II. Planning Activities - Detecting Fraud

Question 1

What is the definition of fraud in an audit of financial statements?

Answer 1

An intentional act that results in a material misstatement in financial statements that are the subject of an audit.

Question 2

Which of the following factors would be most likely to heighten an auditor’s concern about the risk of fraudulent financial reporting?

Answer 2

An overly complex organizational structure involving unusual lines of authority.

Note: The risk of fraudulent financial reporting is heightened by the existence of an overly complex organizational structure involving unusual lines of authority. This type of structure would make it easier to override internal controls to materially misstate the financial statements.

Question 3

Which of the following circumstances most likely would cause an auditor to suspect that material misstatements exist in a client’s financial statements?

Answer 3

An auditor would suspect material misstatements to be present if differences between reconciliations of control accounts and subsidiary records were not investigated.

note: Such differences should be investigated and corrected to ensure that control accounts and subsidiary records agree.

Question 4

Prior to, or in conjunction with, the information-gathering procedures for an audit, audit team members should discuss the potential for material misstatement due to fraud. Which of the following best characterizes the mindset that the audit team should maintain during this discussion?

Answer 4

Professional skepticism is described as “… an attitude that includes a questioning mind and a critical assessment of audit evidence.”

Question 5

Which of the following situations most likely represents the highest risk of a misstatement arising from misappropriations of assets?

Answer 5

A large number of bearer bonds on hand.

Note: Anything that can be easily converted to assets would create such opportunities to misappropriate assets.

Question 6

While performing an audit of the financial statements of a company for the year ended December 31, year 1, the auditor notes that the company’s sales increased substantially in December, year 1, with a corresponding decrease in January, year 2. In assessing the risk of fraudulent financial reporting or misappropriation of assets, what should be the auditor’s initial indication about the potential for fraud in sales revenue?

Answer 6

Note: The substantial increase in sales in year 1 and substantial decrease in sales in year 2 is consistent with earnings management that might be associated with financial reporting fraud.

Question 7

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

Answer 7

The auditor is required to plan the audit to provide REASONABLE assurance that errors, fraud, and direct effect illegal acts, which materially misstate the financial statements, will be detected.

Question 8

Which of the following statements best describes an auditor’s responsibility to detect errors and irregularities (fraud)?

Answer 8

An auditor must assess the risk that errors and fraud may cause the financial statements to contain a material misstatement. Based on that assessment, the auditor then designs the audit to provide reasonable assurance of detecting errors and fraud that are material to the financial statements.

In other words: An auditor should design the audit to provide reasonable assurance of detecting errors and irregularities that are material to the financial statements.​

Question 9

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

Answer 9

An auditor may withdraw from an engagement when he/she believes that there is such a significant risk of fraud that it is not practicable to modify the procedures that are planned for the audit sufficiently to address the risk.

If management fails to respond appropriately to the auditor’s discovery of the payment of bribes to public officials, it may indicate a more pervasive problem, even though the amounts involved were small. This failure may impact the auditor’s ability to rely on management’s representations and result in withdrawal from the engagement.

Question 10

An auditor of a nonissuer exercising professional skepticism with respect to the risks of material misstatement due to fraud will most appropriately

Answer 10

Consider the reliability of information to be used as audit evidence.

Note:

The auditor should routinely consider the reliability of audit evidence in assessing the risks of material misstatement whether due to fraud or error.

Question 11

Which of the following statements is correct with respect to fraud encountered during an audit engagement of a nonissuer?

Answer 11

The determination of whether a misstatement is intentional (fraud) or unintentional (error) may be difficult, especially in subjective circumstances involving accounting estimates or the application of accounting principles.

Question 12

Which of the following is most likely to be considered a risk factor relating to fraudulent financial reporting?

Answer 12

Negative cash flows from operations.

Why?

Negative cash flows from operations may result in pressure upon management to overstate the results of operations.

Question 13

What type of inquiry should be made to managment from the auditor?

Answer 13

Does it have knowledge of fraud or suspect fraud?

Does it have programs to mitigate fraud risks?

Has it reported to the audit committee the nature of the company’s internal control?

Question 14

During an audit there is ordinarily a presumption of overstatements relating to

Answer 14

Revenue

Why?

professional standards suggest that there is a presumption that improper revenue recognition is a fraud risk.

Question 15

Auditor’s responsibility for detecting misstatements due to errors and fraud

Answer 15

Auditor should design the audit to provide reasonable assurance of detecting misstatements due to errors and fraud that are material to the financial statements.

Question 16

What would an auditor most likely consider a risk factor relating to misstatements arising from fraudulent financial reporting?

Answer 16

Management is interested in maintaining the entity’s earnings trend by using aggressive accounting practices.

• represent such a risk factor.

Question 17

In planning an audit, an auditor should document in the working papers the auditor’s risk assessment of a material misstatement of the financial statements due to fraud. What is included in workpaper documentation?

Answer 17

Those risk factors identified

Question 18

What most likely heighten an auditor’s concern about the risk of fraudulent financial reporting?

Answer 18

An overly complex organizational structure involving unusual lines of authority.

Question 19

Which of the following situations most likely represents the highest risk of a misstatement arising from misappropriations of assets?

Answer 19

A large number of bearer bonds on hand.

Why?

Bearer bonds may be sold by anyone—thus, if stolen, those bonds can be easily converted into cash that may be stolen.

Question 20

The most difficult type of misstatement to detect is fraud based on

Answer 20

The nonrecording of transactions.

Question 21

What is fraudulent financial reporting and give an example

Answer 21

fraudulent financial reporting involves intentional misstatements or omissions of amounts or disclosures in financial statements to deceive financial statement users and improperly recording the revenue results in such misstatements.

Ex:

Company management improperly records as revenue the proceeds of a loan.

Question 22

What best describes the auditor’s responsibility regarding the detection of material errors and fraud?

Answer 22

Auditing procedures may or may not need to be extended if the auditor’s analysis indicates the existence of fraud risk factors.

Note: When fraud risk factors exist, the auditor should consider whether already designed procedures adequately consider the existence of fraud. When they do not, audit procedures should be extended.

Question 23

At what stage may fraud risk factors be identified?

Answer 23

fraud risk factors may be identified during planning, obtaining an understanding, or while conducting fieldwork; in addition, they may be identified while considering acceptance or continuance of clients and engagements.

Question 24

What best describe the auditor’s responsibility to detect conditions relating to financial stress of employees or adverse relationships between a company and its employees?

Answer 24

The auditor is not required to plan the audit to discover these conditions, but should consider them if he or she becomes aware of them during the audit.

Question 25

When performing a financial statement audit, auditors are required to explicitly assess the risk of material misstatement due to

Answer 25

Fraud.

Note:

They should consider this when designing the audit

Question 26

Most likely would heighten an auditor’s concern about the risk of intentional manipulation of financial statements?

Answer 26

Management places substantial emphasis on meeting earnings projections.

Inability to generate cash flows from operations while reporting substantial earnings growth.

• such a situation causes one to question whether the earnings being reported are proper.

Question 27

characteristic of fraud

Answer 27

Collusion.

Concealment.

Falsified documentation

Intentional

Question 28

In general, material fraud perpetrated by which of the following are most difficult to detect?

Answer 28

Controller

Note:

A fraud committed by the controller is most difficult to detect because the controller is in control of the recordkeeping function and thus may be able to commit a fraud and then manipulate the accounting records so as to make its discovery unlikely.

Question 29

Which of the following characteristics most likely would heighten an auditor’s concern about the risk of material misstatement arising from fraudulent financial reporting?

Answer 29

Management had frequent disputes with the auditor on accounting matters.

Question 30

Which of the following is a risk factor relating to the misappropriation of assets?

Answer 30

Large amounts of cash on hand.

Question 31

“fraud risk factor”

Answer 31

It has been observed in circumstances where frauds have occurred.

• while fraud risk factors do not necessarily indicate the existence of fraud, they often have been observed in circumstances where frauds have occurred.
  *

Question 32

Most likely to affect the auditor’s assessment of the risk of misstatement due to fraud?

Answer 32

Missing documents.

Note: Missing documents may be indicative of fraud.

Question 33

Not normally cause the auditor to question whether material errors or fraud exist?

Answer 33

The client’s information system generates exception reports which periodically include bookkeeping errors.

Why?

Client may be expected to correct errors included on a computer-generated exception report.

Question 34

Which of the following, if material, would be fraud as defined in Statements on Auditing Standards?

Answer 34

Misappropriation of assets.

Question 35

Prior to, or in conjunction with, the information-gathering procedures for an audit, audit team members should discuss the potential for material misstatement due to fraud. Which of the following best characterizes the mind-set that the audit team should maintain during this discussion?

Answer 35

Questioning.

Note: auditors should maintain a questioning mind and exercise professional skepticism.

Question 36

Most likely to be an overall response to fraud risks identified in an audit?

Answer 36

overall responses to the risk of material misstatement due to fraud include:

(1) assigning personnel with particular skills relating to the area and considering the necessary extent of supervision to the audit,

(2) increasing the consideration of management’s selection and application of accounting principles, and

(3) making audit procedures less predictable.

Question 37

Auditor’s consideration of fraud

Answer 37

The auditor’s interest in fraud consideration relates to fraudulent acts that cause a material misstatement of financial statements.

Question 38

Professional skepticism, when exercised during the consideration of the risk of misstatement due to fraud

Answer 38

Is an attitude that includes a questioning mind.

Note:

Professional skepticism requires that an auditor neither assume dishonesty nor unquestioned honesty.

Question 39

most likely cause an auditor to suspect that material fraud exists in a client’s financial statements?

Answer 39

Significantly fewer responses to confirmation requests than were expected is considered a circumstance that should cause the auditor to consider whether material misstatements exist.

Question 40

Which of the following is most likely to be an example of fraud?

Answer 40

Defalcations occurring due to invalid electronic approvals.

Note: “Defalcation” is another term for misstatements arising from misappropriation of assets, a major type of fraud.

Question 41

Management’s attitude toward aggressive financial reporting and its emphasis on meeting projected profit goals most likely would significantly influence an entity’s control environment when

Answer 41

When management is dominated by one individual, that individual may be able to follow overly aggressive accounting principles.

Question 42

fraudulent financial reporting

and

misappropriation of assets.

Answer 42

FFR example:

Company management changes inventory count tags and overstates ending inventory, while understating cost of goods sold.

• intentional misstatements or omissions of amounts or disclosures in financial statements to deceive financial statement users and changing the inventory count tags results in such a misstatement.

MOA example:

• The treasurer diverts customer payments to his personal due, concealing his actions by debiting an expense account, thus overstating expenses.
• An employee steals inventory and the “shrinkage” is recorded in cost of goods sold.
• An employee steals small tools from the company and neglects to return them; the cost is reported as a miscellaneous operating expense.

Question 43

Most important concerning an auditor’s responsibility to detect errors and fraud?

Answer 43

The risk that mistakes, falsifications, and omissions may cause the financial statements to contain material misstatements.

Why?

auditor should assess the risk that errors and fraud (which include mistakes, falsifications and omissions) may cause the financial statements to contain material misstatements.

Question 44

most likely to be presumed to represent fraud risk on an audit?

Answer 44

Improper revenue recognition.

Question 45

overall responses to the risk of material misstatements due to fraud include:

Answer 45

(1) assigning personnel with particular skills relating to the area and considering the necessary extent of supervision to the audit,

(2) increasing the consideration of management’s selection and application of accounting principles, and

(3) making audit procedures less predictable.

Question 46

Factors or conditions is an auditor likely to plan an audit to discover

Answer 46

• High turnover of senior management.
• Inadequate monitoring of significant controls.
• Inability to generate positive cash flows from operations.

Question 47

Likely to indicate a risk of possible misstatement due to fraud?

Answer 47

• Failure to correct known significant deficiency on a timely basis.
• Nonfinancial management’s preoccupation with the selection of accounting principles.
• Significant portion of management’s compensation represented by bonuses based upon achieving unduly aggressive operating results.

Question 48

Not required when considering fraud in a financial statement audit?

Answer 48

Conduct the audit with professional skepticism, which includes an attitude that assumes balances are incorrect until documented by the auditor.

Why?

professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence—it does not assume that balances are incorrect until documented by the auditor.

Question 49

Situations most likely could lead to an embezzlement scheme?

Answer 49

Access to blank checks and signature plates is restricted to the cash disbursements bookkeeper who personally reconciles the monthly bank statements.

Note: bookkeeper’s access both to blank checks and the signature plates allows that person to embezzle cash by writing and signing checks and subsequently to hide the embezzlement during the reconciliation process.