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Auditing Chapter 3 and 4

Engagement risk is the auditor’s exposure to loss or injury of his or her reputation from events arising in connection
with financial statements audited. True False
TRUE
Which of the following factors most likely would lead a CPA to conclude that a potential audit engagement should
be rejected?
A. The details of most recorded transactions are not available after a specified period of time.
B. Internal control activities requiring segregation of duties are subject to management override.
C. It is unlikely that sufficient appropriate evidence is available to support an opinion on the financial statements.
D. Management has a reputation for consulting with several accounting firms about significant accounting issues
C. It is unlikely that sufficient appropriate evidence is available to support an opinion on the financial
statements.
Hawkins requested permission to communicate with the predecessor auditor and review certain portions of the
predecessor auditor’s working papers. The prospective client’s refusal to permit this will bear directly on Hawkins’
decision concerning the
A. Adequacy of the preplanned audit program.
B. Ability to establish consistency in application of accounting principles between years.
C. Apparent scope limitation.
D. Integrity of management.
D. Integrity of management.
Which of the following should an auditor obtain from the predecessor auditor prior to accepting an audit
engagement?
A. Analysis of balance sheet accounts.
B. Analysis of income statement accounts.
C. All matters of continuing accounting significance.
D. Facts that might bear on management integrity.
D. Facts that might bear on management integrity.
The risk of material misstatement differs from detection risk in that it
A. Arises from the misapplication of auditing procedures.
B. May be assessed in either quantitative or qualitative terms.
C. Exists independently of the actions of the auditor.
D. Can be changed at the auditor’s discretion.
C. Exists independently of the actions of the auditor.
To provide for the greatest degree of independence in performing internal audit activities, the internal audit function
most likely should report to the
A. Vice-President – Finance
B. Corporate controller.
C. Audit committee of the board of directors.
D. Corporate stockholders.
C. Audit committee of the board of directors
In the context of an audit of financial statements, substantive procedures are audit procedures that
A. May be eliminated under certain conditions.
B. Are primarily designed to discover significant subsequent events.
C. May be either tests of details of transactions, tests of details of account balances, or analytical procedures.
D. Will increase proportionately with an increase in the auditor’s reliance on internal control.
C. May be either tests of details of transactions, tests of details of account balances, or analytical procedures
To emphasize auditor independence from management, publicly traded corporations are required to
A. Appoint a partner of the CPA firm conducting the examination to the corporation’s audit committee.
B. Establish a policy of discouraging social contact between employees of the corporation and the independent
auditors.
C. Request that a representative of the independent auditor be on hand at the annual stockholders’ meeting.
D. Have the independent auditor report to an audit committee of independent members of the board of directors
D. Have the independent auditor report to an audit committee of independent members of the board of
directors.
As the acceptable level of detection risk decreases, the assurance directly provided from
A. Substantive procedures should increase.
B. Substantive procedures should decrease.
C. Tests of controls should increase.
D. Tests of controls should decrease.
A. Substantive procedures should increase
. Which of the following arranges the general types of audit tests in the order they are normally performed in an
audit?
A. Substantive procedures, tests of controls, and risk assessment procedures.
B. Substantive procedures, risk assessment procedures, and tests of controls.
C. Risk assessment procedures, tests of controls, and substantive procedures.
D. Risk assessment procedures, substantive procedures, and tests of controls.
C. Risk assessment procedures, tests of controls, and substantive procedures.
An auditor has withdrawn from an audit engagement of a publicly held company after finding fraud that may
materially affect the financial statements. The auditor should set forth the reasons and findings in correspondence
with the
A. Securities and Exchange Commission.
B. Client’s legal counsel.
C. Stock exchanges where the company’s stock is traded.
D. Audit committee of the board of directors.
D. Audit committee of the board of directors.
The risk of material misstatement includes which of the following?
A. Detection risk.
B. Audit risk.
C. Inherent risk.
D. Nonsampling risk.
C. Inherent risk.
When an entity moves into a significant new line of business, all of the following increase except:
A. Client risk.
B. Acceptable audit risk.
C. Risk of material misstatement.
D. Entity business risk.
B. Acceptable audit risk
The risk that an auditor will conclude, based on substantive procedures, that a material error does not exist in an
account balance when, in fact, such an error does exist is referred to as
A. Sampling risk.
B. Detection risk.
C. Nonsampling risk.
D. Inherent risk.
B. Detection risk
Which of the following is not a qualitative factor that may affect an auditor’s establishment of materiality?
A. Potential for fraud.
B. The company is close to violating loan covenants.
C. Firm policy sets materiality at 4% of pretax income.
D. A small misstatement would interrupt an earnings trend.
C. Firm policy sets materiality at 4% of pretax income
Tolerable misstatement is
A. Materiality allocated to an assertion.
B. Materiality for the balance sheet as a whole.
C. Materiality for the income statement as a whole.
D. Materiality allocated to a specific account
D. Materiality allocated to a specific account.
Which of the following audit risk components may be assessed in qualitative terms?
A. Risk of material misstatement.
B. Detection risk.
C. Neither risk of material misstatement nor detection risk.
D. Both risk of material misstatement and detection risk.
D. Both risk of material misstatement and detection risk.
What is the difference between audit risk and engagement risk?
Audit risk is the risk that the auditor may unknowingly fail to appropriately modify the opinion on financial
statements that are materially misstated. It can be directly controlled by the scope of the auditor’s test
procedures. Engagement risk, on the other hand, is the auditor’s exposure to loss or injury to professional
practice from litigation, adverse publicity, or other events arising in connection with financial statements audited
and reported on. It cannot be directly controlled by the auditor, but some control can be exercised through the
careful acceptance and continuance of clients.
Discuss the purposes for planning the audit and identify the steps that are performed during this phase of the
engagement.
Engagement planning involves all of the issues the auditor should consider in developing an overall strategy
for conducting the audit. The objective of the audit plan is to conduct an effective and efficient audit. This
means that the audit is to be conducted in accordance with auditing standards and that the risk of material
misstatements is reduced to an acceptably low level. The audit plan should also consider how to conduct the
engagement in a cost-effective manner. When preparing the audit plan, the auditor should be guided by the
results of the risk assessment and procedures performed to gain and support the understanding of the entity.
Additional steps that should be performed include:
1. Assess a preliminary level for control risk by account and assertion.
2. Assess the possibility of illegal acts.
3. Identify related parties.
4. Conduct preliminary analytical procedures.
5. Develop an overall audit strategy and prepare audit programs.
6. Consider additional value-added services
Name three Sarbanes-Oxley Act requirements of the members and duties of the audit committee of a public
company.
Students must provide three of the following:
1. Each member of the audit committee must be a member of the board of directors and must be independent.
2. The audit committee is directly responsible for the appointment, compensation, and oversight of the work of
any registered public accounting firm employed by the company.
3. The audit committee must preapprove all audit and nonaudit services provided by its auditor.
4. The audit committee must establish procedures for the receipt, retention, and treatment of complaints
received by the company regarding accounting, internal control, and auditing.
5. Each audit committee member must have the authority to engage independent counsel, or other advisors, as
he or she deems necessary to carry out his or her duties.
In one sentence each, define misstatements arising from fraudulent financial reporting and misstatements arising
from misappropriation of assets
Misstatements arising from fraudulent financial reporting are intentional misstatements or omissions of amounts
or disclosures in financial statements intended to deceive financial statement users.
Misstatements arising from misappropriation of assets involve the theft of an entity’s assets where the theft
causes the financial statements to be misstated.
In the planning stages of an audit, what information does an auditor gain through analytical procedures?
An auditor is required to apply analytical procedures at the planning phase for all audits. In the planning
phase, analytical procedures help the auditor to understand the client’s business and transactions. Analytical
procedures also guide the auditor towards financial statement accounts that are likely to contain errors. With
this information, the auditor is able to plan the nature, timing, and extent of audit procedures.

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