements are
the responsibility of the
company's management
Yes
Ratios to be used by the auditor in
the planning phase
Yes

B)
The financial statements are
the responsibility of the
company's management
No
Ratios to be used by the auditor in
the planning phase
No

C)
The financial statements are
the responsibility of the
company's management
Yes
Ratios to be used by the auditor in
the planning phase
No

D)
The financial statements are
the responsibility of the
company's management
No
Ratios to be used by the auditor in
the planning phase
Yes

24) When may the auditor refer to a specialist in the audit report?
A)
Only if the specialist's report Only if the specialist assisted in the
results in a modification of the audit audit of an account material to the
opinion financial statements
Yes Yes

B)
Only if the specialist's report Only if the specialist assisted in the
results in a modification of the audit audit of an account material to the
opinion financial statements
No No

C)
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 Only if the specialist's report Only if the specialist assisted in the
results in a modification of the audit audit of an account material to the
opinion financial statements
Yes No

D)
Only if the specialist's report Only if the specialist assisted in the
results in a modification of the audit audit of an account material to the
opinion financial statements
No Yes

25) Which is usually included in the engagement letter?

A)
Name(s) of the client personnel
The projected type of opinion on the responsible for supplying the auditor with
financial statement to be audited information
Yes Yes

B)
Name(s) of the client personnel
The projected type of opinion on the responsible for supplying the auditor with
financial statement to be audited information
No No

C)
Name(s) of the client personnel
The projected type of opinion on the responsible for supplying the auditor with
financial statement to be audited information
Yes No

D)
Name(s) of the client personnel
The projected type of opinion on the responsible for supplying the auditor with
financial statement to be audited information
No Yes

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26) Which is usually included in the engagement letter?
A)
List of audit procedures to be used
in inventory observation The auditors' assessment of audit risk
Yes Yes

B)
List of audit procedures to be used
in inventory observation The auditors' assessment of audit risk
No No

C)
List of audit procedures to be used
in inventory observation The auditors' assessment of audit risk
Yes No

D)
List of audit procedures to be used
in inventory observation The auditors' assessment of audit risk
No Yes

27) Discuss the factors an auditor should consider before accepting a company as an audit client.
Answer: The auditor should investigate and consider the prospective client's standing in the
business community, financial stability, management's integrity, and relations with its bankers,
attorneys, and previous CPA firm. The auditor should also determine whether he or she possesses
the required competence and independence to do the audit.

28) Discuss the primary purpose of an audit engagement letter. Is an engagement letter required?
Answer: The purpose of an audit engagement letter is to establish a clear understanding between
the auditor and the client regarding the terms of the engagement. An engagement is required for
both public and private company audits.

29) Discuss the essential activities involved in the initial planning of an audit.
Answer: There are four essential activities involved in the initial planning of an audit. These are:
1. Client acceptance or continuation. In the case of a new client, the auditor must determine
whether the client is one with which they wish to be associated with. In the case of a
continuing client, an auditor must determine whether continuing the relationship is
appropriate and in the firm's best interest.

2. Identify client’s reasons for audit. The remainder of the planning activities may be
impacted by the client's reason for requesting the audit.

3. Obtain an understanding with the client. An understanding with the client should be
obtained to avoid misunderstandings. Auditors are required to obtain an understanding
with their clients in an engagement letter.

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 4. Develop an overall audit strategy. The strategy should consider the reasons for the audit,
including engagement staffing and any required audit specialists. Setting a strategy helps
the auditor determine the resources required for the engagement.

30) Discuss the required communications between predecessor and successor auditors.
Answer: Auditing standards require a successor auditor to communicate with the predecessor
auditor whenever accepting a client that has been previously audited. The purpose of the
communication is to help the successor auditor evaluate whether to accept the engagement.
While the burden of initiating the communication rests on the successor auditor, the predecessor
auditor must respond to the request for information. However, because of the requirements
related to confidentiality, the predecessor must obtain the former client's permission prior to
providing information to the successor.

31) Discuss several reasons why an auditor may not wish to continue a relationship with an
existing audit client.
Answer: There are a number of reasons an auditor may choose not to continue a relationship with
an existing client. Examples include:
1. previous conflicts over the appropriate scope of the audit, the type of opinion to issue, unpaid
fees, or other matters
2. management integrity may be deemed to be insufficient
3. legal action initiated by either the auditor or client related to prior audit services
4. the presence of excessive risk which could result in financial failure of the client or lawsuits
against the audit firm

32) Discuss four of the matters that should be specified in an engagement letter.
Answer: Auditing standards require that auditors obtain an understanding with the client in an
engagement letter, including the engagement’s objectives, the responsibilities of the auditor and
management, identification of the financial reporting framework used by management, reference
to the expected form and content of the audit report, and the engagement’s limitations.

True false questions

33) Before accepting a new client, most CPA firms investigate the company to determine its
acceptability. However, AICPA confidentiality requirements prohibit CPA firms from contacting
certain parties–namely the company's attorneys and bankers–during this investigation. False

34) For prospective clients that have previously been audited by another CPA firm, the
predecessor auditor must initiate the communication with the successor auditor. False

35) When a successor auditor contacts a company's previous auditor, the predecessor auditor is
required to respond fully and without limit to the request for information. False

36) A predecessor auditor who has been contacted by a successor auditor for information about
the client does not have to obtain permission from the former client before providing any
confidential information to the successor auditor because the confidentiality requirement does
not extend to former clients. False

37) An auditor must evaluate a specialist's professional qualifications and understand the
objectives of the specialist's work. True
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38) Because of audit risk, some CPA firms now refuse any new clients in certain high-risk
industries. True

39) An engagement letter establishes a clear understanding of the terms of the engagement
between the client and the auditor. True

40) Because auditors are responsible for having appropriate competence and capabilities to
perform an audit, auditors are not normally permitted to consult with outside specialists during
an audit engagement. False

41) If a prospective client has been audited in the past, the successor auditor will typically rely
solely on the representations about the client by the predecessor auditor. False

42) A major consideration in audit staffing is the need for continuity from year to year. True

43) When a successor auditor requests information from a company's previous auditor, and there
are legal problems or disputes between the client and the predecessor auditor, the predecessor
auditor's response to the new auditor may be limited to stating that no information will be
provided. True

44) Staff assigned to an audit engagement must be knowledgeable about the client's industry.
True

8.3 Learning Objective 8-3

1) In order to obtain an understanding of the client's business, the audit firm will consider
A) inherent and control risk of the client.
B) audit risk to the CPA firm.
C) the client's business risk and the risk of material misstatements in the financial statements.
D) the CPA firm's potential ongoing revenue from the audit client.

2) Most auditors assess the risk of material misstatement as high for related parties and related-
party transactions because
A) of the unique classification of related-party transactions required on the balance sheet.
B) of the lack of independence between the parties.
C) of the unique classification of related-party transactions required on the income statement.
D) it is required by generally accepted accounting principles.

3) A tour of the client's facilities provides the auditor an opportunity to

A) meet key personnel.
B) observe operations.
C) assess physical safeguards over assets.
D) all of the above

4) The auditor determines that Matthews Company occupies the 3rd floor of an office tower for
which it pays no rent. The most likely explanation is
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A) they got lucky the landlord hasn't noticed the lack of payments.
B) the landlord has weak internal controls over billings.
C) a related party transaction in which a major shareholder owns the office tower.
D) Matthews Company is engaging in fraudulent activities.

5) An official record of meetings of the board of directors and stockholders is included in the
corporate
A) bylaws.
B) charter.
C) minutes.
D) license.

6) A related party transaction may be indicated when another company

A) subsidizes certain operating expenses of the company.
B) purchases its securities at their fair value.
C) loans to company at market rates.
D) has had a distributor relationship with the company for 10 years.

7) Which of the following is an accurate statement regarding a public company's code of ethics?
A) A code of ethics is required under The Foreign Corrupt Practices Act.
B) A code of ethics is required only for mid-level managers and below.
C) The SEC requires companies to disclose amendments and waivers to the code of ethics for the
CEO, CFO and principal accounting officer.
D) The PCAOB requires companies to review their code of ethics every five years.

8) An auditor should examine minutes of the board of directors' meetings

A) through the date of the financial statements.
B) through the date of the audit report.
C) only at the beginning of the audit.
D) on a test basis.t

9) Which of the following would most likely not be classified as a related-party transaction?
A) an advance of one week's salary to an employee
B) sales of merchandise between affiliated companies
C) loans or credit sales to the principal owner of the client company
D) exchanges of equipment between two companies owned by the same person

10) Which of the following best describes the corporate minutes of an entity?
A) official record of the meetings of the board of directors and the stockholders
B) unofficial record of the meeting of the board of directors
C) official record of management meeting with investors and creditors of the company
D) unofficial record of the board of directors meetings

11) Related party

A) transactions must be disclosed in the footnotes even if the amounts are immaterial.
B) disclosures include the nature of the related party relationship and a description of the
transaction.
C) transactions are considered arm's-length transactions.
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D) disclosures are required only for public companies.

12) Auditors should understand client objectives related to

A) reliability of financial reporting.
B) effectiveness and efficiency of operations.
C) compliance with laws and regulations.
D) all of the above.

13) When analyzing a client's performance measurement system,

A) ratio analysis and benchmarking against key competitors are utilized.
B) only income statement numbers are used.
C) inherent risk of financial statement misstatements may be decreased if the performance
measurement system encourages aggressive accounting.
D) the auditor is likely to decrease the extent of testing if the client has set unreasonable
objectives.

14) Define the term "related party" and discuss why an auditor should identify the client's related
parties early in the audit.
Answer: A related party is an affiliated company, principal owner of the client company, or any
other party with which the client deals, where one of the parties can influence the management or
operating policies of the other. Transactions with related parties are important to auditors because
accounting standards require that they be disclosed in the financial statements. Auditors need to
be aware of who the client's related parties are early in the audit to enable the auditor to identify
related-party transactions, especially those that have not been disclosed.

15) What documents do auditors routinely obtain to aid in their understanding of a client's
governance system? Briefly discuss each of these documents.
Answer: Auditors commonly obtain the company's organizational structure, code of ethics, and
the minutes of meetings of the board of directors and shareholders. To gain an understanding of
the client's governance system, the auditor should understand how the board and the audit
committee exercise oversight, including consideration of the company's code of ethics and
evaluation of the corporate minutes. Companies frequently communicate the entity's values and
ethical standards through policy statements and codes of conduct. The corporate minutes are the
official record of the meetings of the board of directors and stockholders. They include
summaries of the most important topics discussed and decisions made at the board meetings.

16) What are three factors that have increased the importance of obtaining an understanding of a
client's business and industry? How can an auditor obtain this understanding?
Answer: Factors that have increased the importance of obtaining an understanding of a client's
business and industry include:
1. Recent significant declines in economic conditions around the world are likely to
significantly increase a client's business risks. Auditors need to understand the nature of
the client's business to understand the impact of major economic downturns on the
client's financial statements and ability to continue as a going concern.
2. Information technology connects client companies with major customers and suppliers.
As a result, auditors need greater knowledge about major customers and suppliers and the
related risks. That connectivity also exposes the client to potential cyber risks that the
auditor should consider.
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 3. Companies have expanded operations globally, often through joint ventures and strategic
alliances.
Auditors consider these factors using a strategic approach to understand the client's business.
The auditor can obtain a good understanding of the client's business and industry through
various means.

17) There are three primary reasons for obtaining a thorough understanding of the client's
industry and external environment. What are these reasons?
Answer: The three reasons are:
1. Risks associated with specific industries may affect the auditor's assessment of client
business risk and acceptable audit risk.
2. Many risks are typically common to all clients in certain industries. Familiarity with
those risks aids the auditor in determining their relevance to the client when assessing
client business risk and risk of material misstatement.
3. Many industries have unique accounting requirements that the auditor must understand to
evaluate whether the client's financial statements are in accordance with accounting
standards.

True false questions

18) Auditors should obtain copies of the client's code of ethics and minutes of the meetings of the
board of directors to aid in their understanding of the company's management and governance
structure. True

19) Many risks are common to all clients in certain industries. True

20) Transactions with related parties must be disclosed in the financial statements if they are
deemed to be material. True

21) All known related parties must be identified and included in the auditor's permanent files
related to the client. True

22) Because of the lack of independence between related parties, the Sarbanes-Oxley Act
prohibits all related party transactions. False

23) Management's philosophy and operating style influence the risk of material misstatements in
the financial statements. True

24) The auditor should read the corporate minutes to obtain authorizations and other information
that is relevant to performing the audit. True

25) Material transactions between the client and the client's related parties must be disclosed in
the auditor's report. False

26) A tour of the client's facilities can help the auditor assess physical safeguards over assets and
interpret accounting data related to assets such as factory equipment. True

27) Operations are approaches followed by the entity to achieve organizational objectives. False

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8.4 Learning Objective 8-4

1) Which of the following is a correct statement regarding analytical procedures?

A) A major strength in using industry ratios for auditing is the difference between the nature of
the client's financial information and that of the firms making up the industry totals.
B) Common-size financial statements display all items as a percentage change from a base year.
C) In identifying areas of specific risk, the auditor is likely to focus on the liquidity activity
ratios.
D) In order to look for a misstatement in the allowance for bad debts, the auditor should divide
gross sales by sales returns and allowances.

2) Which of the following would not be classified as an analytical procedure?

A) benchmarking the company's profitability ratios against others in the industry
B) preparing common size financial statements
C) calculating income statement account balances as a percent of sales when the level of sales
has changed from the prior year
D) reconciling fixed asset dispositions with the fixed asset ledger

3) When performing planning analytical procedures for a client the auditor detected that the
gross profit percentage had declined by 50% from the previous year to the year currently under
audit. The auditor should
A) investigate the possibility the client may have made an error in their cost of goods sold
computation.
B) assist management in developing greater cost efficiencies in their product line.
C) prepare a going concern opinion for the client.
D) advise the client to have extensive disclosure to alleviate investor concerns.

4) Which is a liquidity activity ratio?

A) profit margin
B) inventory turnover
C) return on assets
D) times interest earned

5) When using financial ratios, the most important comparisons are to those of previous years for
the company and to industry averages or similar companies for the same year. True

6) Auditors perform preliminary analytical procedures to better understand the client's business
and to assess client business risk. True

7) In order to be meaningful, a company's ratios should be compared to their prior year's ratios,
not industry benchmarks. False

8) Preliminary analytical procedures can help the auditor assess client business risk. True

8.5 Learning Objective 8-5

1) Auditing standards define ________ as the magnitude of misstatements that individually, or

when aggregated with other misstatements, could reasonably be expected to influence the
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economic decisions of users made on the basis of the financial statements.
A) fraud
B) inherent risk
C) materiality
D) significant

2) Which of the following is part of planning?

A) Set materiality for the financial statements as a whole.
B) Estimate total misstatement in the segment.
C) Estimate the combined misstatement.
D) Compare the combined estimated with preliminary judgment.

3) When dealing with materiality,

A) if the client refuses to correct a material misstatement, the auditor is required to adjust the
financial statements.
B) management is responsible for determining whether financial statements are materially
misstated.
C) materiality must be determined as a percentage of sales.
D) the auditor must bring any material misstatements to the client's attention.

4) ________ materiality is materiality for segments of the audit.

A) Segment
B) Individual
C) Financial statement
D) Performance

True false questions

5) Materiality does not depend on the decisions of users who rely on the statements to make the
decisions. False

6) The first step in applying materiality is to determine performance materiality. False

8.6 Learning Objective 8-6

1) Audit standards require the auditor to consider materiality early in the audit. Which
statement(s) regarding preliminary materiality are true?
I. Preliminary materiality may change during the engagement.
II. Preliminary materiality is the maximum amount by which the auditor believes the financials
could be misstated and still not affect the decisions of reasonable users.
A) I only
B) II only
C) both I and II
D) neither I nor II

2) Why do auditors establish a preliminary judgment about materiality?

A) to determine the appropriate level of staff to assign to the audit
B) so the client can know what records to make available to the auditor
C) to help plan the appropriate evidence to accumulate
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D) to finalize the control risk assessment

3) If an auditor establishes a relatively high level for materiality, then the auditor will
A) accumulate more evidence than if a lower level had been set.
B) accumulate less evidence than if a lower level had been set.
C) accumulate approximately the same evidence as would be the case were materiality lower.
D) accumulate an undetermined amount of evidence.

4) Which of the following is a reason that the auditors may change the preliminary judgment
about materiality?
A) The auditors decide that the preliminary judgment was too large.
B) The auditors decide that the preliminary judgment was too small.
C) Client circumstance may have changed due to qualitative events.
D) all of the above

5) Which of the following is the primary basis used to decide materiality for a profit-oriented
entity?
A) net sales
B) net assets
C) net income before tax
D) all of the above

6) Auditing standards ________ that the basis used to determine the preliminary judgment about
materiality be documented in the audit files.
A) permit
B) do not allow
C) require
D) strongly encourage

7) Amounts involving fraud are usually considered ________ important than unintentional errors
of equal dollar amounts.
A) less
B) no less
C) no more
D) more

8) Qualitative factors can affect an auditor's assessment of materiality. Which of the following
statements is true?
I. Misstatements that are otherwise immaterial may be material if they affect earnings trends.
II. Misstatements that are otherwise minor may be material if there are possible consequences
arising from contractual obligations.
A) I only
B) II only
C) I and II
D) neither I nor II

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9) The five steps in applying materiality are listed below in random order.
1. Estimate the combined misstatement.
2. Estimate the total misstatement in the segment.
3. Set materiality for the financial statements as a whole.
4. Determine performance materiality.
5. Compare combined estimate with preliminary judgment about materiality.
The first three steps in correct sequence would be
A) 1, 2, 5
B) 3, 4, 2
C) 2, 1, 5
D) 3, 2, 4

10) Which of the following statements is not correct?

A) Materiality is a relative rather than an absolute concept.
B) The most important base used as the criterion for deciding materiality is total assets.
C) Qualitative factors as well as quantitative factors affect materiality.
D) Given equal dollar amounts, frauds are usually considered more important than errors.

11) Certain types of misstatements are likely to be more important than other types to users, even
if the dollar amounts are the same. Which of the following demonstrates this?
A)
Amounts involving frauds are Misstatements that are otherwise
considered more important than immaterial may be material if they
errors of equal amount. affect a trend in earnings.
Yes Yes

B)
Amounts involving frauds are
considered more important than
errors of equal amount.
No
Misstatements that are otherwise
immaterial may be material if they
affect a trend in earnings.
No

C)
Amounts involving frauds are
considered more important than
errors of equal amount.
Yes
Misstatements that are otherwise
immaterial may be material if they
affect a trend in earnings.
No

D)
Amounts involving frauds are
considered more important than
errors of equal amount.
No
Misstatements that are otherwise
immaterial may be material if they
affect a trend in earnings.
Yes

12) When setting a preliminary judgment about materiality,

A) more evidence is required for a low dollar amount than for a high dollar amount.
B) less evidence is required for a low dollar amount than for a high dollar amount.
C) the same amount of evidence is required for either low or high dollar amounts.
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D) there is no relationship between materiality and the dollar amount of evidence needed.

13) Lewis Corporation has a few large accounts receivable that total one million dollars, whereas
Clark Corporation has many small accounts receivable that total one million dollars.
Misstatement in any one account is more significant for Lewis corporation because of the
concept of
A) materiality.
B) audit risk.
C) reasonable assurance.
D) comparative analysis.

14) When determining materiality,

A) the preliminary judgment about materiality can be increased, but not decreased during the
audit.
B) auditing standards provide specific materiality guidelines to practitioners.
C) only one benchmark can be used.
D) the application of guidelines requires considerable professional judgment.

15) Audit standards require the auditor to consider the combined amount of misstatement early in
the audit. This is known as preliminary materiality judgment. List and discuss the three main
factors that affect an auditor's preliminary judgment about materiality.
Answer: The three main factors that affect an auditor's judgment about materiality are:
1. 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.
2. Benchmarks are needed for evaluating materiality. Because materiality is relative, it is
necessary to have benchmarks for establishing whether misstatements are material. Net
income before taxes is normally the most commonly used benchmark, but other possible
benchmarks include current assets, total assets, current liabilities, and owners' equity.
3. Qualitative factors also affect materiality. Certain types of misstatements are likely to be
more important to users than others, even if the dollar amounts are the same, such as
misstatements involving frauds.

16) Due to qualitative factors, certain types of misstatements are likely to be more important to
users than others, even if the dollar amounts are the same. Identify two qualitative factors that
might significantly affect an auditor's materiality judgment, and give an example of each.
Answer: Qualitative factors that affect an auditor's materiality judgment include:
1. Amounts involving fraud. Amounts involving fraud are usually considered more
important than unintentional errors of equal dollar amounts because fraud reflects on the
honesty and reliability of the management or other personnel involved. For example, an
intentional misstatement of inventory would be more important to users than a clerical
error in inventory of the same amount.
2. Amounts affecting a trend in earnings. Amounts that are otherwise immaterial may be
material if they affect a trend in earnings. An example is if reported income has increased
three percent annually for the past five years but income for the current year has declined
one percent, that change may be material. Similarly, a misstatement that would cause a
loss to be reported as a profit may be of concern.

19
True false questions
17) Determining materiality requires professional judgment. True

18) The auditor's preliminary judgment about materiality is the maximum amount by which the
auditor believes the financial statements could be misstated and still not affect the decisions of
reasonable users. True

19) Preliminary judgments about materiality are often changed during the course of the
engagement. True

20) Net assets are the most often used base for deciding materiality. False

21) The lower the dollar amount of the preliminary judgment, the more audit evidence is
required. True

22) Amounts involving fraud are not usually considered qualitative factors affecting the
preliminary materiality judgment. False

23) CPA firms can establish policy guidelines to help their auditors determine materiality. True

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

25) If the preliminary judgment of materiality increases, the amount of audit evidence required
will decrease. True

26) Net income before taxes is the normal base used to determine materiality for a not-for-profit
organization. False

8.7 Learning Objective 8-7

1) The amount(s) set by the auditor at less than the materiality for the financial statements as a
whole to reduce to an appropriately low level the probability that the aggregate of uncorrected
and undetected misstatements exceeds materiality for the financial statements as a whole is
referred to as
A) the materiality range.
B) the error range.
C) tolerable materiality.
D) performance materiality.

2) Auditors generally allocate the preliminary judgment about materiality to the:

A) balance sheet only.
B) income statement only.
C) income statement and balance sheet.
D) statement of cash flows.

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3) Which of the following is an incorrect statement regarding the allocation of the preliminary
judgment about materiality to balance sheet accounts?
A) Auditors expect certain accounts to have more misstatements than others.
B) The allocation has virtually no effect on audit costs because the auditor must collect sufficient
appropriate audit evidence.
C) Auditors expect to identify overstatements as well as understatements in the accounts.
D) Relative audit costs affect the allocation.

4) Which of the following statements is true concerning the allocation of preliminary materiality?
A) It is necessary to allocate preliminary materiality to financial statements as a whole rather
than by segments.
B) Preliminary materiality should be allocated to income statement accounts only.
C) Preliminary materiality is required by the SEC.
D) The PCAOB term used when preliminary materiality is allocated to segments is tolerable
misstatement.

5) Which of the following statements is false?

A) Either an overstatement of an asset account or an understatement of a liability account would
have the same effect on the income statement.
B) A misclassification in the balance sheet will have no effect on operating income.
C) Either an overstatement of an asset account or an overstatement of a liability account would
have the same effect on the income statement.
D) Either an understatement of an asset account or an overstatement of a liability account would
have the same effect on the income statement.

6) Which of the following are major difficulties auditors face when allocating materiality to
balance sheet accounts?
A)
Certain accounts contain
more misstatements Only overstatements Audit costs can
than others. need be considered. affect allocation.
Yes No Yes

B)
Certain accounts contain
more misstatements Only overstatements Audit costs can
than others. need be considered. affect allocation.
Yes Yes No

C)
Certain accounts contain
more misstatements Only overstatements Audit costs can
than others. need be considered. affect allocation.
Yes Yes Yes

D)
Certain accounts contain Only overstatements Audit costs can
more misstatements need be considered. affect allocation.

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 than others.
No Yes No

7) When allocating performance materiality,

A) it is easy to predict in advance which accounts are most likely to be misstated.
B) only overstatements need to be considered.
C) professional judgment is critical.
D) the sum of all the performance materiality levels cannot exceed the preliminary judgment
about materiality.

8) When allocating materiality, most practitioners choose to allocate to

A) the income statement accounts because they are more important.
B) the balance sheet accounts because most audits focus on the balance sheet.
C) both balance sheet and income statement accounts because there could be errors on either.
D) all of the financial statements because it is required by GAAS.

9) Which of the following is a correct statement regarding performance materiality?

A) Determining performance materiality is necessary because auditors accumulate evidence by
segments.
B) The level of performance materiality does not affect the amount of evidence needed.
C) Performance materiality cannot vary for different classes of transactions.
D) Performance materiality is required for public companies, but not for private companies.

10) Explain why it is necessary to allocate the preliminary judgment about materiality to
individual accounts (segments) in the financial statements. Also explain why allocating to
balance sheet accounts is more common than allocating to income statement accounts.
Answer: Because evidence is accumulated for accounts (segments) rather than for the financial
statements as a whole. Allocating to accounts (segments) establishes a tolerable misstatement
amount for each account, which helps the auditor decide the appropriate audit evidence to
accumulate for each account.
Most practitioners allocate materiality to balance sheet accounts rather than income
statement accounts because most income statement misstatements have an equal effect on the
balance sheet due to the nature of double-entry accounting. Because there are fewer balance
sheet accounts than income statement accounts in most audits, and because most audit
procedures focus on balance sheet accounts, materiality should be allocated only to balance sheet
accounts.

11) Auditor's allocate the preliminary judgment about materiality to financial statement segments
rather than by financial statements as a whole. What is the term for the auditor's allocation of
preliminary misstatement to account balances? What are three difficulties auditors face when
allocating materiality to balance sheet accounts?
Answer: Performance materiality is the term for the auditor's allocation of the preliminary
judgment of materiality to any given account balance. The three difficulties auditors face when
allocating the preliminary materiality to account balances are:
1. Auditors expect certain accounts to have more misstatement than others.
2. Both overstatements and understatements must be considered.
3. Audit costs can affect the allocation.
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True false questions
12) Most practitioners allocate the preliminary judgment about materiality to both the balance
sheet and income statement accounts. False

13) The primary purpose of allocating the preliminary judgment about materiality to financial
statement accounts is to help the auditor decide the appropriate evidence to accumulate. True

14) Both overstatements and understatements must be considered when allocating materiality to
balance sheet accounts. True

15) If an auditor assigns a tolerable misstatement of $1,000 to accounts payable, he or she would
need to obtain more audit evidence for that account than if $100,000 had been assigned. True

16) To maximize audit efficiency, the auditor should allocate less tolerable misstatement to
accounts that can be verified by using low-cost audit procedures, such as analytical procedures,
than to accounts that are more costly to audit. True

8.8 Learning Objective 8-8

1) Auditors are ________ to document the known and likely misstatements in the financial
statements under audit.
A) permitted
B) required
C) not allowed
D) strongly encouraged

2) ________ misstatements are those where the auditor can determine the amount of the
misstatement in the account.
A) Potential
B) Likely
C) Known
D) Projected

3) Likely misstatements can result from

A)
Projections of
Differences between misstatements based on
Computation of the management's and an an auditor's tests of a
sampling error for the auditor's judgment about sample from a
cash account account balances population
No Yes Yes

B)
Computation of the Differences between Projections of
sampling error for the management's and an misstatements based on
cash account auditor's judgment about an auditor's tests of a
account balances sample from a

23
 population
Yes Yes No

C)
Projections of
Differences between misstatements based on
Computation of the management's and an an auditor's tests of a
sampling error for the auditor's judgment about sample from a
cash account account balances population
No No Yes

D)
Projections of
Differences between misstatements based on
Computation of the management's and an an auditor's tests of a
sampling error for the auditor's judgment about sample from a
cash account account balances population
Yes No No

4) When evaluating the audit findings, the auditor should be satisfied that the
A) amount of known misstatement is documented in the management representation letter.
B) estimate of the total known and likely misstatements is less than a material amount.
C) estimate of the total likely misstatement includes sample error.
D) amount of known misstatement is acknowledged and recorded by the client.

5) List the five steps in applying materiality in an audit.

Answer:
Step 1. Set materiality for the financial statements as a whole.
Step 2. Determine performance materiality.
Step 3. Estimate total misstatement in segment.
Step 4. Estimate the combined misstatement.
Step 5. Compare combined estimate with preliminary or revised judgment about materiality.

True false questions

6) The preliminary judgment on materiality is compared to the total estimated misstatement
amount to determine if an account balance is materially misstated. True

7) Total estimated misstatements include known misstatements and projected misstatements plus
a sampling error. True

8) If the total misstatement of an account is known, a sampling error still needs to be determined.
False

9) Sampling risk results if the sample accurately represents the population. False

10) If the auditor approaches the audit of the accounts in s sequential manner, the findings of the
24
audit of accounts audited earlier can be used to revise the performance materiality established for
accounts audited later. True

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