AUD 3.4 - Understanding the Entity and Its Environment Flashcards
Prior to beginning the field work on a new audit engagement in which a CPA does not possess expertise in the industry in which the client operates, the CPA should:
A. Design special substantive procedures to compensate for the lack of industry expertise.
B. Reduce audit risk by lowering initial levels of materiality.
C. Engage financial experts familiar with the nature of the industry.
D. Perform risk assessment procedures.
Answer (D) is correct.
The auditor should obtain an understanding of the entity and its environment, including its internal control. For this purpose, the auditor performs the following risk assessment procedures: (1) inquiries of management and others within the entity, (2) analytical procedures, and (3) observation and inspection.
In performing interviews and examining documents related to preliminary work in a financial statement audit of a nonissuer, an auditor identifies a business risk associated with plans for a new product line. What should the auditor do as a result?
A. Modify the financial statement disclosures to include the newly identified risk if it is likely that the new product line will have an adverse effect on the company’s profitability.
B. Analyze the newly identified risk in conjunction with economic circumstances related exclusively to the new product line and consider whether there is an immediate consequence for the risk of material misstatement for affected classes of transactions.
C. Analyze the newly identified risk in conjunction with other known business risks and consider whether there is an immediate consequence for the risk of material misstatement at various levels of the audit.
D. Modify the scope of the engagement to include an analysis of the budget for the new product line and consider the new risk in conjunction with other risks after the budget items have been analyzed.
Answer (C) is correct.
A business risk results from (1) significant factors that could adversely affect an entity’s ability to achieve its objectives and execute its strategies or (2) setting inappropriate objectives and strategies. The auditor should obtain an understanding of the entity’s objectives and strategies and the related business risks that may result in risks of material misstatement. For example, business risks may result from developing new products that may fail. The auditor considers the possible immediate consequence for the risk of material misstatement and whether the same risk has a longer term consequence given the entity’s circumstances.
Answer (B) is incorrect.
The auditor should consider business risks in the context of industry, regulatory, and other external and internal factors.
To obtain an understanding of a continuing client in planning an audit, an auditor most likely would:
A. Perform tests of details of transactions and balances.
B. Reevaluate the risks of material misstatement.
C. Read internal audit reports.
D. Read specialized industry journals.
Answer (C) is correct.
The auditor performs risk assessment procedures to obtain the understanding of the entity and its environment, including its internal control. These include, for example, reading (1) internal audit reports, (2) interim statements, (3) quarterly reports, and (4) minutes of board meetings.
Which of the following procedures is the auditor most likely to perform after accepting an initial audit engagement?
A. Assess control risk for the assertions embodied in the financial statements.
B. Consult with and review the work of the predecessor auditor prior to discussing the engagement with the client management.
C. Tour the client’s facilities.
D. Prepare a rough draft of the financial statement and of the auditor’s report.
Answer (C) is correct.
The auditor performs risk assessment procedures to obtain an understanding of the entity and its environment, including internal control. They include (1) inquiries within the entity, (2) analytical procedures, and (3) observation and inspection. An example of observation and inspection is touring the client’s facilities.
Answer (A) is incorrect.
The auditor must obtain an understanding of internal control before assessing control risk.
An auditor reviews an audit client’s accounting policies when considering which of the following matters?
A. Nature of reports to be issued.
B. Understanding the entity and its environment, including its internal control.
C. Preliminary judgments about materiality levels.
D. Method of sampling to be used.
Answer (B) is correct.
Among the reasons for obtaining the understanding is the consideration of the entity’s accounting policies and disclosures. Thus, the auditor should understand the entity’s selection and application of accounting policies, including the reasons for changes. The auditor evaluates whether policies are appropriate for the entity and consistent with the appropriate reporting framework (AU-C 315).
Which of the following procedures would an auditor most likely perform before auditing the balance sheet?
A. Determine whether there are any liens or encumbrances on assets that have been pledged as collateral.
B. Obtain an understanding of the client’s internal control activities.
C. Consider the client’s plans and ability to meet imminent purchase commitments and cash flow obligations.
D. Confirm with client’s lawyer that all litigation probable of assertion has been disclosed to the auditor.
Answer (B) is correct.
Planning an audit initially requires developing an overall strategy and an audit plan. Planning includes obtaining an understanding of the entity and its environment, including its internal control, to identify and assess the risks of material misstatement (RMMs) of the financial statements, whether due to fraud or error. The understanding provides a basis for designing and implementing responses to the assessed RMMs. Risk assessment procedures are performed to obtain the understanding. They include (1) inquiries of management, appropriate individuals in the internal audit function, and others within the entity; (2) analytical procedures; and (3) observation and inspection. The plan also includes further procedures at the relevant assertion levels for material transaction classes, account balances, and disclosures. Thus, initial planning activities occur before procedures are applied to amounts reported in the balance sheet.
Which of the following statements indicates that the auditor has gained a sufficient understanding of a client’s internal controls related to the sales order process?
A. In a statistically valid sample of 100 sales transactions, the auditor found five undiscovered exceptions and concluded that the system was weak.
B. The auditor compared sales orders processed to processing clerk head count for 3 years and noted that processed orders significantly declined while clerk head count remained the same.
C. The auditor interviewed the company’s supervisor of sales clerks and reviewed six shipment-exception reports that were randomly selected and that showed significant unrecorded balances.
D. The auditor noted in a narrative that the documentation for the sales order system showed the printing of a shipment-exception report listing noninvoiced shipments.
Answer (D) is correct.
The auditor obtains an understanding of the entity and its environment, including its internal control, to identify and assess the risks of material misstatement of the financial statements, whether due to fraud or error. The understanding provides a basis for designing and implementing responses to the assessed risks of material misstatement. The auditor documents that understanding in the working papers with narratives, questionnaires, and flowcharts.
Answer (A) is incorrect.
The discovery of the exceptions is the result of audit procedures performed to test controls related to the sales order process. Gaining an understanding of the sales order process resulted in the development of audit procedures to identify any weaknesses in the system.
Answer (B) is incorrect.
The analysis of the sales orders processed for 3 years is a substantive procedure that would have been designed and carried out as a result of the auditor gaining an understanding of the sales order process.
Answer (C) is incorrect.
The interview of the supervisor regarding the significant unrecorded balances is a substantive procedure that would have been designed and carried out as a result of the auditor gaining an understanding of the sales order process.
An auditor most likely obtains an understanding of a new client to:
A. Evaluate whether the aggregation of known misstatements causes the financial statements taken as a whole to be materially misstated.
B. Make constructive suggestions concerning improvements to the client’s internal control.
C. Identify areas of audit emphasis.
D. Develop an attitude of professional skepticism concerning management’s financial statement assertions.
Answer (C) is correct.
The understanding provides a basis for assessing risks of material misstatement and responding to them in the exercise of professional judgment. For example, the auditor needs to identify areas that need special audit consideration, such as complex or unusual transactions or related-party transactions.
A CPA wishes to determine how various issuers have complied with the disclosure requirements in a new Accounting Standards Update. Which of the following information sources would the CPA most likely consult for this information?
A. AICPA Audit and Accounting Manual.
B. FASB Technical Bulletins.
C. FASB Statements of Financial Accounting Concepts.
D. AICPA Accounting Trends & Techniques.
Answer (D) is correct.
Practical guidance for conducting accounting and audit engagements can be found in various nonauthoritative publications, such as Accounting Trends and Techniques, which describes current practice regarding corporate financial accounting and disclosure policies. It is a useful source for practitioners in industry and public practice. This annual AICPA publication is based on a survey of the annual financial reports of over 600 public companies.
A CPA wishes to determine how various issuers have complied with the disclosure requirements of a new financial accounting standard. Which of the following information sources would the CPA most likely consult for this information?
A. AICPA Accounting Trends and Techniques.
B. SEC Statement 10-K Guide.
C. PCAOB Inspection Reports.
D. AICPA Codification of Statements on Auditing Standards.
Answer (A) is correct.
Practical guidance for accounting and auditing engagements can be found in various nonauthoritative publications. An example is Accounting Trends and Techniques, which describes current practice regarding corporate financial accounting and disclosure policies. It is a useful source for practitioners in industry and public practice. This annual AICPA publication is based on a survey of the annual financial reports of over 600 public companies.
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
A. ABC.
B. BAC.
C. BCA.
D. ACB.
Answer (B) is correct.
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.
