3.6 Flashcards
During an audit, an auditor discovers a fraudulent expense reimbursement for a low-level manager. The auditor determines that this transaction is inconsequential and several similar transactions would not be material to the financial statements in the aggregate. Which of the following statements best describes the auditor’s required response to the discovery?
The auditor should bring the transaction to the attention of an appropriate level of management.
Inconsequential fraud should be communicated to the appropriate level of management.
In a financial statement audit, inherent risk is evaluated to help an auditor assess which of the following?
The susceptibility of a financial statement assertion to a material misstatement before consideration of related controls.
Control risk and inherent risk are the components of the risk of material misstatement (RMM). The auditor determines the appropriate level of detection risk based on the assessment of RMMs and the acceptable level of audit risk. Inherent risk is the susceptibility of an assertion about a transaction class, account balance, or disclosure that could be material, individually or combined with other misstatements, before consideration of any related controls.
Which of the following characteristics most likely would heighten an auditor’s concern about the risk of material misstatements arising from fraudulent financial reporting?
The entity’s industry is experiencing declining customer demand.
Certain risk factors are related to misstatements arising from fraudulent reporting. These factors may be grouped in three categories: (1) incentives or pressures, (2) opportunities, and (3) attitudes or rationalizations. One set of risk factors in the incentives or pressures category consists of threats to financial stability or profitability by economic, industry, or entity operating conditions. Examples are significant declines in customer demand and increasing business failures in either the industry or the overall economy (AU-C 240).
An auditor’s document includes the following statement:
“Our audit is subject to the risk that errors, fraud, or illegal acts, if they exist, will not be detected. However, we will inform you of any such matters that come to our attention.”
The above passage is most likely from
An engagement letter.
The primary purpose of an engagement letter is to document in written form the agreement with the client about the services to be provided by the auditor. It sets forth the rights and responsibilities of the parties and the objective and scope of the audit (AU-C 210).
The element of the audit-planning process most likely to be agreed upon with the client before implementation of the audit strategy is the determination of the
Timing of inventory observation procedures to be performed.
The client is responsible for taking the physical inventory. The auditor is responsible for observing this process and performing test counts. The audit procedures are dependent upon management’s plans. Thus, the auditor must coordinate the collection of this evidence with management.
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.
Analytical procedures are evaluations of financial information made by a study of plausible relationships among financial and nonfinancial data. However, statistical sampling applies an audit procedure to a portion of the items under audit for the purpose of drawing a conclusion about a characteristic of a balance or transaction class. It is applicable to tests of controls and substantive testing. It is not an analytical procedure.
Auditing standards require that sufficient appropriate evidence be obtained by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements under audit. The substantive evidence required may be obtained, in part, through
Analytical procedures.
Analytical procedures are evaluations of financial information made by a study and comparison of the relationships among data. The premise is that certain relationships prevail in the absence of known conditions to the contrary. Analytical procedures may be, but are not required to be, used as substantive procedures (along with tests of details) to provide sufficient appropriate evidence about specific financial statement assertions related to account balances or classes of transactions.
Upon discovering fraudulent data in a client’s tax return that the client would not correct, a CPA withdraws from the engagement. How should the CPA respond if asked by the successor CPA why the relationship was terminated?
“I suggest you get the client’s permission for us to discuss all matters freely.”
The predecessor CPA should inform the successor CPA that (s)he must obtain the client’s permission before they may discuss the reasons for termination of the previous relationship.
An auditor is planning an audit engagement for a new client in a business that is unfamiliar to the auditor. Which of the following would be the least useful source of information for the auditor during the preliminary planning stage, when the auditor is trying to obtain a general understanding of audit problems that might be encountered?
Results of performing substantive procedures.
Substantive procedures are performed to detect material misstatements at the relevant assertion level. They include tests of details and substantive analytical procedures. They are performed after the auditor has obtained an understanding of the entity and its environment, including its internal control.
Which of the following statements concerning noncompliance with laws and regulations by clients is correct?
An auditor has responsibility to detect noncompliance with laws and regulations that has a direct effect on the financial statements.
According to AU-C 250, the auditor should obtain sufficient appropriate audit evidence regarding material amounts and disclosures in the financial statements that are determined by the provisions of those laws and regulations generally recognized to have a direct effect on their determination.
Inherent risk and control risk differ from detection risk in that they
Exist independently of the financial statement audit.
Inherent risk is the susceptibility of a relevant assertion to a material misstatement before considering related controls. Control risk is the risk that internal control will not timely prevent, or detect and correct, a material misstatement of a relevant assertion that could occur. Inherent risk and control risk are the entity’s risks. They exist independently of the audit and cannot be changed by the auditor. GAAS ordinarily do not refer to inherent risk and control risk separately but instead to a combined assessment of the risks of material misstatement. This assessment may change as more evidence is collected, but the entity’s risks do not. Detection risk is the risk that the auditor’s procedures performed to reduce audit risk to an acceptably low level will not detect a material misstatement that exists in a relevant assertion. It can be changed at the auditor’s discretion by altering the nature, timing, or extent of the audit procedures.
Fact Pattern:
During the annual audit of BCD Corp., an issuer, Smith, CPA, a continuing auditor, determined that illegal political contributions had been made during each of the past 7 years, including the year under audit. Smith notified the directors of BCD Corp. of the illegal contributions, but they refused to take any action because the amounts involved were immaterial to the financial statements.
Smith should reconsider the intended degree of reliability of the
Management representation letter.
The auditor should consider the implications of an illegal act in relation to the other representations of management. If management cannot be trusted in this matter, serious doubts arise about the other representations. The auditor must also consider the possible effects of continuing association with the client (AU-C 250).
Which of the following is a false statement about materiality?
An auditor considers materiality for planning purposes in terms of the largest aggregate level of misstatements that could be material to any one of the financial statements.
Materiality is defined for planning purposes at three levels. Materiality for the financial statements as a whole is determined when designing the overall audit strategy. Materiality is also set for specific account balances, transaction classes, or disclosures. In certain cases, these amounts could influence users. Performance materiality is less than that for the statements as a whole or for specific balances, etc. Performance materiality is an adjustment for (1) individually immaterial misstatements and (2) possible uncorrected misstatements. But materiality for planning purposes ordinarily is not set for one financial statement. When designing audit procedures to be applied at the balance, transaction class, or disclosure level, the auditor plans to obtain reasonable assurance of detecting misstatements that, when aggregated with misstatements in other balances, etc., could be material to the statements as a whole.
In a financial statement audit, substantial consideration must be given to potential fraud. The conditions for fraud ordinarily include
The ability to rationalize commission of fraud.
The three conditions that are normally present when fraud occurs are (1) incentives or pressures that give managers or employees a motive to commit fraud; (2) opportunity, such as ineffective controls or the ability to override controls; and (3) an ability to rationalize the commission of fraud, for example, because the individual has an attitude, character, or set of values permitting intentional misconduct. However, not all conditions need to exist or be observed. In particular, an auditor may not be able to observe that the third condition is present.
Which of the following ratios would be the least useful in reviewing the overall profitability of a manufacturing company?
Net income to working capital.
The ratio of net income to working capital is not typically considered in evaluating overall profitability. It does not give a broad measure of how effectively the firm is managed because it does not consider noncurrent assets and liabilities.
