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

Chapter 8 Audit Planning and Materiality

8.1 Learning Objective 8-1

1) A measure of how willing the auditor is to accept that the financial statements may be
materially misstated after the audit is completed and an unqualified opinion has been issued is
the
A) inherent risk.
B) acceptable audit risk.
C) statistical risk.
D) financial risk.

Terms: Acceptable audit risk

Difficulty: Easy
Objective: LO 8-1
AACSB: Reflective thinking

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

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

Terms: Steps in planning an audit and designing an audit approach

Difficulty: Moderate
Objective: LO 8-1
AACSB: Reflective thinking

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

Terms: Risk of material misstatements

Difficulty: Easy
Objective: LO 8-1
AACSB: Reflective thinking

1
Copyright © 2020 Pearson Education, Inc.
4) In what order should the following steps occur?
A. Set preliminary judgment of materiality and performance materiality.
B. Understand the client's business and industry.
C. Perform preliminary analytical procedures.
D. Accept the client and perform initial audit planning.
A) D, B, C, A
B) B, A, C, D
C) B, D, A, C
D) D, C, B, A

Terms: Steps in planning an audit and designing an audit approach

Difficulty: Moderate
Objective: LO 8-1
AACSB: Reflective thinking

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

Terms: Client business risk

Difficulty: Challenging
Objective: LO 8-1
AACSB: Analytic thinking

6) When an auditor sets a low acceptable audit risk, it means that he or she wants to be more
certain that the financial statements are not materially misstated.

Terms: Acceptable audit risk

Difficulty: Moderate
Objective: LO 8-1
AACSB: Reflective thinking

7) As acceptable audit risk is decreased, the likely cost of conducting an audit increases.

Terms: Acceptable audit risk

Difficulty: Challenging
Objective: LO 8-1
AACSB: Reflective thinking

2
Copyright © 2020 Pearson Education, Inc.
8) Assessing acceptable audit risk, client business risk, and risk of material misstatement helps
determine the audit procedures that will be needed.

Terms: Assessing risk and planning audit procedures

Difficulty: Moderate
Objective: LO 8-1
AACSB: Reflective thinking

9) A 100% audit risk is complete certainty.

Terms: Acceptable audit risk

Difficulty: Moderate
Objective: LO 8-1
AACSB: Reflective thinking

10) Zero risk is certainty, and a 100% audit risk is complete uncertainty.

Terms: Acceptable audit risk

Difficulty: Moderate
Objective: LO 8-1
AACSB: Reflective thinking

11) Client business risk is the risk that the entity fails to achieve its objectives or execute its
strategies.

Terms: Client business risk

Difficulty: Moderate
Objective: LO 8-1
AACSB: Reflective thinking

12) Client business risk includes the auditor identifying declines in economic conditions that
adversely affect both sales and the collectability of accounts receivable.

Terms: Client business risk

Difficulty: Easy
Objective: LO 8-1
AACSB: Reflective thinking

13) The risk of material misstatement is the risk that the financial statements contain a material
misstatement due to fraud or error prior to the audit.

Terms: Risk of material misstatement

Difficulty: Easy
Objective: LO 8-1
AACSB: Reflective thinking

3
Copyright © 2020 Pearson Education, Inc.
14) The risk of material misstatement is a function of the susceptibility of the financial
statements to misstatement; the effectiveness of the client's controls in preventing or detecting
these misstatements has no impact on the risk of material misstatement.

Terms: Risk of material misstatement

Difficulty: Moderate
Objective: LO 8-1
AACSB: Reflective thinking

15) Assume an audit client identified in the planning stage of the audit the risk of material
misstatement for revenue recognition and accounts receivable due to complex valuation related
issues; this situation warrants the auditor to accumulate additional audit evidence and to assign
more experienced staff to perform the testing in this area.

Terms: Risk of material misstatement

Difficulty: Moderate
Objective: LO 8-1
AACSB: Reflective thinking

16) There are three main reasons why an auditor should properly plan audit engagements.
Discuss each of these reasons.
Terms: Reasons auditor should properly plan audit engagement
Difficulty: Moderate
Objective: LO 8-1
AACSB: Reflective thinking

4
Copyright © 2020 Pearson Education, Inc.
8.2 Learning Objective 8-2

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

B)
Engagement objectives Engagement limitations
No No

C)
Engagement objectives Engagement limitations
Yes No

D)
Engagement objectives Engagement limitations
No Yes

Terms: Engagement letter

Difficulty: Easy
Objective: LO 8-2
AACSB: Reflective thinking

5
Copyright © 2020 Pearson Education, Inc.
2) The auditor is likely to accumulate more evidence when the audit is for a company
A)
Which has large amounts of debt Which is to be sold in the near future
Yes Yes

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

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

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

Terms: Reasons for an audit and audit evidence

Difficulty: Easy
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Initial audit planning

Difficulty: Easy
Objective: LO 8-2
AACSB: Reflective thinking

6
Copyright © 2020 Pearson Education, Inc.
4) Smith, CPA, has requested permission to communicate with the predecessor auditor in order
to review certain workpapers for high risk accounts for a new audit client. The new audit client's
refusal to allow this communication to occur would impact Smith's decision concerning
A) the auditor's ability to design audit tests.
B) possible scope exception due to lack of access.
C) the desirability of accepting the prospective engagement.
D) violation of the GAAP rules concerning consistency and comparability of financial
information.

Terms: New audit client's refusal to allow communication between predecessor and successor
auditors
Difficulty: Easy
Objective: LO 8-2
AACSB: Reflective thinking

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

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

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

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

Terms: Successor auditor may perform communication for new audit client
Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

7
Copyright © 2020 Pearson Education, Inc.
6) When dealing with audit risk,
A) audit risk should not be a factor when determining if a new client should be accepted.
B) audits with a low acceptable audit risk generally result in lower audit fees.
C) if management of a company has a reputation of integrity, but is also known to take
aggressive financial risks, the auditor should not accept the company as a new client.
D) if the auditor concludes that acceptable audit risk is low, but the client is still acceptable, the
auditor may still accept the engagement but increase the fee proposed to the client.

Terms: Lower acceptable audit risk

Difficulty: Challenging
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Written understanding detailing what auditor will do and what auditor expects from
client in performing audit
Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Responsibility for agreeing nonaudit services for a public company audit client
Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

8
Copyright © 2020 Pearson Education, Inc.
9) Which of the following statements is true regarding communications between predecessor and
successor auditors?
A) The burden of initiating the communication rests with the predecessor.
B) The predecessor's response can be limited to stating that no information will be provided.
C) The predecessor should communicate with the successor only if the client is public.
D) The predecessor auditor of a public company does not need permission from the client before
communicating with the successor auditor.

Terms: Communications between predecessor and successor auditors

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

10) The purpose of an engagement letter is to

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

Terms: Purpose of engagement letter

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Reasons for an audit and audit evidence

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

9
Copyright © 2020 Pearson Education, Inc.
12) Which of the following normally signs the engagement letter for an audit of a private
company?
A) management
B) board of directors' representative
C) audit committee representative
D) corporate treasurer

Terms: Normally signs engagement letter for audit of private company

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Audit risk

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Engagement letter sent to publicly held client

Difficulty: Challenging
Objective: LO 8-2
AACSB: Reflective thinking

15) The preliminary audit strategy

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

Terms: Audit strategy

Difficulty: Moderate
Objective: LO 8-2
AACSB: Analytic thinking

10
Copyright © 2020 Pearson Education, Inc.
16) The purpose of the requirement in having communication between the predecessor and
successor auditors is to
A) allow the predecessor to disclose information which would otherwise be confidential.
B) help the successor auditor to evaluate whether to accept the engagement.
C) help the client by facilitating the change of auditors.
D) ensure the predecessor collects all unpaid fees prior to a change in auditor.

Terms: Purpose of having communication between predecessor and successor audit

Difficulty: Challenging
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Predecessor auditor respond to request of successor auditor for information

Difficulty: Challenging
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Understand responsibilities of the auditor and company for the audit
Difficulty: Challenging
Objective: LO 8-2
AACSB: Reflective thinking

11
Copyright © 2020 Pearson Education, Inc.
19) When selecting staff for the audit engagement,
A) only staff members who are CPAs should be assigned to the audit.
B) only managers and above need to have appropriate competence and capabilities to perform
the audit.
C) continuity of staff members from year to year should not be a factor.
D) staff assigned to the audit must be knowledgeable about the client's industry.

Terms: Selection of audit staff for engagement

Difficulty: Easy
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Overall strategy for the audit

Difficulty: Challenging
Objective: LO 8-2
AACSB: Reflective thinking

12
Copyright © 2020 Pearson Education, Inc.
21) Which is usually included in an engagement letter?
A)
Estimate of hours required to Dollar estimate of fees to be billed to
complete audit the client
Yes Yes

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

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

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

Terms: Engagement letter

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

13
Copyright © 2020 Pearson Education, Inc.
22) Which is usually included in an engagement letter?
A)
The objectives of the Identification of the financial
engagement reporting framework used by
management
Yes Yes

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

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

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

Terms: Engagement letter

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

14
Copyright © 2020 Pearson Education, Inc.
23) Which is usually included in an engagement letter?
A)
The financial statements are Ratios to be used by the auditor in
the responsibility of the the planning phase
company's management
Yes Yes

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

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

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

Terms: Engagement letter

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

15
Copyright © 2020 Pearson Education, Inc.
24) When may the auditor refer to a specialist in the audit report?
A)
Only if the specialist's report Only if the specialist assisted in the
results in a modification of the audit audit of an account material to the
opinion financial statements
Yes Yes

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

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

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

Terms: Engagement letter

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

16
Copyright © 2020 Pearson Education, Inc.
25) Which is usually included in the engagement letter?
A)
The projected type of opinion on the Name(s) of the client personnel
financial statement to be audited responsible for supplying the auditor
with information
Yes Yes

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

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

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

Terms: Engagement letter

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

17
Copyright © 2020 Pearson Education, Inc.
26) Which is usually included in the engagement letter?
A)
List of audit procedures to be used The auditors' assessment of audit risk
in inventory observation
Yes Yes

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

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

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

Terms: Engagement letter

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Acceptance of new client

Difficulty: Easy
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Communications between predecessor and successor auditors

Difficulty: Easy
Objective: LO 8-2
AACSB: Reflective thinking

18
Copyright © 2020 Pearson Education, Inc.
29) When a successor auditor contacts a company's previous auditor, the predecessor auditor is
required to respond fully and without limit to the request for information.

Terms: Communications between predecessor and successor auditors

Difficulty: Easy
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Communications between predecessor and successor auditors

Difficulty: Easy
Objective: LO 8-2
AACSB: Reflective thinking

31) An auditor must evaluate a specialist's professional qualifications and understand the
objectives of the specialist's work.

Terms: Auditor evaluates specialist's work

Difficulty: Easy
Objective: LO 8-2
AACSB: Reflective thinking

32) Because of audit risk, some CPA firms now refuse any new clients in certain high-risk
industries.

Terms: Audit risk

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Engagement letter

Difficulty: Easy
Objective: LO 8-2
AACSB: Reflective thinking

19
Copyright © 2020 Pearson Education, Inc.
34) Because auditors are responsible for having appropriate competence and capabilities to
perform an audit, auditors are not normally permitted to consult with outside specialists during
an audit engagement.

Terms: Use of outside specialists during audit engagement

Difficulty: Easy
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Communications between predecessor and successor auditors

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Consideration in assigning staff to audit engagement

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Communications between predecessor and successor auditors

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

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

Terms: Selection of audit staff for engagement

Difficulty: Challenging
Objective: LO 8-2
AACSB: Reflective thinking

20
Copyright © 2020 Pearson Education, Inc.
39) The burden of initiating communication with the successor audit rests with the predecessor
auditor, especially in the event of legal problems or disputes between the client and the
predecessor auditor.

Terms: Communications between predecessor and successor auditors

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

40) If the client will not permit the predecessor auditor to communicate with the successor
auditor, or the predecessor does not provide a comprehensive response to the successor auditor,
the successor auditor must not accept the audit engagement.

Terms: Communications between predecessor and successor auditors

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

41) A successor auditor must seek the written permission of a prospective audit client before
making other investigations regarding the prospective audit client, including gathering
information from local attorneys, other CPAs, banks, and other businesses.

Terms: Communications between predecessor and successor auditors

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

42) AICPA auditing standards require the auditor to determine whether the financial statement
framework to be used by management to prepare the financial statements is appropriate under the
circumstances.

Terms: Communications between predecessor and successor auditors

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

43) A CPA firm may decide not to continue doing audits for an existing audit client simply due
to what the CPA firm deems to be excessive risk, alone, even if the audit engagement is very
profitable to the CPA firm.

Terms: Continuing clients audit risk and acceptable audit risk

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

21
Copyright © 2020 Pearson Education, Inc.
44) Auditing standards recommend, but do not require, that auditors obtain an understanding
with the client in an engagement letter approved by the audit committee of public companies.

Terms: Obtaining an understanding with the client and engagement letters

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

45) The engagement letter may include an agreement to provide other services to the audit client
such as tax returns and management consulting services allowed under the Code of Professional
Conduct and regulatory requirements.

Terms: Obtaining an understanding with the client and engagement letters

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

46) Specialists may be employed by the client, employed by the audit firm, or affiliated with the
client and the audit firm.

Terms: Evaluating the need for outside specialists

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

47) The auditor's report should not refer to the specialist unless the specialist's report results in a
modification of the audit opinion.

Terms: Evaluating the need for outside specialists

Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

48) Discuss the factors an auditor should consider before accepting a company as an audit client.
Terms: Factors to consider before accepting audit client
Difficulty: Easy
Objective: LO 8-2
AACSB: Reflective thinking

22
Copyright © 2020 Pearson Education, Inc.
49) Discuss the primary purpose of an audit engagement letter. Is an engagement letter required?
Terms: Reasons for an audit and audit evidence
Difficulty: Easy
Objective: LO 8-2
AACSB: Reflective thinking

50) Discuss the essential activities involved in the initial planning of an audit.
Terms: Essential activities involved in initial planning of audit
Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

51) Discuss the required communications between predecessor and successor auditors.
uditing standards require a successor auditor to communicate with the predecessor auditor
whenever accepting a client that has been previously audited. The purpose of the communication
is to help the successor auditor evaluate whether to accept the engagement. While the burden of
initiating the communication rests on the successor auditor, the predecessor auditor must respond
to the request for information. However, because of the requirements related to confidentiality,
the predecessor must obtain the former client's permission prior to providing information to the
successor.
Terms: Required communications between predecessor and successor auditors
Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

23
Copyright © 2020 Pearson Education, Inc.
52) Discuss several reasons why an auditor may not wish to continue a relationship with an
existing audit client.
Terms: Reasons auditor may not wish to continue relationship with existing audit client
Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

53) Discuss four of the matters that should be specified in an engagement letter.
Terms: Items included in engagement letter
Difficulty: Moderate
Objective: LO 8-2
AACSB: Reflective thinking

8.3 Learning Objective 8-3

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

Terms: Understanding the client's business and industry

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

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

Terms: Risk of material misstatement assessed high for related party transactions
Difficulty: Easy
Objective: LO 8-3
AACSB: Reflective thinking

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

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

Terms: Understand responsibilities of the auditor and company for the audit
Difficulty: Moderate
Objective: LO 8-3
24
Copyright © 2020 Pearson Education, Inc.
AACSB: Reflective thinking

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

Terms: Related party transactions

Difficulty: Challenging
Objective: LO 8-3
AACSB: Analytic thinking

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

Terms: Official record of meetings of board of directors and stockholders

Difficulty: Easy
Objective: LO 8-3
AACSB: Reflective thinking

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

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

Terms: Related party transactions

Difficulty: Moderate
Objective: LO 8-3
AACSB: Analytic thinking

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

Terms: Code of ethics

Difficulty: Moderate
Objective: LO 8-3
25
Copyright © 2020 Pearson Education, Inc.
AACSB: Reflective thinking

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

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

Terms: Minutes of the board of directors' meetings

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

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

Terms: Related party transactions

Difficulty: Challenging
Objective: LO 8-3
AACSB: Reflective thinking

26
Copyright © 2020 Pearson Education, Inc.
10) Which of the following best describes the corporate minutes of an entity?
A) official record of the meetings of the board of directors and the stockholders
B) unofficial record of the meeting of the board of directors
C) official record of management meeting with investors and creditors of the company
D) unofficial record of the board of directors' meetings

Terms: Corporate minutes

Difficulty: Easy
Objective: LO 8-3
AACSB: Reflective thinking

11) Related party

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

Terms: Related party transactions

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

12) Auditors should understand client objectives related to

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

Terms: Client objectives and strategies

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

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

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

Terms: Performance measurement system

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

27
Copyright © 2020 Pearson Education, Inc.
14) Auditors should obtain copies of the client's code of ethics and minutes of the meetings of
the board of directors to aid in their understanding of the company's management and
governance structure.

Terms: Code of ethics and board of directors' meeting minutes; Understanding of company
management and governance structure
Difficulty: Easy
Objective: LO 8-3
AACSB: Reflective thinking

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

Terms: Common risks

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

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

Terms: Related parties

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

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

Terms: Related parties

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

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

Terms: Related parties

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

28
Copyright © 2020 Pearson Education, Inc.
19) Management's philosophy and operating style influence the risk of material misstatements in
the financial statements.

Terms: Management integrity

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

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

Terms: Corporate minutes

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

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

Terms: Material related party transactions

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

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

Terms: Business risk and factors that impact auditor's assessment

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

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

Terms: Client objectives and strategies

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

24) Given the extensive use of third-party vendors for a variety of information technology-
related services, management must obtain greater knowledge regarding these suppliers, not the
auditor, when performing their risk assessment procedures.

Terms: Risk assessment procedures

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking
29
Copyright © 2020 Pearson Education, Inc.
25) Auditors cannot learn about potential related parties for an audit client by reviewing
Securities and Exchange Commission (SEC) filings.

Terms: Related party transactions

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

26) A public company must disclose if the company has not adopted a code of ethics that applies
to senior management, but not the reason why it has not done so.

Terms: Code of ethics

Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

27) Define the term "related party" and discuss why an auditor should identify the client's related
parties early in the audit.
related party is an affiliated company, principal owner of the client company, or any other party
with which the client deals, where one of the parties can influence the management or operating
policies of the other. Transactions with related parties are important to auditors because
accounting standards require that they be disclosed in the financial statements. Auditors need to
be aware of who the client's related parties are early in the audit to enable the auditor to identify
related-party transactions, especially those that have not been disclosed.
Terms: Related parties
Difficulty: Easy
Objective: LO 8-3
AACSB: Reflective thinking

28) What documents do auditors routinely obtain to aid in their understanding of a client's
governance system? Briefly discuss each of these documents.
uditors commonly obtain the company's organizational structure, code of ethics, and the minutes
of meetings of the board of directors and shareholders. To gain an understanding of the client's
governance system, the auditor should understand how the board and the audit committee
exercise oversight, including consideration of the company's code of ethics and evaluation of the
corporate minutes. Companies frequently communicate the entity's values and ethical standards
through policy statements and codes of conduct. The corporate minutes are the official record of
the meetings of the board of directors and stockholders. They include summaries of the most
important topics discussed and decisions made at the board meetings.
Terms: Documents for client's governance system
Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

30
Copyright © 2020 Pearson Education, Inc.
29) What are three factors that have increased the importance of obtaining an understanding of a
client's business and industry? How can an auditor obtain this understanding?
Terms: Factors that increase the importance of obtaining an understanding of a client's business
and industry
Difficulty: Challenging
Objective: LO 8-3
AACSB: Reflective thinking

30) There are three primary reasons for obtaining a thorough understanding of the client's
industry and external environment. What are these reasons?
Terms: Primary reasons for obtaining understanding client's industry and external environment
Difficulty: Moderate
Objective: LO 8-3
AACSB: Reflective thinking

31
Copyright © 2020 Pearson Education, Inc.
8.4 Learning Objective 8-4

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

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

Terms: Preliminary analytical procedures

Difficulty: Moderate
Objective: LO 8-4
AACSB: Reflective thinking

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

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

Terms: Analytical procedures

Difficulty: Moderate
Objective: LO 8-4
AACSB: Reflective thinking

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

Terms: Analytical procedures in planning phase

Difficulty: Challenging
Objective: LO 8-4
AACSB: Reflective thinking

32
Copyright © 2020 Pearson Education, Inc.
4) Which is a liquidity activity ratio?
A) profit margin
B) inventory turnover
C) return on assets
D) times interest earned

Terms: Liquidity ratio

Difficulty: Moderate
Objective: LO 8-4
AACSB: Reflective thinking

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

Terms: Common financial ratios

Difficulty: Easy
Objective: LO 8-4
AACSB: Reflective thinking

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

Terms: Analytical procedures

Difficulty: Easy
Objective: LO 8-4
AACSB: Reflective thinking

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

Terms: Analytical procedures

Difficulty: Easy
Objective: LO 8-4
AACSB: Reflective thinking

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

Terms: Preliminary analytical procedures

Difficulty: Easy
Objective: LO 8-4
AACSB: Reflective thinking

33
Copyright © 2020 Pearson Education, Inc.
9) Preliminary analytical procedures for an audit client focusing on liquidity activity ratios find
that the client's accounts receivable turnover ratio is significantly better than in previous years.
The ratio is also significantly better compared to similar firms in the same industry. The results
of this ratio indicate, preliminarily, that the accounts receivable area has been identified as
having increased risk to the auditor.

Terms: Preliminary analytical procedures

Difficulty: Easy
Objective: LO 8-4
AACSB: Reflective thinking

8.5 Learning Objective 8-5

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

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

Terms: Materiality
Difficulty: Easy
Objective: LO 8-5
AACSB: Reflective thinking

2) Which of the following is part of planning?

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

Terms: Materiality during the planning phase

Difficulty: Moderate
Objective: LO 8-5
AACSB: Reflective thinking

34
Copyright © 2020 Pearson Education, Inc.
3) When dealing with materiality,
A) if the client refuses to correct a material misstatement, the auditor is required to adjust the
financial statements.
B) management is responsible for determining whether financial statements are materially
misstated.
C) materiality must be determined as a percentage of sales.
D) the auditor must bring any material misstatements to the client's attention.

Terms: Materiality
Difficulty: Easy
Objective: LO 8-5
AACSB: Reflective thinking

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

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

Terms: Performance materiality

Difficulty: Moderate
Objective: LO 8-5
AACSB: Reflective thinking

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

Terms: Materiality
Difficulty: Moderate
Objective: LO 8-5
AACSB: Reflective thinking

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

Terms: Steps in applying materiality

Difficulty: Moderate
Objective: LO 8-5
AACSB: Reflective thinking

7) Once the auditor has made a preliminary judgment about materiality, the auditor may change
that judgement during the audit.

Terms: Preliminary judgement about materiality

Difficulty: Moderate
Objective: LO 8-5
AACSB: Reflective thinking

35
Copyright © 2020 Pearson Education, Inc.
8) Materiality is an absolute, rather than a relative, concept in auditing.

Terms: Factors affecting preliminary judgement about materiality

Difficulty: Moderate
Objective: LO 8-5
AACSB: Reflective thinking

9) Income before taxes is often used by the auditor as a benchmark for materiality. Once income
before taxes is established as a benchmark for materiality for a particular audit client, the auditor
still must decide whether any misstatements could affect other benchmarks such a current assets
or current liabilities, for example.

Terms: Benchmarks for evaluating materiality

Difficulty: Moderate
Objective: LO 8-5
AACSB: Reflective thinking

8.6 Learning Objective 8-6

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

Terms: Preliminary materiality assessment

Difficulty: Easy
Objective: LO 8-6
AACSB: Reflective thinking

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

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

Terms: Purpose to establish preliminary judgment about materiality

Difficulty: Easy
Objective: LO 8-6
AACSB: Reflective thinking

36
Copyright © 2020 Pearson Education, Inc.
3) If an auditor establishes a relatively high level for materiality, then the auditor will
A) accumulate more evidence than if a lower level had been set.
B) accumulate less evidence than if a lower level had been set.
C) accumulate approximately the same evidence as would be the case were materiality lower.
D) accumulate an undetermined amount of evidence.

Terms: High level for materiality

Difficulty: Easy
Objective: LO 8-6
AACSB: Reflective thinking

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

Terms: Preliminary judgments about materiality

Difficulty: Moderate
Objective: LO 8-6
AACSB: Reflective thinking

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

Terms: Primary basis to decide materiality for a for-profit entity

Difficulty: Easy
Objective: LO 8-6
AACSB: Reflective thinking

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

Terms: Auditing standards; Preliminary judgment about materiality documented

Difficulty: Easy
Objective: LO 8-6
AACSB: Reflective thinking

37
Copyright © 2020 Pearson Education, Inc.
7) Amounts involving fraud are usually considered ________ important than unintentional errors
of equal dollar amounts.
A) less
B) no less
C) no more
D) more

Terms: Amounts involving fraud

Difficulty: Easy
Objective: LO 8-6
AACSB: Reflective thinking

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

Terms: Qualitative factors can affect auditor's assessment of materiality

Difficulty: Easy
Objective: LO 8-6
AACSB: Reflective thinking

9) The five steps in applying materiality are listed below in random order.
1. Estimate the combined misstatement.
2. Estimate the total misstatement in the segment.
3. Set materiality for the financial statements as a whole.
4. Determine performance materiality.
5. Compare combined estimate with preliminary judgment about materiality.

The first three steps in correct sequence would be

A) 1, 2, 5
B) 3, 4, 2
C) 2, 1, 5
D) 3, 2, 4

Terms: Five steps in applying materiality

Difficulty: Moderate
Objective: LO 8-6
AACSB: Reflective thinking

38
Copyright © 2020 Pearson Education, Inc.
10) Which of the following statements is not correct?
A) Materiality is a relative rather than an absolute concept.
B) The most important base used as the criterion for deciding materiality is total assets.
C) Qualitative factors as well as quantitative factors affect materiality.
D) Given equal dollar amounts, frauds are usually considered more important than errors.

Terms: Materiality
Difficulty: Moderate
Objective: LO 8-6
AACSB: Reflective thinking

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

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

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

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

Terms: Certain types of misstatements are likely more important than other types
Difficulty: Moderate
Objective: LO 8-6
AACSB: Reflective thinking

39
Copyright © 2020 Pearson Education, Inc.
12) When setting a preliminary judgment about materiality,
A) more evidence is required for a low dollar amount than for a high dollar amount.
B) less evidence is required for a low dollar amount than for a high dollar amount.
C) the same amount of evidence is required for either low or high dollar amounts.
D) there is no relationship between materiality and the dollar amount of evidence needed.

Terms: Setting preliminary judgment about materiality

Difficulty: Challenging
Objective: LO 8-6
AACSB: Reflective thinking

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

Terms: Misstatements
Difficulty: Challenging
Objective: LO 8-6
AACSB: Reflective thinking

14) When determining materiality,

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

Terms: Materiality
Difficulty: Moderate
Objective: LO 8-6
AACSB: Reflective thinking

15) Determining materiality requires professional judgment.

Terms: Materiality
Difficulty: Easy
Objective: LO 8-6
AACSB: Reflective thinking

40
Copyright © 2020 Pearson Education, Inc.
16) The auditor's preliminary judgment about materiality is the maximum amount by which the
auditor believes the financial statements could be misstated and still not affect the decisions of
reasonable users.

Terms: Preliminary judgments about materiality

Difficulty: Easy
Objective: LO 8-6
AACSB: Reflective thinking

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

Terms: Preliminary judgments about materiality

Difficulty: Easy
Objective: LO 8-6
AACSB: Reflective thinking

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

Terms: Base for deciding materiality

Difficulty: Easy
Objective: LO 8-6
AACSB: Reflective thinking

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

Terms: Amount of preliminary judgment and audit evidence required

Difficulty: Easy
Objective: LO 8-6
AACSB: Reflective thinking

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

Terms: Qualitative factors affecting preliminary materiality judgment; Fraud

Difficulty: Easy
Objective: LO 8-6
AACSB: Reflective thinking

21) Performance materiality is commonly set at 50-75 percent of overall materiality.

Terms: Determining performance materiality

Difficulty: Moderate
Objective: LO 8-6
AACSB: Reflective thinking

41
Copyright © 2020 Pearson Education, Inc.
22) CPA firms can establish policy guidelines to help their auditors determine materiality.

Terms: Difficulty in applying concept of materiality

Difficulty: Moderate
Objective: LO 8-6
AACSB: Reflective thinking

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

Terms: Statements on Auditing Standards; Objective guidance on establishing preliminary

materiality level
Difficulty: Moderate
Objective: LO 8-6
AACSB: Reflective thinking

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

Terms: Preliminary judgment of materiality and audit evidence

Difficulty: Moderate
Objective: LO 8-6
AACSB: Reflective thinking

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

Terms: Base used to determine materiality

Difficulty: Moderate
Objective: LO 8-6
AACSB: Reflective thinking

26) The term "tolerable misstatement," used by the Public Company Accounting Oversight
Board auditing standards, has the same meaning as "performance materiality," described by
AICPA and International Auditing and Assurance Standards Board standards.

Terms: Performance materiality vs tolerable misstatement

Difficulty: Moderate
Objective: LO 8-6
AACSB: Reflective thinking

42
Copyright © 2020 Pearson Education, Inc.
27) Audit standards require the auditor to consider the combined amount of misstatement early in
the audit. This is known as preliminary materiality judgment. List and discuss the three main
factors that affect an auditor's preliminary judgment about materiality.
Terms: Factors that affect auditor's preliminary judgment
Difficulty: Moderate
Objective: LO 8-6
AACSB: Reflective thinking

28) Due to qualitative factors, certain types of misstatements are likely to be more important to
users than others, even if the dollar amounts are the same. Identify two qualitative factors that
might significantly affect an auditor's materiality judgment, and give an example of each.
Terms: Qualitative factors that affect auditor's materiality judgment
Difficulty: Moderate
Objective: LO 8-6
AACSB: Reflective thinking

43
Copyright © 2020 Pearson Education, Inc.
8.7 Learning Objective 8-7

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

Terms: Allocate preliminary judgment about materiality to account balances

Difficulty: Easy
Objective: LO 8-7
AACSB: Reflective thinking

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

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

Terms: Preliminary materiality allocation

Difficulty: Easy
Objective: LO 8-7
AACSB: Reflective thinking

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

Terms: Allocation of preliminary judgment about materiality

Difficulty: Moderate
Objective: LO 8-7
AACSB: Reflective thinking

44
Copyright © 2020 Pearson Education, Inc.
4) Which of the following statements is true concerning the allocation of preliminary
materiality?
A) It is necessary to allocate preliminary materiality to financial statements as a whole rather
than by segments.
B) Preliminary materiality should be allocated to income statement accounts only.
C) Preliminary materiality is required by the SEC.
D) The PCAOB term used when preliminary materiality is allocated to segments is tolerable
misstatement.

Terms: Allocation of preliminary materiality

Difficulty: Moderate
Objective: LO 8-7
AACSB: Reflective thinking

5) Which of the following statements is false?

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

Terms: Effects of misstatements

Difficulty: Moderate
Objective: LO 8-7
AACSB: Reflective thinking

45
Copyright © 2020 Pearson Education, Inc.
6) Which of the following are major difficulties auditors face when allocating materiality to
balance sheet accounts?
A)
Certain accounts contain Only overstatements Audit costs can
more misstatements need be considered. affect allocation.
than others.
Yes No Yes

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

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

D)

Certain accounts contain Only overstatements Audit costs can

more misstatements need be considered. affect allocation.
than others.
No Yes No

Terms: Major difficulties auditors face when allocating materiality to balance sheet accounts
Difficulty: Moderate
Objective: LO 8-7
AACSB: Reflective thinking

7) When allocating performance materiality,

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

Terms: Major difficulties auditors face when allocating materiality to balance sheet accounts
Difficulty: Moderate
Objective: LO 8-7
AACSB: Reflective thinking

46
Copyright © 2020 Pearson Education, Inc.
8) When allocating materiality, most practitioners choose to allocate to
A) the income statement accounts because they are more important.
B) the balance sheet accounts because most audits focus on the balance sheet.
C) both balance sheet and income statement accounts because there could be errors on either.
D) all of the financial statements because it is required by GAAS.

Terms: Allocating materiality

Difficulty: Challenging
Objective: LO 8-7
AACSB: Reflective thinking

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

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

Terms: Performance materiality

Difficulty: Challenging
Objective: LO 8-7
AACSB: Reflective thinking

10) Most practitioners allocate the preliminary judgment about materiality to both the balance
sheet and income statement accounts.

Terms: Allocate preliminary judgment about materiality to balance sheet accounts

Difficulty: Moderate
Objective: LO 8-7
AACSB: Reflective thinking

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

Terms: Primary purpose of allocating the preliminary judgment about materiality

Difficulty: Easy
Objective: LO 8-7
AACSB: Reflective thinking

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

Terms: Allocating materiality; Consideration of overstatements and understatements

Difficulty: Easy
Objective: LO 8-7
AACSB: Reflective thinking

47
Copyright © 2020 Pearson Education, Inc.
13) If an auditor assigns a tolerable misstatement of $1,000 to accounts payable, he or she would
need to obtain more audit evidence for that account than if $100,000 had been assigned.

Terms: Tolerable misstatements and audit evidence

Difficulty: Moderate
Objective: LO 8-7
AACSB: Reflective thinking

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

Terms: Maximize audit efficiency, allocate less tolerable misstatements

Difficulty: Challenging
Objective: LO 8-7
AACSB: Reflective thinking

15) Explain why it is necessary to allocate the preliminary judgment about materiality to
individual accounts (segments) in the financial statements. Also explain why allocating to
balance sheet accounts is more common than allocating to income statement accounts.
llocating the preliminary judgment about materiality to individual accounts (segments) is
necessary because evidence is accumulated for accounts (segments) rather than for the financial
statements as a whole. Allocating to accounts (segments) establishes a tolerable misstatement
amount for each account, which helps the auditor decide the appropriate audit evidence to
accumulate for each account. Most practitioners allocate materiality to balance sheet accounts
rather than income statement accounts because most income statement misstatements have an
equal effect on the balance sheet due to the nature of double-entry accounting. Because there are
fewer balance sheet accounts than income statement accounts in most audits, and because most
audit procedures focus on balance sheet accounts, materiality should be allocated only to balance
sheet accounts.
Terms: Allocation of the preliminary judgment about materiality
Difficulty: Moderate
Objective: LO 8-7
AACSB: Reflective thinking

48
Copyright © 2020 Pearson Education, Inc.
16) Auditors allocate the preliminary judgment about materiality to financial statement segments
rather than by financial statements as a whole. What is the term for the auditor's allocation of
preliminary misstatement to account balances? What are three difficulties auditors face when
allocating materiality to balance sheet accounts?
Terms: Allocation of preliminary misstatement to account balances and difficulties that auditors
face allocating preliminary materiality judgment to account balances
Difficulty: Moderate
Objective: LO 8-7
AACSB: Reflective thinking

8.8 Learning Objective 8-8

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

Terms: Documenting known and likely misstatements

Difficulty: Easy
Objective: LO 8-8
AACSB: Reflective thinking

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

Terms: Misstatements where auditor can determine the amount

Difficulty: Moderate
Objective: LO 8-8
AACSB: Reflective thinking

49
Copyright © 2020 Pearson Education, Inc.
3) Likely misstatements can result from
A)
Computation of the Differences between Projections of
sampling error for the management's and an misstatements based on
cash account auditor's judgment about an auditor's tests of a
account balances sample from a population
No Yes Yes

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

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

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

Terms: Likely misstatements result from

Difficulty: Moderate
Objective: LO 8-8
AACSB: Reflective thinking

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

Terms: Evaluating audit findings and materiality

Difficulty: Challenging
Objective: LO 8-8
AACSB: Reflective thinking

50
Copyright © 2020 Pearson Education, Inc.
5) The preliminary judgment on materiality is compared to the total estimated misstatement
amount to determine if an account balance is materially misstated.

Terms: Preliminary judgment on materiality; Estimated total misstatements

Difficulty: Moderate
Objective: LO 8-8
AACSB: Reflective thinking

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

Terms: Total estimated misstatements and sampling error

Difficulty: Moderate
Objective: LO 8-8
AACSB: Reflective thinking

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

Terms: Total estimated misstatements and sampling error

Difficulty: Moderate
Objective: LO 8-8
AACSB: Reflective thinking

8) Sampling risk results if the sample accurately represents the population.

Terms: Sampling risk

Difficulty: Moderate
Objective: LO 8-8
AACSB: Reflective thinking

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

Terms: Total estimated misstatements and sampling error

Difficulty: Moderate
Objective: LO 8-8
AACSB: Reflective thinking

10) To calculate the estimate of the likely misstatement of a total population, the auditor makes a
direct projection of the known misstatement from the sample to the population, and subtracts an
estimated allowance for sampling risk.

Terms: Calculating the estimate of likely misstatement

Difficulty: Moderate
Objective: LO 8-8
AACSB: Reflective thinking
51
Copyright © 2020 Pearson Education, Inc.
11) List the five steps in applying materiality in an audit.
Terms: Five steps in applying materiality
Difficulty: Challenging
Objective: LO 8-8
AACSB: Reflective thinking

52
Copyright © 2020 Pearson Education, Inc.