Auditing Chapter 2 Questions
LO 6 Define corporate governance, identify the parties involved, and describe their respective activities.
Corporate governance is a process by which the owners (stockholders) and creditors of an organization exert control and require accountability for the resources entrusted to the organization. Governance starts with the owners delegating responsibilities to management through an elected board of directors—including a subcommittee of the board that serves as an audit committee. In turn, responsibilities are handed to operating units with oversight and assistance from internal auditors. The board of directors and its audit committee oversee management, and, in that role, are expected to protect the stockholders' rights and ensure that controls exist to prevent and detect fraud. However, it is important to recognize that management is part of the governance framework; management can influence who sits on the board and the audit committee, as well as other governance controls that might be put into place.
LO 5 An important change resulting from the Sarbanes-Oxley Act is that auditors are no longer allowed to provide most consulting services for their public company audit clients.
Eh true? Section 201 prevents audit firms from providing many consulting services to audit clients, which was an issue cited as a significant driver of the failed audits of Enron.
LO 4 The investing public generally recognizes that it is very difficult for auditors to detect fraud, and so it does not hold auditors accountable when auditors fail to detect it.
False. It is increasingly clear that the general public, as reflected in the orientation of the PCAOB, expects that auditors have a responsibility to detect and report on material frauds.
LO 6 Organizations with effective corporate governance are more risky to audit.
False. Organizations with effective corporate governance are less likely to experience fraud and are therefore less risky to audit.
LO 1 The Great Salad Oil Swindle of 1963 could best be categorized as an asset misappropriation fraud.
False. The Focus on Fraud feature "The Great Salad Oil Swindle of 1963" is a classic example of fraudulent financial reporting.
LO 5 The Sarbanes-Oxley Act of 2002 was written by Congress to address problems revealed in frauds that were committed in the late 1980s.
False. The financial scandals and associated stock market declines in the late 1990s and early 2000s dramatically illustrated the costs of inappropriate ethical decisions by various parties, of weak corporate governance, of low audit quality, and of insufficient auditor independence. The bankruptcy of Enron and the subsequent collapse of Arthur Andersen were such dramatic events that Congress was compelled to respond, and it did so in the form of the Sarbanes-Oxley Act of 2002.
LO 1 Define the various types of fraud that affect organizations.
Fraud is an intentional act involving the use of deception that results in a misstatement of the financial statements. Two types of misstatements are relevant to auditors' consideration of fraud: (a) misstatements arising from misappropriation of assets and (b) misstatements arising from fraudulent financial reporting.
LO 4 Discuss auditors' fraud related responsibilities and users' related expectations.
Planning and performing the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. The standard acknowledges that there is an unavoidable risk that some material misstatements may be undetected, even if the audit is properly planned and performed. The detection of material fraud is a reasonable expectation of users of audited financial statements.
LO 6 Audit committee activities and responsibilities include which of the following? a. Selecting the external audit firm. b. Approving corporate strategy. c. Reviewing management performance and determining compensation. d. All of the above. e. None of the above.
a. Selecting the external audit firm. Broad role: Provide oversight of the internal and external audit function and over the process of preparing the annual financial statements and public reports on internal control Specific activities include: ●Selecting the external audit firm ●Approving any nonaudit work performed by the audit firm ●Selecting and/or approving the appointment of the chief audit executive (internal auditor) ●Reviewing and approving the scope and budget of the internal audit function ●Discussing audit findings with internal and external auditors, and advising the board (and management) on specific actions that should be taken
LO 4 Which of the following statements is accurate regarding the CAQ's 2010 paper on deterring and detecting fraud in financial reporting? a. It recognizes that preventing and detecting fraud is the job of the external auditor alone. b. It notes that an effective fraud risk management program can be expected to prevent virtually all frauds, especially those perpetrated by top management. c. It illustrates that communication among those involved in the financial reporting process is critical. d. All of the above. e. None of the above.
c. It illustrates that communication among those involved in the financial reporting process is critical. The CAQ also recognizes that preventing and detecting fraud cannot be the job of the external auditor alone; all the parties involved in preparing and opining on audited financial statements need to play a role in preventing and detecting fraud.
LO 3 Which of the following types of transactions did WorldCom management engage in as part of that company's fraudulent financial reporting scheme? a. Recorded barter transactions as sales. b. Used restructuring reserves from prior acquisitions to decrease expenses. c. Capitalized line costs rather than expensing them. d. All of the above. e. None of the above.
d. All of the above.
LO 5 Which of the following statements is correct regarding the PCAOB? a. The PCAOB is a nonprofit corporation, not an agency of the U.S. government. b. The PCAOB will have five financially literate members who are prominent individuals of integrity and reputation with a commitment to the interests of investors and the public. c. The PCAOB has authority to set standards related to public company audit reports and to conduct inspections of registered external audit firms. d. All of the above. e. None of the above.
d. All of the above. Establishment and administrative provisions. The Board: ●Is a nonprofit corporation, not an agency of the U.S. government ● Will have five financially literate members who are prominent individuals of integrity and reputation with a commitment to the interests of investors and the public ●Has authority to set standards related to audit reports and to conduct inspections of registered public accounting firms
LO 4 Which of the following statements are true? a. Unless an independent audit can provide reasonable assurance that financial information has not been materially misstated because of fraud, it has little, if any, value to society. b. Repeated revelations of accounting scandals and audit failures related to undetected frauds have seriously damaged public confidence in external auditors. c. A strong ethical tone at the top of an organization that permeates corporate culture is essential in mitigating the risk of fraud. d. All of the above. e. None of the above.
d. All of the above. The mission of the PCAOB is to restore the confidence of investors, and society generally, in the independent auditors of companies. There is no doubt that repeated revelations of accounting scandals and audit failures have seriously damaged public confidence. The detection of material fraud is a reasonable expectation of users of audited financial statements. Society needs and expects assurance that financial information has not been materially misstated because of fraud. Unless an independent audit can provide this assurance, it has little if any value to society.
LO 2 The three elements of the fraud triangle include incentive, opportunity, and rationalization.
True.
LO 4 Auditing standards historically have reflected the belief that it is not reasonable to expect auditors to detect cleverly hidden frauds.
True. Auditing standards historically have reflected a belief that it is not reasonable to expect auditors to detect cleverly implemented frauds.
LO 6 Corporate governance is the process by which the owners and creditors of an organization exert control over and require accountability for the resources entrusted to the organization.
True. Corporate governance is a process by which the owners (stockholders) and creditors of an organization exert control and require accountability for the resources entrusted to the organization.
LO 3 In the Enron fraud, one of the ways that management covered up the fraud was to shift debt off the balance sheet to SPEs.
True. Much of the fraud involved special-purpose entities (SPEs), partnerships that often involved substantial loans from banks to be secured by assets transferred to the SPE, partners dominated by Enron executives, and a small outside interest (exceeding 3% per the accounting rule). The company transferred devalued assets to the SPEs and recognized gains on the books. It kept borrowing off the books by having the SPEs borrow from banks and purchase Enron assets. It even recognized over $100 million in anticipated sales that it hoped would occur with a joint venture with Blockbuster on rental movies over the Internet.
LO 3 Professional skepticism related to possible fraud involves the validation of information through probing questions, critical assessment of evidence, and attention to inconsistencies.
True. Skepticism involves the validation of information through probing questions, the critical assessment of evidence, and attention to inconsistencies.
LO 1 The Koss Corporation fraud could best be categorized as fraudulent financial reporting.
True. Koss Corporation reported an embezzlement of funds of approximately $31 million orchestrated by its chief financial officer (CFO) over a five-year period when the company's reported earnings were only $26 million.
LO 3 Describe implications for auditors of recent fraudulent financial reporting cases and the 2010 COSO report on fraud.
The patterns evident across the frauds imply the following regarding the conduct of the audit: ●The auditor should be aware of the pressure that analyst following and earnings expectations create for top management. ●If there are potential problems with revenue, the audit cannot be completed until there is sufficient time to examine major year-end transactions. ●The auditor must understand complex transactions to determine their economic substance and the parties that have economic obligations. ●The auditor must clearly understand and analyze weaknesses in an organization's internal controls in order to determine where and how a fraud may take place. ●Audit procedures must be developed to address specific opportunities for fraud to take place. Overall, the 2010 COSO report shows that fraudulent financial reporting remains a very significant problem. Commonly cited motivations for fraud included the need to meet internal or external earnings expectations, an attempt to conceal the company's deteriorating financial condition, the need to increase the stock price, the need to bolster financial performance for pending equity or debt financing, or the desire to increase management compensation based on financial results.
LO 2 Define the fraud triangle and describe its three elements.
The three elements of the fraud triangle include: ●Incentive to commit fraud ●Opportunity to commit and conceal the fraud ●Rationalization—the mind-set of the fraudster to justify committing the fraud
LO 5 Explain how various requirements in the Sarbanes-Oxley Act of 2002 are designed to help prevent the types of frauds perpetrated in the late 1990s and early 2000s.
Title I and its relevant sections effectively remove self-regulation of the auditing profession and replace it with independent oversight by the PCAOB. Section 201 prevents audit firms from providing many consulting services to audit clients, which was an issue cited as a significant driver of the failed audits of Enron. Sections 204, 301, and 407 significantly expand the power, responsibilities, and disclosures of corporate audit committees, thereby addressing concerns over weak corporate governance. Audit committees are directly responsible for the oversight of the company's external auditors and have the power to hire and fire the auditors. Section 404 requires management assessment and external audit firm attestation regarding the effectiveness of internal control over financial reporting—a key structural problem in many organizations experiencing fraud. Finally, many sections of the Sarbanes-Oxley Act significantly enhance the penalties for criminal wrongdoing that affects the securities markets, individual shareholders, and the general public.
LO 5 The Sarbanes-Oxley Act enacted which of the following provisions as a response to a growing number of frauds? a. The PCAOB was established, and it has the power to conduct inspections of public company audits. b. The lead audit partner and reviewing partner must rotate off the audit of a publicly traded company at least every ten years. c. Annual reports must state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting, and management must have the company's internal audit function attest to the accuracy of the annual reports. d. All of the above. e. None of the above.
a. The PCAOB was established, and it has the power to conduct inspections of public company audits. Audit partner rotation. The lead partner and reviewing partner must rotate off the issuer engagement at least every five years. Management assessment of internal controls: ●Annual reports must state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting. ●Annual reports must contain an assessment of the effectiveness of the internal control structure and procedures of the issuer for financial reporting. ●Each registered accounting firm must attest to and report on the assessment made by the management of the issuer, and such attestation must not be the subject of a separate engagement (in other words, requires an integrated audit).
LO 2 Which of the following is a common rationalization for fraudulent financial reporting? a. This is a one-time transaction and it will allow the company to get through the current financial crisis, but I'll never do it again. b. I am only borrowing the money; I will pay it back next year. c. Executives at other companies are getting paid more than I am, so I deserve the money. d. The accounting rules don't make sense for our company, and they make our financial results look weaker than is necessary; so we have a good reason to record revenue using a nonGAAP method. e. Both (a) and (d).
a. This is a one-time transaction and it will allow the company to get through the current financial crisis, but I'll never do it again.
LO 6 Which of the following audit committee responsibilities has the NYSE mandated? a. Obtaining each year a report by the internal auditor that addresses the company's internal control procedures, any quality-control or regulatory problems, and any relationships that might threaten the independence of the internal auditor. b. Discussing in its meetings the company's earnings press releases as well as financial information and earnings guidance provided to analysts. c. Reviewing with the internal auditor any audit problems or difficulties that they have had with management. d. All of the above. e. None of the above.
b. Discussing in its meetings the company's earnings press releases as well as financial information and earnings guidance provided to analysts. ●Obtaining an annual report by the external auditor that addresses the company's internal control procedures, any quality-control or regulatory problems, and any relationships that might threaten the independence of the external auditor ●Discussing the company's financial statements with management and the external auditor ●Discussing in its meetings the company's earnings press releases, as well as financial information and earnings guidance provided to analysts ●Discussing in its meetings policies with respect to risk assessment and risk management ●Meeting separately with management, internal auditors, and the external auditor on a periodic basis ●Reviewing with the external auditor any audit problems or difficulties that they have had with management ●Setting clear hiring policies for employees or former employees of the external auditor ●Reporting regularly to the board of directors
LO 2 Which of the following factors creates an opportunity for fraud to be committed in an organization? a. Management demands financial success. b. Poor internal control. c. Commitments tied to debt covenants. d. Management is aggressive in its application of accounting rules.
b. Poor internal control. Some of the opportunities to commit fraud that the auditor should consider include the following: ●Significant related-party transactions ●A company's industry position, such as the ability to dictate terms or conditions to suppliers or customers that might allow individuals to structure fraudulent transactions ●Management's inconsistency involving subjective judgments regarding assets or accounting estimates ●Simple transactions that are made complex through an unusual recording process ●Complex or difficult-to-understand transactions, such as financial derivatives or special-purpose entities ●Ineffective monitoring of management by the board, either because the board of directors is not independent or effective, or because there is a domineering manager ●Complex or unstable organizational structure ●Weak or nonexistent internal controls, especially a lack of segregation of duties
LO 1 Which of the following best represents an example of fraudulent financial reporting? a. The transfer agent issues 40,000 shares of the company's stock to a friend without authorization by the board of directors. b. The controller of the company inappropriately records January sales in December so that year-end results will meet analysts' expectations. c. The in-house attorney receives payments from the French government for negotiating the development of a new plant in Paris. d. The accounts receivable clerk covers up the theft of cash receipts by writing off older receivables without authorization.
b. The controller of the company inappropriately records January sales in December so that year-end results will meet analysts' expectations. Fraud is an intentional act involving the use of deception that results in a misstatement of the financial statements.
LO 1 What is the primary difference between fraud and error in financial statement reporting? a. The materiality of the misstatement. b. The intent to deceive. c. The level of management involved. d. The type of transaction effected.
b. The intent to deceive. Intent to deceive is what distinguishes fraud from errors. Auditors routinely find financial errors in their clients' books, but errors are not intentional.
LO 3 Which of the following is a valid conclusion of the 2010 COSO report? a. The most common frauds involve outright theft of assets. b. The individuals most often responsible for fraud include lowlevel accounting personnel, such as accounts payable clerks. c. The majority of frauds took place at smaller companies that were listed on the OTC market rather than the larger companies listed on the NYSE. d. All of the above. e. None of the above.
e. None of the above. COSO 2010 findings: ●The amount and incidence of fraud remains high. The total amount of fraud was more than $120 billion spread across just 300 companies. ●The median size of the company perpetrating the fraud rose tenfold to $100 million during the 1998-2007 period (as compared to the previous ten years). ●There was heavy involvement in the fraud by the CEO and/or CFO, with at least one of them named in 89% of the cases. ●The most common fraud involved revenue recognition—60% of the cases during the latest period compared to 50% in previous periods. ●One-third of the companies changed auditors during the latter part of the fraud (with the full knowledge of the audit committee) compared to less than half that amount of auditor changes taking place with the nonfraud companies. ●Consistent with previous COSO studies, the majority of the frauds took place at companies that were listed on the over-the-counter (OTC) market, rather than those listed on the NYSE or NASDAQ.
