Audit - Chapter 4

As lower acceptable levels of both audit risk and materiality are established, the auditor should plan more work on individual accounts to a. Find smaller errors. b. Find larger errors. c. Increase the tolerable misstatements in the accounts. d. Decrease the risk of overreliance.

A

The existence of audit risk is recognized by the statement in the auditor's standard report that the auditor a. Obtains reasonable assurance about whether the financial statements are free of material misstatement. b. Assesses the accounting principles used and evaluates the overall financial statement presentation. c. Realizes that some matters, either individually or in the aggregate, are important, while other matters are not important. d. Is responsible for expressing an opinion on the financial statements, which are the responsibility of management

A

Which of the following is an example of fraudulent financial reporting? a. Company management falsifies the inventory count, thereby overstating ending inventory and understating cost of sales. b. An employee diverts customer payments to his personal use, concealing his actions by debiting an expense account, thus overstating expenses. c. An employee steals inventory, and the shrinkage is recorded as a cost of goods sold. d. An employee borrows small tools from the company and neglects to return them; the cost is reported as a miscellaneous operating expense.

A

Which of the following is correct concerning required auditor communications about fraud? a. Fraud that involves senior management should be reported directly by the auditor to the audit committee regardless of the amount involved. b. Fraud with a material effect on the financial statements should be reported directly by the auditor to the Securities and Exchange Commission. c. Any requirement to disclose fraud outside the entity is the responsibility of management and not that of the auditor. d. The professional standards provide no requirements related to the communication of fraud, but the auditor should use professional judgment in determining communication responsibilities.

A

Auditing standards require auditors to make certain inquiries of management regarding fraud. Which of the following inquiries is required? a. Whether management has ever intentionally violated the securities laws. b. Whether management has any knowledge of fraud that has been perpetrated on or within the entity. c. Management's attitudes toward regulatory authorities. d. Management's attitude about hiring ethical employees.

B

Risk of material misstatement refers to a combination of which two components of the audit risk model? a. Audit risk and inherent risk. b. Audit risk and control risk. c. Inherent risk and control risk. d. Control risk and detection risk.

C

When is a duty to disclose fraud to parties other than the entity's senior management and its audit committee most likely to exist? a. When the amount is material. b. When the fraud results from misappropriation of assets rather than fraudulent financial reporting. c. In response to inquiries from a successor auditor. d. When a line manager rather than a lower-level employee commits the fraudulent act.

C

Which of the following characteristics most likely would heighten an auditor's concern about the risk of intentional manipulation of financial statements? a. Turnover of senior accounting personnel is low. b. Insiders recently purchased additional shares of the entity's stock. c. Management places substantial emphasis on meeting earnings projections. d. The rate of change in the entity's industry is slow.

C

Which of the following is a misappropriation of assets? a. Classifying inventory held for resale as supplies. b. Investing cash and earning at a 3 percent rate of return as opposed to paying off a loan with an interest rate of 7 percent. c. An employee of a consumer electronics store steals 12 CD players. d. Management estimates bad debt expense as 2 percent of sales when it actually expects bad debts equal to 10 percent of sales.

C

When planning a financial statement audit, a CPA must understand audit risk and its components. The firm of Pack & Peck evaluates the risk of material misstatement (RMM) by disaggregating RMM into its two components: inherent risk and control risk. Required: For each illustration, select the component of audit risk that is most directly illustrated. The components of audit risk may be used once, more than once, or not at all. Components of Audit Risk: a. Control risk b. Detection risk c. Inherent risk Disbursements have occurred without proper approval

Control risk

When planning a financial statement audit, a CPA must understand audit risk and its components. The firm of Pack & Peck evaluates the risk of material misstatement (RMM) by disaggregating RMM into its two components: inherent risk and control risk. Required: For each illustration, select the component of audit risk that is most directly illustrated. The components of audit risk may be used once, more than once, or not at all. Components of Audit Risk: a. Control risk b. Detection risk c. Inherent risk There is inadequate segregation of duties.

Control risk

Which of the following concepts are pervasive in the application of generally accepted auditing standards, particularly the standards of field work and reporting? a. Internal control. b. Expected misstatement. c. Control risk. d. Materiality and audit risk.

D

When planning a financial statement audit, a CPA must understand audit risk and its components. The firm of Pack & Peck evaluates the risk of material misstatement (RMM) by disaggregating RMM into its two components: inherent risk and control risk. Required: For each illustration, select the component of audit risk that is most directly illustrated. The components of audit risk may be used once, more than once, or not at all. Components of Audit Risk: a. Control risk b. Detection risk c. Inherent risk A necessary substantive audit procedure is omitted.

Detection risk

When planning a financial statement audit, a CPA must understand audit risk and its components. The firm of Pack & Peck evaluates the risk of material misstatement (RMM) by disaggregating RMM into its two components: inherent risk and control risk. Required: For each illustration, select the component of audit risk that is most directly illustrated. The components of audit risk may be used once, more than once, or not at all. Components of Audit Risk: a. Control risk b. Detection risk c. Inherent risk Confirmation of receivables by an auditor fails to detect a material misstatement.

Detection risk

Why would a company institute a control policy that required mandatory vacations?

First started in banking companies, mandatory vacations were used to uncover fraudulent activities conducted by the employees. A fraud activity by an employee requires fake documents and activities and continues reconciliation. These activities require constant attention and effort on part of the employee. Mandatory vacations help in identifying these frauds as the work of the fraudulent employee is shifted to co-worker and unless the co-worker is also involved, such frauds would be detected by the co-worker. It is therefore possible that companies may require mandatory vacations.

c. The First National Bank of Pond City has been your client for the past two years. During that period you have had numerous arguments with the president and the controller over a number of accounting issues. The major issue has related to the bank's reserve for loan losses and the value of collateral. Your prior audits have indicated that a significant adjustment is required each year to the loan loss reserves.

In the case of First National Bank of Pond City, numerous reasons can be attributed to the increased risk of material misstatements: Auditor has conducted audit of the bank for only 2 years. There has been controversial accounting issues related to the bank's reserve for loan losses and the value of collateral. Prior audits have mentioned that a significant adjustment is required each year to the loan loss reserve; it indicates the existence of misstatements in the loan loss reserves. The rise in the risk of material misstatements from these factors results in the lower determination of detection risk, and it leads to more substantive tests.

For each of the following situations, explain how risk of material misstatement should be assessed and what effect that assessment will have on detection risk. a. Johnson, Inc., is a fast-growing trucking company operating in the southeastern part of the United States. The company is publicly held, but Ivan Johnson and his sons control 55 percent of the stock. Ivan Johnson is chairman of the board and CEO. He personally makes all major decisions with little consultation with the board of directors. Most of the directors, however, are either members of the Johnson family or long-standing friends. The board basically rubber-stamps Ivan Johnson's decisions.

In the case of Johnson, Inc., there are 2 factors that assess the risk of material misstatements. First, the person who makes the decision making for the company also has the authority to control the stock. This causes high risk of material misstatement because nobody is there for reviewing the main decisions, and the action that will be taken may not always be in the best interest of the company or its shareholders. Second, the company is growing fast throughout the south-eastern part of the United States. This can cause material misstatements because decision making may be decentralized without internal control. The rise in the risk of material misstatements from these two factors results in the lower determination of detection risk, and it will also increase the scope of the auditor's work as a result.

For each of the following situations, explain how risk of material misstatement should be assessed and what effect that assessment will have on detection risk. b. MaxiWrite Corporation is one of several companies engaged in the manufacture of high-speed, high-capacity data storage devices. The industry is very competitive and subject to quick changes in technology. MaxiWrite's operating results would place the company in the second quartile in terms of profitability and financial position. The company has never been the leader in the industry, with its products typically slightly behind the industry leader's in terms of performance.

In the case of MaxiWrite Corporation, the factors that assess the risk of material misstatements are all related to its industry. First, because the industry is very competitive, it can lead to price cutting, which can affect revenues. Second, the industry is affected by technological advancements. As not a leader in this industry, there are lots of competitors. Third, compared to other companies in the industry, MaxiWrite is not as financially strong and profitable. The rise in the risk of material misstatements from these factors results in the lower determination of detection risk, and it leads to more substantive tests.

When planning a financial statement audit, a CPA must understand audit risk and its components. The firm of Pack & Peck evaluates the risk of material misstatement (RMM) by disaggregating RMM into its two components: inherent risk and control risk. Required: For each illustration, select the component of audit risk that is most directly illustrated. The components of audit risk may be used once, more than once, or not at all. Components of Audit Risk: a. Control risk b. Detection risk c. Inherent risk Cash is more susceptible to theft than an inventory of coal.

Inherent risk

When planning a financial statement audit, a CPA must understand audit risk and its components. The firm of Pack & Peck evaluates the risk of material misstatement (RMM) by disaggregating RMM into its two components: inherent risk and control risk. Required: For each illustration, select the component of audit risk that is most directly illustrated. The components of audit risk may be used once, more than once, or not at all. Components of Audit Risk: a. Control risk b. Detection risk c. Inherent risk Notes receivable are susceptible to material misstatement, assuming there are no related internal controls.

Inherent risk

When planning a financial statement audit, a CPA must understand audit risk and its components. The firm of Pack & Peck evaluates the risk of material misstatement (RMM) by disaggregating RMM into its two components: inherent risk and control risk. Required: For each illustration, select the component of audit risk that is most directly illustrated. The components of audit risk may be used once, more than once, or not at all. Components of Audit Risk: a. Control risk b. Detection risk c. Inherent risk Technological developments make a major product obsolete.

Inherent risk

When planning a financial statement audit, a CPA must understand audit risk and its components. The firm of Pack & Peck evaluates the risk of material misstatement (RMM) by disaggregating RMM into its two components: inherent risk and control risk. Required: For each illustration, select the component of audit risk that is most directly illustrated. The components of audit risk may be used once, more than once, or not at all. Components of Audit Risk: a. Control risk b. Detection risk c. Inherent risk The client is very close to violating debt covenants.

Inherent risk

When planning a financial statement audit, a CPA must understand audit risk and its components. The firm of Pack & Peck evaluates the risk of material misstatement (RMM) by disaggregating RMM into its two components: inherent risk and control risk. Required: For each illustration, select the component of audit risk that is most directly illustrated. The components of audit risk may be used once, more than once, or not at all. Components of Audit Risk: a. Control risk b. Detection risk c. Inherent risk XYZ Company, a client, lacks sufficient capital to continue operations.

Inherent risk

How do inherent risk and control risk differ from detection risk?

Inherent risk (IR) and control risk (CR) are not part of audit, these risk are the function of the entity and its environment. So, auditors do not have control over these risks. According to auditing standard, the grouping of IR and CR is considered as the risk material misstatement (RMM). RMM = IR x CR Detection risk is the risk that the auditor will not identify the material misstatement existed in the financial data. this risk is determined by the way of audit's procedure applied by an auditor. So, if an auditor wants, he can control over this risk by following the correct and proper procedure of auditing.

The auditor should consider audit risk when planning and performing an audit of financial statements in accordance with generally accepted auditing standards. Audit risk should also be considered together in determining the nature, timing, and extent of auditing procedures and in evaluating the results of those procedures. Required: a. Define audit risk. b. Describe the components of audit risk (e.g., inherent risk, control risk, and detection risk). c. Explain how these components are interrelated.

a. Audit risk is the risk that material misstatements may not be identified by the audit procedures. It is the risk that an inappropriate opinion may be expressed when the financial statements are misstated. b. Inherent risk is the risk that a material misstatement due to errors, omissions, or other reasons may exist and which could be material individually or when aggregated without considering the internal controls. Control risks are the risk that material misstatements may not be detected and corrected by the internal controls of the company. Detection risk is the risk that material misstatement may not be detected by the audit procedures performed by the auditors. c. Detection risk is inversely related to inherent and control risk. For an assignment where auditor expects high inherent and control risk, the detection risk would be kept low by the auditor to ensure that the overall risk of assignment is within an acceptable limit.

When planning a financial statement audit, a CPA must understand audit risk and its components. The firm of Pack & Peck evaluates the risk of material misstatement (RMM) by disaggregating RMM into its two components: inherent risk and control risk. Required: For each illustration, select the component of audit risk that is most directly illustrated. The components of audit risk may be used once, more than once, or not at all. Components of Audit Risk: a. Control risk b. Detection risk c. Inherent risk A client fails to discover employee fraud on a timely basis because bank accounts are not reconciled monthly.

control risk