Chapter 3 Questions

If the risk of material misstatement is low, auditors should use the

reliance on controls approach

If control risk is set at high and auditors choose not to test controls, auditors will

use the substantive audit strategy.

If audit risk is set at 1.6%, inherent risk is 80%, and control risk is 80%, what should auditors set for detection risk? And, what is the best audit strategy?

2.5% and substantive approach

If detection risk is set at 5%, inherent risk is 80%, and control risk is 70%, what should be the audit risk set by auditors?

2.8%

Which of the following alternatives best synthesizes the purpose of developing an audit strategy?

Audit strategy is the process by which auditors determine the most appropriate scope, direction, and timing of audit engagement. An audit strategy also helps to develop an audit plan for the success of audit engagement, as well as set the right audit approach.

With regard to setting materiality, which of the following alternatives is best?

Auditors select an appropriate benchmark using their professional judgment and based upon their knowledge of the client, the client's industry, and the needs of financial statement users for their decision making. Moreover, auditors rely heavily on their professional judgment to determine an appropriate percentage of the selected benchmark.

Which statement below exemplifies the relationship between independence of an auditor and the proper way to act in the fraud risk assessment process?

Auditors should adopt an attitude of professional skepticism to ensure any indicator of a potential fraud is properly investigated. This means auditors must remain independent of the client, maintain a questioning attitude, and search thoroughly for corroborating evidence to validate information provided by the client.

Given the following information about a not-for-profit organization's financial situation, what is the range for the most appropriate quantitative assessment of planning materiality for 2022? Total Assets 2022 $1.70B Pre-tax income 2022 $31 B A $4.25M-$34M B $0.0775M-$0.62M C $1.55M-$3.1M D $85M-170M

For a not-for-profit organization, total assets or total revenue are generally used as a benchmark. As we don't have information regarding total revenue, we should look at the total assets. The typical range for total assets is between 0.25% and 2%. This translates into 0.0025 X $1.70B to 0.02 X $1.70B or $4.25M to $34M.

Which of the following is correct with regard to incentives to commit and perpetrate fraud? I. Poor corporate governance mechanisms provide an opportunity to perpetrate a fraud. II. A poor system of internal control is an incentive and pressure to commit a fraud. III. Poor cash flows combined with high earnings is an opportunity to perpetrate a fraud. IV. A threat of bankruptcy is an incentive and pressure to commit a fraud.

I and IV

If the auditor determines that inherent risk and control risk are low, the best audit strategy to use is the

reliance on controls approach

Toshiba Corporation is a publicly traded Japanese company headquartered in Tokyo that makes consumer electronics, household electronics, office equipment, and more. In July 2015, the CEO of Toshiba announced he was resigning amid an accounting scandal in which profits had been overstated for the past seven years by approximately $1.9 billion. The technology industry is extremely competitive, and Toshiba's upper management set aggressive profit targets. The home electronics and appliances division was showing losses and the memory chip division was feeling pressure because of decreasing demand from Chinese electronics companies. Overall, there was a lack of internal controls in upper management and an unethical corporate culture led by upper management. Controls that did exist were overridden by upper management's pressure to show profits. Which statement below is an example of opportunities, incentives or pressures to commit fraud that Toshiba faced? A : An unethical corporate culture led by upper management is an example of incentives to commit a fraud. B : Lack of internal controls is an example of opportunity to perpetrate a fraud. C : Lack of internal controls is an example of rationalization to justify a fraud. D : The technology industry being extremely competitive is an example of opportunity to perpetrate a fraud.

Lack of internal controls is an example of opportunity to perpetrate a fraud.

If audit risk is set at low, inherent risk is high, and control risk is high, what should auditors set for detection risk?

Low

If audit risk is set at low, inherent risk is medium, and control risk is high, what should auditors set for detection risk?

Low

If audit risk is set at low, inherent risk is high, and control risk is low, what should auditors set for detection risk?

Medium

Which of the following best summarizes the concepts of Fraudulent Financial Reporting and Misappropriation of Assets with the respective example? Misappropriation of Assets is an intentional theft of a company's assets by employees. Employees remaining on the payroll after ceasing employment is an example of Misappropriation of Assets. Fraudulent Financial Reporting is an intentional theft of a company's assets by employees. Recording fictitious sales is an example of Fraudulent Financial Reporting. Misappropriation of Assets is intentionally misstating items or omitting important facts from financial statements. Unauthorized discounts or refunds to customers is an example of Misappropriation of Assets. Fraudulent Financial Reporting is intentionally misstating items or omitting important facts from financial statements. Writing checks to fictitious vendors is an example of Fraudulent Financial Reporting.

Misappropriation of Assets is an intentional theft of a company's assets by employees. Employees remaining on the payroll after ceasing employment is an example of Misappropriation of Assets.

When pretax income is either negative or fluctuating drastically from year to year, auditors should use total revenues or total assets as a base for calculating

Quantitative planning materiality

A client sells concrete pipe and has a high-voltage fence surrounding the pipe inventory. Inherent risk is low for the assertion of inventory existence because concrete pipe is very heavy and difficult to move. It is unlikely that recorded pipe quantities do not exist. After testing that the security system is working and has been operational throughout the year, the auditor can set control risk low. What is the best alternative for the auditor if one wants to keep audit risk low?

The auditor will set a high detection risk and spend less time performing audit procedures

A client sells high-end fashion clothing and has inadequate security. Inherent risk is high for the assertion of inventory existence because expensive clothing inventory may be stolen. Control risk is high because there is inadequate security, which increases the risk of theft. The auditor cannot rely on the client's security system to reduce the risk of material misstatement associated with the existence of inventory. What is the best alternative for the auditor to keep audit risk low?

The auditor will set a low detection risk and spend more time performing audit procedures.

Which of the following is the best synthesis of the fraud risk assessment process? A The primary procedure auditors use in the fraud risk assessment process is brainstorming, wherein they discuss the susceptibility of the client's financial statements to a material fraud. The discussion includes topics related to gaining an understanding of the entity and its environment because these topics are also related to risk of fraud. For example, discussions about changes in the client's industry or changes in the client's internal controls lead to ideas about why management would have an incentive or opportunity to commit fraud. B It is the responsibility of auditors to assess the risk of fraud and the effectiveness of the client's attempts to prevent and detect fraud via its internal control systems. When assessing the risk of fraud, auditors consider the fraud risk factors: incentives and pressures to commit a fraud such as a threat of bankruptcy; opportunities to perpetrate a fraud such as rapid growth; and, rationalization to justify a fraud such as a poor system of internal controls. C The primary procedure auditors use in the fraud risk assessment process is brainstorming, wherein they discuss the susceptibility of the client's financial statements to a material fraud. The discussion includes topics related to gaining an understanding of the entity because that topic is also related to risk of fraud. For example, discussions about changes in the client's industry lead to ideas about the rationalization to justify a fraud. D The primary procedure auditors use in the fraud risk assessment process is brainstorming, wherein they discuss the susceptibility of the client's financial statements to a material fraud. Auditors must maintain an attitude of professional skepticism. Therefore, the external auditor should not trust the client's internal audit function and should avoid inquiring of internal auditors about fraud risk.

The primary procedure auditors use in the fraud risk assessment process is brainstorming, wherein they discuss the susceptibility of the client's financial statements to a material fraud. The discussion includes topics related to gaining an understanding of the entity and its environment because these topics are also related to risk of fraud. For example, discussions about changes in the client's industry or changes in the client's internal controls lead to ideas about why management would have an incentive or opportunity to commit fraud.

Toshiba Corporation is a publicly traded Japanese company headquartered in Tokyo that makes consumer electronics, household electronics, office equipment, and more. In July 2015, the CEO of Toshiba announced he was resigning amid an accounting scandal in which profits had been overstated for the past seven years by approximately $1.9 billion. The technology industry is extremely competitive, and Toshiba's upper management set aggressive profit targets. The home electronics and appliances division was showing losses and the memory chip division was feeling pressure because of decreasing demand from Chinese electronics companies. Overall, there was a lack of internal controls in upper management and an unethical corporate culture led by upper management. Controls that did exist were overridden by upper management's pressure to show profits. Compounding the problem was the Japanese culture of obedience, which discourages subordinates from questioning orders from upper management. One of the areas that was heavily manipulated was estimates involving long-term projects. Estimation techniques relied heavily on internal data, and internal controls over the estimation process were easily overridden by upper management. Based on the information above, which statement below is an example of opportunities, incentives, or pressures to commit fraud that Toshiba faced?

The scenario identifies the incentives to commit a fraud, opportunities to perpetrate it, and rationalization to justify it. The examples are respectively: the technology industry being extremely competitive; lack of internal controls in upper management; and an unethical corporate culture led by upper management.

The planning materiality threshold for company A is $300 million and auditors decided that one-third of that amount, $100 million, is an appropriate performance materiality threshold at the account level to determine if individual accounts or transactions are materially misstated. Generally, auditors would spend minimal time performing detailed audit testing on all accounts EXCEPT Property, Plant and Equipment- $50M. Intangible Assets - $40M. Valuation Allowance - $50M. Other Investments - $45M.

Valuation Allowance is the only account in the financial statements that is part of a bigger account, accounts receivable, so the valuation allowance will be audited in conjunction with accounts receivable if necessary.

Auditors will use larger sample sizes when inherent risk is high. detection risk is high. detection risk is low. inherent risk is low.

detection risk is low

The use of performance materiality indicators should _____ the probability that the sum of immaterial and/or undetected misstatements in the financial statements is _____ than materiality for the financial statements as a whole.

decrease; greater