Audit Chapter 4

Failure to meet company objectives is a result of a. Information risk. b. Audit risk. c. Business risk. d. Inherent risk.

c. Correct This is the definition of business risk.

The risk that the auditors' own testing procedures will lead to the decision that material mis- statements do not exist in the financial statements when in fact such misstatements do exist is a. Audit risk. b. Inherent risk. c. Control risk. d. Detection risk.

d. Correct This is the definition of detection risk.

Auditors are not responsible for accounting estimates with respect to a. Making the estimates. b. Determining the reasonableness of estimates. c. Determining that estimates are presented in conformity with GAAP. d. Determining that estimates are adequately disclosed in the financial statements.

A. Correct Management is responsible for making the estimates in the first place, just as management is primarily responsible for all the financial statement elements.

It is acceptable under generally accepted auditing standards for an audit team to a. Assess risk of material misstatement at high and achieve an acceptably low audit risk by performing extensive substantive tests. b. Assess control risk at zero and perform a minimum of detection work. c. Assess inherent risk at zero and perform a minimum of detection work. d. Decide that audit risk can be 40 percent.

a. Correct. The objective is to perform a quality audit and keep audit risk low.

The risk of material misstatement is composed of which audit risk components? a. Inherent risk and control risk. b. Control risk and detection risk. c. Inherent risk and detection risk. d. Inherent risk, control risk, and detection risk.

a. Correct. The risk of material misstatement is composed of inherent risk and control risk.

An audit strategy memorandum contains a. Specifications of auditing standards relevant to the financial statements being audited. b. Specifications of procedures the auditors believe appropriate for the financial statements under audit. c. Documentation of the assertions under audit,the evidence obtained,and the conclusions reached. d. Reconciliation of the account balances in the financial statements with the account bal- ances in the client's general ledger.

b. Correct. An audit strategy contains specifications of procedures the auditors believe appropriate for the financial statements under audit.

Which of the following matters relating to an entity's operations would an auditor most likely consider as an inherent risk factor in planning an audit? a. The entity's fiscal year ends on June 30. b. The entity enters into significant derivative transactions as hedges. c. The entity's financial statements are generated at an outside service center. d. The entity's financial data is available only in computer-readable form.

b. Correct. By their very nature, derivative transactions are designed to be used as hedges for exposure on existing contracts are quite complex. The accounting rules that provide the basis for GAAP in this area are also complex. As a result of this complexity, the inherent risk of material misstatement is higher.

The auditors assessed risk of material misstatement at 0.50 and said they wanted to achieve a 0.05 risk of failing to express a correct opinion on financial statements that were materially misstated. What detection risk do the auditors plan to use for planning the remainder of the audit work? a. 0.20. b. 0.10. c. 0.75. d. 0.00.

b. Correct. DR = AR/ (IR x CR) = 0.05/0.50 = 0.10.

Which of the following circumstances would most likely cause an audit team to perform extended procedures? a. Supporting documents are produced when requested. b. The client made several large adjustments at or near year-end. c. The company has recently hired a new chief financial officer after the previous one retired. d. The company maintains several different petty cash funds.

b. Correct. If the client made several large adjustments at year-end (a red flag), extended procedures would be considered necessary to ensure that fraud was not taking place.

One of the typical characteristics of management fraud is a. Falsification of documents in order to misappropriate funds from an employer. b. Victimization of investors through the use of materially misleading financial statements. c. Illegal acts committed by management to evade laws and regulations. d. Conversion of stolen inventory to cash deposited in a falsified bank account.

b. Correct. Management fraud is victimization of investors through the use of materially misleading financial statements.

Under the Private Securities Litigation Reform Act (the Act), independent auditors are required to first a. Report in writing all instances of noncompliance with the Act to the client's board of directors. b. Report to the SEC all instances of noncompliance with the Act they believe have a material effect on financial statements if the board of directors does not first report to the SEC. c. Report clearly inconsequential noncompliance with the Act to the audit committee of the client's board of directors. d. Resign from the audit engagement and report the instances of noncompliance with the Act to the SEC.

b. Correct. Once informed, the board of directors has the first responsibility to report to the SEC. If the board does not report these items to the SEC, the law then requires the auditors to do so.

When evaluating whether accounting estimates made by management are reasonable, audi- tors would be most interested in which of the following? a. Key factors that are consistent with prior periods. b. Assumptions that are similar to industry guidelines. c. Measurements that are objective and not susceptible to bias. d. Evidence of a conservative systematic bias.

b. Correct. Once informed, the board of directors has the first responsibility to report to the SEC. If the board does not report these items to the SEC, the law then requires the auditors to do so.

When auditors become aware of noncompliance with a law or regulation committed by cli- ent personnel, the primary reason that the auditors should obtain a better understanding of the nature of the act is to a. Recommend remedial actions to the audit committee. b. Evaluate the effect of the noncompliance on the financial statements. c. Determine whether to contact law enforcement officials. d. Determine whether other similar acts could have occurred.

b. Correct. The audit team's first concern is the effect of the noncompliance on the financial statements.

When a company that sells its products with a positive gross profit increases its sales by 15 percent and its cost of goods sold by 7 percent, the cost of goods sold ratio will a. Increase. b. Decrease. c. Remain unchanged. d. Not be able to be determined with the information provided.

b. Correct. The numerator (cost of goods sold) increases relatively less than the denominator (sales) increases.

Auditors perform analytical procedures in the planning stage of an audit for the purpose of a. Deciding the matters to cover in an engagement letter. b. Identifying unusual conditions that deserve more auditing effort. c. Determining which of the financial statement assertions are the most important for the client's financial statements. d. Determining the nature,timing,and extent of further audit procedures for auditing the inventory.

b. Correct. This is the "attention directing" purpose.

If tests of controls induce the audit team to change the assessed level of control risk for fixed assets from 0.4 to 1.0 and audit risk (0.05) and inherent risk remain constant, the acceptable level of detection risk is most likely to a. Change from 0.1 to 0.04. b. Change from 0.2 to 0.3. c. Change from 0.25 to 0.1. d. Be unchanged.

c. Correct This solution is both mathematically and practically correct.

An audit committee is a. Composed of internal auditors. b. Composed of members of the audit team. c. Composed of members of a company's board of directors who are not involved in the day-to-day operations of the company. d. A committee composed of persons not associating in anyway with the client or the board of directors.

c. Correct. An audit committee is composed of members of a company's board of directors who are not involved in the day-to-day operations of the company.

Analytical procedures are generally used to produce evidence from a. Confirmations mailed directly to the auditors by client customers. b. Physical observation of inventories. c. Relationships among current financial balances and prior balances, forecasts, and nonfi- nancial data. d. Detailed examination of external, external-internal, and internal documents.

c. Correct. Analytical procedures incorporate information from a variety of sources.

Which of the following statements best describes auditors' responsibility for detecting a client's noncompliance with a law or regulation? a. The responsibility for detecting noncompliance exactly parallels the responsibility for errors and fraud. b. Auditors must design tests to detect all material noncompliance that indirectly affects the financial statements. c. Auditors must design tests to obtain reasonable assurance that all noncompliance with direct material financial statement effects is detected. d. Auditors must design tests to detect all noncompliance that directly affects the financial statements.

c. Correct. Auditors must design tests to obtain reasonable assurance that all noncompliance with direct material financial statement effects is detected.

Which of the following risk types increase when an auditor performs substantive analytical audit procedures for financial statement accounts at an interim date? a. Inherent. b. Control. c. Detection. d. Sampling.

c. Correct. The decision to perform substantive analytical procedures (as compared to a test of details) at interim (as compared to the balance sheet date) would increase detection risk.

What is the primary objective of the fraud brainstorming session? a. Determine audit risk and materiality. b. Identify whether analytical procedures should be applied to the revenue accounts. c. Assess the potential for material misstatement due to fraud. d. Determine whether the planned procedures in the audit plan will satisfy the general audit objectives.

c. Correct. The fraud brainstorming session is primarily focused on fraud risk assessment, which is the potential for material misstatement due to fraud in the financial statements. This is the primary objective of the session, according to professional standards (i.e., SAS No. 99).

Which of the following is a specific audit procedure that would be completed in response to a particular fraud risk in an account balance or class of transactions? a. Exercising more professional skepticism. b. Carefully avoiding conducting interviews with people in areas that are most susceptible to fraud. c. Performing procedures such as inventory observation and cash counts on a surprise or unannounced basis. d. Studying management's selection and application of accounting principles more carefully.

c. Correct. This is a specific procedural response mentioned in audit standards.

Auditing standards do not require auditors of financial statements to a. Understand the nature of errors and frauds. b. Assess the risk of occurrence of errors and frauds. c. Design audits to provide reasonable assurance of detecting errors and frauds. d. Report all errors and frauds found to police authorities.

d. Correct. Auditors are not required to report all finding of errors and frauds to police authorities.

If sales were overstated by recording a false credit sale at the end of the year, where could you find the false "dangling debit"? a. Inventory. b. Cost of goods sold. c. Bad debt expense. d. Accounts receivable

d. Correct. In (fictitious) credit sales and (fictitious) receivables.

Analytical procedures can be used in which of the following ways? a. As a means of overall review near the end of the audit. b. As "attention-directing" methods when planning an audit at the beginning. c. As substantive audit procedures to obtain evidence during an audit. d. All of the above.

d. Correct. The answer is all of the above. Analytical procedures can be used when planning the audit, when performing substantive procedures

A primary objective of analytical procedures used in the final review stage of an audit is to a. Identify account balances that represent specific risks relevant to the audit. b. Gather evidence from tests of details to corroborate financial statement assertions. c. Detect fraud that may cause the financial statements to be misstated. d. Assist the auditor in evaluating the overall financial statement presentation.

d. Correct. This is the correct answer. At the final review stage, analytical review procedures are designed to provide an overall test of reasonableness about the financial statements being reviewed, in light of all available evidence.

The likelihood that material misstatements may have entered the accounting system and not been detected and corrected by the client's internal control is referred to as a. Inherent risk. b. Control risk. c. Detection risk. d. Risk of material misstatement.

d. Correct. This is the definition of the risk of material misstatement.

Analytical procedures used when planning an audit should concentrate on a. Weaknesses in the company's internal control activities. b. Predictability of account balances based on individual significant transactions. c. Management assertions in financial statements. d. Accounts and relationships that can represent specific potential problems and risks in the financial statements.

d. Correct. With preliminary analytical procedures, the auditors are looking for signs of accounts and relationships that may represent specific potential problems and risks in the financial statements.