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Additional Multiple-Choice Questions for Audit Risk Questions

1. As part of a financial statement audit, an auditor is performing substantive testing procedures to gather evidence about a companys reported Inventory balance. Which of the following statements is not true? a. The auditor hopes to reduce the likelihood that a material misstatement exists in any of the financial statement assertions to an acceptably low level. b. The auditor hopes to reduce the assessment of audit risk to an acceptably low level. c. The auditor hopes to be able to provide reasonable assurance that the financial statements are present fairly according to US generally accepted accounting principles. d. The auditor hopes to reduce the assessment of inherent risk to an acceptably low level. 2. Early in an audit engagement, a CPA assesses the inherent risk that is present. In the current audit, the assessment of inherent risk turns out to be higher than the auditor had anticipated. Which of the following is the most likely result of that change in estimation? a. The assessment of control risk will need to be reduced. b. Materiality levels will need to be reduced. c. The acceptable level of detection risk will need to be reduced. d. The acceptable level of audit risk will need to be reduced. 3. A CPA begins an audit engagement and discovers that the chief financial officer of the company has much less practical experience than had been anticipated. What is the result of this new knowledge? a. The assessment of inherent risk goes up. b. The assessment of control risk goes up. c. The acceptable level of detection risk goes up. d. The acceptable level of audit risk goes up. 4. When do brainstorming sessions take place and what is their purpose? a. Brainstorming sessions occur at the beginning of an audit and periodically thereafter so that the audit team can consider how fraud might take place. b. Brainstorming sessions occur at the end of an audit to ensure that all required audit steps have been properly followed. c. Brainstorming sessions occur after the assessment of inherent risk to determine the impact on substantive testing. 2006 by Kaplan CPA Education, a division of Dearborn Financial Publishing, Inc. Page 1 of 10

d. Brainstorming sessions occur after the assessment of control risk to determine the impact on substantive testing. 5. In what areas of an audit should the independent auditor always presume a risk of misstatement due to fraud exists? a. None; there needs to be the discovery of a fraud risk factor before risk levels are assessed as high b. Bad debts and inventory impairment c. Revenue recognition and managements possible override on internal controls. d. Contingent liabilities and long-term debts 6. In looking at an audit client, an independent CPA should always be alert for possible problems in the fraud triangle. One point of that triangle is that management or other employees have an incentive to commit fraud or they are under pressure that could lead them to commit fraud. A second point of the triangle is that the management or other employee is able to rationalize a fraudulent act as being consistent with their personal code of ethics. What is the third point of the triangle? a. Monetary assets are more subject to fraud than nonmonetary assets. b. Circumstances that may exist that provide a reasonable opportunity to commit fraud. c. Management members create more of a risk of fraud than do other employees of the reporting company. d. Revenue recognition and the related management decisions about revenue recognition. 7. Which of the following is not an incentive for the commission of fraudulent financial reporting or pressure to commit fraudulent financial reporting by a member of management or other employee of the reporting company? a. Company needs to obtain additional financing b. Company has engaged in numerous related party transactions. c. Company is facing the threat of bankruptcy. d. Company faces a high degree of stiff competition 8. Which of the following is not an opportunity for management or other company employees to carry out fraudulent financial reporting? a. Company appears to be falling short of its projected net income for the current year. b. Significant operations are located across international borders c. Board of directors is not effective d. Significant estimates are required for financial reporting and they are quite subjective in nature.

2006 by Kaplan CPA Education, a division of Dearborn Financial Publishing, Inc. Page 2 of 10

9. An independent auditor has become concerned that the reporting companys attitudes toward fraudulent reporting as well as its ability to rationalize fraudulent behavior are not good. Which of the following is not a possible reason for this concern? a. Management is told of a reportable condition in internal control but takes no remedial action. b. Management has stated its intention of keeping the companys stock price at its high for the current year. c. Large amounts of cash are left at the company each evening. d. Company has a history of violating securities laws. 10. The CPA firm of Simpson, East, and Watts is performing an audit of the financial statements of Halsey Corporation. The audit team has uncovered several significant fraud risk factors. Which of the following is true? a. A scope qualification or a disclaimer of opinion must be rendered. b. The firm should consider doing better quality of substantive testing such as using more physical inspection of assets. c. An opinion qualification or an adverse opinion must be rendered. d. The firm should resign because of the increased risk levels. 11. An independent auditor discovers that an audit client does not promptly reconcile its assets on hand to its records. What type of fraud risk factor is indicated by this problem? a. Employees can rationalize the misappropriation of assets. b. Employees have the opportunity to misappropriate assets. c. Employees have the incentive for fraudulent financial reporting d. Employees can rationalize fraudulent financial reporting. 12. An independent auditor discovers that the management of the reporting company is dominated by one person, the chief executive officer. What type of fraud risk factor is indicated by this situation? a. Employees can rationalize fraudulent financial reporting. b. Employees have the opportunity for fraudulent financial reporting. c. Employees have the incentive to misappropriate assets d. Employees can rationalize the misappropriation of assets. 13. An auditor begins an audit engagement and soon finds that the initial assessment of inherent risk needs to be raised while the initial assessment of control risk can be lowered. Which of the following statements is true? a. The acceptable level of overall audit risk will not be affected. b. The assessed level of detection risk will have to be reduced c. The amount of substantive testing will have to be increases d. The change in the assessment of inherent risk caused the change in the assessment of control risk.

2006 by Kaplan CPA Education, a division of Dearborn Financial Publishing, Inc. Page 3 of 10

14. In the current audit, the CPA firm moved substantive testing for a particular account from three weeks before the end of the year to three months before the end of the year. Which of the following is the most likely reason for that change? a. Inherent risk was assessed early in the year and proved to be higher than expected. b. The acceptable level of overall audit risk for this account was reassessed at a lower level than originally anticipated. c. The acceptable level of detection risk for this account was reassessed at a higher level than originally anticipated. d. Control risk was assessed early in the year and proved to be higher than expected. 15. The auditor is making an assessment of inherent risk in the early stages of an audit. Which of the following would be least likely to create an increase in the assessed risk level? a. This is the companys first audit. b. The manager of the accounting department retired with three months left in the year and has not yet been replaced. c. Significant balances are the result of estimations d. In performing analytical procedures, the client figure for sales is at the high end of the auditors anticipated range. 16. Early in an audit, the independent CPA decides that special action needs to be taken to reduce the risk of fraud in connection with the reporting companys payroll account. Which of the following is the least likely reason for this action? a. The layoff of a number of employees has been rumored. b. It was the result of a brainstorming session. c. The company does not anticipate reaching its projected net income for the year. d. The personnel department and the payroll department are completely independent within the organization. 17. The following are four fraud risk factors. Which is normally identified with having the attitude or being able to rationalize committing fraudulent financial reporting? a. Lack of mandatory vacations for employees performing key control functions. b. A practice by management of committing to achieve unrealistic income forecasts. c. Failure by company to complete timely reconciliation of assets. d. Inadequate system of authorization for purchases made. 18. Which of the following is not a fraud risk factor that warns the independent auditor of the opportunity that employees have to misappropriate assets? a. Members of management have personally guaranteed the debts of the company. 2006 by Kaplan CPA Education, a division of Dearborn Financial Publishing, Inc. Page 4 of 10

b. Applicants for jobs that involve access to monetary assets are not adequately screened. c. Fixed assets are small and marketable. d. There is inadequate recordkeeping in connection with the companys assets. 19. Domination of management by one person and having an ineffective board of directors are both fraud risk factors. Which of the following statements is true? a. Both domination of management by one person and having an ineffective board of directors denotes possible fraudulent financial reporting. b. Both domination of management by one person and having an ineffective board of directors denotes possible misappropriation. c. Domination of management by one person denotes possible fraudulent financial reporting whereas having an ineffective board of directors denotes possible misappropriation. d. Domination of management by one person denotes possible misappropriation whereas having an ineffective board of directors denotes possible fraudulent financial reporting. 20. Early in an audit, several fraud risk factors are discovered. Which of the following is least likely to be the response of the independent CPA? a. Substantive testing procedures are moved away from the end of the year so that differences can be more easily resolved. b. The auditor should attempt to become more unpredictable in the testing that is done. c. The auditor should attempt to gather more evidence through physical inspection. d. Analytical procedures should still be carried out but a more disaggregated level. 21. Toward the end of an audit, the CPA begins to carry out a number of surprise inspections of assets such as inventory, equipment, and investment certificates. What is the most likely reason for this action? a. Acceptable audit risk is particularly high. b. Conditions have been discovered that make the CPA especially concerned by the presence of fraud. c. The auditor feels that these tests are necessary to get an accurate assessment of inherent risk. d. The auditor feels that these tests are necessary to get an accurate assessment of control risk. 22. An audit client has an accounting system where all information is transmitted, processed, and maintained electronically. Because the company has very little tangible data available, the independent auditor has come to the decision that it will be impossible to do enough substantive testing to reduce overall audit risk to an acceptably low level. In that situation, what should the auditor do? 2006 by Kaplan CPA Education, a division of Dearborn Financial Publishing, Inc. Page 5 of 10

a. Provide a qualified opinion or a disclaimer. b. Resign from the engagement c. Perform additional tests of controls in hopes of reducing overall audit risk. d. Recommend that the client convert a portion of this system to a manual system so backup documentation can be generated.

Answers
1. Answer: D The fundamental purpose of substantive testing is to gather evidence to reduce the auditors assessment of the likelihood that a material misstatement exists within any one of the five financial statement assertions made by management. If the chance of a material misstatement (known as audit risk) can be reduced to an acceptably low level, then the independent auditor is able to provide reasonable assurance that the financial statements are presented fairly according to US generally accepted accounting principles. The term inherent risk relates to the possibility that a material misstatement will occur in the accounting system of the reporting company and is just one component of overall audit risk. 2. Answer: C The CPA sets the acceptable level of audit risk and it should be unaffected by the levels of inherent risk and control risk. The assessment of inherent risk and the assessment of control risk are independent so that one really does not impact the other. Thus, if either the assessment of inherent risk or the assessment of control risk is higher than anticipated and the acceptable level of audit risk stays the same, the acceptable level of detection risk must be reduced in order to compensate. Detection risk levels can be reduced by performing more testing or by carrying out a better quality of testing such as closer to the end of the year or using more sophisticated techniques (such as positive confirmations rather than negative confirmations) or employing auditors with more experience. 3. Answer: B Inherent risk is the possibility that a material misstatement will occur within the reporting companys accounting system. If the chief financial officer has less experience than expected, the chance of a material misstatement taking place is increased. Thus, inherent risk should be assessed at a higher level. The assessment of inherent risk and control risk are independent so there is no impact on control risk. Because inherent risk is higher, the acceptable level of detection risk must go down to compensate and bring overall audit risk to the acceptable level. 4. Answer: A Brainstorming sessions were created in hopes of reducing the possibility of fraud occurring that was not discovered by the independent auditor. The members of the audit engagement (or, at least, the senior members of the engagement) are required to meet and discuss where fraud is most likely to occur and how. These sessions always take place at 2006 by Kaplan CPA Education, a division of Dearborn Financial Publishing, Inc. Page 6 of 10

the beginning of each audit. In addition, especially for larger audits, they should take place periodically throughout the engagement as more information is gathered. 5. Answer: C History has shown that fraud often occurs in connection the method by which a company recognizes its revenue and as a result of management being able to override the control policies and procedures established by the company. Because of the prevalence of problems in these areas, the independent auditor has been directed to presume that the potential fraud does exist in every audit regardless of the evidence that is found. 6. Answer: B Having (a) the incentive to commit fraud and (b) the ability to rationalize the action are by themselves not enough to actually lead to the commission of fraud. However, if the person also has the opportunity, then the chances of fraud become quite high. Thus, if one or two points of the fraud triangle are found to exist, the auditor needs to take the increase in risk into consideration in designing the audit. When all three points of the triangle can be identified in an audit, extreme caution should be taken to ensure that fraud is not present. 7. Answer: B If the company faces a problem such as the need for more financing or the threat of bankruptcy or difficult competition, company personnel are under a significant amount of pressure to make the company appear as good as possible. This type of pressure may lead the management or other employees to commit fraud to make the companys financial operations and position look improved. Related party transactions can provide the opportunity for this fraud since transactions are not subject to the control of a thirdparty but they do not create the incentive for fraud or the pressure to commit such fraud. 8. Answer: A When a companys reported figures come up short of expectations, that provides management and other company employees with an incentive to commit fraudulent reporting but does not, of itself, provide any opportunity. Conversely, the reporting problems caused by distant operations and/or significant estimations frequently give employees some chance of committing fraudulent reporting. In such cases, control over the reporting process becomes more difficult. The same concern arises when the board of directors is not effective. A level of control over reporting is lost. 9. Answer: C If a company does not fix reportable conditions in its internal control or has a history of violating securities laws, there are signs that the company has an attitude that does not necessarily prize fairly presented financial statements. In much the same way, if the management wants to keep stock prices at a high level, this desire may outweigh an attitude directed toward fair presentation. However, large amounts of available cash can provide the opportunity for theft but it does not relate directly to an attitude about fraudulent reporting. 10. Answer: B Uncovering fraud risk factors does not necessarily mean that any fraud at all has taken place. It simply indicates that the likelihood for fraud is high and the auditor should take remedial actions such as additional testing, using more reliable evidence-gathering 2006 by Kaplan CPA Education, a division of Dearborn Financial Publishing, Inc. Page 7 of 10

techniques (such as more physical inspection), test closer to the end of the fiscal year, and perform analytical procedures at a more disaggregated level. If the independent auditor is able to obtain sufficient evidence to reduce audit risk to an acceptably low level, an unqualified opinion can be given. However, as a result of the presence of fraud risk factors, more evidence or a better quality of evidence will probably be needed to reach that acceptable level. 11. Answer: B Without a prompt reconciliation of the assets with the related financial records, company officials do not know whether assets are missing. Thus, employees recognize that theft may well go undetected, giving them the opportunity needed for theft with a reduced risk of being caught. 12. Answer: B When management is dominated by one person, there really is no system in the company to control the actions of that person. Thus, the individual can manipulate the financial records with no fear that anyone in the company will have the power or authority to prevent the fraud. With this much power, the person just has the opportunity to create fraudulent financial information. 13. Answer: A The auditor makes two independent assessments: one of inherent risk and one of control risk. Based on the levels of risk that are present, the auditor determines the level of detection risk that must be achieved to arrive at the acceptable level of overall audit risk. Therefore, the two assessments will affect acceptable detection risk and the substantive testing used to reduce detection risk but not the overall goal: the acceptable level of audit risk. Because one risk level went up whereas the other went down, the impact on acceptable detection risk (and, thus, substantive testing) cannot be known without more information. 14. Answer: C Moving a test further from the end of the year means that the evidence that is being gathered is of a lower quality. That would be expected when either the assessment of inherent risk or control risk that is being faced is lower than anticipated. That would also result when the overall acceptable audit risk is not as low as originally set. Here, for some reason (possibly control or detection risk levels are lower or the acceptable level of overall audit risk is higher than first thought), the auditor is willing for detection risk to be at a higher level. That allows the auditor to settle for a lower quality of audit evidence. 15. Answer: D Inherent risk is raised whenever potential accounting problems are discovered or when any uncertainty is encountered in the audit or the accounting system. A first audit, an accounting department without a manager, and significant balances based on estimates all have a greater amount of uncertainty than would be desired. Each would cause the auditor to consider raising the assessment of inherent risk. The results of analytical procedures can also lead to an increased assessment but that would normally only be the case when the client figure falls outside of the anticipated range. 2006 by Kaplan CPA Education, a division of Dearborn Financial Publishing, Inc. Page 8 of 10

16. Answer: D Brainstorming sessions are carried out by the audit team or the senior members of that team to discuss possible fraud areas. The possible loss of jobs (and income) could provide the incentive for one or more employees to steal money from the company. The apparent failure to reach income projections could provide an incentive for management to understand salary expense which is often a companys largest expense. However, the personnel department and the payroll departments should be independent of each other. That is the proper organizational structure. 17. Answer: B Lack of mandatory vacations, failure to complete timely reconciliations, and an inadequate system of authorizing purchases all provide an opportunity for employees to steal from the company (misappropriation). They are fraud risk factors but they point out the possibility of that type of fraudulent action. Conversely, if management has committed to achieving a forecast and cannot reach that level because it is unrealistic, management may be able to justify fraudulent financial reporting so that the forecasts are achieved. 18. Answer: A The personal guaranteeing of business debts gives management and employees an incentive for fraudulent financial reporting rather than an opportunity for theft. However, not properly screening employees who work with monetary assets, having fixed assets that are small and marketable, and inadequate recordkeeping all open up the chance that misappropriation can occur. 19. Answer: A Both of these fraud risk factors indicate that management is not well controlled. Without control, management has the opportunity to manipulate the financial accounts so that fraudulent financial reporting can take place. 20. Answer: A Testing procedures are viewed as gathering a better quality of evidence as they move closer to the end of the year so that problems are less likely to occur after the testing. Unpredictable testing is better quality because anyone involved with the fraud will have less chance of anticipating the testing to be done, making hiding problems more difficult. Physical inspection provides a better quality evidence because documents can be forged or changed relatively easily. Analytical procedures at a more disaggregated level (such as store by store rather than for the company as a whole) are better because smaller differences from expected norms will be spotted. 21. Answer: B If an auditor comes to suspect that fraud exists, consideration should be taken toward utilizing one or more of a number of specific steps to gather evidence in any particularlyrisky area. These steps include surprise inspections of assets, testing closer to year-end, oral confirmations as well as written ones, and detailed analysis of large transactions. Inspection of assets is a substantive test and not related to either the assessment of 2006 by Kaplan CPA Education, a division of Dearborn Financial Publishing, Inc. Page 9 of 10

inherent risk or control risk. When acceptable audit risk is particularly high, the auditor tends to do less testing rather than more extensive testing such as surprise inspections. 22. Answer: C Because of the auditors inability to do sufficient substantive testing, it appears to be impossible to reduce overall audit risk to an acceptably low level. To compensate, the auditor should attempt to do additional tests of controls. The goal is to reduce overall audit risk by reducing the assessment of control risk.

2006 by Kaplan CPA Education, a division of Dearborn Financial Publishing, Inc. Page 10 of 10