ch. 6

What term fits best in the following statement? [Assertions, Audit Plan, Time Budget, Engagement Letter, Inherent Risk, Audit Risk, Significant Risk, Business Risk] At the overall engagement level, this is the risk that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated.

Audit Risk

h. The risk that the auditors will conclude, based on substantive procedures, that a material misstatement does not exist in an account balance when, in fact, such misstatement does exist is referred to as____________ Business risk. Engagement risk. Control risk. Detection risk.

Detection risk. The objective of tests of details of transactions performed as substantive procedures is to detect material misstatements in the financial statements as transactions are tested to determine whether they have been properly recorded.

What term fits best in the following statement? [Assertions, Audit Plan, Time Budget, Engagement Letter, Inherent Risk, Audit Risk, Significant Risk, Business Risk] A description of the nature, timing, and extent of the audit procedures to be performed.

Audit Plan

Mary Deming has been asked to accept an engagement to audit a small financial institution. Deming has not previously audited a financial institution.

(1) The nature of the client, including the client's application of accounting policies—The auditors' understanding of this area will include the client's competitive position, organizational structure, accounting policies and procedures, ownership, capital structure, and product lines. The understanding will also encompass an understanding of the client's business model and its major business processes. (2) The industry, regulatory, and other external factors—The factors included here are industry conditions, such as the competitive environment, supplier and customer relationships, and technological developments. They also include the regulatory, legal, and political environment, and general economic conditions. (3) Objectives and strategies and related business risks—The auditors obtain an understanding of the operating and financing strategies of management. They also obtain an understanding of management's risk assessment process. This assists the auditors in identifying significant business risks that may create risks of material misstatement of the financial statements. (4) Methods of measuring and reviewing performance—The auditors obtain an understanding of the methods management uses to measure and review performance at various levels within the organization. These methods are important to determining incentives of management and other employees. The measures may also be used in designing effective analytical procedures. (5) Internal control—The auditors' understanding of internal control assists them in planning the audit and assessing control risk.

c. Which of the following should not normally be included in the engagement letter for an audit? A description of the responsibilities of client personnel to provide assistance. An indication of the amount of the audit fee. A description of the limitations of an audit.. A listing of the client's branch offices selected for testing.

A listing of the client's branch offices selected for testing. Management should not be informed about which branches were selected for testing at all or at least not until just before testing is to be done.

a. In planning and performing an audit, auditors are concerned about risk factors for two distinct types of fraud: fraudulent financial reporting and misappropriation of assets. Which of the following is a risk factor for misappropriation of assets? Generous performance-based compensation systems. Management preoccupation with increased financial performance. An unreliable accounting system. Strained relationships between management and the auditors.

An unreliable accounting system. An unreliable accounting system provides an opportunity for an individual to misappropriate assets. The other items create risks of fraudulent financial reporting.

What term fits best in the following statement? [Assertions, Audit Plan, Time Budget, Engagement Letter, Inherent Risk, Audit Risk, Significant Risk, Business Risk] Representations by management that are communicated, explicitly or implicitly, in the financial statements.

Assertions

What term fits best in the following statement? [Assertions, Audit Plan, Time Budget, Engagement Letter, Inherent Risk, Audit Risk, Significant Risk, Business Risk] A risk that threatens management's ability to achieve the organization's objectives.

Business Risk

g. The primary objective of tests of details of transactions performed as substantive procedures is to: Comply with generally accepted auditing standards. Attain assurance about the reliability of the accounting system. Detect material misstatements in the financial statements. Evaluate whether management's policies and procedures are operating effectively.

Detect material misstatements in the financial statements. The objective of tests of details of transactions performed as substantive procedures is to detect material misstatements in the financial statements as transactions are tested to determine whether they have been properly recorded.

following statement? [Assertions, Audit Plan, Time Budget, Engagement Letter, Inherent Risk, Audit Risk, Significant Risk, Business Risk] The purpose of this document is to avoid misunderstandings between the auditors and the client.

Engagement Letter

j. Which of the following best describes what is meant by the term "fraud risk factor"? Factors that, when present, indicate that risk exists. Factors often observed in circumstances where frauds have occurred. Factors that, when present, require modification of planned audit procedures. Weaknesses in internal control identified during an audit.

Factors often observed in circumstances where frauds have occurred. Fraud risk factors are factors that have been observed in circumstances in which fraud has occurred. The fraud risk factors were identified by researchers and practitioners through analyses of many past frauds. Yet, none of the factors was always present in the various individual cases included in the analyses. Answer (1) is incorrect because in any particular circumstance, the existence of a fraud risk factor may or may not indicate that in that circumstance the risk of fraud is high. Answer (3) is incorrect because the existence of a fraud risk factor may not require modification of planned audit procedures (e.g., the audit plan may already have audit procedures that consider the factor). Answer (4) is incorrect because a fraud risk factor may or may not be a significant deficiency.

e. Which of the following should the auditors obtain from the predecessor auditors before accepting an audit engagement? Analysis of balance sheet accounts. Analysis of income statement accounts. All matters of continuing accounting significance. Facts that might bear on the integrity of management.

Facts that might bear on the integrity of management.

i. Which of the following elements underlies the application of generally accepted auditing standards, particularly the standards of fieldwork and reporting? Adequate disclosure. Quality control. Materiality and audit risk. Client acceptance.

Materiality and audit risk. Materiality and audit risk underly the application of generally accepted auditing standard in that so many audit decisions are affected by the amount used as a materiality measure and the level of audit risk assumed on the engagement.

b. The audit committee of a company must be made up of: Representatives from the client's management, investors, suppliers, and customers. The audit partner, the chief financial officer, the legal counsel, and at least one outsider. Representatives of the major equity interests, such as preferred and common stockholders. Members of the board of directors who are not officers or employees.

Members of the board of directors who are not officers or employees. Members of the audit committee should be independent of management. Therefore, the individuals should be board members who are not employees or officers, and who have no relationship with management that might impair their objectivity.

f. As one step in testing sales transactions, a CPA traces a random sample of sales journal entries to debits in the accounts receivable subsidiary ledger. This test provides evidence as to whether: Each recorded sale represents a bona fide transaction. All sales have been recorded in the sales journal. All debit entries in the accounts receivable subsidiary ledger are properly supported by sales journal entries. Recorded sales have been properly posted to customer accounts.

Recorded sales have been properly posted to customer accounts. Because entries in the sales journal represent recorded sales, tracing entries from it to debits in the accounts receivable ledger provides evidence on whether recorded sales have been properly posted to customer accounts.

What term fits best in the following statement? [Assertions, Audit Plan, Time Budget, Engagement Letter, Inherent Risk, Audit Risk, Significant Risk, Business Risk] An identified risk that requires special audit consideration.

Significant Risk

d. Which portion of an audit is least likely to be completed before the balance sheet date? Tests of controls. Issuance of an engagement letter. Substantive procedures. Assessment of control risk.

Substantive procedures. Substantive procedures substantiate the account balances as of the balance sheet date and therefore cannot be completed prior to that date. The other items pertain to the operation of the system during the year under audit and could be completed in the interim period.

k. Three conditions generally are present when fraud occurs. Select the one below that is not one of those conditions. Incentive or pressure. Opportunity. Supervisory position. Attitude.

Supervisory position. AICPA AU-C 240 (PCAOB AS 2401) outlines the three factors generally necessary for fraud as (1) incentive or pressure, (2) opportunity, and (3) attitude. Being in a supervisory position is not one of those conditions, although it may provide the individual an opportunity to commit fraud.

Morgan, CPA, is approached by a prospective audit client who wants to engage Morgan to perform an audit for the current year. In prior years, this prospective client was audited by another CPA. Identify the specific procedures that Morgan should follow in deciding whether to accept this client.

The procedures that Morgan should apply in deciding whether to accept this prospective audit client would ordinarily include the following: (1) Evaluate the CPA firm's independence with respect to the prospective audit client. (2) Explain to the prospective client the need to make inquiries of the predecessor auditor, requesting that the client authorize the predecessor auditor to respond fully and to allow a review of the predecessor's audit working papers. (3) Make inquiries of the predecessor auditor concerning such matters as the integrity of management, any disagreements with management as to accounting principles, the reason for the change in auditors, and any other matters affecting the decision of whether to accept the engagement. (4) Make inquiries of other appropriate third parties regarding the history of the prospective client and the reputations of its management and directors. These third parties may include the client's bankers, legal counsel, and underwriters. (5) Obtain a knowledge of the client's business activities and business environment. Sources of this information include inquiries of management and others within the organization, inspection of internal documents and records, the client's website, AICPA accounting and audit guides, registration statements and Form 10-Ks filed with the SEC, interim financial statements, income tax returns, and credit reports. (6) Consider any special problems or unique risks likely to be associated with the engagement. (7) Hold preliminary meetings with management and the audit committee to discuss such matters as the scope of the services to be performed, timing of the performance and completion of the audit, basis for the fee, and work that may be done by the client's staff in preparation for the audit. Upon acceptance of the engagement, Morgan should issue an engagement letter summarizing the arrangements reached with the client.

What term fits best in the following statement? [Assertions, Audit Plan, Time Budget, Engagement Letter, Inherent Risk, Audit Risk, Significant Risk, Business Risk] An estimate of the time required to perform each step in the audit.

Time budget

l. Which of the following is most likely to be an overall response to fraud risks identified in an audit? Supervise members of the audit team less closely and rely more upon judgment. Use less predictable audit procedures. Use only certified public accountants on the engagement. Place increased emphasis on the audit of objective transactions rather than subjective transactions.

Use less predictable audit procedures. Less predictable audit procedures are likely to be used when fraud risks are high. SAS 99 also suggest that the auditors have increased skepticism, assign more skilled staff, and consider further management's selection and application of accounting principles. Answer (1) is incorrect because supervision of members of the audit team will be closer, not less. Answer (3) is incorrect because team members may or may not be CPAs (e.g., a fraud specialist who is not a CPA might be added to the team). Answer (4) is incorrect because subjective, rather than objective transactions may often be emphasized—depending upon the nature of the fraud risks identified.

What term fits best in the following statement? [Assertions, Audit Plan, Time Budget, Engagement Letter, Inherent Risk, Audit Risk, Significant Risk, Business Risk] The risk of material misstatement of an assertion about an account without considering internal control.

Inherent risk