A3 - Risk, Evidence, and Sampling

Question 1

Two types of fraud risk:

Answer 1

fraudulent financial reporting and misappropriation of assets

Question 2

fraudulent financial reporting?

Answer 2

intentional misstatements or omission of amounts and disclosures in the FS with the intent to deceive the user

Question 3

misappropriation of assets?

Answer 3

theft of an entity’s assets

Question 4

Three fraud risk factors:

Answer 4

1. incentive/pressures exist when there is a reason to commit fraud
2. opportunity to commit fraud exists due to lack of effective controls
3. Rationalization/attitude associated with attempting to justify fraudulent behavior

Question 5

Management’s responsibility with respect to fraud:

Answer 5

to design and implement programs and controls to prevent, detect, and deter fraud

Question 6

Auditor’s responsibility with respect to fraud:

Answer 6

to obtain reasonable assurance about whether the FS are free from material misstatement

Question 7

(T/F) When there is an indication of fraud, the auditor should communicate this with the appropriate level of management at least one level above the parties involved.

Answer 7

T

Question 8

(T/F) Fraud that causes material misstatement or involves senior management should be reported to the audit committee/those charged with governance

Answer 8

T

Question 9

(T/F) Complete documentation of the auditor’s fraud risk assessment and response is required

Answer 9

T

Question 10

Audit risk?

Answer 10

risk that the FS are materially misstated (RMM), but the opinion is not appropriately modified (DR)

Question 11

Misstatements can occur due to:

Answer 11

unintentional errors or intentional fraud

Question 12

Three types of misstatements:

Answer 12

1. factual misstatements
2. judgmental misstatements
3. projected misstatements

Question 13

The risk of material misstatement (RMM) is composed of two risks that must be assessed by the auditor:

Answer 13

Inherent risk (IR) and control risk (CR)

Question 14

Inherent risk (IR)

Answer 14

susceptibility of a relevant assertion to a material misstatement, assuming no related controls

inherent risk is high if the account is more likely to contain a material misstatement

High inherent risk examples:

• high volume transactions
• amounts derived from estimates
• cash
• technology that renders a product obsolete
• a lack of working capital
• a decline in the overall industry or economy

Question 15

control risk (CR)

Answer 15

risk that a material misstatement that could occur in a relevant assertion will not be prevented or detected and corrected on a timely basis by the entity’s internal control

control risk is high if:

• there are no effective controls relative to the specific assertion
• the implemented controls are not operating effectively
• it would not be efficient to test the operating effectiveness of controls

Question 16

detention risk (DR)

Answer 16

risk that the auditor does not detect a material misstatement that exists in a relevant assertion. This is the only element that the auditor can control by varying the nature, extent, or timing of audit procedures

Question 17

Audit risk model formula?

Answer 17

AR = RMM (IR X CR) X DR

Audit risk - should be low

Risk of material misstatement - is assessed by auditor

Detention risk - controlled by auditor

Question 18

(T/F) The components of audit risk may be assessed either quantitatively (as a percentage) or nonquantitatively (high, medium, low)

Answer 18

T

Question 19

(T/F) When the auditor determines that the RMM is high, DR should be set at a low level.

Answer 19

T

less work = accept more risks
more work = accept less risks

Question 20

The auditor uses the understanding of the entity to identify an assess the RMM:

Answer 20

1. at the FS level
2. at the assertions level
3. to identify any significant risks

Question 21

Two audit responses for identified risks at assertion level:

Answer 21

1. substantive approach - only substantive procedures (account testing), no control testing unless extensive use of technology
2. combined approach - tests of controls are performed with the hope of reducing substantive testing. Substantive tests are always required for each material transaction class, account balance, or disclosure item. (dual purpose tests can be used to test controls concurrently with tests of details)

Question 22

Two types of substantive procedures:

Answer 22

1. tests of details

2. substantive analytical procedures

Question 23

Liquidity ratios: (see comprehensive example on A3M7 for practice)

Answer 23

short-term ability to pay

1. current ratio = current assets/ current liabilities
2. quick ratio = cash and cash equivalents + short-term marketable securities + receivables/current liabilities

Question 24

Activity ratios: (see comprehensive example on A3M7 for practice)

Answer 24

how effectively enterprises are using its assets

1. AR turnover = sales/ average AR
2. Days sales in AR - ending AR/sales
3. Inventory turnover = COGS/ avg. inventory
4. days in inventory = ending inventory/ COGS/365
5. AP turnover = COGS/ Avg. AP
6. Days of payables outstanding = ending AP/COGS/365
7. Cash conversion cycle = days sales in AR + Days in inventory - days of payables outstanding
8. Asset turnover = sales/avg. total assets

Question 25

Profitability ratios: (see comprehensive example on A3M7 for practice)

Answer 25

financial performance

1. profit margin = NI/Sales
2. return on assets = NI/Avg. total assets
3. return on sales = income before interest income, interest expense, and taxes/ sales
4. return on equity = NI/ avg. total euity
5. gross profit margin = sales - COGS/sales
6. Operating cash flow ratio = CF from operations/Ending current liabilities

Question 26

Investor ratios : (see comprehensive example on A3M7 for practice)

Answer 26

interest to investors

1. Basic EPS = Income available to common shareholders/weighted avg. common shares outstanding
2. Price earnings ratio = price per share/ basic EPS
3. Dividend payout = Cash dividends/ NI

Question 27

LT debt-paying ability ratios (coverage ratios) : (see comprehensive example on A3M7 for practice)

Answer 27

solvency long term

1. debt to equity = total liabilities/ total equity
2. total debt ratio = total liabilities/ total assets
3. equity multiplier = total assets/ total equity
4. times interest earned = income before interest expense and taxes/ interest expense

Question 28

4 rules of sampling:

Answer 28

1. always assume that the population being sampled is normally distributed, that is, it can be described by a normal or bell-shaped curve
2. For random selections: every item must have equal chance of being selected and the CPA does not use judgment
3. If the sample is large enough, then the sample will likely have the same statistical characteristics (mean and standard deviation) as the underlying population
4. Standard deviation is a measure of variability, which refers to the range of values within the population

Question 29

(T/F) Statistical sampling eliminates the need for auditing judgment.

Answer 29

F

Question 30

Two primary mistakes the auditor can make in sampling:

Answer 30

1. fail to identify an existing problem (incorrect acceptance and assessing control too low)
2. falsely indetify a problem where none actually exists (incorrect rejection or assessing control risk too high)

Question 31

relationship between allowance for sampling risk and upper deviation rate:

Answer 31

allowance for sampling risk + sample deviation rate = upper deviation rate

Question 32

(T/F) Due to the concept of conservatism, it is the upper deviation rate, and not the the rate found in the sample, that is compared with the tolerable rate in developing conclusions

Answer 32

T

Question 33

(T/F) Tolerable misstatement may be the same as performance materiality or it may be an amount smaller than performance materiality

Answer 33

T