Auditing and Assurance Services, 17e (Arens/Elder/Beasley)

Chapter 9 Assessing the Risk of Material Misstatement

9.1 Learning Objective 9-1

1) Which of the following would not increase the risks of material misstatement at the overall
financial statement level?
A) effective oversight by the board of directors
B) deficiencies in management's integrity
C) inadequate accounting systems
D) all of the above

2) The auditor's responsibility section in an audit report states that "…the standards require that
we plan and perform the audit to obtain ________ assurance about whether the financial
statements are free of material misstatement." What type of assurance is given?
A) immediate
B) limited
C) reasonable
D) absolute

3) ________ 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.
A) Material
B) Account balance
C) Control
D) Inherent

4) Risk of material misstatement at the assertion level

A) is only relevant to account balances.
B) determines the nature, timing, and extent of further auditing procedures.
C) refers to risks that are pervasive to the financial statements as a whole.
D) consists of business risk and inherent risk.

5) Assessing the risk of material misstatement is closely related to each of the following except
A) the auditor's overall audit responsibilities.
B) the auditor's materiality and audit planning.
C) not a critical consideration in most financial statement audits.
D) the auditor's review of the key transaction cycles and associated audit objectives.

6) The risk of material misstatement exists only at the overall financial statement level.

7) Significant changes in the industry may increase the risk of material misstatement at the
assertion level.

8) Inherent risk and control risk exist independent of the audit of the financial statements.

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9) Audit reports issued under the PCAOB and the AICPA standards contain two important
phrases that are directly related to materiality and to risk: obtain absolute assurance and free of
material misstatement.

10) Audit reports contain the phrase obtain reasonable assurance, which is intended to inform
users that auditors do not guarantee or ensure the fair presentation of the financial statements
which the audit reports cover.

11) Some risk exists that the financial statements are not fairly stated, even when the auditor's
opinion is unmodified.

12) The phrase free of material misstatement informs users that the auditor's responsibility is not
limited to only material financial information.

13) For well-planned audits, it is practical for auditors to provide assurances on immaterial
amounts included in the financial statements.

14) As management is responsible for the financial statements, failure to assess the risk of
material misstatement is not detrimental to the auditor.

9.2 Learning Objective 9-2

1) Risk assessment procedures include inquiries of management and others by the auditor. As
part of these procedures, the auditor should talk to
A) internal auditors.
B) board of directors.
C) individuals involved with regulatory compliance.
D) all of the above.

2) Risk assessment procedures include

A) a required discussion among the staff members of the audit and the client regarding material
misstatements in the financial statement.
B) determination of the type of audit opinion to issue.
C) observation of the entity's operations.
D) assessing acceptable audit risk.

3) The performance of risk assessment procedures is designed to help the auditor obtain an
understanding of the entity.

4) Auditing standards require the engagement partner to be included in discussions about the
susceptibility of the client's financial statements to material misstatements.

5) Auditors are not allowed to make inquires of employees who are not considered management,
such as marketing or sales personnel.

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6) Auditing standards emphasize the benefits and importance of obtaining information or
different perspectives through inquiries of others within the entity and employees with differing
levels of authority within the organization.

7) PCAOB auditing standards require the auditor to make inquiries of the audit committee about
the risks of material misstatement.

8) The PCAOB, but not the AICPA, auditing standards require inquiry of internal audit
personnel by the auditor when that function exists within the audit client.

9) Discussions, including exchanges of ideas or brainstorming among the engagement team

members about business risks should include the financial statements, but not necessarily the
related disclosures.

10) Risk assessment procedures are performed to identify and assess the risk of material
misstatement. List three risk assessment procedures.

9.3 Learning Objective 9-3

1) When considering the risk of misstatement due to fraud,

A) the risk of not detecting a material misstatement due to fraud is lower than the risk of not
detecting a misstatement due to error.
B) the risk is only made at the financial statement level.
C) auditing standards require the auditor to presume that risk of fraud exists in expense
transactions.
D) auditing standards outline procedures the auditor should perform to obtain information from
management about their consideration of fraud.

2) Individuals engaged in conducting a fraud will generally not misrepresent information to the
auditor.

3) The auditor's risk assessment for fraud should be ongoing throughout the audit.

4) The application of professional skepticism consists of two primary components: a questioning

mind and a critical assessment of the audit evidence obtained during the audit.

5) The auditor's consideration of the risk of material misstatement due to fraud is made primarily
at the financial statement level, not at the assertion level.

6) Revenue transactions and account balances subject to significant risk are not required to be
documented in the working papers if the auditor determines significant risk does not apply in a
particular audit engagement.

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9.4 Learning Objective 9-4

1) A ________ risk represents an identified and assessed risk of material misstatement that, in
the auditor's professional judgment, requires special audit consideration.
A) material
B) substantial
C) financial statement
D) significant

2) Which of the following will generally be considered a significant risk?

A) a sale to a customer
B) the determination of the amount of bad debt expense
C) the purchase of inventory
D) obtaining a loan from the bank

3) Significant risks often relate to routine transactions.

4) The auditor must perform substantive tests related to assertions deemed to have significant
risks.

5) Financial statement matters like estimates for the allowance for doubtful accounts and
allowances for slow-moving inventories, are deemed significant matters which should be
addressed by auditor in their assessment of the risk of material misstatement.

6) Nonroutine transactions are unusual in nature but not infrequent in occurrence.

7) Nonroutine transactions may not necessarily increase the risk of material misstatement.

9.5 Learning Objective 9-5

1) Which of the following risks are used in the audit risk model?
A)
Planned Detection
Control Risk Inherent Risk Risk
Yes Yes Yes

B)
Planned Detection
Control Risk Inherent Risk Risk
Yes Yes No

C)
Planned Detection
Control Risk Inherent Risk Risk
No No Yes

D)
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 Planned Detection
Control Risk Inherent Risk Risk
No No No

2) Based on audit evidence gathered and evaluated, an auditor decides to increase the assessed
level of control risk from that originally planned. To achieve an overall audit risk level that is
substantially the same as the planned audit risk level, the auditor would
A) increase materiality levels.
B) decrease detection risk.
C) decrease substantive testing.
D) increase inherent risk.

3) When dealing with audit risk,

A) auditors cannot accept any level of risk in performing the audit function.
B) most risks that auditors encounter are relatively easy to measure.
C) the audit risk model is only used for classes of transactions.
D) the audit risk model helps the auditor to decide how much and what types of evidence to
accumulate.

4) The measurement of the auditor's assessment of the susceptibility of an assertion to material

misstatement, before considering the effectiveness of related internal controls is defined as
A) audit risk.
B) inherent risk.
C) sampling risk.
D) detection risk.

5) The risk that audit evidence for an audit objective will fail to detect misstatements exceeding
performance materiality levels is
A) audit risk.
B) control risk.
C) inherent risk.
D) planned detection risk.

6) If the auditor decides to reduce acceptable audit risk, planned detection risk
A) increases.
B) decreases.
C) stays the same.
D) cannot be determined.

7) Inherent risk is ________ related to planned detection risk and ________ related to the
amount of audit evidence.
A) directly; inversely
B) directly; directly
C) inversely; inversely
D) inversely; directly

8) Auditors frequently refer to the terms audit assurance, overall assurance, and level of
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assurance instead of
A) detection risk.
B) audit report risk.
C) acceptable audit risk.
D) inherent risk.

9) If planned detection risk is reduced, the amount of evidence the auditor accumulates will
A) increase.
B) decrease.
C) remain unchanged.
D) be indeterminate.

10) Planned detection risk

I. determines the amount of substantive evidence the auditor plans to accumulate.
II. is dependent on inherent risk and business risk.
A) I only
B) II only
C) both I and II
D) neither I nor II

11) Inherent risk is often high for an account such as

A) inventory.
B) land.
C) capital stock.
D) notes payable.

12) Inherent risk and control risk

A) are inversely related to each other.
B) are inversely related to detection risk.
C) are directly related to detection risk.
D) are directly related to audit risk.

13) To what extent do auditors typically rely on internal controls of their public company
clients?
A) extensively
B) only very little
C) infrequently
D) never

14) Auditors typically rely on internal controls of their private company clients
A) only as needed to complete the audit and satisfy Sarbanes-Oxley requirements.
B) only if the controls are determined to be effective.
C) only if the client asks an auditor to test controls.
D) only if the controls are sufficient to increase control risk to an acceptable level.

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15) Which is a true statement about audit risk?
A) Audit risk measures the risk that a material misstatement could occur and not be detected by
internal control.
B) When auditors decide on a higher acceptable audit risk, they want to be more certain that the
financial statements are not materially misstated.
C) Audit assurance is the complement of acceptable audit risk.
D) There is an inverse relationship between acceptable audit risk and planned detection risk.

16) The risk of material misstatement refers to

A) control risk and acceptable audit risk.
B) inherent risk.
C) the combination of inherent risk and control risk.
D) inherent risk and audit risk.

17) When assessing risk, it is important to remember that

A) for acceptable audit risk, the SEC decides the risk the CPA firm should take for public clients.
B) inherent risk can be changed by the auditor.
C) detection risk can only be determined after audit risk, inherent risk, and control risk are
determined.
D) control risk is determined by company management since they are responsible for internal
control.

18) Which of the following is a correct relationship?

A) Acceptable audit risk and planned detection risk have an inverse relationship.
B) Control risk and planned detection risk have a direct relationship.
C) Planned detection risk and inherent risk have an inverse relationship.
D) All of the above are correct relationships.

19) In a financial statement audit, inherent risk is evaluated to help an auditor assess which of the
following?
A) the internal audit department's objectivity in reporting a material misstatement of a financial
statement assertion it detects to the audit committee
B) the risk that the internal control system will not detect a material misstatement of a financial
statement assertion
C) the risk that the audit procedures implemented will not detect a material misstatement of a
financial statement assertion
D) the susceptibility of a financial statement assertion to a material misstatement, assuming there
are no related controls

20) Which of the following statements is not true?

A) Inherent risk is inversely related to the amount of audit evidence whereas detection risk is
directly related to the amount of audit evidence required.
B) Inherent risk is directly related to evidence whereas detection risk is inversely related to the
amount of audit evidence required.
C) Inherent risk is the susceptibility of the financial statements to material error, assuming no
internal controls.
D) Inherent risk and control risk are assessed by the auditor and function independently of the
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financial statement audit.

21) An auditor who audits a business cycle that has low inherent risk should
A) increase the amount of audit evidence gathered.
B) assign more experienced staff to that area.
C) expand planning procedures.
D) do none of the above.

22) The most important element of the audit risk model is control risk.

23) The audit risk model that must be used for planning audit procedures and evaluating audit
results is:
= AAR.

24) If acceptable audit risk is low, and inherent risk and control risk are both low, then planned
detection risk should be high.

25) If the audit assurance rate is 95%, then the level of acceptable audit risk is 5%.

26) A high detection risk equates to a low amount of audit evidence needed.

27) For a private company client, auditors are required to test any internal controls they believe
have not been operating effectively during the period under audit.

28) There is a direct relationship between acceptable audit risk and planned detection risk.

29) Acceptable audit risk and the amount of substantive evidence required are inversely related.

30) As control risk increases, the amount of substantive evidence the auditor plans to accumulate
should increase.

31) Inherent risk and control risk are directly related.

32) Audit assurance is the complement of planned detection risk, that is, one minus planned
detection risk.

33) The auditor assesses risks at the overall financial statement level but not at the audit
objective level for the acquisition and payment cycle.

34) After assessing internal controls are being effective in the sales and collection cycle, the
auditor can assume that internal controls will be effective at each of the client's other transaction
cycles.

35) A planned detection risk (PDR) of .05 means the auditor plans to accumulate audit evidence
until the risk of misstatement exceeding performance materiality is reduced to 5 percent.

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36) The audit committee should determine the risk the CPA firm is willing to take that the
financial statements are misstated after the audit is completed.

37) An example of where the auditor will accept very low risk (low acceptable audit risk) is for
an audit client having an initial public offering.

38) Why do auditors use the audit risk model when planning an audit?

39) Match the terms below (a-h) with the definitions provided below (1-8).

a. preliminary judgment about materiality

b. inherent risk
c. planned detection risk
d. audit assurance
e. acceptable audit risk
f. performance materiality level
g. control risk
h. materiality

________ 1. a measure of the risk that audit evidence for a segment will fail to detect
misstatements exceeding the performance materiality amount, should such misstatements exist

________ 2. a measure of the auditor's assessment of the likelihood that misstatements exceeding
a performance materiality in a segment will not be prevented or detected by the client's internal
controls

________ 3. a measure of how much risk the auditor is willing to take that the financial
statements may be materially misstated after the audit is completed and an unqualified audit
opinion has been issued

________ 4. the materiality allocated to any given account balance

________ 5. the maximum amount by which the auditor believes that the statements could be
misstated and still not affect the decisions of reasonable users

________ 6. This term is synonymous with acceptable audit risk.

________ 7. the magnitude of an omission or misstatement of accounting information that makes

it probable that the judgment of a reasonable person would have been changed

________ 8. a measure of the auditor's assessment of the likelihood that there are material
misstatements before considering the effectiveness of internal control

40) Using your knowledge of the relationships among acceptable audit risk, inherent risk, control
risk, planned detection risk, performance materiality, and planned evidence, state the effect on
planned evidence (increase or decrease) of changing each of the following factors, while the
other factors remain unchanged.
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1. an increase in acceptable audit risk ________
2. an increase in inherent risk ________
3. a decrease in control risk ________
4. an increase in planned detection risk ________
5. an increase in performance materiality ________

9.6 Learning Objective 9-6

1) If an auditor believes the chance of financial failure is high and there is a corresponding
increase in business risk for the auditor, acceptable audit risk would likely
A) be reduced.
B) be increased.
C) remain the same.
D) be calculated using a computerized statistical package.

2) When management has an adequate level of integrity for the auditor to accept the engagement
but cannot be regarded as completely honest in all dealings, auditors normally
A) reduce acceptable audit risk and increase inherent risk.
B) reduce inherent risk and control risk.
C) increase inherent risk and control risk.
D) increase acceptable audit risk and reduce inherent risk.

3) When the auditor is attempting to determine the extent to which external users rely on a
client's financial statements, they may consider several factors except for
A) client size.
B) concentration of ownership.
C) nature and amounts of liabilities.
D) assessment of detection risk.

4) ________ is the risk that the auditor or audit firm will suffer harm after the audit is finished,
even though the audit report was correct.
A) Inherent risk
B) Audit risk
C) Engagement risk
D) Control risk

5) If an auditor believes the client will have financial difficulties after the audit report is issued,
and external users will be relying heavily on the financial statements, the auditor will probably
set acceptable audit risk as low.

6) Overall assessment of acceptable audit risk is highly subjective.

7) An acceptable audit risk assessment of low indicates a risky client requiring more extensive
evidence, assignment of more experienced personnel, and/or a more extensive review of audit
files.

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8) In assessing management integrity for potential new audit clients, the auditor should examine
the prospective client's standing in the business community, financial stability, and relations with
its previous CPA firm, among other procedures.

9) There are several factors that affect engagement risk and, therefore, acceptable audit risk.
Discuss three of these factors.

9.7 Learning Objective 9-7

1) Which of the following statements regarding inherent risk is correct?

A) Inherent risk is unaffected by the auditor's experience with client's organization.
B) Most auditors set a low inherent risk in the first year of an audit and increase it if experience
shows that it was incorrect.
C) Most auditors set a high inherent risk in the first year of an audit and reduce it in subsequent
years as they gain more knowledge about the company.
D) Inherent risk is dependent upon the strengths in client's internal control system.

2) Auditors begin their assessments of inherent risk during audit planning. Which of the
following would not help in assessing inherent risk during the planning phase?
A) obtaining client's agreement on the engagement letter
B) obtaining knowledge about the client's business and industry
C) touring the client's plant and offices
D) identifying related parties

3) Which of the following is not a primary consideration when assessing inherent risk?
A) nature of client's business
B) existence of related parties
C) effectiveness of internal controls
D) susceptibility to misappropriation of assets

4) Which of the following is an accurate statement regarding inherent risk?

A) The profession has established guidelines for setting inherent risk.
B) Auditors are generally conservative in setting inherent risk.
C) Factors impacting inherent risk will affect all cycles, balances, and disclosures.
D) Inherent risk has no impact on the amount of evidence gathered.

5) The risk of fraud should be assessed for the entire audit as well as by cycle, account, and
objective.

6) The auditing profession has established guidelines for setting inherent risk.

7) Accounts that require considerable judgment have a higher inherent risk.

8) The risk of material misstatement is a combination of two client-controlled factors: inherent

risk and control risk. What is inherent risk and why is it important? Give examples of inherent
risk factors.

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9.8 Learning Objective 9-8

1) Which of the following is true regarding audit risk for segments?

A) Control risk must be assessed at the same level for all accounts.
B) Factors affecting inherent risk do not differ from account to account.
C) Acceptable audit risk is ordinarily assessed by the auditor during the substantive test of
balances phase and is held constant for each major cycle and account.
D) In some cases, a lower acceptable audit risk may be more appropriate for one account than for
others.

2) Auditors respond to risk primarily by

I. changing the extent of testing.
II. changing the types of audit procedures.
A) I only
B) II only
C) both I and II
D) neither I nor II

3) When using the audit risk model,

A) auditors find it relatively easy to measure the components of the model.
B) many auditors use broad and subjective measurement terms.
C) auditors find it easy to measure the amount of evidence implied by a given planned detection
risk.
D) auditors are only concerned with understating accounts.

4) In applying the audit risk model, auditors are concerned about overstatements, not
understatements.

5) One major limitation in the application of the audit risk model is the difficulty of measuring
the components of the model.

6) Since the audit risk model is a planning model, it assists the auditor in evaluating results.

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 planned detection risk and the amount of
evidence you would plan to gather ("planned evidence") using the terms high, medium, or low.

SITUATION SITUATION SITUATION SITUATION

1 2 3 4
Acceptable audit risk Low Low High High
Inherent risk High Low Low Low
Control risk High Low Medium Low
Planned detection risk ________ ________ ________ ________
Planned evidence ________ ________ ________ ________

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8) Dracule Industries is a privately-owned business that sells medical product and devices to
hospitals, clinics and the public. Certain changes have occurred in Dracule Industries during the
year undergoing the audit. Harker needs to evaluate the effect these changes have on audit risk.
Audit risk at the financial statement level is influenced by the risk of material misstatement;
which include factors related to management, the industry and the entity or a combination
thereof. For each of the following changes that have occurred during the year under audit
identify the appropriate audit response for the list of responses. Each response can be used once,
more than once or not at all.

Client changes: Possible effect on the audit:

1. An internal audit department has been a. increases the acceptable level of detection
established. risk
2. A new inventory control system has b. decreases the acceptable level of detection
been installed that reduces the access of risk
unauthorized parties. c. change has no effect on the acceptable
3. Inexperienced accounting personnel level of detection risk
were hired in the accounting department.
4. Excess cash was used to purchase
complex derivatives.
5. Controls over the sales credit approval
process have laxed.
6. New government regulations now apply
to Dracule Industries.
7. Management has become overly
aggressive in reaching target goals.
8. An expert was hired to help determine
the value of the ore content in ending
materials inventory.

9.9 Learning Objective 9-9

1) When taken together, the concepts of risk and materiality in auditing

A) measure the uncertainty of amounts of a given magnitude.
B) measure uncertainty only.
C) measure magnitude only.
D) measure inherent risk.

2) Which of the following is a correct statement?

A) There is no relationship between materiality and risk in auditing.
B) Risk is a measure of magnitude or size.
C) The combination of performance materiality and the audit risk model factors determines
planned audit evidence.
D) Performance materiality is part of the audit risk model.

3) Performance materiality impacts inherent risk and control risk.

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4) Performance materiality does not affect any of the four risks to planned audit evidence.

5) The combination of performance materiality and the audit risk model factors does not affect
the auditor's planned audit evidence.

6) The statement that the auditor plans to accumulate evidence that there is only a 5 percent
acceptable audit risk of failing to uncover misstatements exceeding performance materiality of
$250,000 is a precise and meaningful statement.

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