4 Audit Risk, Business Risk, and Audit Planning

Chapter 4: Audit Risk, Business Risk, and Audit Planning
TRUE/FALSE
1. Risk is the uncertainty about events and/or their outcomes that could have a material effect on the
organization.
ANS: T PTS: 1 OBJ: Nature of Risk

NAT: AACSB-Analytical skills | AICPA BB-Risk analysis, Critical thinking
2. Risk is cumulative. If business risk is very high, the auditor should make a decision to not be
associated with a client because engagement risk will be too high.

3. To assess management's integrity, the auditor may interview management.
ANS: T PTS: 1
OBJ: Managing Engagement Risk Through Client Acceptance and Retention Decisions
4. Controls are an accounting related object and do not extend beyond the accounting and finance
activities.
ANS: F PTS: 1 OBJ: Planning the Audit Using the Audit Risk Model
5. Residual audit risk is the remaining risk in specific account balances after assessing all factors dealing
with expectation about the correctness of account balances.
ANS: T PTS: 1 OBJ: Planning the Audit Using the Audit Risk Model
6. A basic premise underlying analytical procedures is that implausible relationships among data may
reasonably be expected to exist.
ANS: F PTS: 1
OBJ: Preliminary Financial Statement Review: Using Analytical Techniques to Identify Areas of
Heightened Risk NAT: AACSB-Analytical skills | AICPA BB-Risk analysis, Critical thinking
7. Ratio analysis only involves a year-to-year comparison of account balances.
ANS: F PTS: 1
8. Trend analysis is proven to be more effective than ratio analysis.
ANS: F PTS: 1
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9. Analytical techniques contain a combination of both quantitative and qualitative techniques.
ANS: T PTS: 1
10. Intentional manipulation of financial statements is a form of fraud.

11. Tour of the client's production facilities is not an acceptable method for an auditor in understanding the
client's business processes.
12. Risk analysis does not include identifying risks associated with management's intent to misstate
financial statements.
13. An auditor will typically review clients annually to determine whether to retain them or not.
ANS: T PTS: 1
14. Engagement risk is said to increase when a client suffers a business failure.

15. Prior year audit experience is not beneficial to an auditor in assessing management integrity because
management may have different attitudes in subsequent periods.
ANS: F PTS: 1
16. The auditor is not concerned with illegal acts of clients because such acts are not within the scope of
financial statement reporting.
ANS: F PTS: 1
17. Audit risk is the risk that the auditor will be sued by the client because of fraudulent actions.
ANS: F PTS: 1 OBJ: Nature of Risk

18. In an audit of financial statements, it is implied that absolute assurance will be provided.
ANS: F PTS: 1
19. The likelihood of misstatements in the financial statements increases if the client has poor internal
control.

20. Actions to keep detection risk at a lower level are under the direct control of the auditor.
ANS: T PTS: 1 OBJ: Understanding the Audit Risk Model

21. Control risk can be referred to as the client's ability to mitigate overall audit risk.
22. Inherent risk involves many external factors on the organization that may assist in the existence of
misstatements in the financial statements.

23. Management integrity and ethics have little to do with engagement risk.
ANS: F PTS: 1
24. The auditor is required to speak to the previous audit firm before accepting a prospective client in
order to better understand the conditions surrounding the change in auditors.
ANS: T PTS: 1
25. Materiality provides reasonable assurance that material misstatements will be detected.
ANS: T PTS: 1 OBJ: Managing Audit Risk

26. Materiality is judged using only quantitative factors.
ANS: F PTS: 1 OBJ: Managing Audit Risk

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

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

29. In the audit risk model there is a direct relationship between inherent and control risk with detection
risk.
ANS: F PTS: 1 OBJ: Understanding the Audit Risk Model

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

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

32. 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.

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

34. In the audit risk model each of its components are treated as separate and independent..
ANS: T PTS: 1 OBJ: Limitations of the Audit Risk Model

35. 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.

36. The audit risk model can be used by the auditor as a multiplicative model.
37. After determining an overall materiality level for the financial statements the auditor uses the
assessment in evaluating the materiality of account balances.
ANS: F PTS: 1 OBJ: Managing Audit Risk

38. Consistently “passing” individual adjustments may not be considered material in nature.

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

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

MULTIPLE CHOICE
1. 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
ANS: D PTS: 1 OBJ: Nature of Risk
2. 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.
ANS: D PTS: 1 OBJ: Planning the Audit Using the Audit Risk Model
3. 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
ANS: A PTS: 1 OBJ: Understanding the Audit Risk Model
4. 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.
ANS: A PTS: 1 OBJ: Planning the Audit Using the Audit Risk Model
5. 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.
ANS: D PTS: 1
6. 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.
ANS: B PTS: 1
7. 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.
ANS: A PTS: 1 OBJ: Planning the Audit Using the Audit Risk Model
8. 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.
ANS: C PTS: 1 OBJ: Planning the Audit Using the Audit Risk Model
9. 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.
10. What analysis best considers the economic relationships among account balances?
a. Altman "Z" Analysis
b. Ratio analysis.
c. Vertical analysis.
d. Horizontal analysis.
ANS: B PTS: 1
11. 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.
12. 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.
ANS: B PTS: 1 OBJ: Limitations of the Audit Risk Model
13. JaNae Jones, CPA is proposing on a prospective audit engagement for White Quack Enterprises. After
obtaining written permission of White Quack, JaNae 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 Quack.
b. Contact the former auditor to ensure all disagreements have been resolved.
c. Contact the former auditor about certain matters of interest in JaNae's decision to accept
White Quack 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.
ANS: C PTS: 1
14. 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.
ANS: D PTS: 1
15. What is the most value achieved by the auditor in requiring an engagement letter be entered into with
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.
ANS: D PTS: 1
16. 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.
ANS: B PTS: 1 OBJ: Nature of Risk
17. 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.
18. 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.
ANS: B PTS: 1 OBJ: Nature of Risk
19. Kool Connections, Inc. requests that Wreath and Greenworth propose on audit services. 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.
ANS: C PTS: 1
20. Which of the following is typically not a significant 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.
ANS: C PTS: 1
21. 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.
ANS: D PTS: 1
22. 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.
ANS: A PTS: 1
23. 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.
ANS: B PTS: 1
24. 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.
25. 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
considered by the auditor in evaluating corporate governance?
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.
ANS: C PTS: 1
26. 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.
ANS: C PTS: 1 OBJ: Nature of Risk
27. 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.
28. 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.
ANS: B PTS: 1 OBJ: Understanding the Audit Risk Model
29. 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.
ANS: D PTS: 1 OBJ: Understanding the Audit Risk Model
30. 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.
ANS: D PTS: 1 OBJ: Understanding the Audit Risk Model
31. 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.
ANS: B PTS: 1 OBJ: Understanding the Audit Risk Model
32. 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.
ANS: B PTS: 1 OBJ: Limitations of the Audit Risk Model
33. 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.
ANS: A PTS: 1 OBJ: Managing Audit Risk
34. 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.
ANS: D PTS: 1 OBJ: Planning the Audit Using the Audit Risk Model
35. 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.
36. 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.
37. 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.
38. 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
ANS: C PTS: 1 OBJ: Understanding the Audit Risk Model
ESSAY
1. New audit client acceptance
Discuss and analyze the audit risks involved with accepting a new client. Explain how an auditor
might determine client acceptance.
ANS:
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.
PTS: 1
NAT: AACSB-Communication skills, Analytical skills | AICPA BB-Risk analysis, Critical thinking
2. Engagement letters
Explain the overall Purpose of an Engagement Letter?
ANS:
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.
PTS: 1
3. Analytical Techniques
What are various assumptions underlying analytical techniques?
ANS:
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.
PTS: 1
Heightened Risk
4. 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?
ANS:
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.
PTS: 1
Heightened Risk
5. 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?
ANS:
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.
PTS: 1 OBJ: Planning the Audit Using the Audit Risk Model
6. 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.
ANS:
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
PTS: 1
OBJ: Understanding the Audit Risk Model | Limitations of the Audit Risk Model
7. 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?
ANS:
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?
PTS: 1 OBJ: Managing Audit Risk

8. 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.
ANS:
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.
PTS: 1 OBJ: Understanding the Audit Risk Model


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4 Audit Risk, Business Risk, and Audit Planning

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Chapter 4: Audit Risk, Business Risk, and Audit Planning

ANS: T PTS: 1 OBJ: Nature of Risk

ANS: T PTS: 1 OBJ: Nature of Risk

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

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

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

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

ANS: T PTS: 1 OBJ: Nature of Risk

ANS: T PTS: 1 OBJ: Nature of Risk

ANS: F PTS: 1 OBJ: Nature of Risk

ANS: T PTS: 1 OBJ: Nature of Risk

ANS: T PTS: 1 OBJ: Understanding the Audit Risk Model

ANS: T PTS: 1 OBJ: Understanding the Audit Risk Model

ANS: T PTS: 1 OBJ: Managing Audit Risk

26. Materiality is judged using only quantitative factors.

ANS: F PTS: 1 OBJ: Managing Audit Risk

ANS: T PTS: 1 OBJ: Managing Audit Risk

ANS: T PTS: 1 OBJ: Nature of Risk

ANS: F PTS: 1 OBJ: Understanding the Audit Risk Model

ANS: F PTS: 1 OBJ: Understanding the Audit Risk Model

ANS: T PTS: 1 OBJ: Understanding the Audit Risk Model

ANS: T PTS: 1 OBJ: Understanding the Audit Risk Model

ANS: F PTS: 1 OBJ: Understanding the Audit Risk Model

ANS: T PTS: 1 OBJ: Limitations of the Audit Risk Model

ANS: T PTS: 1 OBJ: Understanding the Audit Risk Model

ANS: F PTS: 1 OBJ: Managing Audit Risk

ANS: T PTS: 1 OBJ: Managing Audit Risk

ANS: T PTS: 1 OBJ: Managing Audit Risk

ANS: T PTS: 1 OBJ: Understanding the Audit Risk Model

7. The preliminary use of analytical review procedures by the auditor is

12. Which is a primary limitation of the audit risk model?

36. Residual risk is defined as

Discussions with the prior audit firm

Explain the overall Purpose of an Engagement Letter?

What are various assumptions underlying analytical techniques?

4. Analytical techniques in an audit

5. Understanding the client's processes

6. Audit risk model

PTS: 1 OBJ: Managing Audit Risk

8. Audit risk model and audit evidence

PTS: 1 OBJ: Understanding the Audit Risk Model

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