Chapter 3 Flashcards
Which of the following should an auditor do when control risk is assessed at the maximum level?
Document the assessment is correct. The professional standards require documentation of the assessment when control risk is assessed at a maximum level.
Which of the following characteristics most likely would heighten and auditors concern about the risk material misstatements in an entity’s financial statements?
The entities industry is experiencing declining customer demand is correct. When an auditor assesses the risk of a client’s potential to reporting material misstatements, they should consider areas that pose a threat to the company’s profitability. In the event of threatened profitability, a client might be more inclined to attempt to fraudulently report its financial statements. Reduction of customer demand is considered an economic downturn which is considered an inherent risk to the client. When inherent risk is high, the overall risk of a material mistatement is also very high (risk of material mistatement = inherent risk x control risk).
Which of the following types of risks most likely would increase if accounts receivable are confirmed three months before year end?
Detection risk is correct. Since this is addressing what type of risk an auditor has control over based on the nature, timing, and extent of the audit procedures being performed, then we need to know this is addressing detection risk. Detection risk is the risk that audit procedures will not detect material misstatements, and it would increase if accounts receivable are confirmed three months before year-end. One way the auditor could reduce detection risk is by confirming accounts receivable at year-end to make sure the balances in the financial statements are accurate based on confirmation sent to customers. Therefore, detection risk is the correct answer.
Detection risk is a function of:
The effectiveness of audit procedures and of the manner in which they are applied is correct. Detection risk is controlled by the audit team and is based on the combined assessment of inherent risk and control risk. If detection risk is set at low, that means that the audit team needs to perform more effective audit procedures to detect material misstatements. Therefore, the audit team would perform substantive tests that are more effective like observation or confirmations, rather than relying on internal evidence from the company.
In response to an increased level of assessed risk of material misstatement, an auditor of a nonissuer would generally:
Increase the emphasis on professional skepticism when gathering and evaluating audit evidence with the audit team is correct. If the risk of material misstatement (“RMM”) increased, then the auditor would increase audit procedures and increase the level of professional skepticism as there is a higher chance of material misstatement existing in the financial statements.
An audit team has concluded that inventory is highly susceptible to misappropriation and that a potential misstatement would be material to the financial statements. How should the audit team address the audit procedures to the increased risk?
Review the client’s control procedures over the safeguarding of inventory and perform a physical inventory count on the last day of the current year is correct. The question indicates that the risk of material misstatement is very high. This could be driven by the company’s lack of controls and systems in place to safeguard its assets making it difficult to track inventory movements and prevent theft. Since risk of material misstatement is high, then the level of detection risk is also low, so the auditor would need to perform substantive procedures that would provide a high level of evidence. The main difference between each option is the level of substantive procedures performed and which one provides the greatest level of assurance. Performing inventory counts on the last date of the year will provide the highest level of assurance since it allows us to evaluate the inventory balance on the actual reporting date.
Payton and Eli are auditing a professional football team in New York. Which of the following statements best describes why Payton and Eli would use only substantive procedures to evaluate specific relevant assertions and risks?
Testing the operating effectiveness of the relevant controls would not be efficient is correct. At the end of the day, an audit firm has to perform a cost-effective audit to make money. An audit firm is a business like every other professional accounting firm. So, unless the audit team is required to report on the internal control framework (PCAOB audit), the audit team can decide not to rely on controls at all and perform only substantive testing. As long as the audit team is not required to test controls, they would only do so to reduce the nature, timing, and extent of substantive audit procedures. If the audit team already knows that the internal control environment is not effective, then the audit team can opt to not test internal controls.
Which of the following courses of action is the most appropriate if an auditor concludes that there is a high risk of material misstatement?
Select more effective substantive tests is correct. If we think back to our audit risk seesaw, as risk of material misstatement gets higher, detection risk is lower, so the audit must increase the level of substantive procedures and the effectiveness of substantive procedures. When we talk about performing more effective audit procedures, that would impact the “nature” of test that we perform.
An auditor of a nonissuer should design tests of details to ensure that sufficient audit evidence supports which of the following?
The planned level of assurance at the relevant assertion level is correct. The visual below illustrates the two main types of risks. Test of details focus on risks specific to transactions, account balances, or disclosures (i.e. management assertion level). The audit team needs to understand what the planned level of assurance is and what type of audit evidence is needed to address the risks at the relevant assertion level.
If interim substantive procedures for an account identified no exceptions, which of the following would the auditor not perform on that account at year end?
Tests of details for the entire year under audit is correct. When an audit team performs test of details during the interim period (e.g. January to September), then at year-end, the audit team would only perform test of details on the untested period (October to December). If the audit team performed interim testing, there is NO reason for the audit team to test the entire year when performing procedures at year-end.
Of the following audit evidence, which is generally deemed most reliable?
Confirmation of account information is correct. I want you to think about the hierarchy of audit evidence when evaluating what the most reliable form of evidence is. Confirmations relate to bank confirmations, legal confirmations, account receivable confirmations, etc. In general, we would send confirmations to validate information with a 3rd party. The rationale is that why would a 3rd party have any incentive to provide audit team with false information. Confirmations represents external evidence (#2 in visual).
Of the following matters, which must an auditor communicate to those charged with governance or an entity’s audit committee?
I. Any satisfactorily resolved disagreements with management about significant matters pertaining to the entity’s financial statements.
II. The views of the auditor with regards to qualitative aspects of the entity’s significant accounting practices; particularly financial statement disclosures, accounting estimates, and accounting policies.
Both I and II is correct. There is no hard rule on what is required or should be communicated to the audit committee or those charged with governance. Just think about whether its important or not. For the exam, unless its obvious that the matter is unimportant, I would error on the side of saying “yes, absolutely communicated it to the audit committee or those charged with governance”.
Cynthia’s favorite thing to do is audit related party transactions. What should Cynthia place her primary emphasis on?
The adequacy of the disclosure of the related party transactions is correct. The most important thing for Cynthia to do is ensure that all related party transactions are adequately disclosed or explained in the financial statements.
The adequacy of the disclosure of the related party transactions is correct. The most important thing for Cynthia to do is ensure that all related party transactions are adequately disclosed or explained in the financial statements.
Raise or lower the materiality level as appropriate to the situation is correct. Materiality is the auditor’s assessment of what is considered material to the users of the financial statements. There is a combination of ways that an audit can calculate materiality, which includes % of revenue, % of net income, % of assets, etc. Materiality in theory is the largest misstatement allowable that would not influence or change the decisions of any reasonable decision maker that is analyzing the financial statements.
Now, when an auditor calculates materiality, it is usually during the planning phase, which is way before any actual results for the current year financials would be available. The auditor would use forecasted revenues or earnings to calculate materiality. At year-end, the auditor would have to plug in actual revenue or EBITDA to confirm the materiality calculations. If there are big fluctuations, up or down, the auditor should modify the materiality level to reflect those changes.
Blue Marlin CPA has just agreed to audit a nonpublic entity. Which of the following would Blue Marlin CPA most likely use in determining the auditor’s preliminary judgment about materiality?
The entity’s annualized interim financial statements is correct. The reality is that Blue Marlin CPA should first use financial statements to help provide directional guidance on where materiality should be set. They could use the prior year financial statements or annualize the current year results. Since the question says preliminary judgement, that means the audit team is assessing materiality in the planning phase, so the audit wouldn’t have performed any audit procedures yet.
