audit Chapter 4

Certain conditions and circumstances are often present when management fraud occurs. Which of the following is not such a condition or circumstance?

High liquidity.

Which of the following is an acceptable response to fraud risks related to sales that were identified in an audit?

Increase the assessment of detection risk for sales.

Auditors would use the enterprise risk model

to evaluate management's risk assessment.

Errors

A bookkeeper inadvertently recorded depreciation by transposing numbers in a journal entry.

White-collar crime

Misdeeds done by people who steal with a pencil or computer

Independent auditors who consider fraud in the course of financial statement audits are well-advised to quantify "materiality" in terms of:

a cumulative amount of misstatement of assets or income over several years past and current that might mislead investors in relation to the latest financial statements under audit.

The auditor uses the assessed level of risk of material misstatement to determine the acceptable level of detection risk for financial statement assertions. As the acceptable level of detection risk decreases, the auditor may do one or more of the following except change the:

assurances provided by substantive tests to a lower level.

The probability that an audit team will give an inappropriate opinion on financial statements best describes:

audit risk.

The existence of audit risk is recognized by the statement in the auditor's standard report that the:

auditor obtains reasonable assurance about whether the financial statements are free of material misstatement.

Embezzlement or defalcation

A type of fraud involving employees or nonemployees wrongfully taking money or property entrusted to their care.

Larceny

An employee in a supermarket takes home bags of fresh fruit each day without paying for them

What assurance does the auditor provide that errors, frauds, and direct effect noncompliance that are material to the financial statements will be detected?

Errors: Reasonable; Frauds: Reasonable; Direct effect noncompliance: Reasonable.

AU 540: "Auditing Accounting Estimates"

Evaluate the net realizable value of inventory.

(free response question) What are the independent auditor's responsibilities to detect and report errors and frauds?

Independent auditors have the responsibility to (1) assess the risk that errors and frauds may cause a client's financial statements to be materially misstated, and (2) design the audit to provide reasonable assurance of detecting errors and frauds material to the financial statements. Extended procedures should be performed if evidence indicates that material errors or frauds might exist.

Inherent risk and control risk differ from detection risk in which of the following ways?

Inherent risk and control risk exist independently of the audit

Which of the following accounts tends to be most predictable for purposes of analytical procedures?

Interest expense

AU 240: "Consideration of Fraud in a Financial Statement Audit"

Investigate large and unusual transactions, particularly those that occur at or near year-end.

Analytical procedures are most appropriate when testing which of the following types of transactions?

Operating expense transactions.

Which of the following would not be considered an analytical procedure?

Projecting a deviation rate by comparing the results of a statistical sample with the actual population characteristics.

Prior to, or in conjunction with, the information-gathering procedures for an audit, audit team members should discuss the potential for material misstatement due to fraud. Which of the following best characterizes the mind-set that the audit team should maintain during this discussion?

Questioning.

Which of the following pieces of information discovered by an auditor when performing substantive tests of account balances would most likely raise red flags about the possible existence of material fraudulent financial reporting?

The client's estimate of the allowance for doubtful accounts is lower than the auditor's independent evaluation of the allowance.

While performing an audit of the financial statements of a company for the year ended December 31, year 1, the auditor notes that the company's sales increased substantially in December, year 1, with a corresponding decrease in January, year 2. In assessing the risk of fraudulent financial reporting or misappropriation of assets, what should be the auditor's initial indication about the potential for fraud in sales revenue?

There is a broad indication of financial reporting fraud

Analytical procedures used in planning an audit should focus on:

enhancing the auditor's understanding of the client's business.

When an auditor increases the planned assessed level of control risk because certain control activities were determined to be ineffective, the auditor would most likely increase the:

extent of substantive tests of details.

External auditors are responsible:

for reporting immaterial frauds to a level of management at least one level above the people involved

In the planning stage, analytical procedures are used to:

identify potential problem areas

If fictitious credit sales were recorded, and the fictitious accounts receivable were later directly written off as bad debt expense,

income would not be misstated.

If an auditor encounters significant risks at the client, the auditor should do all of the following except:

inform the SEC.

Management fraud generally refers to:

intentional distortions of financial statements.

The major emphasis in GAAS related to consideration of fraud in a financial statement audit (AU 240) is on:

management fraud.

When determining the inherent risk related to an account balance, an auditor theoretically does not explicitly consider the:

related internal control policies and procedures.

Generally accepted auditing standards states that analytical procedures:

should be applied in the planning and final review stages of the audit and can be used as a substantive test during the audit.

In auditing related party transactions, an auditor ordinarily places primary emphasis on:

the adequacy of the disclosure of the related party transactions.

Post, CPA, accepted an engagement to audit the financial statements of General Co., a new client. General is a publicly held retailing entity that recently replaced its operating management. In the course of applying audit procedures, Post discovered that General's financial statements may be materially misstated due to the existence of fraud. Required: (a) Describe Post's responsibilities on the circumstances described above. (b) Describe Post's responsibilities for reporting on General's financial statements and other communications if Post is precluded from applying necessary procedures in searching for frauds. (c) Describe Post's responsibilities for reporting on General's financial statements and other communications if Post concludes that General's financial statements are materially affected by frauds.

(a) If Post discovers that General's financial statements may be materially misstated due to the existence of frauds, Post should consider the implications for other aspects of the audit and discuss the matter and approach to further investigation with an appropriate level of management that is at least one level above those involved with the frauds. Post should also attempt to obtain sufficient competent evidential matter to determine whether, in fact, material frauds exist and, if so, their effect. Post may suggest that General consult with its legal counsel on matters concerning questions of law. (b) If Post is precluded from applying necessary procedures, Post should disclaim or qualify an opinion on the financial statements and communicate these findings to General's audit committee or its board of directors. Post should also consider resigning from the audit. (c) If Post concludes that General's financial statements are materially affected by frauds, Post should insist that the financial statements be revised and, if they are not, express a qualified or an adverse opinion on the financial statements, disclosing all the substantive reasons for such an opinion. Additionally, Post should adequately inform General's audit committee or its board of directors about the frauds.

For each of the descriptions in Column A, match the correct word or words from Column B. 1. Refers to changes across two or more years 2. A wide range of evidence-gathering activity that occurs before year-end 3. Chain of evidence found at an audit client 4. Procedures performed that rely on relationships among account balances and/or relevant non-financial data 5. Financial statement amounts expressed as proportions of a base

1. Horizontal analysis 2. Interim audit work 3. Audit trail 4. Analytical procedures 5. Interim audit work

) Items 1 through 6 represent an auditor's observed changes in certain financial statement ratios or amounts from the prior year's ratios or amounts. For each observed change, select the most likely explanation or explanations from the list of explanations provided. Answers on the list may be selected once, more than once, or not at all Auditor's observed changes (considered independent of each other). 1. Inventory turnover increased substantially from the prior year. (Select 3 explanations) 2. Accounts receivable turnover decreased substantially from the prior year. (Select 3 explanations) 3. Allowance for doubtful accounts increased from the prior year, but allowance for doubtful accounts as a percentage of accounts receivable decreased from the prior year. (Select 3 explanations) 4. Long term debt increased from the prior year, but interest expense increased a larger than proportionate amount than long term debt. (Select 1 explanation) 5. Operating income increased from the prior year although the entity was less profitable than in the prior year. (Select 2 explanations) 6. Gross margin percentage was unchanged from the prior year although gross margin increased from the prior year. (Select 1 explanation) Explanations A. Items shipped on consignment during the last month of the year were recorded as sales. B. A significant number of credit memos for returned merchandise that were issued during the last month of the year were not recorded. C. Year-end purchases of inventory were overstated by incorrectly including items received in the first month of the subsequent year. D. Year-end purchases of inventory were understated by incorrectly excluding items received before the year-end. E. A larger percentage of sales occurred during the last month of the year, as compared to the prior year. F. A smaller percentage of sales occurred during the last month of the year, as compared to the prior year. G. The same percentage of sales occurred during the last month of the year, as compared to the prior year. H. Sales increased at the same percentage as cost of goods sold, as compared to the prior year. I. Sales increased at a greater percentage than cost of goods sold increased, as compared to the prior year. J. Sales increased at a lower percentage than cost of goods sold increased, as compared to the Prior year. K. Interest expense decreased, as compared to the prior year. L. The effective income tax rate increased, as compared to the prior year. M. The effective income tax rate decreased, as compared to the prior year. N. Short-term borrowing was refinanced on a long-term basis at the same interest rate. O. Short-term borrowing was refinanced on a long-term basis at lower interest rates. P. Short-term borrowing was refinanced on a long-term basis at higher interest rates.

1. Inventory turnover increased substantially from the prior year. (Select 3 explanations) (A) Items shipped on consignment during the last month of the year were recorded as sales. (B) A significant number of credit memos for returned merchandise that were issued during the last month of the year were not recorded. (D) Year-end purchases of inventory were understated by incorrectly excluding items received before the year end. 2. Accounts receivable turnover decreased substantially from the prior year. (Select 3 explanations) (A) Items shipped on consignment during the last month of the year were recorded as sales. (B) A significant number of credit memos for returned merchandise that were issued during the last month of the year were not recorded. (F) A smaller percentage of sales occurred during the last month of the year, as compared to the prior year. 3. Allowance for doubtful accounts increased from the prior year, but allowance for doubtful accounts as a percentage of accounts receivable decreased from the prior year. (Select 3 explanations) (A) Items shipped on consignment during the last month of the year were recorded as sales. (B) A significant number of credit memos for returned merchandise that were issued during the last month of the year were not recorded. (F) A smaller percentage of sales occurred during the last month of the year, as compared to the prior year. 4. Long-term debt increased from the prior year, but interest expense increased a larger-than-proportionate amount than long-term debt. (Select 1 explanation) (P) Short-term borrowing was refinanced on a long-term basis at higher interest rates. 5. Operating income increased from the prior year although the entity was less profitable than in the prior year. (Select 2 explanations) (L) The effective income tax rate increased, as compared to the prior year. (P) Short-term borrowing was refinanced on a long-term basis at high interest rates. 6. Gross margin percentage was unchanged from the prior year although gross margin increased from the prior year. (Select 1 explanation) (H) Sales increased at the same percentage as cost of goods sold, as compared to the prior year.

Can an auditor place complete reliance on internal control to the exclusion of other audit procedures? Explain your answer using the audit risk model.

An auditor cannot place complete reliance on internal control to the exclusion of other audit procedures. You cannot have a condition where: AR = IR × CR (= 0) × DR = 0

Which of the following statements concerning noncompliance by clients is correct?

An auditor's responsibility to detect noncompliance that has a direct and material effect on the financial statements is the same as that for errors and frauds.

Which of the following would not likely be found in the minutes of the board of directors?

Approval of a new desktop computer for the controller.

) For audits of financial statements made in accordance with generally accepted auditing standards, the use of analytical procedures is required to some extent.

As a substantive test: No; In the final review stage: Yes.

Why is it important for auditors to understand their clients' business risks?

Auditing standards recognize that most business risks are eventually reflected in the financial statements. So audit teams now devote a significant amount of their engagement planning to their clients' business risks. Firms believe they must learn more about their clients' business strategies and processes to understand whether the financial statements are fairly presented.

Which of the following statements best describes auditors' responsibility to detect errors and frauds?

Auditors should design an audit to provide reasonable assurance of detecting errors and frauds that are material to the financial statements.

Sources of financial and nonfinancial data do not include:

Bureau of Labor statistics.

Which of the following analytical procedures most likely would be used during the planning stage of an audit?

Comparing current-year to prior-year sales volumes.

Which of the following is not required by AU 240, "Consideration of Fraud in a Financial Statement Audit"?

Conduct inquiries of shareholders as to their views about the risks of fraud and their knowledge of any fraud or suspected fraud.

If control risk increases, and all other risks in the audit risk model stay constant except the one referred to below, which of the following statements is correct?

Detection risk will decrease.

) Jones, CPA, is auditing the financial statements of XYZ Retailing Inc. What assurance does Jones provide that direct effect noncompliance that is material to XYZ's financial statements, and noncompliance that has a material, but indirect effect on the financial statements will be detected?

Direct effect noncompliance: Reasonable; Indirect effect noncompliance: None

AU 260: "The Auditor's Communication with Those Charged with Governance"

Disagreements with management on significant accounting and auditing matters.

AU 250: "Consideration of Laws and Regulations"

Make inquiries about management's policies and procedures for compliance with laws and regulations.

If not already performed during the overall review stage of the audit, the auditor should perform analytical procedures relating to which of the following transaction cycles?

Revenue.

Management fraud

The controller changed the journal entry for estimating bad debt expense to a smaller number to hide the poor results from extending credit to high risk customers. This made income materially higher than it otherwise would have been

Which of the following information that comes to an auditor's attention most likely would raise a question about the occurrence of illegal acts?

The discovery of unexplained payments made to government employees.

Analytical procedures are one type of evidence gathering procedure. According to auditing standards, there are five general forms of analytical procedures. Auditing standards also provide examples of five sources of information for analytical procedures. Required: Describe three of the five general forms of analytical procedures. For each form, describe a typical source of the information for the form. For each source, include any questions or concerns an auditor would have about the reliability or relevancy of the source.

The five general forms of analytical procedures (and sources of information): 1. Comparison of current year account balances of one or more comparable periods. 2. Financial account information for comparable prior period(s). 3. Comparison of the current year account balances to anticipated results found in the company's budgets and forecasts. 4. Evaluation of the relationships of current year account balances to other current year balances and conformity with predictable patterns based on the company's experience. (Financial relationships among accounts in the current period.) 5. Comparison of current year account balances and financial relationships (e.g., ratios) with similar information for the industry in which the company operates. (Industry statistics.) Study of the relationships of current year account balances with relevant nonfinancial information (e.g., physical production statistics). Considerations about relevance and reliability of sources of information: (Note to instructor: These considerations are not explicitly discussed in the chapter with regard to analytical procedures. Additional considerations are possible.) 1. Has the financial information from prior period(s) been audited? 2. Are company budgets or forecasts generally accurate? What processes does the client go through to develop these? 3. Are the industry statistics from a reliable source? Are the industry statistics specific enough to the client or the particular segment or division of the client being examined? 4. Has the nonfinancial information been audited? Have the controls over the production of the nonfinancial information been tested?

Audit risk

The probability that an auditor will give an inappropriate opinion on financial statements

Detection risk

The probability that audit procedures will fail to produce evidence of material misstatements.

Inherent risk

The probability that material misstatements have occurred in transactions entering the accounting system.

Control risk

The probability that the client's internal control policies and procedures will fail to detect material misstatements if they have entered the accounting system

While performing interim audit procedures of accounts receivable, numerous unexpected errors are found resulting in a change of risk assessment. Which of the following audit responses would be most appropriate?

Use more experienced audit team members to perform year-end testing.

Analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data. They range from simple comparisons to the use of complex models involving many relationships and elements of data. They involve comparisons of recorded amounts, or ratios developed from recorded amounts, to expectations developed by auditors. Required: a. Describe the broad purposes of analytical procedures. b. Identify the sources of information from which an auditor develops expectations

a. Analytical procedures are used for these broad purposes: 1. To assist the auditor in planning the nature, timing, and extent of other audit procedures. 2. As a substantive test to obtain evidential matter about particular assertions related to account balances or classes of transactions. 3. As an overall review of the financial information in the final review stage of the audit. b. An auditor's expectations are developed from the following sources of information: 1. Financial information for comparable prior periods considering known changes. 2. Anticipated results for example, budgets, forecasts, and extrapolations. 3. Relationships among elements of financial information within the period. 4. Information regarding the industry in which the client operates. 5. Relationships of financial information with relevant nonfinancial information.

This question tests your ability to perceive the place(s) where various potential problems may exist and the type of problem (overstatement or understatement) that may exist. It asks that you supply the words or descriptions that complete the analysis begun by applying analytical procedures. Required: For each of the items below, identify the account(s) that need(s) to be audited carefully and the reason (i.e., potential overstatement or understatement of _______). a. If the current year accounts receivable are larger than last year but the allowance for doubtful accounts is the same. b. If the current year inventory is larger than last year and the current year gross margin (profit) is larger. c. If current year long-term liabilities are larger than last year and the interest expense is the same. d. If current year fixed assets are larger and current depreciation expense is the same as last year.

a. The collectability of accounts receivable is of concern. The allowance for doubtful accounts may be understated. The bad debt expense may be understated. b. The existence of the inventory account is of concern. Inventory may be overstated. Cost of goods sold may be understated. c. The amount of accrued interest is of concern. Interest expense may be understated. Less likely, long-term liabilities could be overstated. d. Depreciation expense and accumulated depreciation may be understated. It may also be possible that fixed assets are overstated.

An auditor assesses the risk of material misstatement because it:

affects the level of detection risk that the auditor may accept

An auditor's analytical procedures indicate a lower than expected return on an equity method investment. This situation most likely could have been caused by:

an error in recording amortization of the excess of the investor's cost over the investment's underlying book value.

The acceptable level of detection risk is inversely related to the:

assurance provided by substantive tests.

Horizontal analysis refers to:

changes of financial statement numbers and ratios across several years

Based on audit evidence gathered and evaluated, an auditor decides to increase the assessed level of control risk from that originally planned. To achieve an overall audit risk level that is substantially the same as the planned audit risk level, the auditor would:

decrease detection risk

According to auditing standards, external auditors' responsibilities for indirect noncompliance do not include:

designing audit procedures to detect noncompliance in the absence of specific information brought to the auditors' attention

The risk that an auditor's procedures will lead to the conclusion that a material misstatement does not exist in an account balance when, in fact, such misstatement actually exists is:

detection risk.

An audit team uses the assessed risk of material misstatement to:

determine the acceptable level of detection risk for financial statement assertions.

When an auditor becomes aware of possible noncompliance by a client, the auditor should obtain an understanding of the nature of the act to:

evaluate the effect on the financial statements.

The risk of material misstatement differs from detection risk in that it:

exists independently of the financial statement audit.

Inherent risk and control risk differ from detection risk in that inherent risk and control risk are:

functions of the client and its environment whereas detection risk is not

Analytical procedures are audit methods of evaluating financial statement accounts by studying and comparing relationships among financial and nonfinancial data. The primary purpose of analytical procedures conducted during the planning stages is to:

identify unusual conditions that deserve additional audit effort.

Managing business risk is the responsibility of:

management.

Experience has shown that the many large fraudulent transactions can be found in:

non-routine, nonsystematic journal entries.

Assume that application of analytical procedures revealed significant unexplained differences between recorded amounts and the expectations (estimates) developed by the auditor. If management is unable to provide an acceptable explanation, the auditor should:

perform additional audit procedures to investigate the matter further.

Inherent risk is the:

probability that material misstatements have occurred in transactions entering the accounting system used to develop financial statements.

An auditor who discovers that client employees have committed an illegal act that has a material effect on the client's financial statements most likely would withdraw from the engagement if:

the client does not take the remedial action that the auditor considers necessary.

Auditors use brainstorming:

to heighten the audit team's awareness of fraud potential.

The purpose of an audit strategy is:

to set the scope, timing, and direction for auditing each relevant assertion.

The type of financial analysis that expresses balance sheet accounts as percentages of total assets is known as:

vertical analysis.

When fraud risk is significant, and management cooperation is unsatisfactory, the auditors will most likely:

withdraw from the engagement.

If tests of controls induce the auditor to change the assessed level of control risk for Property Plant & Equipment from 50% to 100%, and audit risk (6%) and inherent risk remain constant, the acceptable level of detection risk:

would most likely change from 30% to 15%.