Chapter 4: Audit Risk, Business Risk, and Audit

Planning

Student: ___________________________________________________________________________

1. Risk is the uncertainty about events and/or their outcomes that could have a material
effect on the organization.
True False

2. Risk is cumulative. If business risk is extremely high, the auditor will likely make a
decision to not be associated with a client because engagement risk will be too high.
True False

3. To assess management's integrity, the auditor may interview management.

True False

4. Controls are an accounting related object and do not extend beyond the accounting
and finance activities.
True False

5. An auditor must use professional judgment and skepticism when considering the
subjective nature of some of the evidence that might be gathered and evaluated by the
audit team.
True False

6. A basic premise underlying analytical procedures is that implausible relationships

among data may reasonably be expected to exist.
True False

7. Ratio analysis only involves a year-to-year comparison of account balances.

True False
8. Trend analysis is proven to be more effective than ratio analysis.
True False

9. Analytical techniques contain a combination of both quantitative and qualitative

techniques.
True False

10. Intentional manipulation of financial statements is a form of fraud.

True False

11. Tour of the client's production facilities is not an acceptable method for an auditor in
understanding the client's business processes.
True False

12. Risk analysis does not include identifying risks associated with management's intent
to misstate financial statements.
True False

13. An auditor will typically evaluate their clients annually to determine whether to retain
them or not.
True False

14. Engagement risk is said to increase when a client suffers a business failure.
True False

15. Prior year audit experience is not beneficial to an auditor in assessing management
integrity because management may have different attitudes in subsequent periods.
True False

16. The auditor is not concerned with illegal acts of clients because such acts are not
within the scope of financial statement reporting.
True False
17. Audit risk is the risk that the auditor will be sued by the client because of fraudulent
actions.
True False

18. In an audit of financial statements, it is implied that absolute assurance will be

provided.
True False

19. The likelihood of misstatements in the financial statements increases if the client has
poor internal control.
True False

20. Actions to keep detection risk at a lower level are under the direct control of the
auditor.
True False

21. Control risk can be referred to as the client's ability to mitigate overall audit risk.
True False

22. Management integrity and ethics have little to do with engagement risk.
True False

23. The auditor may choose to speak to the previous audit firm before accepting a
prospective public client in order to better understand the conditions surrounding the
change in auditors but it is not required.
True False

24. Materiality provides reasonable assurance that material misstatements will be

detected.HERE
True False

25. Materiality is judged using only quantitative factors.

True False
26. The SEC has been critical of the accounting profession for not sufficiently examining
qualitative factors in making materiality decisions.
True False

27. Audit risk is the risk that the auditor may give an unqualified opinion on financial
statements that are materially misstated.
True False

28. In the audit risk model there is no relationship between inherent risk, control risk,
and detection risk.
True False

29. In the audit risk model the auditor is only able to manipulate inherent and control
risk.
True False

30. In the audit risk model the auditor is only able to assess inherent and control risk.
True False

31. In the audit risk model the auditor manipulates detection risk based upon an
assessment of inherent and control risk to maintain an acceptably low audit risk.
True False

32. In the audit risk model as detection risk is increased by the auditor the amount of
evidence required and its persuasiveness increases.
True False

33. In the audit risk model each of its components are treated as separate and
independent..
True False
34. Inherent risk is the susceptibility of a transaction or accounting adjustment to be
recorded in error, or for the transaction not to be recorded in the absence of internal
controls.
True False

35. The audit risk model can be used by the auditor as a multiplicative model.
True False

36. After determining an overall materiality level for the financial statements the auditor
uses the assessment in evaluating the materiality of account balances.
True False

37. It would be considered unethical for an auditor to consistently “pass” on adjusting

detected errors in order to avoid conflict with managers.
True False

38. The concept of materiality is pervasive to the audit process and guides the nature
and extent of audit testing.
True False

39. Based upon an assessment of engagement risk the auditor determines an acceptable
level of audit risk.
True False

40. Which one of the following is not a critical component of risks relevant in conducting
an audit?
A. Business risks
B. Audit risks
C. Engagement risks
D. Decentralize risks
41. Which one of the following is a valid source of information about the client's
processes?
A. Management inquiry
B. Review of the client's budget
C. Tour of client’s plant and operations
D. All are valid sources.

42. The risk that financial statements are likely to be misstated materially without regard
to the effectiveness of internal control is which type of risk?
A. Inherent risk
B. Audit risk
C. Client risk
D. Control risk

43. A stipulation in an agreement between an entity and its creditor that places
documented restrictions on the organization is referred to as
A. debt covenants.
B. representation agreements.
C. engagement letters.
D. current maturities of long-term obligations.

44. Analytical procedures are used in an audit because it is assumed of financial

statements that
A. management fraud can be discovered using such procedures.
B. it is plausible that no relationship among data exists.
C. analytical procedures are used as tests of controls.
D. plausible relationships among data may reasonably be expected to exist and continue.

45. An auditor compares year-to-year account balances in order to perform analytical

procedures. This is an example of:
A. ratio analysis.
B. trend analysis.
C. internal control analysis.
D. vertical analysis.
46. The preliminary use of analytical review procedures by the auditor is
A. required to identify areas of heightened risk
B. optional in accordance with auditor judgment.
C. only used when other planning procedures cannot be applied.
D. used to assist the auditor in documenting internal control.

47. The auditor is required to discuss with the audit committee whether or not the
financial statements are fairly presented and appropriately applied in accordance with
A. GAAS.
B. EITF.
C. GAAP.
D. PCAOB.

48. What is the most relevant use of a knowledge management system for an auditor?
A. Professionals may input client data and have procedures performed automatically.
B. Auditors are not required to make judgments collectively or individually.
C. Professionals may share information related to auditing, accounting standards and
risks.
D. Auditors may work entirely from the firm location rather than at the client location.

49. What analysis best considers the economic relationships among account balances?
A. Altman "Z" Analysis
B. Ratio analysis.
C. Vertical analysis.
D. Horizontal analysis.

50. Why will the external auditor typically interview the internal audit department as it
relates to its risk-based approach?
A. To appropriately change internal controls.
B. To comment on the deficiency of internal audit control.
C. To understand and assess management risk processes.
D. To perform effective analytical procedures.
51. Which is a primary limitation of the audit risk model?
A. The audit risk model does not adequately consider external forces on the client
organization.
B. Components of audit risk are treated as independent variables even though many
interdependencies exist between them.
C. The audit technology achieves approximate precision outside of a mathematical
model.
D. Control risk must be adjusted at the hands of the auditor, not by an arbitrary
estimation.

52. Janie Jones, CPA is proposing on a prospective audit engagement for White Mountain
Enterprises. After obtaining written permission of White Mountain, Janie is required to
perform what procedure prior to accepting it as a new client?
A. Provide full disclosure of fees that will be billed to White Mountain.
B. Contact the former auditor to ensure all disagreements have been resolved.
C. Contact the former auditor about certain matters of interest in Janie’s decision to
accept White Mountain as a client.
D. Contact the former auditor to determine if all fees have been paid, the change in
auditors have been approved and integrity issues have been overcome.

53. Which of the following will an auditor most likely discuss with the former auditors of a
potential client prior to acceptance?
A. Integrity of management.
B. Reasons for changing audit firms.
C. Disagreements with management regarding accounting principles.
D. All of the above must be discussed.

54. What is the most important purpose that is achieved by having an auditor write a
formal engagement letter that is signed by the client?
A. Documented proof of auditor responsibility for financial statements in accordance with
GAAP.
B. Multiple degrees of legal separation of the client from the auditor.
C. A locking-in of fees and timetable that must be adhered to by the client.
D. A communication and clarification of the responsibilities and expectations of the
auditor and the client.

55. What is the primary difference between financial reporting risk and audit risk?
A. The application of accounting principles.
B. Responsibilities of the respective parties involved.
C. Demands of users of financial statements.
D. Risks of being sued by third parties.
56. The auditor commences to understand the client and related risks of the organization
for what purpose?
A. To determine the audit opinion that will be issued.
B. To determine the appropriate understanding of internal controls by management.
C. To determine the detection of audit procedures in the period under audit.
D. To determine whether the auditor has sufficient knowledge to perform the
engagement/audit.

57. In determining audit risk, the auditor decides how much risk will be taken on by the
firm. Which of the following is correct regarding this decision by the auditor?
A. The auditor may decide to intentionally render an inappropriate opinion.
B. The auditor may decide not to take the audit engagement.
C. The auditor may decide to accept audit risk at 100%.
D. The auditor may decide that engagement risk is an appropriate measure of audit risk.

58. Kool Connections, Inc. requests that Wreath and Greenworth Auditors make a
proposal to provide audit services for the company. Which of the following is a correct
assumption surrounding the result of the proposal?
A. Greenworth is required to accept Kool Connections if selected as its auditors.
B. Greenworth should interview the prior audit firm prior to releasing the proposal to Kool
Connections.
C. Greenworth may decide not to accept Kool Connections based upon the perceived risk
of being associated with Kool.
D. Greenworth will contact the PCAOB or the AICPA and ask for a review of the proposal
prior to acceptance.

59. Which of the following is typically not a significant risk factor that an auditor will
consider in the client acceptance of Stitch Magee Co.?
A. Brad Stitch, the president and 50% owner of Stitch Magee was investigated for
securities violations four years earlier.
B. Stitch Magee Co. is a public company in the high technology industry.
C. Stitch Magee Co. is a manufacturing company that procures much of its raw materials
from the Detroit, Michigan area.
D. Stitch Magee Co. sells 25% of its inventory to Nani, Inc. which is owned primarily by
Nani Magee, the father of Stitch Magee's treasurer, vice president of finance and 50%
owner.
60. The auditor will utilize many resources to assess management integrity in the client
acceptance process. Which of the following will an auditor most likely refrain from using
in this search?
A. Predecessor auditor.
B. Other professionals in the business community.
C. Public databases.
D. All of the above will typically be used by an auditor in the search.

61. Which of the following industries is usually considered high risk by audit firms?
A. High technology companies such as Internet firms.
B. Manufacturing companies such as toy producers.
C. Legal services such as attorney firms.
D. Non-profit companies such as trade associations.

62. In accepting a client, auditing standards suggest that the auditor focus on four
questions. Which of the following is not one of those four required questions of the
predecessor?
A. Integrity of management.
B. The strength of the client’s internal control.
C. Disagreements with management as to accounting principles, auditing standards, or
other similarly significant matters.
D. Any communications by the predecessor to the client’s management or audit
committee concerning fraud, illegal acts by the client, and matters related to internal
control.

63. Engagement risk has been defined as the risk of potential losses that are incurred by
the auditor in being associated with a particular client. Which of the following factors are
not associated with increased engagement risk for the auditor?
A. Management with questionable integrity.
B. A failed company.
C. Materially misstated financial statements.
D. All of these factors increase engagement risk.

64. In evaluating the quality of corporate governance, the auditor analyzes several key
factors in determining to accept or retain a client. Which of the following factors are not
one of those key factors?
A. Independence and competency of the audit committee.
B. Participation of key stakeholders.
C. Existence of measurement risk.
D. Quality of management’s risk management process and internal controls.
65. Risk is pervasive to the audit process. An overview of the risk process associated
with an audit includes all of the following risks except which one?
A. Audit risk.
B. Engagement risk.
C. Economic risk.
D. Business risk.

66. Financial reporting risks are those risks that relate directly to the recording of
transactions and the presentation of financial data in an organization’s financial
statements. Which of the following factors is not one of the key factors affecting financial
reporting risk?
A. Competence and integrity of management
B. Complexity of the company’s transactions and financial reporting.
C. Quality of the company’s internal controls.
D. All of these factors affect financial reporting risks.

67. Which of the following factors is not a component of the audit risk model?
A. Inherent risk.
B. Statistical risk.
C. Detection risk.
D. Control risk.

68. In the audit risk model, which of the risk components can be assessed by the
auditor?
A. Inherent risk.
B. Control risk.
C. Detection risk.
D. Both A and B.

69. In the audit risk model, its risk components are either determined, assessed, or
manipulated. Which of the following risks are controllable by the auditor?
A. Audit risk.
B. Control risk.
C. Detection risk.
D. Both A and C.
70. Several general premises have been incorporated into the audit risk model. Which of
the following general premises have not been incorporated into the model?
A. Complex or unusual transactions are more likely to be recorded in error than are
recurring or routine transactions.
B. Good internal controls reduce the acceptable level of audit risk.
C. The amount and persuasiveness of audit evidence gathered should vary inversely
with audit risk.
D. The better the organization’s internal controls, the lower the likelihood of material
misstatements.

71. In implementing the audit risk model, which of the following is not a limitation of the
model that makes its implementation difficult?
A. Inherent risk is difficult to formally assess.
B. Audit risk is objectively determined.
C. The model treats each risk component as separate and independent.
D. Audit technology is not precisely developed in assessing each component.

72. During the 1990s the SEC was critical of the accounting profession for not sufficiently
examining qualitative factors in making materiality decision. A qualitative factor
generally not criticized by the SEC was
A. assessing materiality levels too minimally.
B. netting material misstatements.
C. not applying materiality to “swings” in accounting estimates.
D. consistently “passing” on individual adjustments not considered material.

73. In implementing the audit risk model, which of the following is not a component step
in applying the model?
A. Understand management’s risk processes.
B. Develop expectations.
C. Assess quality of control system.
D. All are component steps in implementing the audit risk approach.

74. Under the audit risk approach which of the following is not a method used by the
auditor to manage detection and audit risk?
A. Adjusting audit staffing to reflect the risk associated with the client.
B. Developing direct tests of account balances consistent with the detection risk.
C. Anticipating potential misstatements or accounting problems likely to be associated
with account balances.
D. Adjusting the timing of audit tests to maximize overall audit risk.
75. Residual risk is defined as
A. susceptibility of a transaction or accounting adjustment to be recorded in error, or for
the transaction not to be recorded in the absence of internal controls.
B. the risk that the client’s internal controls system will fail to prevent or detect a
misstatement.
C. the risk left in an account balance after application of internal controls.
D. risk that the audit procedures will fail to detect a material misstatement.

76. The risk based approach to auditing is dependent upon the auditor’s ability to
understand the business sufficient to identify and adjust to the residual risk left in
account balances. What is the effect upon the nature, extent and timing of audit
evidence if the auditor assessment of internal controls of the client indicates that a
higher degree of residual risk remains in account balances?
A. Gather less persuasive evidence.
B. Smaller sample sizes.
C. Gather more data at or after year end.
D. All of these effects on the nature, extent and timing of audit evidence are applicable.

77. Audit risk in the audit risk model concerns the risk that the auditor may issue an
unqualified opinion on financial statements that are materially misstated. What is the
manner in which the auditor assesses audit risk in using the audit risk model to
determine the nature, extent and timing of audit evidence to collect in an audit.
A. assessed to maintain low level of audit risk given residual risk
B. assessed to maintain low level of audit risk given financial statement risk
C. assessed to maintain a low level of audit risk given engagement risk
D. assessed to maintain a low level of audit risk given enterprise risk

78. New audit client acceptance

Discuss and analyze the audit risks involved with accepting a new client. Explain how an
auditor might determine client acceptance.
79. Engagement letters

Explain the overall purpose of an engagement letter.

80. Analytical Techniques

What are various assumptions underlying analytical techniques?

81. Analytical techniques in an audit

Why would an auditor use trend analysis on an audit? How and when would such an
analysis be used by the auditor?
82. Understanding the client's processes

You are on the audit team of Buckner and Halston, LLP. Your firm as has accepted Boris
Spyder, Inc., a manufacturer of fish food. What are some methods you will use in order
to understand the business and accounting processes of Boris?

83. Audit risk model

Write out the audit risk model, define each of its components and indicate their expected
relationship. Also discuss the purpose and limitations of the model.

84. Materiality

Discuss what materiality is for the auditor and how it is used in the audit process Why
has the SEC been concerned about materiality?
85. Audit risk model and audit evidence

Discuss the effect of the audit risk model on the nature, extent and timing of the
evidence to be collected.

86. Professional Skepticism

Discuss how the concept of professional skepticism affects the nature of procedures
performed on account balances that contain the highest risk of material misstatement?
In addition, discuss how should professional skepticism affect the judgment of the
auditor when assessing the susceptibility of the financial statements to material
misstatement due to fraud?
Chapter 4: Audit Risk, Business Risk, and Audit
Planning Key

1. Risk is the uncertainty about events and/or their outcomes that could have a material
effect on the organization.
TRUE

2. Risk is cumulative. If business risk is extremely high, the auditor will likely make a
decision to not be associated with a client because engagement risk will be too high.
TRUE

3. To assess management's integrity, the auditor may interview management.

TRUE

4. Controls are an accounting related object and do not extend beyond the accounting
and finance activities.
FALSE

5. An auditor must use professional judgment and skepticism when considering the
subjective nature of some of the evidence that might be gathered and evaluated by the
audit team.
TRUE

6. A basic premise underlying analytical procedures is that implausible relationships

among data may reasonably be expected to exist.
FALSE

7. Ratio analysis only involves a year-to-year comparison of account balances.

FALSE
8. Trend analysis is proven to be more effective than ratio analysis.
FALSE

9. Analytical techniques contain a combination of both quantitative and qualitative

techniques.
TRUE

10. Intentional manipulation of financial statements is a form of fraud.

TRUE

11. Tour of the client's production facilities is not an acceptable method for an auditor in
understanding the client's business processes.
FALSE

12. Risk analysis does not include identifying risks associated with management's intent
to misstate financial statements.
FALSE

13. An auditor will typically evaluate their clients annually to determine whether to retain
them or not.
TRUE

14. Engagement risk is said to increase when a client suffers a business failure.
TRUE

15. Prior year audit experience is not beneficial to an auditor in assessing management
integrity because management may have different attitudes in subsequent periods.
FALSE

16. The auditor is not concerned with illegal acts of clients because such acts are not
within the scope of financial statement reporting.
FALSE
17. Audit risk is the risk that the auditor will be sued by the client because of fraudulent
actions.
FALSE

18. In an audit of financial statements, it is implied that absolute assurance will be

provided.
FALSE

19. The likelihood of misstatements in the financial statements increases if the client has
poor internal control.
TRUE

20. Actions to keep detection risk at a lower level are under the direct control of the
auditor.
TRUE

21. Control risk can be referred to as the client's ability to mitigate overall audit risk.
FALSE

22. Management integrity and ethics have little to do with engagement risk.
FALSE

23. The auditor may choose to speak to the previous audit firm before accepting a
prospective public client in order to better understand the conditions surrounding the
change in auditors but it is not required.
FALSE

24. Materiality provides reasonable assurance that material misstatements will be

detected.HERE
TRUE

25. Materiality is judged using only quantitative factors.

FALSE
26. The SEC has been critical of the accounting profession for not sufficiently examining
qualitative factors in making materiality decisions.
TRUE

27. Audit risk is the risk that the auditor may give an unqualified opinion on financial
statements that are materially misstated.
TRUE

28. In the audit risk model there is no relationship between inherent risk, control risk,
and detection risk.
FALSE

29. In the audit risk model the auditor is only able to manipulate inherent and control
risk.
FALSE

30. In the audit risk model the auditor is only able to assess inherent and control risk.
TRUE

31. In the audit risk model the auditor manipulates detection risk based upon an
assessment of inherent and control risk to maintain an acceptably low audit risk.
TRUE

32. In the audit risk model as detection risk is increased by the auditor the amount of
evidence required and its persuasiveness increases.
FALSE

33. In the audit risk model each of its components are treated as separate and
independent..
TRUE
34. Inherent risk is the susceptibility of a transaction or accounting adjustment to be
recorded in error, or for the transaction not to be recorded in the absence of internal
controls.
TRUE

35. The audit risk model can be used by the auditor as a multiplicative model.
TRUE

36. After determining an overall materiality level for the financial statements the auditor
uses the assessment in evaluating the materiality of account balances.
FALSE

37. It would be considered unethical for an auditor to consistently “pass” on adjusting

detected errors in order to avoid conflict with managers.
TRUE

38. The concept of materiality is pervasive to the audit process and guides the nature
and extent of audit testing.
TRUE

39. Based upon an assessment of engagement risk the auditor determines an acceptable
level of audit risk.
TRUE

40. Which one of the following is not a critical component of risks relevant in conducting
an audit?
A. Business risks
B. Audit risks
C. Engagement risks
D. Decentralize risks
41. Which one of the following is a valid source of information about the client's
processes?
A. Management inquiry
B. Review of the client's budget
C. Tour of client’s plant and operations
D. All are valid sources.

42. The risk that financial statements are likely to be misstated materially without regard
to the effectiveness of internal control is which type of risk?
A. Inherent risk
B. Audit risk
C. Client risk
D. Control risk

43. A stipulation in an agreement between an entity and its creditor that places
documented restrictions on the organization is referred to as
A. debt covenants.
B. representation agreements.
C. engagement letters.
D. current maturities of long-term obligations.

44. Analytical procedures are used in an audit because it is assumed of financial

statements that
A. management fraud can be discovered using such procedures.
B. it is plausible that no relationship among data exists.
C. analytical procedures are used as tests of controls.
D. plausible relationships among data may reasonably be expected to exist and
continue.

45. An auditor compares year-to-year account balances in order to perform analytical

procedures. This is an example of:
A. ratio analysis.
B. trend analysis.
C. internal control analysis.
D. vertical analysis.
46. The preliminary use of analytical review procedures by the auditor is
A. required to identify areas of heightened risk
B. optional in accordance with auditor judgment.
C. only used when other planning procedures cannot be applied.
D. used to assist the auditor in documenting internal control.

47. The auditor is required to discuss with the audit committee whether or not the
financial statements are fairly presented and appropriately applied in accordance with
A. GAAS.
B. EITF.
C. GAAP.
D. PCAOB.

48. What is the most relevant use of a knowledge management system for an auditor?
A. Professionals may input client data and have procedures performed automatically.
B. Auditors are not required to make judgments collectively or individually.
C. Professionals may share information related to auditing, accounting standards and
risks.
D. Auditors may work entirely from the firm location rather than at the client location.

49. What analysis best considers the economic relationships among account balances?
A. Altman "Z" Analysis
B. Ratio analysis.
C. Vertical analysis.
D. Horizontal analysis.

50. Why will the external auditor typically interview the internal audit department as it
relates to its risk-based approach?
A. To appropriately change internal controls.
B. To comment on the deficiency of internal audit control.
C. To understand and assess management risk processes.
D. To perform effective analytical procedures.
51. Which is a primary limitation of the audit risk model?
A. The audit risk model does not adequately consider external forces on the client
organization.
B. Components of audit risk are treated as independent variables even though many
interdependencies exist between them.
C. The audit technology achieves approximate precision outside of a mathematical
model.
D. Control risk must be adjusted at the hands of the auditor, not by an arbitrary
estimation.

52. Janie Jones, CPA is proposing on a prospective audit engagement for White Mountain
Enterprises. After obtaining written permission of White Mountain, Janie is required to
perform what procedure prior to accepting it as a new client?
A. Provide full disclosure of fees that will be billed to White Mountain.
B. Contact the former auditor to ensure all disagreements have been resolved.
C. Contact the former auditor about certain matters of interest in Janie’s decision to
accept White Mountain as a client.
D. Contact the former auditor to determine if all fees have been paid, the change in
auditors have been approved and integrity issues have been overcome.

53. Which of the following will an auditor most likely discuss with the former auditors of a
potential client prior to acceptance?
A. Integrity of management.
B. Reasons for changing audit firms.
C. Disagreements with management regarding accounting principles.
D. All of the above must be discussed.

54. What is the most important purpose that is achieved by having an auditor write a
formal engagement letter that is signed by the client?
A. Documented proof of auditor responsibility for financial statements in accordance with
GAAP.
B. Multiple degrees of legal separation of the client from the auditor.
C. A locking-in of fees and timetable that must be adhered to by the client.
D. A communication and clarification of the responsibilities and expectations of the
auditor and the client.

55. What is the primary difference between financial reporting risk and audit risk?
A. The application of accounting principles.
B. Responsibilities of the respective parties involved.
C. Demands of users of financial statements.
D. Risks of being sued by third parties.
56. The auditor commences to understand the client and related risks of the organization
for what purpose?
A. To determine the audit opinion that will be issued.
B. To determine the appropriate understanding of internal controls by management.
C. To determine the detection of audit procedures in the period under audit.
D. To determine whether the auditor has sufficient knowledge to perform the
engagement/audit.

57. In determining audit risk, the auditor decides how much risk will be taken on by the
firm. Which of the following is correct regarding this decision by the auditor?
A. The auditor may decide to intentionally render an inappropriate opinion.
B. The auditor may decide not to take the audit engagement.
C. The auditor may decide to accept audit risk at 100%.
D. The auditor may decide that engagement risk is an appropriate measure of audit risk.

58. Kool Connections, Inc. requests that Wreath and Greenworth Auditors make a
proposal to provide audit services for the company. Which of the following is a correct
assumption surrounding the result of the proposal?
A. Greenworth is required to accept Kool Connections if selected as its auditors.
B. Greenworth should interview the prior audit firm prior to releasing the proposal to Kool
Connections.
C. Greenworth may decide not to accept Kool Connections based upon the perceived risk
of being associated with Kool.
D. Greenworth will contact the PCAOB or the AICPA and ask for a review of the proposal
prior to acceptance.

59. Which of the following is typically not a significant risk factor that an auditor will
consider in the client acceptance of Stitch Magee Co.?
A. Brad Stitch, the president and 50% owner of Stitch Magee was investigated for
securities violations four years earlier.
B. Stitch Magee Co. is a public company in the high technology industry.
C. Stitch Magee Co. is a manufacturing company that procures much of its raw materials
from the Detroit, Michigan area.
D. Stitch Magee Co. sells 25% of its inventory to Nani, Inc. which is owned primarily by
Nani Magee, the father of Stitch Magee's treasurer, vice president of finance and 50%
owner.
60. The auditor will utilize many resources to assess management integrity in the client
acceptance process. Which of the following will an auditor most likely refrain from using
in this search?
A. Predecessor auditor.
B. Other professionals in the business community.
C. Public databases.
D. All of the above will typically be used by an auditor in the search.

61. Which of the following industries is usually considered high risk by audit firms?
A. High technology companies such as Internet firms.
B. Manufacturing companies such as toy producers.
C. Legal services such as attorney firms.
D. Non-profit companies such as trade associations.

62. In accepting a client, auditing standards suggest that the auditor focus on four
questions. Which of the following is not one of those four required questions of the
predecessor?
A. Integrity of management.
B. The strength of the client’s internal control.
C. Disagreements with management as to accounting principles, auditing standards, or
other similarly significant matters.
D. Any communications by the predecessor to the client’s management or audit
committee concerning fraud, illegal acts by the client, and matters related to internal
control.

63. Engagement risk has been defined as the risk of potential losses that are incurred by
the auditor in being associated with a particular client. Which of the following factors are
not associated with increased engagement risk for the auditor?
A. Management with questionable integrity.
B. A failed company.
C. Materially misstated financial statements.
D. All of these factors increase engagement risk.

64. In evaluating the quality of corporate governance, the auditor analyzes several key
factors in determining to accept or retain a client. Which of the following factors are not
one of those key factors?
A. Independence and competency of the audit committee.
B. Participation of key stakeholders.
C. Existence of measurement risk.
D. Quality of management’s risk management process and internal controls.
65. Risk is pervasive to the audit process. An overview of the risk process associated
with an audit includes all of the following risks except which one?
A. Audit risk.
B. Engagement risk.
C. Economic risk.
D. Business risk.

66. Financial reporting risks are those risks that relate directly to the recording of
transactions and the presentation of financial data in an organization’s financial
statements. Which of the following factors is not one of the key factors affecting financial
reporting risk?
A. Competence and integrity of management
B. Complexity of the company’s transactions and financial reporting.
C. Quality of the company’s internal controls.
D. All of these factors affect financial reporting risks.

67. Which of the following factors is not a component of the audit risk model?
A. Inherent risk.
B. Statistical risk.
C. Detection risk.
D. Control risk.

68. In the audit risk model, which of the risk components can be assessed by the
auditor?
A. Inherent risk.
B. Control risk.
C. Detection risk.
D. Both A and B.

69. In the audit risk model, its risk components are either determined, assessed, or
manipulated. Which of the following risks are controllable by the auditor?
A. Audit risk.
B. Control risk.
C. Detection risk.
D. Both A and C.
70. Several general premises have been incorporated into the audit risk model. Which of
the following general premises have not been incorporated into the model?
A. Complex or unusual transactions are more likely to be recorded in error than are
recurring or routine transactions.
B. Good internal controls reduce the acceptable level of audit risk.
C. The amount and persuasiveness of audit evidence gathered should vary inversely
with audit risk.
D. The better the organization’s internal controls, the lower the likelihood of material
misstatements.

71. In implementing the audit risk model, which of the following is not a limitation of the
model that makes its implementation difficult?
A. Inherent risk is difficult to formally assess.
B. Audit risk is objectively determined.
C. The model treats each risk component as separate and independent.
D. Audit technology is not precisely developed in assessing each component.

72. During the 1990s the SEC was critical of the accounting profession for not sufficiently
examining qualitative factors in making materiality decision. A qualitative factor
generally not criticized by the SEC was
A. assessing materiality levels too minimally.
B. netting material misstatements.
C. not applying materiality to “swings” in accounting estimates.
D. consistently “passing” on individual adjustments not considered material.

73. In implementing the audit risk model, which of the following is not a component step
in applying the model?
A. Understand management’s risk processes.
B. Develop expectations.
C. Assess quality of control system.
D. All are component steps in implementing the audit risk approach.

74. Under the audit risk approach which of the following is not a method used by the
auditor to manage detection and audit risk?
A. Adjusting audit staffing to reflect the risk associated with the client.
B. Developing direct tests of account balances consistent with the detection risk.
C. Anticipating potential misstatements or accounting problems likely to be associated
with account balances.
D. Adjusting the timing of audit tests to maximize overall audit risk.
75. Residual risk is defined as
A. susceptibility of a transaction or accounting adjustment to be recorded in error, or for
the transaction not to be recorded in the absence of internal controls.
B. the risk that the client’s internal controls system will fail to prevent or detect a
misstatement.
C. the risk left in an account balance after application of internal controls.
D. risk that the audit procedures will fail to detect a material misstatement.

76. The risk based approach to auditing is dependent upon the auditor’s ability to
understand the business sufficient to identify and adjust to the residual risk left in
account balances. What is the effect upon the nature, extent and timing of audit
evidence if the auditor assessment of internal controls of the client indicates that a
higher degree of residual risk remains in account balances?
A. Gather less persuasive evidence.
B. Smaller sample sizes.
C. Gather more data at or after year end.
D. All of these effects on the nature, extent and timing of audit evidence are applicable.

77. Audit risk in the audit risk model concerns the risk that the auditor may issue an
unqualified opinion on financial statements that are materially misstated. What is the
manner in which the auditor assesses audit risk in using the audit risk model to
determine the nature, extent and timing of audit evidence to collect in an audit.
A. assessed to maintain low level of audit risk given residual risk
B. assessed to maintain low level of audit risk given financial statement risk
C. assessed to maintain a low level of audit risk given engagement risk
D. assessed to maintain a low level of audit risk given enterprise risk
78. New audit client acceptance

Discuss and analyze the audit risks involved with accepting a new client. Explain how an
auditor might determine client acceptance.

The auditor incurs certain engagement risks whenever a client is accepted. These risks
include that of the auditor's association with a failed client and the possibility of
misstated financial statements on which the audit firm has issued an unqualified opinion.

An audit firm is very sensitive to the types of warning signs that may be apparent prior
to client acceptance including:

Management integrity
Independence and competence of management and the board of directors
The quality of management’s risk management process and controls
Reporting requirements, including regulatory requirements
Participation of key stakeholders
Existence of related-party transactions
The financial health of the organization

An audit firm will be very cautious in accepting a client and will undertake procedures to
assess the risk of being associated with a client and its financial statements such as:

Discussions with the prior audit firm

Inquiry of prospective client's banks and attorney firms
Independent sources of information such as private investigations, media, and
references
Public databases and the Internet
Interviews with management

The auditor also faces the risk of not being independent of the prospective client. The
audit firm will most likely perform a careful analysis to ensure that all relevant audit
personnel are considered independent of the prospective client. Additionally, the audit
firm will probably perform some diligence to determine whether the potential client's
accounting and business records are in a condition to be audited.
79. Engagement letters

Explain the overall purpose of an engagement letter.

An engagement letter is a document used by auditors in conjunction with planned client

services. It is an agreement that clarifies the responsibilities and activities of both the
audit firm and the client company. An example of this is the delineation between an
auditors' responsibility to audit the financial statements and the client company's
responsibility for the financial statements and the related disclosures. Another example
of clarification is that of the communication in the letter regarding the auditors'
responsibility for detecting fraud. A large area of importance of the engagement letter is
the clarification of the types of services that will be performed.
The auditor and client (the audit committee) should have a mutual understanding of the
nature of the audit services to be performed, the timing of these services, the expected
fees and the basis on which they will be billed, the responsibilities of the auditor in
searching for fraud, the client’s responsibilities for preparing information for the audit,
and the need for other services to be performed by the audit firm. The audit firm should
prepare an engagement letter summarizing and documenting this understanding
between the auditor and the client. The engagement letter clarifies the responsibilities
and expectations of each party and thus is an important element of managing
engagement risk - especially the risk related to litigation.

80. Analytical Techniques

What are various assumptions underlying analytical techniques?

Financial information for equivalent prior periods, such as comparing the trend of fourth-
quarter sales for the past three years and analyzing dollar and percent changes from the
prior year.

Expected or planned results developed from budgets or other forecasts, such as

comparing actual division performance with budgeted performance.

Comparison of linked account relationships, such as interest expense and interest-

bearing debt.

Ratios of financial information, such as examining the relationship between sales and
cost of goods sold or developing and analyzing common-sized financial statements.

Company and industry trends, such as comparing gross margin percentages of product
lines or inventory turnover with industry averages.

Survey of relevant nonfinancial information, such as analyzing the relationship between

the numbers of items shipped and royalty expense or the number of employees and
payroll expense.
81. Analytical techniques in an audit

Why would an auditor use trend analysis on an audit? How and when would such an
analysis be used by the auditor?

Trend analysis is used by audit firms to flag significant changes from period to period in a
client's financial accounting balances. The auditor will look at outliers against individual
expectations and then inquire of management to understand any unresolved changes.
The ultimate understanding of such effects is then utilized in assisting the auditor to
assess inherent risk and to determine areas of audit emphasis and the procedures to be
performed.

Trend analysis includes simple year-to-year comparisons of account balances, graphic

presentations, analysis of financial data, and projections of account balances based on
the history of changes in the accounts. The auditor should establish decision rules in
order to identify unexpected results for further investigation. Trend analysis may be used
over a several year period for key accounts to aid auditors in understanding why
particular changes may have occurred in key accounts.

Analytical procedures are always used in planning an audit. Trend analysis is often one
of these analytical techniques used in the audit planning process.
82. Understanding the client's processes

You are on the audit team of Buckner and Halston, LLP. Your firm as has accepted Boris
Spyder, Inc., a manufacturer of fish food. What are some methods you will use in order
to understand the business and accounting processes of Boris?
It is essential that an auditor understand the client. One area of this understanding that
must be obtained and updated each time an audit is performed is that of its business
and accounting processes. As it pertains to Boris Spyder, Inc., there will be many areas
of operations, accounting, vendors and customers that must be comprehended by us as
the auditors.

In order to understand how Boris' strategy and vision align with the actual business
processes, we will interview key members of accounting, marketing, HR, manufacturing,
in-house attorneys and executive management. We will ask relevant questions to
ascertain the direction of the fish food market and the future plans of Boris Spyder, Inc.
We will also inquire about the possibility of pending or threatened litigation against Boris.

We will review the sales, expense, capital, cash and production budgets of Boris to
analyze changes and challenges that the company is undergoing. The budgets will tell
the story of struggles with negative variances, production flow, sales trends,
discontinued segments, uses of cash, including any purchases of property and
equipment and large expenditures during the period. We will determine from these
budgets the changing demand for fish food from Boris customers, the changing prices of
fish food materials and the various costs of manufacturing.

We will tour the fish production line and warehouse. These tours will aid us in our
understanding of cost accounting assumptions, inventory flow and logistics. This
information will be vital in our audit procedures related to inventory quantities, costing,
valuation and lower of cost or market assumptions.

Though Boris may have only a small data center, it will be imperative to the audit that
we understand how data is stored and secured. We will ask questions regarding not only
the physical security of the hardware, but the availability and accessibility of the data
and systems.

In preparation for the audit, we will read Boris' agreements, legal documents and
minutes of the board of directors. There are many pieces of information that will be
important to understanding Boris and its processes. If Boris has loan agreements, for
instance, there may be covenants that are vital for considering materiality effects,
disclosure items and the risk of the loan coming due earlier than expected. Minutes are
a virtual blueprint of the decisions made by the Boris board of directors during the year
and through the end of fieldwork. Many items of audit importance will be found in the
minutes such as litigation and large business issues, stock issuance, new debt approval,
divestitures, acquisitions, and other authorizations. Future plans for the company will
also be located in the minutes.

We will review any communication between Boris and any regulatory bodies such as the
SEC (if public), the IRS, and possibly the FTC, the FDA and the EPA. Perhaps Boris has
received comment letters on previous filings with the SEC. Though not likely, there may
be a pending investigation by any regulatory body for securities violations, tax issues,
questionable marketing practices, or potential irregular or hazardous materials in the fish
food. All of these items will be pertinent to our understanding the nature of Boris'
business environment and processes.
83. Audit risk model

Write out the audit risk model, define each of its components and indicate their expected
relationship. Also discuss the purpose and limitations of the model.

The audit risk model is: AR = IR x CR x DR, where

Inherent risk is the susceptibility of an account balance to material misstatement without

regard to the effectiveness of internal control, i.e.,some accounts such as cash or
receivables are naturally more likely to misstatement than others.

Control risk is the risk that the internal control system of the client will not prevent or
detect a material misstatement.

Detection risk is the risk that the procedures applied by the auditor will not detect a
material misstatement.

Audit risk is the risk of the auditor issuing an unqualified report on financial statements
that are materially misstated. A material misstatement occurred, was not prevented or
detected by the client’s internal controls, nor was it caught by the auditor’s procedures,
and as a result a clean opinion was rendered on materially misstated financial
statements.

The auditor uses the audit risk model as a conceptual approach to the audit of the
accounts of a client in determining the nature, timing and extent of evidence that needs
to be collected. It can be applied either quantitatively (e.g., .2) or qualitatively (e.g.,
high, low, medium), but is difficult to actually implement in an audit situation because of
its limitations. These limitations are that audit risk is subjectively determine, inherent
risk is difficult to formally assess, the model treats each component as separate and
independent, and the difficulty of accurately assessing each component.

Expected relationships are that within the engagement risk of a particular client where
enterprise risk and financial reporting risk have been evaluated a low level of audit risk is
determined by the auditor in issuing an audit report. To maintain the low level of audit
risk, inherent risk and control risk of the client is assessed and detection risk is
manipulated upwards or downwards. As a result there is an inverse relationship between
inherent and control risk with detection risk. The higher inherent and control risk are, the
lower acceptable detection risk will be. The lower inherent and control risk are, the
higher acceptable detection risk can be.

Limitations:

1 Inherent risk is difficult to formally assess

2 Audit risk is judgmentally determined
3 This model treats each risk component as separate and independent when in fact the components are not
independent
4 Audit technology is not so precisely developed that each component of the model can be accurately
assessed
84. Materiality

Discuss what materiality is for the auditor and how it is used in the audit process Why
has the SEC been concerned about materiality?

Materiality deals with the “magnitude of an omission or misstatement of accounting

information that, in light of surrounding circumstances, makes it probable that the
judgment of a reasonable person relying on the information would have been changed or
influenced by the omission or misstatement”.

In auditing account balances of the client and making judgments as to what has to be
adjusted or not, the auditor has to evaluate the materiality of proposed adjustments and
the extent to which adjustments will be required of the client. Those proposed
adjustments that are not material are below the recognition threshold and by definition
don’t require adjustment. Overall planning materiality is determined at the beginning of
the audit and then allocated to account balances using various methods.

The SEC has been critical of the audit profession for not sufficiently examining qualitative
factors in making materiality decisions. Three specific criticisms are:
-Netting (offsetting) material misstatements and not making adjustments because the
net effect may not be material.
-Not applying materiality concept to “swings” in accounting estimates using a ‘best
estimate’ each year instead of using a two-year period.
-Consistently passing on individual adjustments not considered material. The SEC asks
why would a client not be willing to correct known misstatements?
85. Audit risk model and audit evidence

Discuss the effect of the audit risk model on the nature, extent and timing of the
evidence to be collected.

The auditor uses the audit risk model as a conceptual approach to the audit of the
accounts of a client in determining the nature, timing and extent of evidence that needs
to be collected. It can be applied either quantitatively or qualitatively (e.g., high, low,
medium), but is difficult to actually implement in an audit situation because of its
limitations.

The auditor varies the nature, timing, and extent of audit evidence collected based upon
the manipulation of detection risk to maintain low audit risk. As detection risk is
increased with better internal controls and lower inherent risk, the auditor can gather
less evidence, it does not have to be as persuasive and more can be gathered at the
interim. As acceptable detection risk goes down, however, the auditor must gather more
evidence, it needs to be more persuasive, and more has to be gathered at or after year-
end. The needed persuasiveness of the evidence determines the types of evidence to be
collected, e.g., sometimes analytics and inquiries (at lower end of persuasiveness) are
sufficient evidence to support an account balance, but if there is greater residual risk in
an account balance then third party confirmations (at higher end of persuasiveness
normally) and other types of evidence can be added.

86. Professional Skepticism

Discuss how the concept of professional skepticism affects the nature of procedures
performed on account balances that contain the highest risk of material misstatement?
In addition, discuss how should professional skepticism affect the judgment of the
auditor when assessing the susceptibility of the financial statements to material
misstatement due to fraud?

Professional skepticism requires the audit engagement team members to have an

attitude that includes a questioning mind. They should be careful to set aside prior
personal beliefs that management is honest and has integrity.
The auditor should focus greater professional skepticism and greater audit testing on the
account balances and disclosures that contain the highest risk of material misstatement.
Auditing standards require that key engagement team members discuss the
susceptibility of the organization‘s financial statements to material misstatement caused
by fraud. In considering the possibility of fraud, auditors need to exercise professional
skepticism when they engage in this discussion.