Auditing The Art and Science of Assurance Engagements Canadian 14Th Edition Arens Test Bank Full Chapter PDF

Auditing The Art and Science of
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Auditing, 14e (Arens)
Chapter 7 Assessing the Risk of Material Misstatement
7.1 Define risk in auditing
1) Risk in auditing means that the auditor accepts some level of uncertainty in performing the audit
function. An effective auditor will
A) take any means available to reduce the risk to the lowest possible level.
B) set the risk level between 5% and 10%.
C) perform the audit procedures first and quantitatively set the risk level before forming an opinion and
writing the report.
D) recognize that risks exist and deal with those risks by performing high quality audits.
Answer: D
Diff: 1 Type: MC Page Ref: 209
Learning Obj.: 7-1 Define risk in auditing
2) What are the factors that increase the risk of material misstatement at the overall financial statement
level?
Answer: The factors that increase the risk of material misstatement at the overall financial statement level
are:
1. Deficiencies in management's integrity or competence.
2. Weak entity level controls.
3. Ineffective oversight by the board of directors.
4. Inadequate accounting systems and records.
5. Assertions affecting several classes of transactions, account balances, or financial statement
disclosures.
6. Declining economic conditions.
7. Significant changes in the industry.
Diff: 2 Type: SA Page Ref: 209
3) What are the components of risk of material misstatement at the assertion level?
Answer: The components of risk of material misstatement at the assertion level are:
1. Inherent risk.
2. Control risk.
Inherent risk represents the auditor's assessment of the susceptibility of an assertion to material
misstatement, before considering the effectiveness of the client's internal controls. For example, inherent
risk may be higher for the valuation assertion related to those accounts that require complex calculations
or accounting estimates that involve significant estimation judgment.
Control risk represents the auditor's assessment of the risk that a material misstatement could occur in an
assertion and not be prevented or detected on a timely basis by the client's internal controls. For example,
control risk may be higher for the valuation assertion of those accounts that require complex calculations
or accounting estimates that involve significant estimation judgment if the client's internal control
procedures fail to include independent review and verification of the complex calculations or the
significant estimates developed.
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© 2019 Pearson Canada Inc.
7.2 Distinguish the different types of risk assessment procedures
1) Which of the following best describes risk assessment, from an auditor's perspective?
A) Financial statements cannot be audited, for example, because the auditor was appointed after the year
end.
B) Financial statements distributed by the auditee are not materially false and misleading.
C) The auditor will not overlook significant errors in the financial statements.
D) Identify and assess the risk of material misstatements.
Answer: D
Learning Obj.: 7-2 Distinguish the different types of risk assessment procedures
2) Why does an auditor perform audit risk assessment procedures? What activities are included in risk
assessment procedures?
Answer: The auditor performs risk assessment procedures to identify and assess the risk of material
misstatements, whether due to error or fraud. The performance of risk assessment procedures are
designed to help the auditor obtain an understanding of the entity and its environment, including
internal controls, for purposes of assessing the risk of material misstatement when planning the audit.
Risk assessment procedures include:

1. Inquiries of management and others within the entity.
2. Analytical procedures.
3. Observation and inspection.
4. Discussion among engagement team members.
5. Other risk assessment procedures.
Learning Obj.: 7-2 Distinguish the different types of risk assessment procedures
7.3 Identify significant risks that require special audit consideration
1) Significant risk often relates to

A) low-dollar-value transactions.
B) simple transactions.
C) routine transactions.
D) nonroutine transactions.
Answer: D
Learning Obj.: 7-3 Identify significant risks that require special audit consideration
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2) What is a nonroutine transaction, and give two examples of a nonroutine transaction.
Answer: A nonroutine transaction is a transaction that is unusual, either due to size or nature, and that is
infrequent in occurrence.
An example of a nonroutine transaction is a retail client that normally sells its products through
company-owned stores across the country may decide to sell to a competitor a large block of inventory
located in a distribution centre.
Nonroutine transactions may increase the risk of material misstatement because they often involve a
greater extent of management intervention, including more reliance on manual versus automated data
collection and processing, and they can involve complex calculations or unusual accounting principles
not subject to effective internal controls due to their infrequent nature.
Related-party transactions often reflect these characteristics, thereby increasing the likelihood they are
considered significant risks.
3) CAS 315.28 requires the auditor to consider various factors to identify significant risks. List the factors
the auditors are required to consider.
Answer: Factors that auditors consider during the identification of significant risks are:
1. Risk of fraud.
2. Risk related to recent significant economic, accounting, or other developments.
3. Complexity of transactions.
4. Significant transactions with related parties.
5. Degree of subjectivity in the measurement of financial information, especially measurements involving
a wide range of measurement uncertainty.
6. Non-routine transactions—significant transactions that are outside the normal course of business for
the entity or that otherwise appear to be unusual.
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7.4 Perform a preliminary fraud risk assessment
1) The possibility that fraud has resulted in intentional misstatement in the financial statements is known
as
A) acceptable audit risk.
B) detection risk.
C) control risk.
D) fraud risk.
Answer: D
Learning Obj.: 7-4 Perform a preliminary fraud risk assessment
2) Auditors' responsibility relating to fraud risk is

A) detecting any type of fraud that occurred during the reporting period.
B) detecting fraud only if it is above the planning materiality level.
C) not an issue because the auditor is not responsible for detecting fraud.
D) making inquiries of management about fraud and considering fraud risks.
Answer: D
Diff: 2 Type: MC Page Ref: 216-217
3) As per CAS 240, when an auditor inquires about the risk of fraud and errors within the organization,
what are the auditors not required to discuss with management?
A) Management's assessment of the risk that the financial statements may be materially misstated due to
fraud.
B) Management's communication, if any, to those charged with governance regarding its processes for
identifying and responding to the risks of fraud.
C) Management's process for identifying and responding to the risks of fraud in the entity.
D) The auditor's analytical procedures.
Answer: D
4) List the audit procedures outlined in CAS 240 that the auditor should perform to assess fraud risk.
Answer: Audit procedures performed by auditors to assess fraud risk are:
1. Discuss with audit team members the risks of material misstatement due to fraud.
2. Make inquiries of management, those in charge of governance, and others regarding processes for
identifying and responding to fraud risk.
3. Evaluate unusual and unexpected relationships identified when performing analytical review
procedures.
4. Evaluate the risk for revenue fraud and management override, and understand period-end.
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7.5 Describe the fraud triangle and identify conditions for fraud
1) Three conditions for fraud are referred to as the "fraud triangle." One of the sides of this triangle is
incentives or pressures. The other two sides are
A) opportunities and a desire to meet debt repayment obligations.
B) opportunities and attitudes or rationalizations.
C) attitudes or rationalizations and the need to maintain stock prices.
D) the need to maintain stock prices and the need to meet debt repayment obligations.
Answer: B
Learning Obj.: 7-5 Describe the fraud triangle and identify conditions for fraud
2) Fraud risk factors are examples of factors that increase the risk of fraud. Which of the following is an
example of a management "incentives or pressures" risk factor?
A) Customer demand for a new product line was significantly less than expected.
B) Management and the auditors disagree on how to value a large contract in progress.
C) There is only one board member who understands financial statements and she has suffered a heart
attack.
D) There has been significant turnover in the accounting department in the last year.
Answer: A
3) Fraud risk factors are examples of factors that increase the risk of fraud. Which of the following is an
example of a management "opportunities" risk factor?
A) The company has lost a major account and income is falling.
B) Two major competitors have gone bankrupt as margins decline in the industry.
C) The Chief Executive Officer owns forty percent of the outstanding share capital.
D) New accounting standards provide three different methods for valuing financial instruments.
Answer: D
4) Which of the following is a factor that relates to "incentives or pressures" to commit fraudulent
financial reporting?
A) significant accounting estimates involving subjective judgments
B) excessive pressure for management to meet debt covenant requirements
C) management's practice of making overly achievable forecasts
D) high turnover of accounting, internal audit, and information technology staff
Answer: B
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5) Which of the following is a factor that relates to "attitudes or rationalization" to commit fraudulent
financial reporting?
A) significant accounting estimates involving subjective judgments
B) excessive pressure for management to meet debt repayment requirements
C) management's practice of making overly aggressive forecasts
D) high turnover of accounting, internal audit, and information technology staff
Answer: C
6) Senior managers of Mega Corp. are entitled to receive large bonuses if they achieve earnings targets.
What is the effect of this on the risks associated with recording of revenue?
A) It increases fraud risks associated with revenue.
B) It decreases fraud risks associated with revenue.
C) It increases detection risks associated with revenue.
D) It decreases control risks associated with revenue.
Answer: A
7.6 Develop responses to identified fraud risks
1) What audit procedure would be an auditor's response to address management override of controls ?
A) Evaluate business rationale for significant unusual transactions.
B) Evaluate systematic processing of large volumes of day-to-day ordinary transactions.
C) Evaluate possibilities of petty cash embezzlements.
D) Evaluate in detail payroll transactions.
Answer: A
Learning Obj.: 7-6 Develop responses to identified fraud risks
2) List the audit procedures outlined in CAS 240 that the auditor should perform to address the risk of
management override of controls.
Answer: Audit procedures performed by auditors to address the risk of management override of
controls are:
1.Examine journal entries and other adjustments for evidence of possible misstatements due to fraud.
2. Review accounting estimates for biases.
3. Evaluate the business rationale for significant unusual transactions.
Diff: 2 Type: SA Page Ref: 222-223
Learning Obj.: 7-6 Develop responses to identified fraud risks
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7.7 Understand the audit risk model, its components, and its relevance to audit planning
1) Acceptable audit risk is a measure of

A) the auditor's assessment of the likelihood that a material misstatement might occur in the first place.
B) the probability that the financial statements contain errors.
C) how willing the auditor is to accept that the financial statements may be materially misstated after the
audit is completed.
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
Learning Obj.: 7-7 Understand the audit risk model, its components, and its relevance to audit planning
2) The audit risk model is

A) a planning, testing, and evaluation model.
B) a primary planning tool but of limited value in evaluating results.
C) useful in evaluating results but of limited use in planning.
D) useful when performing the tests of balances, but of little value in either the planning or evaluation
stages.
Answer: B
3) If the auditor assessed the detection risk as high, the extent of evidence the auditor plans to accumulate
is
A) low.
B) high.
C) medium.
D) uncertain: more information is needed.
Answer: A
4) PA has set acceptable audit risk at 5% and determined that inherent risk and control risk is at 100%.
What is the detection risk?
A) 5%
B) 50%
C) 95%
D) 20%
Answer: A
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5) An inherent risk (IR) of 40% and a control risk (CR) of 60% affect detection risk and planned evidence
differently than an
A) IR of 60% and CR of 40%.
B) IR of 100% and CR of 24%.
C) IR of 80% and CR of 30%.
D) IR of 70% and CR of 30%.
Answer: D
6) The auditor set acceptable 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
A) 16%.
B) 10%.
C) 6%.
D) 5%.
Answer: C
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7) A) Explain how auditors use the audit risk model when planning an audit.
B) Describe the audit risk model and each of its components.
Answer:
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 unmodified opinion when material errors do in fact exist
in the financial statements:
DR =
B) The planning form of the audit risk model is stated as follows:
DR =
where: DR = detection risk

AAR = acceptable 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.
Acceptable 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 unmodified 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: 223-227

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8) 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
Acceptable
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%.
9) Which of the following describes the components of the audit risk model that are used to describe the
risk of material misstatement (RMM)?
A) AAR / DR
B) IR × CR
C) IR × DR
D) CR × DR
Answer: B
10) What is the role of internal controls during the assessment of inherent risk?
A) Internal controls are considered separately, so they are ignored during the assessment of inherent risk.
B) As the quality of internal controls increases, inherent risk decreases.
C) As the quality of internal controls improves, inherent risk increases.
D) There is a direct relationship between the quality of internal controls and inherent risk.
Answer: A
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11) 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
A) reliability of management in preventing or detecting fraud.
B) auditor's intention to rely on internal controls.
C) likelihood that the auditor will detect illegal acts.
D) possibility of collusion occurring between two employees.
Answer: B
12) Using the acceptable 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%?
A) acceptable audit risk
B) control risk
C) detection risk
D) inherent risk
Answer: B
13) Assessing design effectiveness and conducting tests of controls are required when the auditor
A) chooses to set control risk below 100 percent and relies on the controls.
B) chooses to set control risk below 100 percent even if there is no reliance placed on controls.
C) is planning the audit.
D) tests the design effectiveness.
Answer: A
14) As the effectiveness of internal control increases, what happens to control risk?
A) It stays the same.
B) It increases.
C) It changes based on the audit procedures conducted.
D) It decreases.
Answer: D
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15) 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?
A) Detection risk will increase.
B) Detection risk will decrease.
C) Detection risk will stay the same.
D) Detection risk will need less documentation.
Answer: B
16) 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?
A) Detection risk will increase.
B) Detection risk will decrease.
C) Detection risk will stay the same.
D) Detection risk will need less documentation.
Answer: B
17) 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
A) acceptable audit risk.
B) inherent risk.
C) control risk.
D) planned detection risk.
Answer: D
18) Because control risk and inherent risk vary from cycle to cycle, account to account, or objective to
objective,
A) acceptable audit risk must also change.
B) planned detection risk and required audit evidence will also vary.
C) planned detection risk will vary but audit evidence will remain constant.
D) planned detection risk will remain constant but audit evidence will vary.
Answer: B
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19) The audit risk model is used primarily
A) for planning purposes in determining how much evidence to accumulate.
B) while doing tests of controls.
C) to determine the type of opinion to express.
D) to evaluate the evidence that has been gathered.
Answer: A
20) 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 senior auditor 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:
A) What factors would affect the client business risk of BMI? Based upon your assessment of BMI's client
business risk, would you adjust acceptable audit risk? Why or why not?
B) What is your preliminary assessment of acceptable audit risk? Justify your answer.
Answer: A) The factors that affect business risk also affect acceptable audit risk:
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 that depend on 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, an auditor would likely lower acceptable audit risk because of the volatility
of the business and the potential for exposure with respect to environmental matters.
B) An auditor would likely assess acceptable audit risk as low, due to factors discussed in part A.
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7.8 Assess acceptable audit risk
1) When external users place heavy reliance on the financial statements, it is appropriate that
A) acceptable audit risk be increased.
B) inherent risk be decreased.
C) inherent risk be increased.
D) acceptable audit risk be decreased.
Answer: D
Learning Obj.: 7-8 Assess acceptable audit risk
2) A PA is working on the audit of a publicly held corporation. At what level will the acceptable auditor
likely set audit risk?
A) low
B) medium
C) high
D) very high
Answer: A
3) A PA firm can experience high levels of business risk if the audit firm
A) does a poor job preparing client risk profiles.
B) pays its employees wages that are not in line with the market.
C) experiences significant litigation or has clients declare bankruptcy.
D) has a generous vacation policy for its staff.
Answer: C
4) A 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, the PA will likely have
A) no changes to the audit risk model.
B) higher control risk.
C) higher acceptable audit risk.
D) lower acceptable audit risk.
Answer: D
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5) 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 installments are not paid on time. For this year's
audit, how will the change in debt structure affect the audit risk model?
A) no effect on the audit risk model
B) higher control risk
C) lower acceptable audit risk
D) higher acceptable audit risk
Answer: C
6) Which of the following would be a signal of possible problems with management integrity?
A) reliance on debt rather than equity for financing permanent assets
B) rotation of holidays in the supervisory area over a period of months
C) rapidly declining profits or increasing losses over a period of years
D) frequent disagreements with regulators and the Canada Revenue Agency
Answer: D
7) If inherent risk is considered at the assertion level, why does the nature of the client's business affect
inherent risk?
A) Certain accounts, such as inventory, are affected by the nature of the client's business.
B) If the client has very basic manufacturing processes, inherent risk is low.
C) When there is a risk of technological obsolescence, a specialist must be used during the engagement.
D) Accounts such as cash, notes, and mortgages payable vary depending upon the type of business.
Answer: A
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8) 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 has been owned by four equal owners since its 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 company's sales are completed via
the company's secure website, 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 over the phone, although a salesperson does spend some time in major cities across the country
visiting some of the large customers and 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 are rarely used as they are 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
its 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.
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2018 2017 2016
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:
A) What acceptable audit risk would you assign to the company? Why? [Tip: Do some calculations and
consider client business risk.]
B) Calculate preliminary materiality. Justify your decision of materiality base and choice of materiality.
Answer:
A)
2018 2017 2016
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 the firm cannot borrow, there could be a going concern problem if the owners cannot contribute
additional capital.
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Client business risk is reduced by:
- the fact that manufacturing is outsourced and there is no inventory, reducing financial exposure for
unsold items.
Acceptable 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
acceptable 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 acceptable audit risk.
B) There are several potential methods for calculating materiality:

1. 3 to 7 percent of net income before taxes:
Net income: $93 593
Low end of range: 3% = $2808
High end of range: 7% = $6552
2. 1 to 3 percent of revenue:
Revenue: $625 310
High end of range: 3% = $18 759
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.
3. 1 to 3 percent of total assets:

Total assets: $434 000
High end of range: 3% = $13 020
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.

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9) Discuss three factors that affect client business risk and therefore acceptable audit risk.
Answer: Business risk and acceptable audit risk are affected by:
• The degree to which external users will rely on the statements. For large, publicly held clients, client
business risk is greater and acceptable acceptable 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 acceptable 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 acceptable audit
risk will be lower when the client's management has questionable integrity.
7.9 Assess inherent risk
1) An important role of inherent risk assessment during the audit process is the need to
A) document the quality of the disaster recovery plan.
B) attempt to predict where misstatements are most and least likely in the financial statement segments.
C) train the audit staff to assess the integrity of management.
D) increase the level of analytical review.
Answer: B
Learning Obj.: 7-9 Assess inherent risk
2) 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?
A) reduce acceptable audit risk and reduce inherent risk
B) increase acceptable audit risk and reduce inherent risk
C) reduce acceptable audit risk and increase inherent risk
D) increase acceptable audit risk and increase inherent risk
Answer: C
3) How much control does the auditor have over inherent risk?
A) The auditor adjusts the controls that are considered (high level of control).
B) The auditor considers inherent risk for the business as a whole (some control).
C) The auditor assesses the factors that make up inherent risk (no control).
D) The auditor calculates inherent risk values as a residual (no control).
Answer: C
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4) 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?
A) increase inherent risk for accounts receivable
B) decrease inherent risk for accounts receivable
C) increase control risk for accounts receivable
D) decrease control risk for accounts receivable
Answer: A
5) 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 in shopping malls and does snow clearing to help boost this 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: Inherent risk for revenue for GreenGrow Limited seems 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; an auditor would need to
determine that the costs and revenues are properly matched in this contract, which would 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.
20
6) 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. 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 changes 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 packaged systems, meaning that there is a greater
likelihood for program errors.
7.10 Understand the relationship between risks and audit evidence
1) If detection risk is reduced, the amount of evidence the auditor accumulates will
A) increase.
B) decrease.
C) remain unchanged.
D) be indeterminate.
Answer: A
Learning Obj.: 7-10 Understand the relationship between risks and audit evidence
2) If acceptable audit risk is increased, what happens to detection risk?

A) It stays the same.
B) It increases.
C) It changes based upon the audit procedures conducted.
D) It decreases.
Answer: D
21
3) All other factors held constant, if the auditor decreases acceptable audit risk then
A) there will be less documentation in the audit file.
B) total audit evidence and audit costs will increase.
C) it will also be necessary to decrease either control risk or inherent risk.
D) less supervision of the audit team will be required.
Answer: B
4) When a different extent of evidence is needed for the various cycles, the difference is caused by
A) errors in the client's accounting system.
B) the client's need to achieve an unqualified opinion.
C) the auditor's need to follow GAAS.
D) the auditor's expectations of errors and assessment of internal control.
Answer: D
5) Acceptable audit risk is ordinarily set by the auditor during planning and
A) held constant for each major cycle and account.
B) held constant for each major cycle but varies by account.
C) varies by each major cycle and by each account.
D) varies by each major cycle but is constant by account.
Answer: A
6) 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,
A) the same amount of evidence will be gathered for each cycle.
B) a different extent of evidence is needed for various cycles.
C) he/she has not followed generally accepted auditing standards.
D) the level for each cycle must be no more than 2% so that the entire audit does not exceed 10%.
Answer: B
22
7) In practice, auditors rarely assign numerical probabilities to inherent risk, control risk, or acceptable
audit risk. It is more common to assess these risks as high, medium, or low. For each of the four situations
below, fill in the blanks for 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
Acceptable
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: 233
23
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Auditing The Art and Science of

Assurance Engagements Canadian

7.1 Define risk in auditing

Risk assessment procedures include:

7.3 Identify significant risks that require special audit consideration

1) Significant risk often relates to

2) Auditors' responsibility relating to fraud risk is

7.6 Develop responses to identified fraud risks

1) Acceptable audit risk is a measure of

2) The audit risk model is

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

where: DR = detection risk

Diff: 2 Type: ES Page Ref: 223-227

Cash $99 000 $110 000 $124 000

Accounts payable $270 000 $180 000 $150 000

Share capital $200 000 $200 000 $200 000

Revenue $625 310 $538 120 $507 380

Administration expenses $89 000 $57 000 $58 000

Net income $93 593 $120 961 $119 657

Client business risk should be set at high, because:

B) There are several potential methods for calculating materiality:

3. 1 to 3 percent of total assets:

Diff: 3 Type: ES Page Ref: 227-228

7.9 Assess inherent risk

7.10 Understand the relationship between risks and audit evidence

2) If acceptable audit risk is increased, what happens to detection risk?

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