3.1.2

Question 1

Misstatements discovered by the auditor were immaterial in the aggregate in prior years. Such misstatements should be

Answer 1

Considered in the evaluation of audit findings in the current year.

The cumulative effect of immaterial uncorrected misstatements related to prior periods may have a material effect on the current period’s financial statements.

Question 2

Which of the following matters does an auditor usually communicate to management?

Answer 2

Arrangements involving a predecessor auditor.

It is necessary to obtain management’s approval before contacting a predecessor auditor.

Question 3

If the predecessor auditor refuses to give the current auditor of a nonissuer access to the documentation, what should the current auditor do?

Answer 3

Review the risk assessment of the opening balances of the financial statements.

When the prior period statements were audited by a predecessor auditor, the auditor should request management to authorize the predecessor to (1) allow a review of audit documentation and (2) respond fully to inquiries by the auditor. Thus, the auditor is provided with information to assist in planning and performing the engagement. The predecessor ordinarily permits the auditor to review audit documentation, including documentation of (1) planning, (2) risk assessment procedures, (3) further audit procedures, (4) audit results, and (5) other matters of continuing accounting and auditing significance. But the predecessor’s denial or limitation of access may affect (1) the auditor’s assessment of risk regarding the opening balances or (2) the nature, timing, and extent of the auditor’s procedures with respect to the opening balances and consistency of accounting principles.

Question 4

Which of the following circumstances most likely will cause an auditor to consider whether material misstatements due to fraud exist in an entity’s financial statements?

Answer 4

Transactions selected for testing are not supported by proper documentation.

Fraud risk factors relate to misstatements arising from (1) fraudulent financial reporting and (2) misappropriation of assets. Each of these categories may be further classified according to the three conditions that ordinarily exist when fraud occurs: (1) incentives/pressures, (2) opportunities, and (3) attitudes/rationalizations. For example, an opportunity for misappropriation of assets may arise because of inadequate control over assets. This fraud risk factor is reflected by a lack of timely and appropriate documentation of transactions, such as credit memos for returns of goods.

Question 5

When an auditor obtains an understanding of the entity and its environment, including its internal control, which of the following is the most likely order of performing the steps A through C below?

A = Tests of controls
B = Preparation of a flowchart documenting the understanding of the client’s internal control 
C = Substantive procedures

Answer 5

BAC

The auditor obtains an understanding of internal control. This understanding may include flowcharting the system. Next, the auditor must assess the risks of material misstatement, whether due to fraud or error. In response to this assessment, the auditor performs further audit procedures. These procedures ordinarily include tests of controls to evaluate their operating effectiveness when (1) the auditor intends to rely on the controls to determine substantive procedures or (2) substantive procedures alone are insufficient.

Question 6

Before accepting an audit engagement, an auditor should make specific inquiries of the predecessor auditor regarding the predecessor’s

Answer 6

Understanding as to the reasons for the change of auditors.

According to AU-C 210, the auditor should make specific and reasonable inquiries of the predecessor auditor regarding issues bearing upon acceptance of the engagement. The inquiries should include specific questions regarding, among other things, the predecessor’s understanding as to the reasons for the change of auditors.

Question 7

An auditor is required to obtain an understanding of the entity’s business, including business cycles and reasons for business fluctuations. What is the audit purpose most directly served by obtaining this understanding?

Answer 7

To assist the auditor to accurately interpret information obtained during an audit.

The auditor performs risk assessment procedures to obtain an understanding of the entity and its environment, including its internal control, to assess the risks of material misstatement. The understanding addresses, for example, (1) the nature of the entity; (2) transactions, balances, and disclosures; (3) objectives, strategies, and business risks; (4) accounting practices; and (5) financial performance. This understanding is necessary for the auditor to interpret the audit evidence obtained and to determine its sufficiency and appropriateness.

Question 8

Which of the following is an analytical procedure that an auditor most likely uses to form an overall conclusion?

Answer 8

Reading the financial statements and considering whether there are any unusual or unexpected balances that were not previously identified.

Analytical procedures used to form an overall conclusion should ordinarily include reading the financial statements and considering (1) the adequacy of evidence gathered in response to unusual or unexpected balances identified in planning or conducting the audit, and (2) unusual or unexpected balances or relationships not previously detected.

Question 9

Which of the following is an example of an inherent risk that an auditor should consider?

Answer 9

Technological developments that may render inventory obsolete.

Inherent risk is the susceptibility of a financial statement assertion to a material misstatement before consideration of any related controls. Inherent risk is higher for some assertions and related transactions, balances, and disclosures. For example, it may be higher for complex calculations or amounts with significant estimation uncertainty. Business risks also may affect inherent risk. For example, technological developments might make a product obsolete, causing inventory to be overstated.

Question 10

In general, fraudulent financial reporting perpetrated by which of the following are most difficult to detect?

Answer 10

Controller.

Regarding detection of fraudulent data, the level of involvement often influences the auditor’s ability to detect. Thus, fraud may be perpetrated by a level of management that is above specific controls or that can override the controls with relative ease. Because the controller is the chief accounting officer, (s)he is especially well placed to manipulate records to conceal wrongdoing.

Question 11

Which of the following situations most likely represents the highest risk of a misstatement arising from misappropriations of assets?

Answer 11

A large number of bearer bonds on hand.

Large purchases of bank checks or bonds payable to bearer are often an indication of illegal or suspicious activity. Bearer instruments are negotiable by delivery alone, that is, without a signature. They are equivalent to cash. Thus, the holder has anonymity. They can be used to evade taxes or conceal business transactions.

Question 12

Which of the following statements about analytical procedures is true?

Answer 12

Analytical procedures alone may provide the appropriate level of assurance for some assertions.

For some assertions, analytical procedures alone may suffice to reduce audit risk to an acceptably low level. For example, the auditor’s risk assessment may be supported by audit evidence from tests of controls. Substantive analytical procedures generally are more applicable to large transaction volumes that are predictable over time (AU-C 330). The decision is based on the auditor’s professional judgment about the expected effectiveness and efficiency of the available procedures.

Question 13

Which of the following procedures would an auditor most likely perform in planning a financial statement audit?

Answer 13

Performing analytical procedures to identify areas that may represent specific risks.

Analytical procedures are applied as risk assessment procedures to obtain an understanding of the entity and its environment, including its internal control. They also may identify unusual transactions and events, and amounts, ratios, and trends with financial statement and audit planning implications.

Question 14

An auditor compares annual revenues and expenses with similar amounts from the prior year and investigates all changes exceeding 10%. This procedure most likely could indicate that

Answer 14

Unrealized gains from increases in the value of available-for-sale securities were recorded in the income account for trading securities.

Unrealized gains from increases in the value of available-for-sale securities should be recorded directly in other comprehensive income (a component of equity). Unrealized gains from increases in the value of trading securities should be included in income. Thus, a more-than-10% increase in income could have been caused by improper accounting for available-for-sale securities.

Question 15

Madison Corporation has a few large accounts receivable that total $1,000,000. Nassau Corporation has a great number of small accounts receivable that also total $1,000,000. The importance of a misstatement in any one account is therefore greater for Madison than for Nassau. This is an example of the auditor’s concept of

Answer 15

Materiality.

The concept of materiality requires the auditor to evaluate the relative importance of items to users of financial statements. In an entity with few but large accounts receivable, the individual accounts are relatively more important and the possibility of material misstatement is greater than in an entity with many small accounts.

Question 16

Analytical procedures are required for which of the following?

Answer 16

Audit planning.

An audit plan based on the audit strategy must be developed and documented for all audit engagements. It includes the nature, timing, and extent of procedures expected to reduce audit risk to an acceptably low level. Thus, the audit plan includes a description of risk assessment procedures. Risk assessment procedures are performed to obtain an understanding of the entity and its environment, including its internal control, to identify and assess the risks of material misstatement (RMMs) at the levels of (1) the financial statements as a whole and (2) relevant assertions. Risk assessment procedures include (1) inquiries of management and others within the entity, (2) analytical procedures, and (3) observation and inspection. The auditor also may perform other appropriate procedures, such as inquiring of external parties (e.g., legal counsel) or reviewing externally generated information (e.g., financial publications). Analytical procedures may be applied not only as risk assessment procedures (analytical procedures used to plan the audit) but also as substantive procedures. These are procedures (tests of details and analytical procedures) designed to detect material misstatements at the assertion level.

Question 17

An auditor of a manufacturer would most likely question whether a client has complied with laws or regulations if the client has

Answer 17

Failed to file a tax return.

Some examples of information raising questions about possible noncompliance are unauthorized or improperly recorded transactions, a governmental investigation, violations reported by regulators, large payments for unspecified services to consultants, excessive commissions or fees, unusual cash payments, unexplained payments to government officials or employees, and failure to file tax returns or pay governmental duties or similar fees.

Question 18

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

Answer 18

Inherent risk and control risk exist independently of the audit.

Audit risk consists of the risks of material misstatement (inherent risk combined with control risk) and detection risk. The RMMs are the entity’s risks, and detection risk is the auditor’s risk. Detection risk is the risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a material misstatement. It is a function of the effectiveness of an audit procedure and its application by the auditor. Detection risk is the only component of audit risk that can be changed at the auditor’s discretion. (Inherent risk and control risk exist independently of the audit and cannot be changed by the auditor.)

Question 19

When an auditor increases the assessed risks of material misstatement because certain control activities were determined to be ineffective, the auditor most likely would increase the

Answer 19

Extent of tests of details.

For a given audit risk, the acceptable detection risk is inversely related to the assessed risks of material misstatement. As the RMMs increase, the acceptable detection risk decreases, and the auditor requires more persuasive audit evidence. The auditor may (1) change the types of audit procedures and their combination, e.g., confirming the terms of a contract as well as inspecting it; (2) change the timing of substantive procedures, such as from an interim date to year end; or (3) change the extent of testing, such as by using a larger sample (AU-C 330 and AS 2301).

Question 20

Which of the following factors most likely would cause a CPA to decide not to accept a new audit engagement?

Answer 20

Management’s disregard of its responsibility to maintain an adequate internal control environment.

The control environment is the foundation for all other control components. It provides discipline and structure, sets the tone of the organization, and influences the control consciousness of employees. A precondition of an audit is management’s acknowledgment of its responsibilities for internal control relevant to financial reporting. Internal control should enable the preparation and fair presentation of financial statements that are free from material misstatement due to fraud or error. However, management’s disregard of this responsibility may raise doubts about the auditability of the financial statements and the integrity of management.

Question 21

Which of the following procedures would an auditor most likely include in the initial planning of a financial statement audit?

Answer 21

Determining the extent of involvement of the client’s internal auditors.

AU-C 610, The Auditor’s Consideration of the Internal Audit Function in an Audit of Financial Statements, states that the independent auditor should obtain an understanding of the internal audit function when obtaining an understanding of a client’s internal control. The understanding should be sufficient to identify internal audit activities relevant to audit planning. Thus, an internal audit function is one of many factors to be considered in determining the nature, timing, and extent of audit procedures.

Question 22

It would not be appropriate for the auditor to initiate discussion with the audit committee concerning

Answer 22

Details of the procedures that the auditor intends to apply.

The auditor should communicate an overview of the scope and timing of the audit to those charged with governance. But the auditor should not communicate the nature and timing of detailed audit procedures. The auditor exercises professional judgment in determining the appropriate procedures. To remain independent, (s)he must not subordinate this judgment to others. Also, audit testing is done on a sample basis, and management should not have knowledge of how samples are selected. With such knowledge, the audit process may be circumvented.