Chapter 3 - Auditing

Given the following information about a publicly-traded company's financial situation, what is the most appropriate quantitative assessment of planning materiality for 2022? 2022 2021 2020 Revenues $1,820M $1,941M $1,916M Total Assets $1,600M $1,721M $1,774M Pre-tax Income $1.5M $45.2M $31.9M -$0.075M -$90.5M -$2.26M -$8M

$8M

You are in client acceptance phase for the audit of Jako Corp. You have determined that your firm has the expertise to perform the services and can meet the client's needs. Which of the following factors related to client acceptance does this affect? -Special circumstances and unusual risks -Integrity of management -Competence -Independence

-Competence

Which of the following are examples of fraudulent financial reporting? -Writing checks to fictitious vendors -Improper asset valuations -Unrecorded liabilities -Recording fictitious sales

-Improper asset valuations -Unrecorded liabilities -Recording fictitious sales

Which of the following are possible indicators of fraud in a company? -A simplified business structure -Overly dominant management -Poor compensation practices -A high turnover of key employees

-Overly dominant management -Poor compensation practices -A high turnover of key employees

CPA What assurance does the auditor provide that errors, irregularities (fraud), and direct effect illegal acts that are material to the financial statements will be detected? Errors Irregularities Direct effect illegal acts -Limited Negative Limited -Limited Limited Reasonable -Reasonable Limited Limited -Reasonable Reasonable Reasonable

-Reasonable Reasonable Reasonable The auditor is required to plan the audit to provide REASONABLE assurance that errors, fraud, and direct effect illegal acts, which materially misstate the financial statements, will be detected.

Which of the following are examples of opportunities that increase the risk that a fraud may have been perpetrated? -Significant adjusting entries and reversals after year-end -Accounts that rely on estimates and judgment -A low turnover of staff with accounting responsibilities -A high volume of transactions close to year-end

-Significant adjusting entries and reversals after year-end -Accounts that rely on estimates and judgment -A high volume of transactions close to year-end

You are in client acceptance phase for the audit of Jako Corp. You have determined that Jako has a week accounting system with few internal controls. Which of the following factors related to client acceptance does this affect? -Competence -Independence -Integrity of management -Special circumstances and unusual risks

-Special circumstances and unusual risks

If audit risk is set at 5%, inherent risk is 100% and control risk is 80%, what should auditors set for detection risk? -12% -5% -10% -6%

6%

You are in client acceptance phase for the audit of Jako Corp. You have determined that management is preoccupied with meeting specific profitability targets. Which of the following factors related to client acceptance does this affect? -Independence -Integrity of management -Special circumstances and unusual risks -Competence

Integrity of management

Which of the following is NOT an example of a fraud red flag? -Overly dominant management -Low turnover of key employees -Weak internal controls -A complex business structure

Low turnover of key employees

During the audit of LEGOND Group, auditors discover a $5,000 understatement of expenses which, although it was a relatively small dollar amount, turned a $3,000 net loss into a $3,000 net profit. This would most likely be which of the following? -Neither quantitatively nor qualitatively material -Qualitatively material -Quantitatively material -Both quantitatively and qualitatively material

Qualitatively material

The risk assessment phase of an audit does not include: -audit execution and reporting -development of an audit strategy and a risk and materiality assessment -identification of factors that may affect the risk of a material misstatement in the financial statements -gaining and understanding of the client

audit execution and reporting

Which of the following statements regarding a substantive approach is correct? -If RMM is low, the audit strategy will be to perform extensive detailed substantive procedures and place little or no reliance on the client's internal controls -If there is an internal control in place, auditors may decide to test the effectiveness of the internal control -If there is no internal control in place, auditors assess RMM as low since both inherent and control risk are low -The process for a substantive approach begins very differently than a reliance on controls approach

If there is an internal control in place, auditors may decide to test the effectiveness of the internal control

If auditors obtain information in the risk response phase that indicates and assessment made during the risk assessment phase was incorrect, the auditor should -consult legal counsel -issue a modified opinion -withdraw from the engagement -reevaluate and revise their audit plan

reevaluate and revise their audit plan

The audit strategy known as "reliance on controls approach": -means the auditor will spend minimum effort testing the client's system of internal controls -means the auditor will conduct extensive year-end account balance testing -requires the auditor to conduct extensive control testing -is appropriate when internal controls are minimal

requires the auditor to conduct extensive control testing

An auditor will identify accounts and related assertions at risk of material misstatement: -after writing the audit report -to plan the audit to focus on those accounts -after testing internal controls -to eliminate audit risk

to plan the audit to focus on those accounts

CPA Before accepting an audit engagement, a successor auditor should make specific inquiries of the predecessor auditor regarding the predecessor's -Opinion of any subsequent events occurring since the predecessor's audit report was issued -Understanding as to the reasons for the change of auditors -Awareness of the consistency in the application of GAAP between periods -Evaluation of all matters of continuing accounting significance

Understanding as to the reasons for the change of auditors A successor auditor should communicate with the predecessor auditor about matters that will assist the successor auditor in deciding whether to accept the engagement. These would include the integrity of management, disagreement with management, and the predecessor's understanding of the reason for the change in auditor

CPA Hill, CPA, has been retained to audit the financial statements of Monday Co. Monday's predecessor auditor was Post, CPA, who has been notified by Monday that Post's services have been terminated. Under these circumstances, which party should initiate the communications between Hill and Post? a. Hill, the successor auditor. b. Post, the predecessor auditor. c. Monday's controller or CFO. d. The chairman of Monday's board of directors.

a. Hill, the successor auditor. The initiative belongs to Hill, the successor auditor. When an auditor has been retained to audit the financial statements of an entity, the auditor contacts the predecessor auditor to obtain information about matters that may affect the conduct of the audit and to review the prior year audit documentation. The successor auditor should contact the predecessor auditor prior to final acceptance of the engagement.

Auditing and Attestation You have been assigned to the audit of Huskie Company. The company was previously audited by another CPA firm. The audit team is currently focused on pre-engagement acceptance and other planning issues. Match the phrases below with the most closely corresponding terms associated with planning activities by selecting from the associated cell. Each source may be used, more than once, or not at all 1. The auditor does not identify a material misstatement that exists in an assertion 2. The nature, timing, and extent of planned substantive audit procedures for each audit area 3. The relative size of financial statement misstatements that the auditor's planned substantive audit procedures is designed to detect 4. The susceptibility of an assertion to a material misstatement, assuming that there are no related controls 5. A material misstatement of the financial statements caused by the theft of cash receipts concealed by false entities in the accounting records

1. Detection risk The "official" definition of detection risk is "the risk that the auditor will not detect a misstatement that exists in a relevant assertion that could be material, either individually or when aggregated with other misstatements" (AU 312). The auditors failure to identify a material misstatement in an assertion is detection risk 2. Audit program Auditors are required to develop an audit plan which includes the "nature, timing, and extent of audit procedures to be performed." The list of audit procedures for a given area, e.g., Cash, is known as an audit program 3. Planning-stage materiality While establishing the overall audit strategy, auditors are required to determine a materiality level for the financial statements as a whole. This is known as "planning stage materiality" or the "preliminary judgement about materiality". Planning stage materiality is an amount which will be considered material and will therefore be used to determine the evidence to be collected. For example, if $100,000 is considered to be material, the auditor must plan the audit to detect all misstatements of $100,000 or more. 4. Inherent risk Inherent risk is "the susceptibility of a relevant assertion to a misstatement that could be material, either individually or in the aggregate" (AU 312). It is the risk that a material misstatement could occur without taking into account any related internal controls. 5. Misappropriation of assets Auditors consider two types of fraud in planning an audit - misstatements arising from fraudulent financial reporting and misstatements arising from misappropriate of assets. The latter type, misstatements arising from misappropriation of assets, involves material thefts of company assets. The theft of cash receipts resulting in a material misstatement of financial statements is a misstatement arising from the misappropriation of assets.

Which of the following statements regarding risk assessment is correct? -Auditors make preliminary risk assessments while planning the audit -An auditor will perform various risk assessment procedures to ensure that appropriate attention is paid to the accounts and transactions least at risk of being materially misstated -Information risk is the risk that an auditor expresses an inappropriate audit opinion when the financial statements are materially misstated -AU-C 200 Planning and Audit and AS 2101 Audit Planning require auditors to plan the audit by assessing risk to increase audit risk to an acceptable high level

Auditors make preliminary risk assessments while planning the audit

Which of the following is an example of fraudulent financial reporting? -Writing checks to fictitious vendors -Capitalizing items that should be expensed -Unauthorized discounts or refunds to customers -Using a company credit card for personal use

Capitalizing items that should be expensed

All of the following factors indicate higher inherent risk EXCEPT -Technological developments in the client's industry increase the risk of obsolescence of certain assets -Transactions or account balances derived from significant estimates -The client's location is at risk of natural disasters such as hurricanes and flooding -Client has sufficient working capital and is not at risk of violating loan contracts

Client has sufficient working capital and is not at risk of violating loan contracts

Which component of audit risk can the auditor control? -Detection risk -Financial risk -Inherent risk -Control risk

Detection risk

CPA Inherent risk and control risk differ from detection risk in that inherent risk and control risk are -Elements of audit risk while detection risk is not -Changed at the auditor's discretion while detection risk is not -Considered at the individual account-balance level while detection risk is not -Functions of the client and its environment while detection risk is not

Functions of the client and its environment while detection risk is not Inherent risk and control risk (also called environmental risks) are functions of the client and its environment, while detection risk is not. As a result, inherent risk and control risk can only be assessed by the auditor, while detection risk is controlled by the auditor.

Lisa is auditing a private company that manufactures batteries for cell phones. While the company has good perpetual inventory records and careful inventory controls, Jennifer is concerned about reported problems with lithium-ion battery fires. It is not clear that the industry has solved these problems. The company has already noted a slowing in sales of one battery model. Which audit strategy or strategies is Lisa most like to take? I. Analytical approach II. Substantive approach III. Reliance approach -II and III -III only -I only -II only

II only

Which of the following statements regarding setting materiality is correct? -When determining planning materiality, auditors will use professional skepticism and are mindful of the secondary users of the financial statements -Audit firms must not vary in the method they use to set planning materiality in the risk assessment phase -In selecting an appropriate benchmark, auditors can choose an item from the balance sheet or the income statement -The auditing standards do not require the auditors reevaluate their overall level of materiality throughout the audit

In selecting an appropriate benchmark, auditors can choose an item from the balance sheet or the income statement

CPA An auditor's engagement letter most likely would include -Management's acknowledgment of its responsibility for maintaining effective internal control -The auditor's preliminary assessment of the risk factors relating to misstatements arising from fraudulent financial reporting. -A reminder that management is responsible for illegal acts committed by employees -A request for permission to contact the client's lawyer for assistance in identifying litigation, claims, and assessments

Management's acknowledgement of its responsibility for maintaining effective internal control AU-C 210 (Terms of Engagement, paragraph 10) requires the following specific matters to be addressed in the engagement letter: a. "The objective and scope of the audit of the financial statements b. The responsibilities of the auditor c. The responsibilities of management d. A statement that because of the inherent limitations of an audit, together with the inherent limitations of internal control, an unavoidable risk exists that some material misstatements may not be detected, even though the audit is properly planned and performed in accordance with GAAS. e. Identification of the applicable financial reporting framework for the preparation of the financial

During the audit of LEGOND Group, auditors discover a $5,000 understatement of expenses that auditors agreed would not be significant enough to influence a user's decisions. This would most likely be which of the following? -Neither quantitatively nor qualitatively material -Both quantitatively and qualitatively material -Qualitatively material -Quantitatively material

Neither quantitatively nor qualitatively material

Which of the following statements regarding audit procedures is correct? -Nature refers to the determination of when a procedure is performed -Tests of controls are designed to detect material misstatements at the assertion level -Extent refers to the type of procedure performed -Tests of controls are audit procedures designed to evaluate the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the assertion level

Tests of controls are audit procedures designed to evaluate the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the assertion level

Which of the following statements regarding risk is correct? -The higher the inherent risk, the lower the control risk is likely to be -The higher the inherent risk, the higher the control risk is likely to be -There is no set relationship between inherent risk and control risk -The higher the control risk, the lower the inherent risk is likely to be

There is no set relationship between inherent risk and control risk

Which of the following statements about auditing standards is correct? -The auditing standards provide rigorous guidelines for determining performance materiality -The auditing standards do not provide any guidelines for the determination of performance materiality -None of the choices is correct -The auditing standards provide limited guidelines for the determination of performance materiality

The auditing standards do not provide any guidelines for the determination of performance materiality

Which of the following is an example of a qualitative materiality factor? -Inventory represents 40% of current assets -The client is experiencing a slowdown in sales and is struggling to pay vendors on time. -Total salaries expense is greater than 5%of income before taxes -The client installed a new security system to protect the building

The client is experiencing a slowdown in sales and is struggling to pay vendors on time.

Which of the following statements regarding an engagement letter is INCORRECT? -An engagement letter is prepared by an auditor and acknowledged by a client before the audit begins -AU-C 210 Terms of Engagement and AS 1301 Communications with Audit Committees provide guidance on the preparation of engagement letters -The first stage in the client acceptance or continuance decision process involves the preparation of an engagement letter -It is not necessary to send a new engagement letter each year for a continuing client unless the terms of the engagement change

The first stage in the client acceptance or continuance decision process involves the preparation of an engagement letter

Which of the following statements regarding risk is correct? -There is both a direct and inverse relationship between the risk of material misstatement and detection risk -There is an inverse relationship between the risk of material misstatement and detection risk -There is a direct relationship between the risk of material misstatement and detection risk -There is neither an inverse nor direct relationship between the risk of material misstatement and detection risk

There is an inverse relationship between the risk of material misstatement and detection risk

An example of an incentive or pressure that increases the risk of fraud is: -the client operates in a highly competitive industry -the client has a history of reporting losses -a significant percentage of management pay is tied to earnings -All of these answer choices are correct

all of these answer choices are correct

An attitude of professional skepticism means: -the auditor is independent of the client -any indicator of fraud is properly investigated -the auditor can rely on management assertions -the auditor can rely on past experience to determine current risk of fraud

any indicator of fraud is properly investigated

CPA Which of the following matters does an auditor usually include in the engagement letter? -arrangements regarding fees and billing -analytical procedures that the auditor plans to perform -indications of negative cash flows from operating activities -identification of working capital deficiencies

arrangements regarding fees and billing The engagement letter identifies the respective responsibilities of the entity and the auditor, and essentially constitutes the contract between the parties. It is customary for the engagement letter to address fee-related issues.

The audit strategy known as the predominantly "substantive approach": -is appropriate when internal controls are very strong -requires the auditor to conduct extensive control testing -means the auditor will conduct some interim testing and minimal year-end account-balance testing -means the auditor will spend minimum effort testing the client's system of internal controls

means the auditor will spend minimum effort testing the client's system of internal controls

Obtaining positive results from testing controls means that: -the auditor can completely rely on a client's system of internal controls -the auditor can plan to reduce the reliance on detailed substantive resting of transactions and account balances -no substantive testing is required -materiality will be set at a low dollar amount

the auditor can plan to reduce the reliance on detailed substantive resting of transactions and account balances

If a prospective new audit client does not allow the auditor to contact its existing auditor: -the auditor should contact the existing auditor anyway because it is their duty -the existing auditor should contact the new auditor to tell them all about the client -the auditor should respect the prospective client's right to privacy -the auditor should consider that a negative factor on the integrity of client management

the auditor should consider that a negative factor on the integrity of client management

CPA The understanding with the client regarding a financial statement audit generally includes which of the following matters? -The audit plan identifying the nature, timing, and extent of planned audit procedures -the responsibilities of the auditor -the contingency fee structure -the preliminary judgment about materiality

the responsibilities of the auditor An engagement letter, which documents the agreed upon terms of the audit engagement, specifically address the respective responsibilities of management and the auditor, among the matters.

CPA As a result of control testing, a CPA has decided to reduce control risk. What is the impact on the substantive testing sample size if all other factors remain constant? -the sample size would be irrelevant -the sample size would be higher -the sample size would be lower -the sample size would be unaffected

the sample size would be lower Lowering the assessment of control risk would permit a somewhat higher level of detection risk. Taking a smaller sample size would be associated with a higher level of detection risk, which would be appropriate in view of the reduced control risk.

CPA In assessing whether to accept a client for an audit engagement, a CPA should consider the Client's business risk - CPA's business risk - Yes Yes - Yes No - No Yes - No No

yes, yes