II. Planning Activities - Detecting Illegal Acts

Question 1

Regarding a nonissuer’s compliance with laws and regulations, an auditor performing an audit of the entity’s financial statements is responsible for

Answer 1

Obtaining a general understanding of the legal and regulatory framework applicable to the entity and how the entity is complying with that framework.

Note: In obtaining an understanding of the entity and its environment, the auditor should obtain an understanding of the entity’s applicable legal and regulatory framework as well as how the entity complies with that framework.

Question 2

During the audit of a new client, the auditor determined that management had given illegal bribes to municipal officials during the year under audit and for several prior years. The auditor notified the client’s board of directors, but the board decided to take no action because the amounts involved were immaterial to the financial statements. Under these circumstances, the auditor should

Answer 2

Consider withdrawing from the audit engagement and disassociating from future relationships with the client.

Note: The auditor may decide that withdrawal is necessary when the client fails to take the remedial action considered necessary. This failure may indicate a greater problem with the control environment and overall governance. As a result, it may affect the auditor’s ability to rely on management representations as well as the relationship with the client going forward.

Question 3

Which of the following information that comes to an auditor’s attention would be most likely to raise a question about the occurrence of illegal acts?

Answer 3

The discovery of unexplained payments made to government employees.

note: Doesn’t this immediately raise questions?! Why would payments be made to government employees, especially unexplained payments? They sound like bribes.

Question 4

Which of the following information discovered during an audit most likely would raise a question concerning possible illegal acts?

Answer 4

The entity prepared several large checks payable to cash during the year.

Note: Large checks payable to cash would be most likely to raise questions regarding possible illegal acts. Valid company disbursements are typically made by check and controlled through accounts payable. Cash payments are unusual and difficult to control. As a result, large checks payable to cash would present a red flag during the audit.

Question 5

An auditor who discovers that a client’s employees paid small bribes to municipal officials most likely would withdraw from the engagement if

Answer 5

Management fails to take the appropriate remedial action.

Note:

Auditor should consider the effects of illegal acts on his/her ability to rely on management’s representations and the possible effects of continuing his/her association with the client.

Question 6

When an auditor becomes aware of a possible client illegal act, the auditor should obtain an understanding of the nature of the act to

Answer 6

when an auditor becomes aware of information concerning a possible illegal act, he or she should obtain an understanding of the nature of the act, the circumstances in which it occurred, and sufficient other information to evaluate its effect on the financial statements.

Remember: Auditor should be more concern about the financial statements

Question 7

Likely result in the discovery of possible illegal acts?

Answer 7

Reading the minutes of the board of directors’ meetings.

Making inquiries of the client’s management.

Performing tests of details of transactions.

Note:

internal control questionnaire may reveal weaknesses in the design of internal control, it will have little or no information on whether an illegal act has occurred.

Question 8

Which of the following information that comes to an auditor’s attention most likely would raise a question about the occurrence of illegal acts?

Answer 8

The discovery of unexplained payments made to government employees.

Note:

unexplained payments made to government employees may well not be legal (e.g., they may be illegal bribes).

Question 9

Most likely could have a material effect on an entity’s financial statements?

Answer 9

An illegal payment to a foreign official that was not recorded.

Note: Illegal payment of immaterial amount may be material if there is a reasonable possibility that it may lead to a material contingent liability or a material loss of revenue.

Question 10

Under the Private Securities Litigation Reform Act of 1995, Baker, CPA, reported certain uncorrected illegal acts to Supermart’s board of directors. Baker believed that failure to take remedial action would warrant a qualified audit opinion because the illegal acts had a material effect on Supermart’s financial statements. Supermart failed to take appropriate remedial action and the board of directors refused to inform the SEC that it had received such notification from Baker. Under these circumstances, Baker is required to

Answer 10

CPAs are required under the law to deliver a report on those illegal acts to the SEC within one business day in such circumstances.

Question 11

An auditor who discovers that client employees have committed an illegal act that has a material effect on the client’s financial statements most likely would withdraw from the engagement if

Answer 11

Auditor may conclude that withdrawal is necessary when the client does not take the remedial action, even when the illegal act is not material to the financial statements.

Question 12

Foreign Corrupt Practices Act

Answer 12

Foreign Corrupt Practices Act’s provisions prohibit

• illegal foreign payments and
• require publicly held companies to devise and maintain adequate internal control.

Question 13

The most likely explanation why the auditor’s examination cannot reasonably be expected to bring noncompliance with all laws by the client to the auditor’s attention is that

Answer 13

Illegal acts by clients often relate to operating aspects rather than accounting aspects.

Note:

Illegal acts relating to the operating aspects of an entity are often highly specialized and complex and often are far removed from the events and transactions reflected in financial statements.

Question 14

What assurance does the auditor provide that misstatements due to errors, fraud, and direct effect illegal acts that are material to the financial statements will be detected?

Answer 14

AU-C 200 requires the auditor to design the audit to provide reasonable assurance of detecting material errors, fraud and direct effect illegal acts.

Question 15

During the annual audit of Ajax Corp., a publicly held company, Jones, CPA, a continuing auditor, determined that illegal political contributions had been made during each of the past seven years, including the year under audit. Jones notified the board of directors about the illegal contributions, but they refused to take any action because the amounts involved were immaterial to the financial statements. Jones should reconsider the intended degree of reliance to be placed on the

Answer 15

Management representation letter.

Note: failure to take remedial action may cause an auditor to decrease reliance on management representations.

Question 16

Most accurately summarizes what is meant by the term “material misstatement”

Answer 16

Material misstatement may occur due to errors, fraud, and illegal acts with a direct effect on financial statement amounts.

Question 17

If specific information comes to an auditor’s attention that implies noncompliance with laws that could result in a material, but indirect effect on the financial statements, the auditor should next

Answer 17

Apply audit procedures specifically directed to ascertaining whether noncompliance has occurred.

Note:

AU-C 250 requires the auditor to apply audit procedures specifically designed to determine whether an illegal act has occurred when such information comes to his/her attention.

In other words:

If specific information concerning an illegal act comes to the auditor’s attention, the auditor should apply audit procedures specifically directed to ascertaining whether an illegal act has occurred.

Question 18

A procedure performed primarily for the purpose of expressing an opinion on the financial statements, but may bring possible illegal acts to the auditor’s attention?

Answer 18

• Obtain an understanding of internal control.
• Tests of transactions.
• Tests of balances.

Question 19

To establish illegal “slush funds,” corporations may divert cash received in normal business operations. An auditor would encounter the greatest difficulty in detecting the diversion of proceeds from

Answer 19

Scrap sales.

Why?

scrap sales are generally irregular in nature and these sales often are inadequately controlled by the internal control. This lack of adequate internal control makes it difficult for the auditor to detect any irregularities.

Question 20

Which of the following illegal acts should an audit be designed to obtain reasonable assurance of detecting?

Answer 20

Accrual and billing of an improper amount of revenue under government contracts.

Note: accrual and billing of an improper amount of revenue under government contracts is an illegal act with a direct effect on the determination of financial statement amounts, and audits are designed to detect such illegal acts.