Specific areas of engagement risk Flashcards
(8 cards)
A material change in an accounting estimate
A. Requires a consistency modification in the auditor’s report and disclosure in the financial statements.
B. Requires a consistency modification in the auditor’s report but does not require disclosure in the financial statements.
C. Affects comparability and may require disclosure in a note to the financial statements but does not require a consistency modification in the auditor’s report.
D. Involves the acceptability of the generally acceptable accounting principles used.
C. Affects comparability and may require disclosure in a note to the financial statements but does not require a consistency modification in the auditor’s report.
(Choice A) This answer is incorrect because a consistency modification is not necessary.
(Choice B) This answer is incorrect because a consistency modification is not necessary.
(Choice C) This answer is correct because whilea consistency modification is not necessary, footnote disclosure is required.
(Choice D) This answer is incorrect because a change in accounting principle has not occurred.
Regarding warranty reserves and their associated auditing issues, which of the following statements is true?
A. The warranty reserve account can be manipulated to understate income during a good sales year.
B. A known decrease in product reliability, with all other factors remaining the same, should lead to a decrease in the warranty reserve account.
C. A common fraud scheme known as “channel stuffing” relies on manipulation of reserve accounts, sometimes including the warranty reserve account.
D. An inherent risk of warranty reserves is the reliance on third parties.
A. The warranty reserve account can be manipulated to understate income during a good sales year.
Management applies judgment and prior experience when determining the estimated cost of fulfilling its warranty obligations. There is no definitive formula or “correct amount” when it comes to establishing a reasonable warranty reserve. As a result, the reserve account is susceptible to manipulation.
Assume total warranty expense is $120,000 for a 3-year period, or $40,000 per year. By decreasing the number of years covered by the warranty from 3 to 2, annual warranty expense is $60,000. In other words, increasing warranty expense from $40,000 to $60,000 reduces income, which reduces taxes.
Although one might assume that an entity would never deliberately reduce income, some entities prefer to keep income stable (ie, not volatile) from year to year. In years with unusually strong profits, an entity might seek to lower (or “smooth out”) its income.
(Choice B) A decrease in product reliability would result in an increase in warranty obligations, not a decrease.
(Choice C) Channel stuffing involves shipping goods to customers in excess of their needs to increase amounts reported as revenues (particularly near yearend); this fraud scheme is not related to the warranty reserve.
(Choice D) Warranty reserves are estimated by management based on its experience and are not dependent on third parties.
Things to remember:
Some entities seek a stable, gradual increase in income over the years (ie, “smoothed out” income). In years with strong profits, this requires manipulating income statement accounts by overstating expenses and understating income. Manipulating accounts is never permissible, regardless of the manipulation’s direction.
Which of the following events would least likely indicate the existence of related party transactions?
A. Making a loan with no scheduled date for the funds to be repaid.
B. Maintaining compensating balance arrangements for the benefit of principal stockholders.
C. Borrowing funds at an interest rate significantly below prevailing market rates.
D. Writing off obsolete inventory to net realizable value just before year end.
D. Writing off obsolete inventory to net realizable value just before year end.
Related party transactions are a high-risk area for auditors because they may present a greater opportunity for collusion, concealment, or manipulation. Auditors are responsible for obtaining evidence to determine whether management has properly identified, disclosed, and presented the transactions in the financial statements.
Auditors need to use professional skepticism when examining potential related party transactions. They should be alert for significant transactions that are outside the normal course of business or seem unusual due to timing, size, or nature. For example, if an entity maintains compensating balances for the benefit of principal stockholders, it may be indebted to those stockholders, possibly indicating related party transactions (Choice B).
However, writing off obsolete inventory to net realizable value just before year end is a normal transaction required by GAAP and does not suggest related party transactions.
(Choices A and C) A related party may make a loan with no scheduled due date or at an unusually low interest rate due to the relationship. Further investigation by the auditor is required.
Things to remember:
Auditors are responsible for identifying and evaluating whether related party transactions have been properly accounted for and disclosed by management. Searching for transactions that do not follow normal business rules (eg, loans made below market interest rates) is one method of identifying such transactions.
During an audit of a nonissuer, if the terms of a related party transaction are found to be materially inconsistent with the explanations provided by management, an auditor should
A. Communicate to those charged with governance that the auditor will be unable to express an opinion on the financial statements.
B. Include an emphasis-of-matter paragraph in the auditor’s report that describes the auditor’s inability to obtain assurance over related party transactions and balances.
C. Include an other-matter paragraph in the auditor’s report describing the inconsistent explanations provided by management.
D. Consider the reliability of management’s explanations and representations on other significant matters.
D. Consider the reliability of management’s explanations and representations on other significant matters.
Audit procedures are intended to identify the risks of material misstatements, including those involving related party transactions. The auditor will ask management about significant related party transactions during the audit and have management sign a written management representation documenting their assertions.
In addition to management’s assertions, the auditor must be alert to related party relationships identified while gathering audit evidence. Management may have a desire to hide related party transactions since they present an increased opportunity for collusion, concealment, or manipulation.
If management’s explanations are materially inconsistent with the audit evidence, the auditor must consider the reliability of management’s explanations and representations in other significant areas.
(Choice A) The auditor should try to determine why the related party transaction terms differ from management’s explanation and determine any financial statement impacts before considering the impact on the audit opinion.
(Choice B) The emphasis-of-matter paragraph in the audit report highlights disclosed information that helps users understand the financial statements. Inconsistencies in management information should be resolved before the report is issued.
(Choice C) The other-matter paragraph in the audit report is intended to provide information about the audit process, not about assertions from management.
Things to remember:
During an audit, management will be asked to explain significant related party transactions. If the explanations are inconsistent with audit evidence, the auditor will need to consider the reliability of management’s other explanations and representations.
What is the auditor’s primary purpose in performing a retrospective review of management’s significant accounting estimates reflected in the prior-year financial statements of a nonissuer?
A. To reevaluate professional judgments made by the auditor in the prior year.
B. To indicate whether a bias by management existed.
C. To indicate whether a significant deficiency existed.
D. To indicate whether an adjustment should have been recorded.
B. To indicate whether a bias by management existed.
Often, when preparing F/S, management must use accounting estimates. Such estimates are used when exact monetary amounts cannot be directly observed. These estimates involve judgment and can be influenced by various factors, leading to subjectivity and potential errors. The complexity of the estimation process and the inherent limitations in knowledge can increase the risk of misstatement in these estimates.
As part of testing accounting estimates, the auditor should obtain an understanding of management’s estimation process. To understand how management developed the estimates, the auditor will need to perform a retrospective review of the prior year’s significant accounting estimates.
The primary purpose of the retrospective review of the prior year’s significant accounting estimates is to see whether there are any indications of possible management bias. If the estimation process has changed or the estimated amounts significantly differ from expectations without explanation, it may suggest bias. This review is not intended to reevaluate the auditor’s previous judgments or to identify deficiencies or adjustments in prior years (Choices A, C, and D). This process will help the auditor evaluate the RMM and the appropriateness of the current year’s financial information.
Things to remember:
By performing a retrospective review of management’s significant accounting estimates, the auditor’s primary objective is to identify any indicators of possible management bias. Bias may be indicated if the estimation process has changed or the estimated amounts differ significantly from expectations without explanation.
Jones, CPA, is auditing an entity’s financial statements in accordance with Government Auditing Standards. Jones should prepare a written report which describes
A. The specific plan for obtaining audit evidence from all the applicable governmental agencies.
B. The scope of the auditor’s testing of compliance with laws and regulations and of internal controls.
C. The auditor’s independence and lack of any personal biases or external influences regarding the client.
D. The list of internal controls tested and the results of the testing.
B. The scope of the auditor’s testing of compliance with laws and regulations and of internal controls.
(Choice A) This answer is incorrect because the auditor is not required to report how the audit evidence is to be obtained.
(Choice B) This answer is correct because Government Auditing Standards requires that auditors report on the scope of their testing of compliance with laws and regulations and of internal controls.
(Choice C) This answer is incorrect because, although the auditor must maintain the appearance and the mental attitude of independence, there is no specific requirement to issue a separate report.
(Choice D) This answer is incorrect because the auditor does not separately report the internal controls tested and the outcome of the tests.
A CPA is engaged to audit the financial statements of a local government that receives federal awards. The CPA will be required to perform a Single Audit for which of the following reasons?
A. To provide reasonable assurance that the financial statements are free of material misstatements, whether caused by error or fraud.
B. To determine whether the entity complied with laws, regulations, and the provisions of contracts or grant agreements pertaining to federal awards that have a direct and material effect on each major program.
C. To provide reasonable assurance of detecting material misstatements resulting from noncompliance with provisions of contracts or grant agreements that have a direct and material effect on the determination of financial statement amounts.
D. To provide reasonable assurance that the financial statements are free of material misstatements resulting from violations of laws and regulations that have a direct and material effect on the determination of financial statement amounts.
B. To determine whether the entity complied with laws, regulations, and the provisions of contracts or grant agreements pertaining to federal awards that have a direct and material effect on each major program.
A Single Audit generally applies to state and local governments and not-for-profit organizations that expend $1,000,000 or more per year in federal funds under major federal financial assistance programs. This single coordinated audit is intended to result in efficiencies by combining multiple audits of the entity at the same time. Single Audits must also be conducted in accordance with GAAS and Generally Accepted Government Auditing Standards (GAGAS)
The auditor should report on:
The fairness of the entity’s F/S and schedule of expenditures of federal awards
I/C over financial reporting
I/C over compliance
Compliance with applicable laws, regulations, and conditions of federal awards with a direct and material impact on each of the entity’s major programs
If audit findings are identified, the auditor should also prepare a schedule of findings and questioned costs. This includes a summary of the audit results for the F/S, I/C, and compliance.
(Choice A, C, and D) The focus on an entity’s F/S amounts originates from GAAS and is not a reason to perform a Single Audit.
Things to remember:
A Single Audit generally applies to entities that expend $1,000,000 or more per year in federal funds under major federal financial assistance programs. The auditor determines whether the entity complied with laws, regulations, and the provisions of contracts or grant agreements pertaining to federal awards that have a direct and material effect on each major program.
Which of the following is a specific documentation requirement that an auditor should follow when auditing in accordance with Government Auditing Standards?
A. The auditor should obtain written representations from management acknowledging responsibility for correcting instances of fraud, abuse, and waste.
B. The auditor should include evidence of supervisory review of the audit before the report is issued.
C. The auditor should document the procedures that ensure discovery of all illegal actsand contingent liabilities resulting from noncompliance.
D. The auditor’s working papers should contain a caveat that all instances of materialmisstatements and fraud may not be identified.
B. The auditor should include evidence of supervisory review of the audit before the report is issued.
When performing audits in accordance with Government Auditing Standards (also known as generally accepted government auditing standards, or GAGAS), auditors are subject to additional documentation requirements. These include evidence of supervisory review before the report is issued and documentation of GAGAS departures and their effects on the audit and audit conclusions.
(Choice A) The auditor would obtain written representations from management regarding the entity’s responsibility to establish and maintain I/C systems to prevent and detect fraud, which may reveal abuse and waste. Management is not responsible for correcting all instances of fraud, abuse, and waste.
(Choice C) The auditor is responsible for planning and performing the audit to obtain reasonable assurance that the F/S are not materially misstated due to fraud or error. This would include consideration of laws and regulations that directly affect the F/S. The auditor does not plan or perform procedures that ensure discovery of all illegal acts and liabilities related to noncompliance.
(Choice D) Reasonable assurance does not guarantee discovery of all material misstatements and fraud. A caveat is not necessary.
Things to remember:
Auditors performing audits under Government Auditing Standards (GAGAS) are subject to additional documentation requirements, such as documenting supervisory review before the report release date.
