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CPA REVIEW SCHOOL OF THE PHILIPPINES

Manila

AUDITING THEORY
AUDIT REPORT

Related PSAs: PSA 700, 710, 720, 560, 570, 600 and 620

1. When an independent auditor expresses an unqualified opinion he asserts that:

(1) He performed the audit in accordance with generally accepted auditing standards.
(2) The company is a profitable and viable entity.
(3) The financial statements examined are in conformity with GAAP.
(4) The financial statements are accurate and free of errors.

a. All of the above statements are true.

b. Only statements (1) and (3) are true.
c. Only statements (2) and (4) are true.
d. All of the above statements are false.

2. An audit report should be dated as of the

a. date the report is delivered to the entity audited.
b. date the financial statements were approved by the client management.
c. balance sheet date of the latest period reported on.
d. date a letter of audit inquiry is received from the entity’s attorney of record.

3. If a company’s external auditor expresses an unqualified opinion as a result of the audit of the
company’s financial statements, readers of the audit report can assume that
a. The external auditor found no fraud.
b. The company is financial sound and the financial statements are accurate.
c. Internal control is effective.
d. All material disagreements between the company and external auditor about the application of
accounting principles were resolved in the satisfaction of the external auditor.

4. A statement that the auditor’s responsibility is to express an opinion on the financial statements is
contained in the:
a. Opening paragraph c. Opening and scope paragraph
b. Scope paragraph d. Opinion paragraph

5. The description of an audit in the scope paragraph of the standard audit report includes all of the
following except:
a. Evaluating the overall financial statement presentation.
b. Assessing control risk.
c. Examining, on a test basis, evidence supporting the amount and disclosures in the financial
statements.
d. Assessing the accounting principles used and significant estimates made by management.

6. The audit report is normally addressed to the:

Board of directors Stockholders Chair of the Audit Committee
a. No Yes No
b. Yes Yes No
c. Yes Yes Yes
d. Yes No Yes

7. If comparative financial statements are presented and the present auditor has audited both years,
the auditor should:
a. Reissue the report c. Redate the report
b. Dual date the report d. Update the report

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8. In which of the following situations would the auditor appropriately issue a standard unqualified
report with no explanatory paragraph concerning consistency?
a. A change in the method of accounting for specific subsidiaries that comprise the
group of companies for which consolidated statements are presented.
b. A change from an accounting principle that is not generally accepted to one that is
generally accepted.
c. A change in the percentage used to calculate the provision for warranty expense.
d. Correction of a mistake in the application of a generally accepted accounting
principle.

9. An auditor’s report contains the following sentences:

We did not audit the financial statements of B Company, a consolidated subsidiary, whose
statements reflect total assets and revenues constituting 20 percent and 22 percent,
respectively, of the related consolidated totals. These statements were audited by other
auditors, whose report has been furnished to us, and our opinion, insofar as it relates to the
amounts included for B Company, is based solely upon the report of the
other auditors.
These sentences
a. disclaim an opinion c. divide responsibility
b. qualify the opinion d. should not be part of the audit report

10. The management of a client company believes that the statement of cash flow is not a useful
document and refuses to include one in the annual report to stockholders. As a result, the
auditor’s opinion should be
a. qualified due to inadequate disclosure c. adverse
b. qualified due to a scope limitation d. unqualified

11. An auditor’s opinion reads as follows: “In our opinion, except for the above-mentioned limitation
on the scope of our audit…” This is an example of a(n)
a. review opinion c. qualified opinion
b. emphasis on a matter d. unacceptable reporting practice

12. Eagle Company’s financial statements contain a departure from generally accepted accounting
principles because, due to unusual circumstances, the statements would otherwise be misleading.
The auditor should express an opinion that is
a. Qualified and describe the departure in a separate paragraph.
b. Unqualified but not mention the departure in the auditor’s report.
c. Qualified or adverse, depending on materiality, and describe the departure in a
separate paragraph.
d. Unqualified and describe the departure in a separate paragraph.

13. An auditor is unable to determine the amounts associated with illegal acts committed by a client.
The auditor would most likely issue
a. Either a qualified opinion or a disclaimer of opinion.
b. An adverse opinion.
c. Either a qualified opinion or an adverse opinion.
d. A disclaimer of opinion.

14. The objective of the consistency standard is to provide assurance that

a. There are no variations in the format and presentation of financial statements.
b. Substantially different transactions and events are not accounted for on an identical
basis.
c. The auditor is consulted before material changes are made in the application of
accounting principles.

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d. The comparability of financial statements between periods is not materially affected

by changes in accounting principles without disclosure.

15. If management fails to provide adequate justification for a change from one generally accepted
accounting principle to another, the auditor should
a. Add an explanatory paragraph and express a qualified or an adverse opinion for lack
of conformity with generally accepted accounting principles.
b. Disclaim an opinion because of uncertainty.
c. Disclose the matter in a separate explanatory paragraph(s) but not modify the opinion
paragraph.
d. Neither modify the opinion nor disclose the matter because both principles are
generally accepted.

16. When an auditor qualifies an opinion because of inadequate disclosure, the auditor should
describe the nature of the omission in a separate explanatory paragraph and modify the
Introductory paragraph Scope paragraph Opinion paragraph
a. Yes No No
b. Yes Yes No
c. No Yes Yes
d. No No Yes

17. An auditor may not express a qualified opinion when

a. A scope limitation prevents the auditor from completing an important audit procedure.
b. The auditor’s report refers to the work of a specialist.
c. An accounting principles at variance with generally accepted accounting principles is
used.
d. The auditor lacks independence with respect to the audited entity.

18. An auditor decides to express a qualified opinion on an entity’s financial statements because a
major inadequacy in its computerized accounting records prevents the auditor from applying
necessary procedures. The opinion paragraph of the auditor’s report should state that the
qualification pertains to
a. A client-imposed scope limitation.
b. A departure from generally accepted auditing standards.
c. The possible effects on the financial statements.
d. Inadequate disclosure of necessary information.

19. Totoy, CPA, was engaged to audit the financial statements of Bibo Co., a new client, for the year
ended December 31, 2004. Totoy obtained sufficient audit evidence for all of Bibo’s financial
statement items except Bibo’s opening inventory. Due to inadequate financial records, Totoy
could not verify Bibo’s January 1, 2004 inventory balances. Totoy’s opinion on Bibo’s 2004
financial statements most likely will be
Balance Sheet Income Statement
a. Disclaimer Disclaimer
b. Unqualified Disclaimer
c. Disclaimer Adverse
d. Unqualified Adverse

20. When management prepares financial statements on the basis of a going concern and the auditor
believes the company may not continue as a going concern, the auditor should issue a(n)
a. qualified opinion
b. unqualified opinion with an explanatory paragraph
c. disclaimer of opinion
d. adverse opinion

21. A dual dated report contains the dates of a subsequent event and the date the:
a. Auditor completed work in the client’s office c. Subsequent event was
resolved

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b. Financial statements were prepared d. Audit report was delivered

22. If the principal auditor decides to take responsibility for the work of other auditors, the principal
auditor should:
a. Modify the opening paragraph c. Modify all three paragraphs
b. Modify the opening and opinion paragraphs d. Issue a standard report

23. An auditor who concludes that an uncertainty is not adequately disclosed in the financial
statements should issue a:
a. Disclaimer of opinion. c. Special report.
b. Unqualified report with an explanatory paragraph. d. Qualified report.

24. An auditor may wish to emphasize a matter included in the financial statements by adding an
explanatory paragraph to the audit report. In this case the following paragraphs of the audit report
should be modified:
a. Introductory paragraph c. Opinion paragraph
b. Scope paragraph d. None

25. In the case of a client imposed scope limitation, the auditor must consider issuing a:
a. Qualified opinion or disclaimer of opinion c. Disclaimer of opinion or adverse
opinion
b. Qualified opinion or adverse opinion d. Disclaimer of opinion

26. Which of the following modifications of the standard auditor’s report does not require an
explanatory paragraph.
a. Reference to other auditors c. Scope limitation
b. Inconsistency d. Adverse opinion

27. Pamela, CPA, was engaged to audit the financial statements of One Co. after its fiscal year had
ended. The timing of Pamela’s appointment as auditor and the start of field work made
confirmation of accounts receivable by direct communication with the debtors ineffective.
However, Pamela applied other procedures and was satisfied as to the reasonableness of the
account balances. Pamela’s auditor’s report most likely contained a(n) a. Unqualified opinion.
b. Unqualified opinion with an explanatory paragraph.
c. Qualified opinion because of a scope limitation.
d. Qualified opinion because of a departure from GAAS.

28. A limitation on the scope of an audit sufficient to preclude an unqualified opinion will always result
when management
a. Engages the auditor after the year-end physical inventory count is completed.
b. Fails to correct a material internal control weakness that had been identified during
the prior year’s audit.
c. Refuses to furnish a management representation letter to the auditor.
d. Prevents the auditor from reviewing the working papers of the predecessor auditor.

29. When an auditor expresses an opinion other than unqualified opinion, a clear description of all
substantive reasons for the modification of the opinion should be included in the report. This
explanation should be presented:
a. As a separate paragraph that precedes the opinion paragraph of the audit report.
b. As a separate paragraph, preferably after the opinion paragraph, of the audit report.
c. In the opinion paragraph
d. As a separate paragraph in the notes to financial statements.

30. Where a limitation on the scope of the auditor’s work requires modification of an unqualified
opinion, the auditor’s report should describe the limitation and:
a. Indicate that the auditor is no longer responsible to his opinion.
b. Indicate the possible adjustments to the financial statements that might have been
determined to be necessary had the limitation not existed.

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c. Refer the users to the particular note to financial statements that adequately
discusses the limitation
d. Indicate that the auditor is not satisfied of the results of the alternative procedures
that he had performed.

31. What is the purpose of the following paragraph in a particular audit report:

“…We draw attention to note X in the financial statements which discusses that the
company incurred a net loss of P6.4 million during the year ended December 31, 2004 and
as of that date, the Company’s liabilities exceeded its total assets by P2,500,000...”

a. A standard reporting requirement.

b. Emphasis of matter about the going concern problems of the entity.
c. Inadequate disclosure qualification.
d. An inappropriate reporting.

32. An explanatory paragraph following an opinion paragraph that describes an uncertainty follows:

As discussed in Note X to the financial statements, the company is a defendant in a lawsuit

alleging infringement of certain patent rights and claiming damages. Discovery
proceedings are in progress. The ultimate outcome of the litigation cannot presently be
determined. Accordingly, no provision for any liability that may result upon adjudication has
been made in the accompanying financial statements.

What type of opinion should the auditor express in this circumstance?

a. unqualified b. qualified c. disclaimer d. adverse

33. If an amendment to other information in a document containing audited financial statements is

necessary and the entity refuses to make the amendment, the auditor would consider issuing: a.
Qualified or adverse opinion c. Unqualified opinion with explanatory paragraph
b. Qualified or disclaimer of opinion d. Unqualified opinion.

34. When management does not amend the financial statements in circumstances where the auditor
believes they need to be amended and the auditor’s report has not been released to the entity, the
auditor should express
a. Qualified or adverse opinion c. Unqualified opinion with explanatory
paragraph
b. Qualified or disclaimer of opinion d. Unqualified opinion.

35. If subsequent to the issuance of the audited financial statements, the auditor becomes aware of
material misstatements in the financial statements that exist prior to the date of the audit report,
the auditor should
a. Notify the parties who currently relying on the financial statements.
b. Discuss the matter with management, and should take the action appropriate in the
circumstances.
c. Document such information in the audit plan for succeeding audit.
d. Submit revised copies of the financial statements and audit report to the
stockholders.

QUIZZERS

1. Which of the following is not explicitly included in the opening paragraph of an audit report?
a. Identification of the financial statements that have been audited.
b. A statement by the auditor that the audit provides a reasonable basis for the
opinion.

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c. Statement that the financial statements are the responsibility of the entity’s
management.
d. Statement that the responsibility of the auditor is to express an opinion on the
financial statements based on his audit.

2. A measure of uniformity in the form and content of the auditor’s report is desirable because a. It
helps the auditors avoid legal liability.
b. It helps the readers understand the report.
c. It helps the auditor identify the usual circumstances that are expected to occur.
d. It makes the auditors more informed of their responsibilities with respect to audit report.

3. The most common type of audit report contains a(n):

a. Adverse opinion. c. Disclaimer of opinion.
b. Qualified opinion. d. Unqualified

4. If an auditor is certain an illegal act has a material effect on financial statements and the clients
agrees to adjust the statements accordingly, the auditor should: a. Withdraw from the
engagement.
b. Disclaim an opinion on the financial statements taken as a whole.
c. Issue a qualified opinion.
d. Issue an unqualified opinion.

5. It exists when other information contradicts information contained in the audited financial
statements.
a. Material misstatement of fact c. Material inconsistency
b. Material error d. Material deviation

6. After issuing a report, a auditor has no longer obligation to make continuing inquiries or perform
other procedures concerning the audited financial statements, unless
a. Management of the entity requests the auditor to reissue the auditor’s report.
b. Information about an event that occurred after the end of fieldwork comes to the
auditor’s attention.
c. Information, which existed at the report date and may affect the report, comes to
the auditor’s attention.
d. Final determinations or resolutions are made of contingencies that had been
disclosed in the financial statements.

7. Which of the following events occurring after the issuance of an auditor’s report most likely would
cause the auditor to make further inquiries about the previously issued financial statements?
a. A technological development that could affect the entity’s future ability to continue
as a going concern.
b. The entity’s sale of a subsidiary that accounts for 30 percent of the entity’s
consolidated sales.
c. The discovery of information regarding a contingency that existed before the
financial statements were issued.
d. The final resolution of a lawsuit explained in a separate paragraph of the auditor’s
report

8. An auditor would issue an adverse opinion if

a. The audit was begun by other independent auditors who withdrew from the
engagement.
b. The statements taken as a whole do not fairly present the financial condition and
results of operations of the company.
c. A qualified opinion cannot be given because the auditor lacks independence.
d. The restriction on the scope of the audit was significant.

9. An audit report contains the following paragraph:

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"Because of the inadequacies in the company's accounting records during the year ended June
30, 2005, it was not practicable to extend our auditing procedures to the extent necessary to
enable us to obtain certain evidential matter as it relates to classification of certain items in the
consolidated statements of operations."

This paragraph most likely describes

a. A material departure from GAAP requiring a qualified audit opinion.
b. An uncertainty that should not lead to a qualified opinion.
c. A material scope restriction requiring a qualification of the audit opinion.
d. A matter that the auditor wishes to emphasize and that does not lead to a
qualified audit opinion.

10. The auditor issued a qualified opinion covering the financial statements of Client A for the year
ended December 31, 2004. The reason for the qualification was a departure from GAAP. In
presenting comparative statements for the years ended December 31, 2004 and 2005, the client
revised the 2004 financial statements to correct the previous departure from GAAP. The auditor's
2005 report on the 12/31/04 and 12/31/05 comparative financial statements will a. Express
unqualified opinions on both the 2004 and 2005 financial statements.
b. Express a qualified opinion on the 2004 financial statements and an unqualified opinion on the
2005 statements.
c. Retain the qualified opinion covering the 2004 statements, but add an explanatory paragraph
describing the correction of the prior departure from GAAP.
d. Render qualified audit opinions for both 2004 and 2005 financial statements given the 2005
carryover effect of the 2004 error.

11. An auditor may reasonably issue an "except for" qualified opinion for

Inadequate disclosure Scope limitation

a. Yes Yes
b. Yes No
c. No Yes
d. No No

12. Soon after Boyd's audit report was issued, Boyd learned of certain related party transactions that
occurred during the year under audit. These transactions were not disclosed in the notes to the
financial statements. Boyd should
a. Plan to audit the transactions during the next engagement.
b. Recall all copies of the audited financial statements.
c. Ask the client to disclose the transactions in subsequent interim statements.
d. Determine whether the lack of disclosure would affect the auditor's report.

13. An auditor includes an explanatory paragraph in an otherwise unqualified report in order to

emphasize that the entity being reported on is a subsidiary of another business enterprise. The
inclusion of this paragraph
a. Is appropriate and would not negate the unqualified opinion.
b. Is a qualification.
c. Is a violation of generally accepted reporting standards if this information is
disclosed in footnotes to the financial statements.
d. Necessitates a revision of the opinion paragraph to include the phrase "with the
foregoing explanation."

14. Which of the following best describes the auditor's responsibility for "other information" included in
the annual report to stockholders which contains financial statements and the auditor's report?
a. The auditor has no obligation to read the "other information."
b. The auditor has no obligation to corroborate the "other information," but should
read the "other information" to determine whether it is materially inconsistent with
the financial statements.
c. The auditor should extend the examination to the extent necessary to verify the
"other information."

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d. The auditor must modify the auditor's report to state that the "other information is
unaudited" or "not covered by the auditor's report."

15. In which of the following circumstances would an auditor be most likely to express an adverse
opinion?
a. The statements are not in conformity with the ASC Statements regarding the
capitalization of leases.
b. Information comes to the auditor's attention that raises substantial doubt about
the entity's ability to continue in existence.
c. The chief executive officer refuses the auditor access to minutes of board of
directors' meetings.
d. Control tests show that the entity's internal control is so poor that the financial
records cannot be relied upon.

16. When a principal auditor decides to make reference to another auditor's examination, the principal
auditor's report should always indicate clearly, in the introductory, scope, and opinion paragraphs,
the
a. Magnitude of the portion of the financial statements examined by the other
auditor. b. Division of responsibility.
c. Disclaimer of responsibility concerning the portion of the financial statements examined by the
other auditor.
d. Name of the other auditor.

17. The independent auditor refers to both GAAP and GAAS when writing the standard audit report.
These terms are mentioned as follows:
a b c d Scope Paragraph GAAP GAAS GAAP GAAS
Opinion Paragraph GAAS GAAP GAAP GAAS

18. Which of the following best describes the reference to the expression “taken as a whole” in the
fourth generally accepted auditing standard of reporting?
a. It applies equally to a complete set of financial statements and to an individual
financial statement.
b. It applies only to a complete set of financial statements.
c. It applies equally to each item in each financial statement.
d. It applies equally to each material item in each financial statement.

19. If an accounting change has no material effect on the financial statements in the current year but
the change is reasonably certain to have a material effect in later years, the change should be
a. Treated as a consistency modification in the auditor’s report for the current year.
b. Disclosed in the notes to the financial statements of the current year.
c. Disclosed in the notes to the financial statements and referred to in the auditor’s
report for the current year.
d. Treated as a subsequent event.

20. An auditor’s standard report expressed an unqualified opinion and includes an explanatory
paragraph that emphasizes a matter included in the notes to the financial statements. The
auditor’s report would be deficient if the explanatory paragraph states that the entity a. Is a
component of a larger business enterprise.
b. Has changed form the completed contract method to the percentage of completion method to
account for long-term construction contracts.
c. Has had a significant subsequent event.
d. Has accounting reclassifications that enhance the comparability between years.

21. In which of the following circumstances would an adverse opinion be appropriate?

a. The auditor is not independent with respect to the enterprise being audited
b. An uncertainty prevents the issuance of an unqualified report
c. The statements are not in conformity with authoritative statements regarding
accounting for pension plans

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d. A client-imposed scope limitation prevents the auditor from complying with

generally accepted auditing standards

22. An auditor is confronted with an exception sufficiently material to warrant departing from the
standard wording of an unqualified report. If the exception relates to a departure from the
generally accepted accounting principles, the auditor must decide between a(n) a. adverse
opinion and an unqualified opinion
b. adverse opinion and a qualified opinion
c. adverse opinion and a disclaimer of opinion
d. disclaimer of opinion and a qualified opinion

23. An auditor had expressed a qualified opinion on the financial statements of a prior period because
the client’s financial statements departed from generally accepted accounting principles. The prior
period statements are restated in the current period to conform with generally accepted
accounting principles. The auditor’s updated report on the prior period statements should
a. express an unqualified opinion about the restated financial statements
b. be accompanied by the auditor’s original report on the prior period
c. bear the same date as the auditor’s original report on the prior period
d. qualify the opinion concerning the restated financial statements because of a
change in accounting principles

24. A successor auditor should refer to a predecessor auditor’s report in the

a. Opening paragraph c. Opinion paragraph
b. Scope paragraph d. Opening and opinion paragraph

25. Because of inadequate records the auditor is uncertain as to whether property and equipment is
stated at cost. The auditor should issue a (n):
a. Qualified opinion c. Adverse opinion
b. Unqualified opinion d. Standard opinion

26. The auditor’s report contains a paragraph explaining that the entity changed from the straightline
to the declining balance method of depreciation. The auditor expressed an:
a. Adverse opinion c. Qualified opinion
b. Unqualified opinion d. Disclaimer of opinion

27. The following circumstances result in a modified, but unqualified report, except:
a. Inconsistent application of accounting principles.
b. Emphasis of a related party transaction that is disclosed in a footnote.
c. Lack of disclosure of a restriction on payment of dividends.
d. Other auditors perform work for which the principal auditor does not assume
responsibility.

28. Under which of the following sets of circumstances might an auditor disclaim an opinion?
a. The financial statements contain a departure from GAAP, the effect of which is
material.
b. The principal auditor decides to make reference to the report of another auditor
who audited a subsidiary.
c. There has been a material change between periods in the method of the
application of accounting principles.
d. There were significant limitations on the scope of the audit.

29. Which of the following description is not included in the scope paragraph of the auditor’s report?
a. Examining, on a test basis, evidence to support the financial statement amounts
and disclosures.
b. Determining the accounting principles used in the preparation of the financial
statements.
c. Assessing the significant estimates made by management in the preparation of
the financial statement.
d. Evaluating the overall financial statement presentation.

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30. Which of the following statements is best described in the scope paragraph of the independent
auditor’s report?
a. The audit was planned and performed to obtain reliable assurance about whether
the financial statements are free of material misstatements.
b. The audit was conducted in accordance with financial reporting framework.
c. The auditor makes the significant estimates in the preparation of the financial
statements.
d. A statement by the auditor that the audit provides a reasonable basis for the
opinion.

31. When there is an assessed substantial doubt about the ability of the entity to continue as a going
concern and such information is adequately disclosed in the notes to financial statements, the
auditor should express a(n):
a. Standard unqualified opinion. c. Qualified opinion
b. Unqualified opinion with explanatory paragraph. d. Adverse opinion

32. If adequate disclosure is not made by the entity regarding substantial doubt about its ability to
continue as a going concern, the auditor should include in his report specific reference to the
substantial doubt as to ability of the company to continue as a going concern and should express:
a. Unqualified opinion with explanatory paragraph
b. A subject to qualified opinion or adverse opinion.
c. Either an “except for” qualified opinion or an adverse opinion.
d. A disclaimer of opinion.

33. Which of the following factors, by itself, would not cause uncertainty about the ability of a company
to continue as a going concern? a. A significant net loss.
b. Inability to pay its obligations as they come due.
c. The occurrence of uninsured catastrophe.
d. Legal proceedings that might jeopardize the entity’s ability to operate.

34. If the auditor concludes that the fraud or error has a material effect on the financial statements and
has not been properly corrected in the financial statements, the auditor should issue a:
a. Unqualified opinion with explanatory paragraph. c. Qualified or disclaimer
of opinion.
b. Qualified or adverse opinion. d. Adverse or disclaimer of
opinion.

35. If the auditor is precluded by the entity from obtaining evidence to evaluate whether fraud or error
that may be material to the financial statements has, or is likely to have, occurred, the auditor
should issue a (n):
a. Unqualified opinion with explanatory paragraph.
b. Qualified or adverse opinion.
c. Qualified or disclaimer of opinion.
d. Adverse or disclaimer of opinion.

36. In which of the following circumstances would an auditor usually choose between expressing a
qualified opinion or disclaiming an opinion?
a. Departure from generally accepted accounting principles
b. Inadequate disclosure of accounting policies
c. Inability to obtain sufficient competent evidential matter
d. Unreasonable justification for a change in accounting principle

PSA 700 – The Auditor’s Report on Financial Statements

37. The element of the auditor’s report that distinguishes it from reports that might be issued by others
is
a. Title c. Auditor’s signature
b. Addressee d. Opinion paragraph

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38. The financial statements audited by the auditor are identified in the
a. Opening paragraph c. Opinion paragraph
b. Scope paragraph d. All of the above.

39. Which of the following statements can be found on the scope paragraph of the standard audit
report?
a. The financial statements are the responsibility of the Company’s management.
b. Our responsibility is to express an opinion on these financial statements based
on our audit.
c. We believe that our audit provides a reasonable basis for our opinion.
d. The financial statements ‘present fairly, in all material respects’.

40. Which statement is incorrect regarding the date of the auditor’s report?
a. The auditor should date the report as of the completion date of the audit.
b. The date of the report informs the reader that the auditor has considered the
effect on the financial statements and on the report of events and transactions of
which the auditor became aware and that occurred up to that date.
c. The auditor should not date the report earlier than the date on which the financial
statements are signed or approved by management.
d. The auditor should date the report as of date the report is delivered to the entity
audited.

41. The following will usually result in a modified report but will not affect the auditor’s opinion, except
a. Existence of going concern problem.
b. There is a significant uncertainty (other than a going concern problem), the
resolution of which is dependent upon future events and which may affect the
financial statements. c. Emphasis of a matter.
d. There is a disagreement with management regarding the acceptability of the accounting policies
selected.

42. In extreme cases, such as situations involving multiple uncertainties that are significant to the
financial statements, the auditor may consider it appropriate to express a
a. Qualified or adverse opinion c. Unqualified opinion with explanatory
paragraph
b. Disclaimer of opinion d. Unqualified opinion.

PSA 710 – Comparatives

43. Which statement is incorrect regarding comparatives?

a. The auditor is not required to determine whether the comparatives comply in all
material respects with GAAP relevant to the financial statements being audited.
b. There are two broad financial reporting frameworks for comparatives: the
corresponding figures and the comparative financial statements.
c. Under the corresponding figures framework, the corresponding figures for the
prior period(s) are an integral part of the current period financial statements and
have to be read in conjunction with the amounts and other disclosures relating to
the current period.
d. Under the comparative financial statements framework, the comparative financial
statements for the prior period(s) are considered separate financial statements.

44. Which statement is incorrect regarding corresponding figures?

a. The corresponding figures are not presented as complete financial statements
capable of standing alone.
b. The level of detail presented in the corresponding amounts and disclosures is
dictated primarily by its relevance to the current period figures.
c. The auditor’s report refers only to the financial statements of the current period.
d. The auditor’s report refers to each period that financial statements are presented.

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45. When the comparatives in which the prior audit report is unmodified, the auditor should issue an
audit report in which:
a. The comparatives are specifically identified in the opening paragraph but not
referred to in the opinion paragraph of the auditor’s report.
b. The comparatives are specifically identified in the opening paragraph and are
referred to in the opinion paragraph.
c. The comparatives are not specifically identified in the audit report.
d. The comparatives are described in the emphasis of matter paragraph of the
auditor’s report.

46. In case the prior period financial statements were audited by another auditor and the incoming
auditor decides to refer to another auditor, the incoming auditor’s report should indicate: a. That
the financial statements of the prior period were audited by another auditor.
b. The type of report issued by the predecessor auditor and, if the report was modified, the
reasons therefore.
c. The date of that report.
d. All of the above.

47. In relation to comparatives as corresponding figures, which of the following is incorrect?

a. When the prior period financial statements are not audited, the incoming auditor
should state in the auditor’s report that the corresponding figures are unaudited.
b. The incoming auditor must refer to the predecessor auditor’s report on the
corresponding figures in the incoming auditor’s report for the current period.
c. When the financial statements of the prior period were audited by another
auditor, the incoming auditor’s report should state that the prior period was
audited by another auditor.
d. In situations were the incoming auditor identified that the corresponding figures
are materially misstated, the auditor should request management to revise the
corresponding figures or if management refuses to do so, appropriately modify
the report.

48. When the financial statements of the prior period were not audited, the incoming auditor should:
a. Insist that an audit of prior year’s financial statements must be made.
b. Not allow the inclusion of the corresponding figures in the financial statements of
the current period.
c. Disclaim his opinion and treat the unaudited corresponding figures as basis of
scope limitation.
d. Obtain sufficient appropriate audit evidence that the corresponding figures meet
the requirements of the relevant financial reporting framework.’

- end of AT-5906 -

CPA REVIEW SCHOOL OF THE PHILIPPINES

Manila

AUDITING THEORY
PRE-ENGAGEMENT

Related PSAs: PSA 210

PSA 210 - Terms of Audit Engagements

The auditor and the client should agree on the terms of the engagement. The agreed terms would
need to be recorded in an audit engagement letter or other suitable form of contract.

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It is in the interest of both client and auditor that the auditor sends an engagement letter, preferably
before the commencement of the engagement, to help in avoiding misunderstandings with respect to
the engagement.

The engagement letter documents and confirms:

1. the auditor’s acceptance of the appointment;
2. the objective and scope of the audit;
3. the extent of the auditor’s responsibilities to the client; and
4. the form of any reports.

Principal Contents

The form and content of audit engagement letters may vary for each client, but they would generally
include reference to:

• The objective of the audit of financial statements.

• Management’s responsibility for the financial statements.
• The scope of the audit, including reference to applicable legislation, regulations, or
pronouncements of professional bodies to which the auditor adheres.
• The form of any reports or other communication of results of the engagement.
• The fact that because of the test nature and other inherent limitations of an audit, together
with the inherent limitations of any accounting and internal control system, there is an
unavoidable risk that even some material misstatement may remain undiscovered.
• Unrestricted access to whatever records, documentation and other information requested in
connection with the audit.

The auditor may also wish to include in the letter:

• Arrangements regarding the planning of the audit.

• Expectation of receiving from management written confirmation concerning representations
made in connection with the audit.
• Request for the client to confirm the terms of the engagement by acknowledging receipt of
the engagement letter.
• Description of any other letters or reports the auditor expects to issue to the client.
• Basis on which fees are computed and any billing arrangements.

When relevant, the following points could also be made:

• Arrangements concerning the involvement of other auditors and experts in some aspects of
the audit.
• Arrangements concerning the involvement of internal auditors and other client staff.
• Arrangements to be made with the predecessor auditor, if any, in the case of an initial audit.
• Any restriction of the auditor’s liability when such possibility exists.
• A reference to any further agreements between the auditor and the client.

Audits of Components

When the auditor of a parent entity is also the auditor of its subsidiary, branch or division
(component), the factors that influence the decision whether to send a separate engagement letter to
the component include:

• Who appoints the auditor of the component.

• Whether a separate audit report is to be issued on the component.
• Legal requirements.
• The extent of any work performed by other auditors.
• Degree of ownership by parent.
• Degree of independence of the component’s management.

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Recurring Audits

On recurring audits, the auditor should consider whether circumstances require the terms of the
engagement to be revised and whether there is a need to remind the client of the existing terms of the
engagement.

The auditor may decide not to send a new engagement letter each period. However, the following
factors may make it appropriate to send a new letter:

• Any indication that the client misunderstands the objective and scope of the audit.
• Any revised or special terms of the engagement.
• A recent change of senior management, board of directors or ownership.
• A significant change in nature or size of the client’s business.
• Legal requirements.

Acceptance of a Change in Engagement

A request from the client for the auditor to change the engagement may result from:

1. a change in circumstances affecting the need for the service;

2. a misunderstanding as to the nature of an audit or related service originally requested; or
3. a restriction on the scope of the engagement, whether imposed by management or caused by
circumstances.

Items 1 and 2 would ordinarily be considered a reasonable basis for requesting a change in the
engagement. In contrast a change would not be considered reasonable if it appeared that the change
relates to information that is incorrect, incomplete or otherwise unsatisfactory.

If the auditor agreed to a change of the engagement:

• the auditor and the client should agree on the new terms;
• the report issued would be that appropriate for the revised terms of engagement; and
• in order to avoid confusing the reader, the report would not include reference to: (a) The
original engagement; or
(b) Any procedures that may have been performed in the original engagement, except
where the engagement is changed to an engagement to undertake agreed-upon
procedures and thus reference to the procedures performed is a normal part of the
report.

If the auditor is unable to agree to a change of engagement and is not permitted to continue the
original agreement:

• the auditor should withdraw; and

• consider whether there is any obligation, either contractual or otherwise, to report to other
parties, such as the board of directors or shareholders, the circumstances necessitating the
withdrawal.

MULTIPLE CHOICE QUESTIONS

1. Prior to the acceptance of an audit engagement with a client who has terminated the services of
the predecessor auditor, the CPA should
a. Contact the predecessor auditor without advising the prospective client and request a
complete report of the circumstance leading to the termination with the understanding that
all information disclosed will be kept confidential.
b. Accept the engagement without contacting the predecessor auditor since the CPA can
include audit procedures to verify the reason given by the client for the termination.

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c. Not communicate with the predecessor auditor because this would in effect be asking the
auditor to violate the confidential relationship between auditor and client.
d. Advise the client of the intention to contact the predecessor auditor and request permission
for the contact.

2. Before accepting an audit engagement, a successor auditor should make specific inquiries of
the predecessor auditor regarding the predecessor’s
a. Opinion of any subsequent events occurring since the predecessor’s audit report was
issued.
b. Understanding as to the reasons for the change of auditors.
c. Awareness of the consistency in the application of GAAP between periods.
d. Evaluation of all matters of continuing accounting significance.

3. A successor auditor most likely would make specific inquiries of the predecessor auditor
regarding
a. Specialized accounting principles of the client’s industry.
b. The competency of the client’s internal audit staff.
c. The uncertainty inherent in applying sampling procedures.
d. Disagreements with management as to auditing procedures.

4. 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 the integrity of management

5. When an independent auditor is approached to perform an audit for the first time, he or she
should make inquiries of the predecessor auditor. Inquiries are necessary because the
predecessor may be able to provide the successor with information that will assist the successor
in determining whether
a. The predecessor’s work should be used.
b. The company rotates auditors.
c. In the predecessor’s opinion, control risk is low.
d. The engagement should be accepted.

6. If permission from client to discuss its affairs with the proposed auditor is denied by the client,
the predecessor auditor should: a. Keep silent of the denial.
b. Disclose the fact that the permission to disclose is denied by the client.
c. Disclose adequately to proposed auditor all noncompliance made by the client.
d. Seek legal advice before responding to the proposed auditor

7. The objective and scope of the audit and the extent of the auditor’s responsibilities to the client
are best documented in
a. Independent auditor’s report c. Client’s representation letter
b. Audit engagement letter d. Audit program

8. The following are valid reasons why an auditor sends to his client an engagement letter:
A B C D
a. Avoid misunderstanding with respect to Yes Yes No Yes engagement
b. Confirms the auditor’s acceptance of the Yes Yes Yes No appointment
c. Objective and scope of the audit Yes Yes Yes Yes
d. Assures CPA’s compliance to GAAS Yes No No Yes

9. Which of the following is appropriately included in an audit engagement letter?

I. Because of the test nature and other inherent limitations of an audit, together with the
inherent limitations of any accounting and internal control system, there is an unavoidable
risk that even some material misstatements may remain undiscovered.

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II. The audit will be made with the objective of expressing an opinion on the financial
statements.
III. An audit also includes assessing the accounting procedures used and significant estimates
made by management.
a. I and II c. II and III
b. I and III d. I, II and III

10. Which of the following is least likely included in an audit engagement letter?
a. The objective of financial reporting.
b. Management responsibility for the financial statements.
c. The form of any reports or other communication of the results of the engagement.
d. Arrangement concerning the involvement of other auditors or experts in some aspects of
the audit.

11. An audit engagement letter least likely includes

a. A reference to the inherent limitation of an audit that some material misstatements may
remain undiscovered.
b. Identification of specific audit procedures that the auditor needs to undertake.
c. Description of any letters or reports that the auditor expects to submit to the client.
d. Arrangements concerning the involvement of internal auditors and other client’s staff.

12. Which of the following least likely requires the auditor to send a new engagement letter?
a. An indication that the client misunderstands the objective and scope of the audit.
b. Any revised or special terms of the engagement.
c. A recent change in the audit firm’s management.
d. Legal requirements and other government agencies’ pronouncements.

13. Which of the following least likely influence the auditor’s decision to send a separate
engagement letter to a component of parent entity client? a. Legal requirements
b. Degree of ownership over a component entity by parent company
c. Location of the principal place of business of the component entity
d. Who appoints the auditor of the component

14. According to PSA 210, which of the following statements is correct?

a. The auditor and the client need not agree on the terms of the engagement.
b. Where the terms of the engagement are changed, the auditor and the client need not agree
on the new terms if they already agreed on the old terms.
c. The engagement letter assists in the supervision and review of the audit work.
d. The auditor may agree to a change of engagement where there is reasonable justification
for doing so.

15. Which of the following is a NOT valid reason for a change of the engagement to a lower “level of
assurance”?
a. Change in circumstances affecting the need for the service.
b. Restriction on the scope of the engagement.
c. Misunderstanding as to the nature of the engagement originally requested.
d. The client’s need is satisfied by an engagement that provides lower level of assurance.

16. When a change in the type of engagement from higher to lower level of assurance is reasonably
justified, the report based on the revised engagement
a. Should contain a separate paragraph that refers to the original engagement.
b. Should always refer to any procedures that may have been performed in the original
engagement.
c. Should qualify the opinion due to scope limitation.
d. Omits reference to the original engagement.

17. Which of the following actions may be appropriate if the auditor is unable to agree to a change of
the engagement and is not permitted to continue the original engagement I. Issue a qualified
opinion due to a significant scope limitation.

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II. Auditor should withdraw from the engagement.

III. Consider whether there is any obligation to report to the board of directors or shareholders
the circumstances necessitating withdrawal
a. I only c. II and III
b. I and II d. I, II and III

- end of AT-5907 -

CPA REVIEW SCHOOL OF THE PHILIPPINES

Manila

AUDITING THEORY
AUDIT PLANNING

Related PSAs: PSA 300, 310, 320, 520 and 570

Appointment of the Independent Auditor

Early appointment of the independent auditor has many advantages to both the auditor and his client.
Early appointment enables the auditor to plan his work so that it may be done expeditiously and to
determine the extent to which it can be done before the balance sheet date.

Although early appointment is preferable, an independent auditor may accept an engagement near or
after the close of the fiscal year. In such instances, before accepting the engagement, he should
ascertain whether circumstances are likely to permit an adequate audit and expression of an
unqualified opinion and, if they will not, he should discuss with the client the possible necessity for a
qualified opinion or disclaimer of opinion.

PSA 300 - Planning

The first standard of fieldwork (performance standards) states that:

”The work is to be adequately planned and assistants, if any, are to be properly

supervised.”

The auditor should plan the audit work so that the audit will be performed in an effective manner.

“Planning” means developing a general strategy and a detailed approach for the expected nature,
timing and extent of the audit. The auditor plans to perform the audit in an efficient and timely manner.

Importance of Adequate Planning

Adequate planning of the audit work helps to ensure that:

1) Appropriate attention is devoted to important areas of the audit; 2)
Potential problems are identified; and 3) The work is completed
expeditiously.

Planning also assists in proper:

1) Assignment of work to assistants; and
2) Coordination of work done by other auditors and experts.

Extent of Planning

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The extent of planning will vary according to the following:

1) Size of the entity;
2) Complexity of the audit; and
3) Auditor’s experience with the entity and knowledge of the business.

The Overall Audit Plan

The auditor should develop and document an overall audit plan describing the expected scope and
conduct of the audit.

While the record of the overall audit plan will need to be sufficiently detailed to guide the development
of the audit program, its precise form and content will vary depending on the following:
1) Size of the entity;
2) Complexity of the audit; and
3) Specific methodology and technology used by the auditor.

Matters to be considered by the auditor in developing the overall audit plan include:

Knowledge of the Business

• General economic factors and industry conditions affecting the entity’s business.
• Important characteristics of the entity, its business, its financial performance and its reporting
requirements including changes since the date of the prior audit.
• The general level of competence of management.

Understanding the Accounting and Internal Control Systems

• The accounting policies adopted by the entity and changes in those policies.
• The effect of new accounting or auditing pronouncements.
• The auditor’s cumulative knowledge of the accounting and internal control systems and the
relative emphasis expected to be placed on tests of control and substantive procedures.

Risk and Materiality

• The expected assessments of inherent and control risks and the identification of significant audit
areas.
• The setting of materiality levels for audit purposes.
• The possibility of material misstatement, including the experience of past periods, or fraud.
• The identification of complex accounting areas including those involving accounting estimates.

Nature, Timing and Extent of Procedures

• Possible change of emphasis on specific audit areas.

• The effect of information technology on the audit.
• The work of internal auditing and its expected effect on external audit procedures.

Coordination, Direction, Supervision and Review

• The involvement of other auditors in the audit of components, for example, subsidiaries, branches
and divisions.
• The involvement of experts.
• The number of locations.
• Staffing requirements.

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Other Matters

• The possibility that the going concern assumption may be subject to question.
• Conditions requiring special attention, such as the existence of related parties.
• The terms of the engagement and any statutory responsibilities.
• The nature and timing of reports or other communication with the entity that are expected under
the engagement.

The Audit Program

The auditor should develop and document an audit program setting out the nature, timing and extent
of planned audit procedures required to implement the overall audit plan.

The audit program serves as a:

1) Set of instructions to assistants involved in the audit; and
2) Means to control and record the proper execution of the work.

The audit program also contains:

1) The audit objectives for each area; and
2) A time budget in which hours are budgeted for the various audit areas or procedures.

In preparing the audit program, the auditor would consider the following:
1) Specific assessments of inherent and control risks and the required level of assurance to be
provided by substantive procedures;
2) Timing of tests of controls and substantive procedures;
3) Coordination of any assistance expected from the entity, the availability of assistants and the
involvement of other auditors or experts; and
4) Other matters considered by the auditor in developing the overall audit plan need to be
considered in more detail during the development of the audit program.

Changes to the Overall Audit Plan and Audit Program

The overall audit plan and the audit program should be revised as necessary during the course of the
audit. Planning is continuous throughout the engagement because of changes in conditions or
unexpected results of audit procedures. The reasons for significant changes would be recorded.

PSA 310 - Knowledge of Business

In performing an audit of financial statements, the auditor should have or obtain a knowledge of the
business sufficient to enable the auditor to identify and understand the events, transactions and
practices that, in the auditor’s judgment, may have a significant effect on the financial statements or
on the examination or audit report.

Required Level of Knowledge

The auditor’s level of knowledge for an engagement would include:

• a general knowledge of the economy and the industry within which the entity operates, and
• a more particular knowledge of how the entity operates.

The level of knowledge required by the auditor would, however, ordinarily be less than that possessed
by management.

Obtaining the Knowledge

Prior to accepting an engagement, the auditor would obtain:

• a preliminary knowledge of the industry and of the ownership,

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• management and operations of the entity to be audited, and

• would consider whether a level of knowledge of the business adequate to perform the audit
can be obtained.

Following acceptance of the engagement, further and more detailed information would be obtained.
To the extent practicable, the auditor would obtain the required knowledge at the start of the
engagement. As the audit progresses, that information would be assessed and updated and more
information would be obtained.

For continuing engagements, the auditor would:

• update and reevaluate information gathered previously, including information in the prior year’s
working papers.
• also perform procedures designed to identify significant changes that have taken place since
the last audit.

The auditor can obtain knowledge of the industry and the entity from a number of sources. For
example:

• Previous experience with the entity and its industry.

• Discussion with people with the entity (for example, directors and senior operating personnel).
• Discussion with internal audit personnel and review of internal audit reports.
• Discussion with other auditors and with legal and other advisors who have provided services to
the entity or within the industry.
• Discussion with knowledgeable people outside the entity (for example, industry economists,
industry regulators, customers, suppliers, competitors).
• Publications related to the industry (for example, government statistics, surveys, texts, trade
journals, reports prepared by banks and securities dealers, financial newspapers).
• Legislation and regulations that significantly affect the entity.
• Visits to the entity’s premises and plant facilities.
• Documents produced by the entity (for example, minutes of meetings, material sent to
shareholders or filed with regulatory authorities, promotional literature, prior years’ annual and
financial reports, budgets, internal management reports, interim financial reports, management
policy manual, manuals of accounting and internal control systems, chart of accounts, job
descriptions, marketing and sales plans).

Using the Knowledge

A knowledge of the business is a frame of reference within which the auditor exercises professional
judgment. Understanding the business and using this information appropriately assists the auditor in:

• Assessing risks and identifying problems.

• Planning and performing the audit effectively and efficiently.
• Evaluating audit evidence.
• Providing better service to the client.

The auditor makes judgments about many matters throughout the course of the audit where
knowledge of the business is important. For example:

• Assessing inherent risk and control risk.

• Considering business risks and management’s response thereto.
• Developing the overall audit plan and the audit program.
• Determining a materiality level and assessing whether the materiality level chosen remains
appropriate.
• Assessing audit evidence to establish its appropriateness and the validity of the related
financial statement assertions.
• Evaluating accounting estimates and management representations.
• Identifying areas where special audit consideration and skills may be necessary.
• Identifying related parties and related party transactions.

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• Recognizing conflicting information (for example, contradictory representations).

• Recognizing unusual circumstances (for example, fraud and noncompliance with laws and
regulations, unexpected relationships of statistical operating data with reported financial
results).
• Making informed inquiries and assessing the reasonableness of answers.
• Considering the appropriateness of accounting policies and financial statement disclosures.

The auditor should ensure that assistants assigned to an audit engagement obtain sufficient
knowledge of the business to enable them to carry out the audit work delegated to them.

To make effective use of knowledge about the business, the auditor should consider how it affects the
financial statements taken as a whole and whether the assertions in the financial statements are
consistent with the auditor’s knowledge of the business.

PSA 320 – Audit Materiality

The auditor should consider materiality and its relationship with audit risk when conducting an audit.

“Information is material if its omission or misstatement could influence the economic decisions of
users taken on the basis of the financial statements. Materiality depends on the size of the item or
error judged in the particular circumstances of its omission or misstatement. Thus, materiality
provides a threshold or cut-off point rather than being a primary qualitative characteristic which
information must have if it is to be useful.”

The auditor considers materiality at both the overall financial statement level and in relation to
individual account balances, classes of transactions and disclosures.

Materiality should be considered by the auditor when:

(a) determining the nature, timing and extent of audit procedures; and (b)
evaluating the effect of misstatements.

The Relationship Between Materiality and Audit Risk

There is an inverse relationship between materiality and the level of audit risk, that is, the higher the
materiality level, the lower the audit risk and vice versa.

Materiality and Audit Risk in Evaluating Audit Evidence

The auditor's assessment of materiality and audit risk may be different at the time of initially planning
the engagement from at the time of evaluating the results of audit procedures. This could be because
of:
• a change in circumstances; or
• because of a change in the auditor's knowledge as a result of the audit.

Evaluating the Effect of Misstatements

In evaluating the fair presentation of the financial statements the auditor should assess whether the
aggregate of uncorrected misstatements that have been identified during the audit is material.

The aggregate of uncorrected misstatements comprises:

(a) specific misstatements identified by the auditor including the net effect of uncorrected
misstatements identified during the audit of previous periods; and

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(b) the auditor's best estimate of other misstatements which cannot be specifically identified (i.e.,
projected errors).

If the auditor concludes that the misstatements may be material the auditor needs to:
• consider reducing audit risk by extending audit procedures; or
• requesting management to adjust the financial statements.

If management refuses to adjust the financial statements and the results of extended audit procedures
do not enable the auditor to conclude that the aggregate of uncorrected misstatements is not material,
the auditor should consider the appropriate modification to the auditor’s report in accordance with
PSA 700 “The Auditor’s Report on Financial Statements.”

MULTIPLE CHOICE QUESTIONS

1. The development of a general strategy and a detailed approach for the expected nature, timing,
and extent of audit refers to :
a. Supervision b. Audit procedures c. Directing d. Planning

2. The auditor should consider the nature, extent, and timing of the work to be performed and
should prepare a written audit program for every audit. Which audit standard is most closely
related to this requirement?
a. The audit is to be performed by a person or persons having adequate technical training and
proficiency as an auditor.
b. In all matters relating to the assignment, an independent mental attitude is to be maintained by
the auditor(s).
c. Due professional care is to be exercised in the planning and performance of the audit and
preparation of the report.
d. The work is to be adequately planned and assistants, if any, are to be properly supervised.

3. Which of the following would a successor auditor normally perform after acceptance of an audit
client?
a. Inquiry of predecessor auditor regarding the client.
b. Review the SEC filings of the client.
c. Inquiry of bankers regarding the client.
d. Review of predecessor auditor working papers.

4. To obtain an understanding of a continuing client’s business in planning an audit, an auditor most

likely would
a. Perform tests of details of transactions and balances.
b. Review prior-year working papers and the permanent file for the client.
c. Read specialized industry journals.
d. Reevaluate client’s internal control environment.

5. Which of the following is required documentation in an audit in accordance with generally

accepted auditing standards?
a. A flowchart or narrative of the information system describing the recording and classification of
transactions for financial reporting.
b. An audit program setting forth in detail the procedures necessary to accomplish the
engagement’s objectives.
c. A planning memorandum establishing the timing of the audit procedures and coordinating the
assistance of entity personnel.
d. An internal control questionnaire identifying policies and procedures that assure specific
objectives will be achieved.

6. Which of the following procedures would an auditor most likely perform in planning a financial
statement audit?
a. Inquiring of the client’s legal counsel concerning pending litigation.
b. Comparing the financial statements to anticipated results.
c. Examining computer generated exception reports to verify the effectiveness of internal
controls.

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d. Searching for unauthorized transactions that may aid in detecting unrecorded liabilities.

7. Analytical procedures used in planning an audit should focus on

a. Reducing the scope of tests of controls and substantive tests.
b. Providing assurance that potential material misstatements will be identified.
c. Enhancing the auditor’s understanding of the client’s business.
d. Assessing the adequacy of the available evidential matter.

8. Analytical procedures, which means the analysis of significant ratios and trends including the
resulting investigation of fluctuations and relationships that are inconsistent with other relevant
information or which deviate from predicted amounts, are not required to be applied a. At the
planning stage of the audit c. As substantive procedures
b. Overall review stage of the audit d. None of the above

9. Which of the following statements is correct concerning analytical procedures?

a. Analytical procedures usually involve comparisons of ratios developed from recorded amounts
to assertions developed by management.
b. Analytical procedures used in planning an audit generally use data aggregated at a high level.
c. Analytical procedures can replace tests of controls in gathering evidence to support the
assessed level of control risk.
d. Analytical procedures are more efficient, but not more effective, than tests of details and
transactions.

10. Which of the following is an effective audit planning and control procedures that helps prevent
misunderstandings and inefficient use of audit personnel?
a. Make copies, for inclusion in the working papers, of those client supporting documents
examined by the auditor.
b. Provide the client with copies of the audit programs to be used during the audit.
c. Arrange a preliminary conference with the client to discuss audit objectives, fees, timing, and
other information.
d. Arrange to have the auditor prepare and post any necessary adjusting or reclassification
entries prior to final closing.

11. Which of the following is an aspect of scheduling and controlling the audit engagement?
a. Including in the audit program a column for estimated and actual time.
b. Performing audit work only after the client’s books of account have been closed for the period
under examination.
c. Writing a conclusion in individual working papers indicating how the results of the audit will
affect the auditor’s report.
d. Including in the engagement letter an estimate of the minimum and maximum audit fee.

12. Which of the following is an engagement attribute for an audit of an entity that processes most of
its financial data in electronic form without any paper documentation? a. Discrete phases of
planning, interim, and year-end field work.
b. Increased effort to search for evidence of management fraud.
c. Performance of audit tests on a continuous basis.
d. Increased emphasis on the completeness assertion.

13. Which of the following statements is not correct about materiality?

a. The concept of materiality recognizes that some matters are important for fair presentation of
financial statements in conformity with GAAP, while other matters are not important.
b. An auditor considers materiality for planning purposes in terms of the largest aggregate level
of misstatements that could be material to any one of the financial statements.
c. Materiality judgments are made in light of surrounding circumstances and necessarily involve
both quantitative and qualitative judgments.
d. An auditor’s consideration of materiality is influenced by the auditor’s perception of the needs
of a reasonable person who will rely on the financial statements.

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14. The risk that the assertion contains material misstatements that, when aggregated with
misstatements in other assertions, could make the entire financial statements materially misstated
is:
a. Individual audit risk b. Inherent risk c. Control risk d. Detection risk

15. Incremental risk is the increased risk that errors may not be detected at the balance sheet date
because:
a. Audit procedures were performed at an interim date
b. Inherent risk was assessed too low.
c. Analytical procedures were not performed.
d. Detection risk was set too high a level.

QUIZZERS

PSA 300 - Planning

1. Adequate planning of the audit work helps the auditor of accomplishing the following objectives,
except:
a. Gathering of all corroborating audit evidence.
b. Ensuring that appropriate attention is devoted to important areas of the audit.
c. Identifying the areas that need a service of an expert.
d. The audit work is completed efficiently.

2. The extent of planning will vary according to any of the following, except:
a. Size of the audit client.
b. Auditor’s experience with the entity and knowledge of the business.
c. The nature and complexity of the audit engagement
d. The assessed level of control risk.

3. Which of the following is least likely considered by the auditor in developing the overall audit plan?
a. Understanding of the accounting and internal control systems.
b. Relevant risk and materiality.
c. The involvement of other auditors in the audit of major component of financial statements
d. The general level of competence of audit assistants.

4. Which of the following is not considered by the CPA when he makes an overall audit plan?
a. Identification of complex accounting areas including those involving accounting estimates.
b. The information technology used by the client.
c. The content of the representation letters.
d. The nature and timing of reports or other communication with the entity that are expected
under the engagement.

5. Audit plan should

A B C D
A. Precede action Yes No Yes No
B. Be fixed Yes No No Yes
C. Be cost beneficial Yes Yes Yes Yes

6. Which of the following least likely affect the form and content of the overall audit plan?
a. Complexity of the audit engagement.
b. Methodology and technology used by the auditor.
c. The entity’s form of business organization.
d. The size of the entity.

7. The audit program should contain the following, except:

a. Audit objective
b. Time budget for the various audit areas
c. Set of planned audit procedures

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d. The combined assessed level of inherent and control risk

PSA 310 - Knowledge of Business

8. Which of the following will most likely help the auditor to identify and understand the events,
transactions and practices of his audit client?
a. Obtaining a sufficient knowledge of the business of his client.
b. Understanding of accounting and internal control.
c. Testing control policies and procedures.
d. Obtaining a representation letter from the client management.

9. The auditor should have or obtain a knowledge of the client’s business sufficient to:
a. Evaluate whether the financial statements are materially misstated.
b. Document material weaknesses in accounting and internal control systems.
c. Identify and understand events, transactions and practices that may have effect on financial
statements.
d. Have an overall evaluation of whether financial assertions are fairly presented in the financial
statements.

10. The auditor is not expected to have

a. A particular knowledge of the economy and the industry within which the entity operates.
b. A particular knowledge of how the entity operates.
c. A level of knowledge of business ordinarily less than that possessed by management.
d. A knowledge of business which is used in assessing inherent and control risk.

11. The auditor obtains knowledge of client’s business

A B C D
Prior to acceptance of engagement No No Yes Yes
Planning stage of the audit Yes Yes Yes No
Testing of transactions stage No Yes Yes Yes

12. Understanding the business and using this information appropriately assists the auditor in, except
a. Deciding whether to do tests of controls.
b. Evaluating audit evidence.
c. Assessing risks and identifying potential problems.
d. Planning and performing the audit effectively and efficiently.

13. Which of the following is the ultimate concern of the knowledge about the business?
a. Consideration of how it affects the financial statements taken as a whole.
b. Assists the auditor in enforcing quality control procedures.
c. To assure that sufficient audit evidence is obtained.
d. It assists in determining the type of audit report to be issued.

14. A knowledge of the business is a frame of reference within which the auditor exercises
professional judgment. This assists the auditor in carrying out the following objectives, except: a.
Assessing risks and identifying problems.
b. Evaluating audit evidence.
c. Determining the audit opinion to be expressed.
d. Planning and performing the audit effectively and efficiently.

15. Throughout the course of the audit, the auditors make judgment about many matters where
knowledge of the business is important. These procedures do not include: a. Evaluating
accounting estimates and management representations.
b. Identifying related parties and related party transactions.
c. Assessing inherent and control risks.
d. Assessing the appropriateness of using statistical sampling instead of judgmental sampling.

PSA 570 – Going Concern

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16. Which of the following factors is inappropriately relevant to the management’s assessment of the
going concern assumption?
a. The degree of uncertainty associated with the outcome of an event or condition decreases
significantly the further into the future of judgment being made about the outcome of an event
or condition.
b. Any judgment about the future is based on information available at the time at which the
judgment is made.
c. The size and complexity of the entity, and the nature and conditions of its business affect the
judgment regarding the outcome of events or conditions.
d. Subsequent events can contradict a judgment which was reasonable at the time it was made.

17. Which of the following may not cast significant doubt about the going concern assumption of an
entity.
a. The entity heavily used equity financing for investment in permanent assets.
b. Non-compliance with capital or other statutory requirements.
c. Pending legal or regulatory proceeding against the entity that may, if successful, result in
claims that are unlikely to be satisfied.
d. Changes in legislation or government policy expected to adversely affect the entity.

18. When events or conditions have been identified which may cast significant doubt on the entity’s
ability to continue as a going concern, the auditor should:
a. Review management’s plans for future actions based on its going concern assessment.
b. Gather sufficient appropriate audit evidence to confirm or dispel whether or not a material
uncertainty exists through carrying out procedures considered necessary, including
considering the effect of any plans of management and other mitigating factors.
c. Seek written representations from management regarding its plans for future action. d. All of
the above.

19. Which of the following proposed actions may mostly mitigate the going concern problem of an
entity?
a. Rescheduling of loan payments.
b. More vigorous business expansion.
c. Acquiring asset replacement using short-term loans.
d. Increasing the amount of cash dividends to be paid.

20. The following are related to the auditor’s responsibility to assess the ability of the company to
continue as a going concern?
I. The auditor should consider the appropriateness of the management’s use of the going
concern assumption in the preparation of the financial statements.
II. The auditor is to consider whether there are material uncertainties about the entity’s ability to
continue as a going concern that needs to be disclosed in the financial statements.
III. The absence of any reference to going concern uncertainty in the auditor’s report is viewed as
a guarantee as to the entity’s ability to continue as a going concern. Which of the foregoing
inappropriately describe(s) the auditor’s responsibility?
a. I only b. I and II only c. II only d. III only

21. The auditor consider events and condition relating to the going concern assumption during the
planning stage in order to:
a. Help management do action that may mitigate its going concern problems.
b. Identifying the areas of accounting and internal control systems that need tests of control.
c. To have a timely discussion with management and a review of management’s plans and
resolutions of any identified going concern issues.
d. In order to shorten assessment period.

22. If adequate disclosure is not made by the entity regarding substantial doubt about its ability to
continue as a going concern, the auditor should include in his report specific reference to the
substantial doubt as to ability of the company to continue as a going concern and should express:
a. Unqualified opinion with explanatory paragraph

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b. A subject to qualified opinion or adverse opinion.

c. Either an “except for” qualified opinion or an adverse opinion.
d. A disclaimer of opinion.

23. If the auditor believes that the entity will not be able to continue as a going concern and the
financial statements are prepared on a going concern basis, the auditor’s report should include: a.
Unqualified opinion with explanatory paragraph. c. Adverse opinion.
b. Qualified opinion. d. Disclaimer of opinion.

24. If the auditor believes that management should extend its assessment but the latter refuses to do
so, the auditor should:
a. Rectify the lack of analysis by management.
b. Extend his audit procedures to obtain sufficiently appropriate evidence regarding the use of the
going concern assumption.
c. Emphasize this matter in the audit report.
d. Consider a modification of the report as a result of the limitation in the scope of the auditor’s
work.

25. The management denied the auditor’s request that the management has to extend its assessment
of its going concern ability. However, the auditor’s other procedures are sufficient to assess the
appropriateness of management use of the going concern assumption in the preparation of the
financial statements. he auditor should issue:
a. Unqualified opinion c. Adverse opinion
b. Unqualified opinion with explanatory paragraph d. Disclaimer of opinion

- end of AT-5908 -

CPA REVIEW SCHOOL OF THE PHILIPPINES

Manila

AUDITING THEORY
Risk Assessment and Response to Assessed Risks

Related PSAs: PSA 400, 315 and 330

1. Which of the following is correct statement?

a. The auditor should use professional judgment to assess audit risk and to design audit
procedures to ensure it is eliminated.
b. The auditor is an insurer, and his or her report constitutes a guarantee.
c. The subsequent discovery that a material misstatement exists in the financial statements is
evidence of inadequate planning, performance, or judgment on the part of the auditor.
d. The auditor should obtain an understanding of the accounting and internal control systems
sufficient to plan the audit and develop an effective audit approach.

2. According to PSA 400 – Risk Assessments and Internal Control, audit risk means
a. The susceptibility of an account balance or class of transactions to misstatement that could be
material, individually or when aggregated with misstatements in other balances or classes,
assuming that there were no related internal controls.
b. The risk that a misstatement, that could occur in an account balance or class of transactions
and that could be material, individually or when aggregated with misstatements in other
balances or classes, will not be prevented or detected and corrected on a timely basis by the
accounting and internal control systems.
c. The risk that an auditor’s substantive procedures will not detect a misstatement that exists in
an account balance or class of transactions that could be material, individually or when
aggregated with misstatements in other balances or classes.
d. The risk that the auditor gives an inappropriate audit opinion when the financial statements are
materially misstated.

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3. Inherent risk and control risk differ from detection risk in that they
a. Arise from the misapplication of auditing procedures.
b. May be assessed in either quantitative or nonquantitative terms.
c. Exist independently of the financial statement audit.
d. Can be changed at the auditor’s discretion.

4. Inherent risk and control risk differ from detection risk in that inherent risk and control risk are
a. Elements of audit risk while detection risk is not.
b. Changed at the auditor’s discretion while detection risk is not.
c. Considered at the individual account-balance level while detection risk is not.
d. Functions of the client and its environment while detection risk is not.

5. Which of the following is an incorrect statement?

a. Detection risk is a function of the effectiveness of an auditing procedure and its application.
b. Detection risk arises partly from uncertainties that exists when the auditor does not examine
100 percent of the population.
c. Detection risk arises partly because of other uncertainties that exist even if the auditor were to
examine 100 percent of the population.
d. Detection risk exists independently of the audit of the financial statements.

6. Which of the following is an incorrect statement?

a. Detection risk cannot be changed at the auditor’s discretion.
b. If individual audit risk remains the same, detection risk bears an inverse relationship to
inherent and control risks.
c. The greater the inherent and control risks the auditor believes exists, the less detection risk
that can be accepted.
d. The auditor might make separate or combined assessments of inherent risk and control risk.

7. Why would the auditor assess control risk?

a. Because it indicates where inherent risk may be the greatest.
b. Because it determines whether sampling risk is sufficiently low.
c. Because it affects the level of detection risk the auditor may accept.
d. Because it includes the aspects of nonsampling risk that are controllable.

8. The relationship between acceptable level of detection risk and the combined level of inherent and
control risk is
a. Direct b. Inverse c. Parallel d. Independent

9. The audit risk model consists of: AR = IR x CR x DR

The detection risk is the dependent variable. What is the acceptable level of detection risk if the
assessed level of Inherent risk is High and the Control risk is Low?
a. Highest b. Medium c. Lower d. Higher

10. An auditor decides to increase the assessed level of control risk from that originally planned on
the basis of audit evidence gathered and evaluated. To achieve an overall audit risk level that is
substantially the same as the planned audit risk level, the auditor would
a. Decrease substantive testing. c. Increase inherent risk.
b. Increase materiality levels. d. Decrease detection risk.

11. As the acceptable level of detection risk decreases, the assurance directly provided from
a. Substantive tests should increase. c. Substantive tests should decrease.
b. Tests of controls should increase. d. Tests of controls should decrease.

12. Which of the following statements is true?

a. If control risk is assessed at maximum, the nature of related substantive tests should be
changed from more to less effective.
b. If control risk is assessed at maximum, the nature of related substantive tests should be
changed from less to more effective.

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c. If control risk is assessed at maximum, the timing of related substantive tests should be
changed from year-end to an interim date.
d. If control risk is assessed at maximum, the extent of related substantive tests should be
changed from a larger to a smaller sample.

13. When the auditor determines that detection risk regarding a financial statement assertion for a
material account balance or class of transactions cannot be reduced to an acceptable level, the
auditor should express
a. Qualified or adverse opinion c. Unqualified opinion with explanatory paragraph
b. Qualified or disclaimer of opinion d. Unqualified opinion.

14. Which of the following is not a distinguishing feature of risk-based auditing?

a. Identifying areas posing the highest risk of financial statement errors.
b. Analysis of internal control.
c. Collecting and evaluating evidence.
d. Concentrating audit resources in those areas presenting the highest risk of financial statement
errors.

15. Which of the following factors is not a good indicator of potential financial failure?
a. Client is constantly short of cash and working capital.
b. Client’s retained earnings were reduced by half as a result of a large dividend payout.
c. Client relies heavily on debt financing, especially by financing permanent assets with short-
term loans.
d. Client has had increasing net losses for several years.

PSA 315 – Understanding the Entity and Its Environment and Assessing the Risks of
Material Misstatement

16. PSA 315 requires

a. The auditor to obtain an understanding of the entity and its environment, including its internal
control.
b. Discussion among the engagement team about the susceptibility of the entity’s financial
statements to material misstatement.
c. The auditor to identify and assess the risks of material misstatement at the financial statement
and assertion levels.
d. All of the above.

17. Which of the following is incorrect regarding PSA 315?

a. The purpose of this PSA is to establish standards and to provide guidance on obtaining an
understanding of the entity and its environment, including its internal control, and on assessing
the risks of material misstatement in a financial statement audit.
b. This PSA requires the auditor to make risk assessments at the financial statement and
assertion levels based on an appropriate understanding of the entity and its environment,
including its internal control.
c. The requirements and guidance of this PSA are to be applied in conjunction with the
requirements and guidance provided in other PSAs.
d. This PSA discusses the auditor’s responsibility to determine overall responses and to design
and perform further audit procedures whose nature, timing, and extent are responsive to the
risk assessments.

18. Which statement is incorrect regarding obtaining an understanding of the entity and its
environment?
a. Obtaining an understanding of the entity and its environment is an essential aspect of
performing an audit in accordance with PSAs.
b. That understanding establishes a frame of reference within which the auditor plans the audit
and exercises professional judgment about assessing risks of material misstatement of the
financial statements and responding to those risks throughout the audit.

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c. The auditor’s primary consideration is whether the understanding that has been obtained is
sufficient to assess the risks of material misstatement of the financial statements and to design
and perform further audit procedures.
d. The depth of the overall understanding that is required by the auditor in performing the audit is
equal to that possessed by management in managing the entity.

19. The main purpose of risk assessment procedures is to

a. Obtain an understanding of the entity and its environment, including its internal control, to
assess the risks of material misstatement at the financial statement and assertion levels.
b. Test the operating effectiveness of controls in preventing, or detecting and correcting, material
misstatements at the assertion level.
c. Detect material misstatements at the assertion level.
d. All of the above.

20. The auditor should perform the following risk assessment procedures to obtain an understanding
of the entity and its environment, including its internal control, except: a. Inquiries of management
and others within the entity.
b. Inquiries of the entity’s external legal counsel or of valuation experts that the entity has used.
c. Analytical procedures.
d. Observation and inspection.

21. Inquiries directed towards those charged with governance may most likely
a. Relate to their activities concerning the design and effectiveness of the entity’s internal control
and whether management has satisfactorily responded to any findings from these activities.
b. Help the auditor understand the environment in which the financial statements are prepared.
c. Relate to changes in the entity’s marketing strategies, sales trends, or contractual
arrangements with its customers.
d. Help the auditor in evaluating the appropriateness of the selection and application of certain
accounting policies.

22. Which statement is incorrect regarding analytical procedures?

a. Analytical procedures may be helpful in identifying the existence of unusual transactions or
events, and amounts, ratios, and trends that might indicate matters that have financial
statement and audit implications.
b. In performing analytical procedures as risk assessment procedures, the auditor develops
expectations about plausible relationships that are reasonably expected to exist.
c. When comparison of those expectations with recorded amounts or ratios developed from
recorded amounts yields unusual or unexpected relationships, the auditor considers those
results in identifying risks of material misstatement.
d. When such analytical procedures use data aggregated at a high level (which is often the
situation), the results of those analytical procedures provide a clear-cut indication about
whether a material misstatement may exist.

23. Which statement is incorrect regarding the discussion among the engagement team about the
susceptibility of the entity’s financial statements to material misstatements?
a. The members of the engagement team should discuss the susceptibility of the entity’s financial
statements to material misstatements.
b. The objective of this discussion is for members of the engagement team to gain a better
understanding of the potential for material misstatements of the financial statements resulting
from fraud or error in the specific areas assigned to them, and to understand how the results of
the audit procedures that they perform may affect other aspects of the audit.
c. The discussion provides an opportunity for more experienced engagement team members,
including the engagement partner, to share their insights based on their knowledge of the
entity, and for the team members to exchange information about the business risks.
d. All the team members should have a comprehensive knowledge of all aspects of the audit.

24. The auditor’s understanding of the entity and its environment consists of an understanding of the
following aspects:
I. Industry, regulatory, and other external factors, including the applicable financial reporting
framework.

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II. Nature of the entity, including the entity’s selection and application of accounting policies.
III. Objectives and strategies and the related business risks that may result in a material
misstatement of the financial statements.
IV. Measurement and review of the entity’s financial performance. V. Internal control.
a. All of the above c. I, II and III
b. I, II, III and IV d. I, II, III and V

25. Nature of an entity refers to

a. The entity’s operations, its ownership and governance, the types of investments that it is
making and plans to make, the way that the entity is structured and how it is financed. b. The
overall plans for the entity.
c. The operational approaches by which management intends to achieve its objectives.
d. The result of significant conditions, events, circumstances, actions or inactions that could
adversely affect the entity’s ability to achieve its objectives and execute its strategies, or the
setting of inappropriate objectives and strategies.

26. Which statement is correct regarding business risks?

a. The risk of material misstatement of the financial statements is broader than business risk,
though it includes the latter.
b. The auditor should identify or assess all business risks.
c. All business risks give rise to risks of material misstatement.
d. A business risk may have an immediate consequence for the risk of misstatement for classes
of transactions, account balances, and disclosures at the assertion level or the financial
statements as a whole.

27. A potential business risk created by industry developments may most likely include a. Increased
product liability.
b. increased legal exposure
c. The entity does not have the personnel or expertise to deal with the changes in the industry.
d. Loss of financing due to the entity’s inability to meet financing requirements.

28. The following are examples of conditions and events that may indicate the existence of risks of
material misstatement, except
a. Operations in regions that are economically stable.
b. Pending litigation and contingent liabilities.
c. Application of new accounting pronouncements.
d. Entities or business segments likely to be sold.

29. Which of the following conditions and events may most likely indicate the existence of risks of
material misstatement?
a. Having personnel with appropriate accounting and financial reporting skills.
b. Accounting measurements that involve simple processes.
c. Significant amount of routine or systematic transactions.
d. Constraints on the availability of capital and credit.

30. Which statement is incorrect regarding significant risks that require special audit consideration?
a. The auditor should determine which of the risks identified are, in the auditor’s judgment, risks
that require special audit consideration.
b. The auditor excludes the effect of identified controls related to the risk to determine whether
the nature of the risk, the likely magnitude of the potential misstatement including the
possibility that the risk may give rise to multiple misstatements, and the likelihood of the risk
occurring are such that they require special audit consideration.
c. Routine, non-complex transactions that are subject to systematic processing are more likely to
give rise to significant risks because they have higher inherent risks.
d. Significant risks are often derived from business risks that may result in a material
misstatement.

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31. Examples of situations where the auditor may find it impossible to design effective substantive
procedures that by themselves provide sufficient appropriate audit evidence that certain
assertions are not materially misstated include the following:
I. An entity that conducts its business using IT to initiate orders for the purchase and delivery of
goods based on predetermined rules of what to order and in what quantities and to pay the
related accounts payable based on system-generated decisions initiated upon the confirmed
receipt of goods and terms of payment. No other documentation of orders placed or goods
received is produced or maintained, other than through the IT system.
II. An entity that provides services to customers via electronic media (for example, an Internet
service provider or a telecommunications company) and uses IT to create a log of the services
provided to its customers, initiate and process its billings for the services and automatically
record such amounts in electronic accounting records that are part of the system used to
produce the entity’s financial statements.
a. I and II b. I only c. II only d. Neither I nor II

PSA 330 – The Auditor’s Procedures In Response to Assessed Risks

32. PSA 330 requires the auditor to

a. Determine overall responses to address risks of material misstatement at the financial
statement level.
b. Design and perform further audit procedures, including tests of the operating effectiveness of
controls, when relevant or required, and substantive procedures, whose nature, timing, and
extent are responsive to the assessed risks of material misstatement at the assertion level.
c. Evaluate whether the risk assessment remain appropriate and to conclude whether sufficient
appropriate audit evidence has been obtained.
d. All of the above.

33. The auditor should determine overall responses to address the risks of material misstatement at
the financial statement level. Such responses least likely include
a. Emphasizing to the audit team the need to maintain professional skepticism in gathering and
evaluating audit evidence.
b. Assigning more experienced staff or those with special skills or using experts.
c. Incorporating additional elements of unpredictability in the selection of further audit procedures
to be performed.
d. Performing substantive procedures at an interim date instead of at period end.

34. The assessment of the risks of material misstatement at the financial statement level is affected by
the auditor’s understanding of the control environment. Weaknesses in the control environment
ordinarily will lead the auditor to
a. Have more confidence in internal control and the reliability of audit evidence generated
internally within the entity.
b. Conduct some audit procedures at an interim date rather than at period end.
c. Modify the nature of audit procedures to obtain more persuasive audit evidence.
d. Decrease the number of locations to be included in the audit scope.

35. The auditor should design and perform further audit procedures whose nature, timing, and extent
are responsive to the assessed risks of material misstatement at the assertion level. Which of the
following is the most important consideration in responding to the assessed risks? a. The nature of
the audit procedures. c. The timing of the audit procedures.
b. The extent of the audit procedures. d. All of these are equally important.

36. The auditor’s assessment of the identified risks at the assertion level provides a basis for
considering the appropriate audit approach for designing and performing further audit procedures.
Which of the following is incorrect?
a. The auditor may determine that only by performing tests of controls may the auditor achieve
an effective response to the assessed risk of material misstatement for a particular assertion.
b. The auditor may determine that performing only substantive procedures is appropriate for
specific assertions and, therefore, the auditor excludes the effect of controls from the relevant
risk assessment.

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c. The auditor needs to be satisfied that performing only substantive procedures for the relevant
assertion would be effective in reducing the risk of material misstatement to an acceptably low
level.
d. The auditor designs and performs substantive procedures for each material class of
transactions, account balance, and disclosure only when the auditor uses the substantive
approach.

37. Which statement is incorrect regarding the nature of further audit procedures?
a. The nature of further audit procedures refers to their purpose and their type.
b. Certain audit procedures may be more appropriate for some assertions than others.
c. The higher the auditor’s assessment of risk, the less reliable and relevant is the audit evidence
sought by the auditor from substantive procedures.
d. The auditor is required to obtain audit evidence about the accuracy and completeness of
information produced by the entity’s information system when that information is used in
performing audit procedures.

38. Which statement is incorrect regarding the timing of further audit procedures?
a. Timing refers to when audit procedures are performed or the period or date to which the audit
evidence applies.
b. The auditor may perform tests of controls or substantive procedures at an interim date or at
period end.
c. If the auditor performs tests of controls or substantive procedures prior to period end, the
auditor considers the additional evidence required for the remaining period.
d. All audit procedures can be performed prior to period end.

39. Which statement is incorrect regarding the extent of further audit procedures?
a. Extent includes the quantity of a specific audit procedure to be performed.
b. The extent of an audit procedure is determined by the judgment of the auditor after considering
the materiality, the assessed risk, and the degree of assurance the auditor plans to obtain.
c. The auditor ordinarily decreases the extent of audit procedures as the risk of material
misstatement increases.
d. Increasing the extent of an audit procedure is effective only if the audit procedure itself is
relevant to the specific risk.

40. Which statement is incorrect regarding tests of controls?

a. Tests of controls are required under certain circumstances.
b. Tests of controls are required when an entity conducts its business using IT and no
documentation of transactions is produced or maintained, other than through the IT system.
c. Tests of the operating effectiveness of controls are performed only on those controls that the
auditor has determined are suitably designed to prevent, or detect and correct, a material
misstatement in an assertion.
d. Testing the operating effectiveness of controls is the same as obtaining audit evidence that
controls have been implemented.

41. Which statement is incorrect regarding the nature of tests of controls?

a. As the planned level of assurance increases, the auditor seeks more reliable audit evidence.
b. Those controls subject to testing by performing inquiry combined with inspection or
reperformance ordinarily provide more assurance than those controls for which the audit
evidence consists solely of inquiry and observation.
c. The absence of misstatements detected by a substantive procedure provides audit evidence
that controls related to the assertion being tested are effective.
d. A material misstatement detected by the auditor’s procedures that was not identified by the
entity ordinarily is indicative of the existence of a material weakness in internal control.

42. Which statement is incorrect regarding the timing of tests of controls?

a. Audit evidence pertaining only to a point in time may be sufficient for the auditor’s purpose, for
example, when testing controls over the entity’s physical inventory counting at the period end.
b. If the auditor plans to rely on controls that have changed since they were last tested, the
auditor should test the operating effectiveness of such controls in the current audit.

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c. If the auditor plans to rely on controls that have not changed since they were last tested, the
auditor should test the operating effectiveness of such controls at least once in every second
audit.
d. When there are a number of controls for which the auditor determines that it is appropriate to
use audit evidence obtained in prior audits, the auditor should test the operating effectiveness
of some controls each audit.

43. Which statement is incorrect regarding the extent of tests of controls?

a. The auditor designs tests of controls to obtain sufficient appropriate audit evidence that the
controls operated effectively throughout the period of reliance.
b. The more the auditor relies on the operating effectiveness of controls in the assessment of
risk, the lesser is the extent of the auditor’s tests of controls.
c. If the rate of expected deviation is expected to be too high, the auditor may determine that
tests of controls for a particular assertion may not be effective.
d. Because of the inherent consistency of IT processing, the auditor may not need to increase the
extent of testing of an automated control.

44. Which statement is incorrect regarding substantive procedures?

a. Substantive procedures are performed in order to detect material misstatements at the
assertion level, and include tests of details of classes of transactions, account balances, and
disclosures and substantive analytical procedures.
b. The auditor always performs substantive procedures for each class of transactions, account
balance, and disclosure.
c. When the auditor has determined that an assessed risk of material misstatement at the
assertion level is a significant risk, the auditor should perform substantive procedures that are
specifically responsive to that risk.
d. In order to obtain sufficient appropriate audit evidence, the substantive procedures related to
significant risks are most often designed to obtain audit evidence with high reliability.

45. The auditor’s substantive procedures should include the following audit procedures related to the
financial statement closing process:
I. Agreeing the financial statements to the underlying accounting records.
II. Examining material journal entries and other adjustments made during the course of preparing
the financial statements.
a. I and II b. I only c. II only d. Neither I nor II

46. Which statement is incorrect regarding the nature, timing and extent of substantive procedures?
a. Substantive analytical procedures are generally more applicable to large volumes of
transactions that tend to be predictable over time.
b. Tests of details are ordinarily more appropriate to obtain audit evidence regarding certain
assertions about account balances, including existence and valuation.
c. Substantive procedures cannot be performed at an interim date.
d. The greater the risk of material misstatement, the greater the extent of substantive procedures.

47. Which statement is incorrect regarding evaluation of the sufficiency and appropriateness of audit
evidence obtained?
a. Based on the audit procedures performed and the audit evidence obtained, the auditor should
evaluate whether the assessments of the risks of material misstatement at the assertion level
remain appropriate.
b. As the auditor performs planned audit procedures, the audit evidence obtained may cause the
auditor to modify the nature, timing, or extent of other planned audit procedures.
c. In developing an opinion, the auditor considers only the audit evidence which corroborate the
assertions in the financial statements.
d. If the auditor is unable to obtain sufficient appropriate audit evidence, the auditor should
express a qualified opinion or a disclaimer of opinion.
- end of AT-5909 -

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CPA REVIEW SCHOOL OF THE PHILIPPINES

Manila

AUDITING THEORY
INTERNAL
CONTROL

Related PSAs/PAPSs: PSA 400, 402 and 315

The auditor should obtain an understanding of the accounting and internal control systems sufficient
to plan the audit and develop an effective audit approach.

Accounting system means the series of tasks and records of an entity by which transactions are
processed as a means of maintaining financial records. Such systems identify, assemble, analyze,
calculate, classify, record, summarize and report transactions and other events.

Internal Control System means all the policies and procedures (internal controls) adopted by the
management of an entity to assist in achieving management’s objective of ensuring, as far as
practicable,:
• orderly and efficient conduct of its business, including adherence to management policies;
• safeguarding of assets;
• prevention and detection of fraud and error;
• accuracy and completeness of the accounting records; and
• timely preparation of reliable financial information.

The internal control system extends beyond those matters which relate directly to the functions of the
accounting system.

Internal Control Components (PSA 315)

(a) The control environment;

(b) The entity’s risk assessment process;
(c) The information system, including the related business processes, relevant to financial reporting,
and communication; (d) Control activities; and
(e) Monitoring of controls.

Control environment

The control environment includes the attitudes, awareness, and actions of management and those
charged with governance concerning the entity’s internal control and its importance in the entity. The
control environment also includes the governance and management functions and sets the tone of an
organization, influencing the control consciousness of its people. It is the foundation for effective
internal control, providing discipline and structure.

The control environment encompasses the following elements:

• Communication and enforcement of integrity and ethical values.

• Commitment to competence.
• Participation by those charged with governance.
• Management’s philosophy and operating style.
• Organizational structure.
• Assignment of authority and responsibility.
• Human resource policies and practices.

Entity’s risk assessment process

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An entity’s risk assessment process is its process for identifying and responding to business risks and
the results thereof. For financial reporting purposes, the entity’s risk assessment process includes
how management identifies risks relevant to the preparation of financial statements that are presented
fairly, in all material respects in accordance with the entity’s applicable financial reporting framework,
estimates their significance, assesses the likelihood of their occurrence, and decides upon actions to
manage them.

Risks can arise or change due to circumstances such as the following:

• Changes in operating environment. Changes in the regulatory or operating environment can

result in changes in competitive pressures and significantly different risks.

• New personnel. New personnel may have a different focus on or understanding of internal
control.
• New or revamped information systems. Significant and rapid changes in information systems
can change the risk relating to internal control.
• Rapid growth. Significant and rapid expansion of operations can strain controls and increase
the risk of a breakdown in controls.
• New technology. Incorporating new technologies into production processes or information
systems may change the risk associated with internal control.
• New business models, products, or activities. Entering into business areas or transactions with
which an entity has little experience may introduce new risks associated with internal control.
• Corporate restructurings. Restructurings may be accompanied by staff reductions and
changes in supervision and segregation of duties that may change the risk associated with internal
control.
• Expanded foreign operations. The expansion or acquisition of foreign operations carries new
and often unique risks that may affect internal control, for example, additional or changed risks from
foreign currency transactions.
• New accounting pronouncements. Adoption of new accounting principles or changing
accounting principles may affect risks in preparing financial statements.

Information system, including the related business processes, relevant to financial reporting,
and communication

An information system consists of infrastructure (physical and hardware components), software,

people, procedures, and data. Infrastructure and software will be absent, or have less significance, in
systems that are exclusively or primarily manual.

The information system relevant to financial reporting objectives, which includes the financial reporting
system, consists of the procedures and records established to initiate, record, process, and report
entity transactions (as well as events and conditions) and to maintain accountability for the related
assets, liabilities, and equity.

Accordingly, an information system encompasses methods and records that:

• Identify and record all valid transactions.

• Describe on a timely basis the transactions in sufficient detail to permit proper classification of
transactions for financial reporting.

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• Measure the value of transactions in a manner that permits recording their proper monetary
value in the financial statements.
• Determine the time period in which transactions occurred to permit recording of transactions in
the proper accounting period.
• Present properly the transactions and related disclosures in the financial statements.

Communication involves providing an understanding of individual roles and responsibilities pertaining

to internal control over financial reporting. It includes the extent to which personnel understand how
their activities in the financial reporting information system relate to the work of others and the means
of reporting exceptions to an appropriate higher level within the entity. Open communication channels
help ensure that exceptions are reported and acted on.

Control activities

Control activities are the policies and procedures that help ensure that management directives are
carried out, for example, that necessary actions are taken to address risks that threaten the
achievement of the entity’s objectives.

Generally, control activities that may be relevant to an audit may be categorized as policies and
procedures that pertain to the following:

• Performance reviews.
• Information processing.
• Physical controls.
• Segregation of duties.

Monitoring of controls

Management’s monitoring of controls includes considering whether they are operating as intended
and that they are modified as appropriate for changes in conditions. Monitoring of controls may
include activities such as management’s review of whether bank reconciliations are being prepared
on a timely basis, internal auditors’ evaluation of sales personnel’s compliance with the entity’s
policies on terms of sales contracts, and a legal department’s oversight of compliance with the entity’s
ethical or business practice policies.

Inherent Limitations of Internal Controls

1. Management’s usual requirement that the cost of an internal control does not exceed the
expected benefits to be derived.
2. Most internal controls tend to be directed at routine transactions rather than non-routine
transactions.
3. The potential for human error due to carelessness, distraction, mistakes of judgment and the
misunderstanding of instructions.
4. The possibility of circumvention of internal controls through the collusion of a member of
management or an employee with parties outside or inside the entity.
5. The possibility that a person responsible for exercising an internal control could abuse that
responsibility, for example, a member of management overriding an internal control.
6. The possibility that procedures may become inadequate due to changes in conditions, and
compliance with procedures may deteriorate.

Accounting and Internal Control Assessment

1st Understanding of accounting and internal control system
2nd Plan the assessed level of control risk
3rd Performance of tests of controls (if appropriate)
th
4 Reassessment of control risk
5th Final assessment of control risk

(1st) Understanding of Accounting and Internal Control Systems

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In the audit of financial statements, the auditor is only concerned with those policies and procedures
within the accounting and internal control systems that are relevant to the financial statement
assertions. The understanding of relevant aspects of the accounting and internal control systems,
together with the inherent and control risk assessments and other considerations, will enable the
auditor to:
(a) identify the types of potential material misstatements that could occur in the
financial statements;
(b) consider factors that affect the risk of material misstatements; and (c) design
appropriate audit procedures.

The nature, timing and extent of the procedures performed by the auditor to obtain an understanding
of the accounting and internal control systems will vary with, among other things:
• The size and complexity of the entity and of its computer system.
• Materiality considerations.
• The type of internal controls involved.
• The nature of the entity’s documentation of specific internal controls.
• The auditor’s assessment of inherent risk.
• Experience gained from prior audits.

Procedures in Obtaining Understanding

1. Make inquiries of appropriate company personnel
2. Inspect documents and records
3. Observe the company’s activities and operations 4. Walk-through

Documentation of Understanding
The auditor should document his understanding of internal control. The extent of documentation is a
matter of the CPA’s judgment and the form of documentation depends upon his preference and skills.
1. Narrative descriptions 3. Flowcharts
2. Internal control questionnaires (ICQ) 4. Checklists

(2nd) Preliminary Assessment of Control Risk

The preliminary assessment of control risk is the process of evaluating the effectiveness of an entity’s
accounting and internal control systems in preventing or detecting and correcting material
misstatements. There will always be some control risk because of the inherent limitations of any
accounting and internal control system.

After obtaining an understanding of the accounting and internal control systems, the auditor should
make a preliminary assessment of control risk, at the assertion level, for each material account
balance or class of transactions.

The auditor ordinarily assesses control risk at a high level for some or all assertions when:
(a) the entity’s accounting and internal control systems are not effective; or
(b) evaluating the effectiveness of the entity’s accounting and internal control systems would not
be efficient.

The preliminary assessment of control risk for a financial statement assertion should be high unless
the auditor:
(a) is able to identify internal controls relevant to the assertion which are likely to prevent or
detect and correct a material misstatement; and
(b) plans to perform tests of control to support the assessment.

(3rd) Test of Controls

If appropriate, tests of control are performed to obtain audit evidence about the effectiveness of the:

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(a) design of the accounting and internal control systems, that is, whether they are suitably
designed to prevent or detect and correct material misstatements; and (b) operation of
the internal controls throughout the period.

Procedures for Performing Tests of Controls

1. Inspection 3. Observation 5. Walk-through

2. Inquiry 4. Reperformance

Assessed Control Risk

High (Maximum) Less than high (Below Maximum)
Understanding of ICS Required Required
Tests of Controls Required Required
Assessment of Control Risk Required Not required
Reason for assessment Not required Required
Required Documentation

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(4th) Reassessment of control risk

Based on the results of the tests of control, the auditor should evaluate whether the internal
controls are designed and operating as contemplated in the preliminary assessment of control risk.
The evaluation of deviations may result in the auditor concluding that the assessed level of control
risk needs to be revised. In such cases, the auditor would modify the nature, timing and extent of
planned substantive procedures.

(5th) Final Assessment of Control Risk

Before the conclusion of the audit, based on the results of the substantive procedures and other
audit evidence obtained by the auditor, the auditor should consider whether the assessment of
control risk is confirmed.
Communication of Weaknesses

As a result of obtaining an understanding of the accounting and internal control systems and tests
of control, the auditor may become aware of weaknesses in the systems. The auditor should
make management aware, as soon as practical and at an appropriate level of responsibility, of
material weaknesses in the design or operation of the accounting and internal control systems,
which have come to the auditor’s attention. The communication to management of material
weaknesses would ordinarily be in writing. However, if the auditor judges that oral communication
is appropriate, such communication would be documented in the audit working papers. It is
important to indicate in the communication that only weaknesses which have come to the auditor’s
attention as a result of the audit have been reported and that the examination has not been
designed to determine the adequacy of internal control for management purposes.

MULTIPLE CHOICE QUESTIONS

1. According to PSA 400, which of the following is correct regarding internal control system?
a. Internal control system refers to all the policies and procedures adopted by the auditor to
assist in achieving management’s objective.
b. A strong environment, by itself, ensure the effectiveness of the internal control system.
c. In the audit of financial statements, the auditor is only concerned with those policies and
procedures within the accounting and internal control systems that are relevant to the
financial statements.
d. The internal control system is confined to those matters which relate directly to the
functions of the accounting system.

2. Which of the following is correct about internal control?

a. Accounting and internal control systems provide management with conclusive evidence that
objectives are reached.
b. One of the inherent limitations of accounting and internal control systems is the possibility
that the procedures may become inadequate due to changes in conditions, and compliance
with procedures may deteriorate.
c. Most internal controls tend to be directed at non-routine transactions.
d. Management does not consider costs of the accounting and internal control systems.

3. Corporate directors, management, external auditors, and internal auditors all play important
roles in creating a proper control environment. Top management is primarily responsible for a.
Establishing a proper environment and specifying overall internal control.
b. Reviewing the reliability and integrity of financial information and the means used to collect
and report such information.
c. Ensuring that external and internal auditors adequately monitor the control environment.
d. Implementing and monitoring controls designed by the board of directors.

4. Which of the following best describe the interrelated components of internal control?
a. Organizational structure, management philosophy, and planning.

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b. Control environment, risk assessment, control activities, information and communication

systems, and monitoring.
c. Risk assessment, backup facilities, responsibility accounting and natural laws.
d. Legal environment of the firm, management philosophy, and organizational structure.

5. In an audit of financial statements, an auditor’s primary consideration regarding a control is

whether it
a. Reflects management’s philosophy and operating style.
b. Affects management’s financial statement assertions.
c. Provides adequate safeguards over access to assets.
d. Enhances management’s decision-making processes.

6. Effective internal control

a. Eliminates risk and potential loss to the organization.
b. Cannot be circumvented by management.
c. Is unaffected by changing circumstances and conditions encountered by the organization.
d. Reduces the need for management to review exception reports on a day-to-day basis.

7. Which of the following statements about internal control is correct?

a. Properly maintained internal controls reasonably assure that collusion among employees
cannot occur.
b. Establishing and maintaining internal control is the internal auditor’s responsibility.
c. Exceptionally strong control allows the auditor to eliminate substantive tests.
d. The cost-benefit relationship should be considered in designing internal control.

8. The ultimate purpose of assessing control risk is to contribute to the auditor’s evaluation of the
risk that
a. Tests of controls may fail to identify controls relevant to assertions.
b. Material misstatements may exist in the financial statements.
c. Specified controls requiring segregation of duties may be circumvented by collusion.
d. Entity policies may be overridden by senior management.

9. A proper understanding of the client’s internal control is an integral part of the audit planning
process. The results of the understanding
a. Must be reported to the shareholders and the SEC.
b. Bear no relationship to the extent of substantive testing to be performed.
c. Are not reported to client management.
d. May be used as the basis for withdrawing from an audit engagement.

10. An entity should consider the cost of a control in relationship to the risk. Which of the following
controls best reflects this philosophy for a large peso investment in heavy machine tools? a.
Conducting a weekly physical inventory.
b. Placing security guards at every entrance 24 hours a day.
c. Imprinting a controlled identification number on each tool.
d. Having all dispositions approved by the vice president of sales.

11. Audit evidence concerning segregation of duties ordinarily is best obtained by

a. Performing tests of transactions that corroborate management’s financial statement
assertions
b. Observing the employees as they apply specific controls.
c. Obtaining a flowchart of activities performed by available personnel.
d. Developing audit objectives that reduce control risk.

12. Which of the following statements about preliminary assessment of control risks is
correct?
a. After obtaining an understanding of the accounting and internal control systems, the auditor
should make a preliminary assessment of control risks, at the assertion level, for all
accounts or transaction classes.
b. The preliminary assessment of control risk can be done only after completing tests of
controls.

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c. The preliminary assessment of control risk for a financial assertion is normally low, unless
the auditor is able to identify weaknesses that may indicate ineffectiveness of accounting
and internal control system.
d. The auditor ordinarily assesses control risk at high level for some or all assertions when it is
not cost efficient to do tests of controls.

13. Which of the following statements concerning control risk is correct?

a. When control risk is at the maximum level, an auditor is required to document the basis for
that assessment.
b. Control risk may be assessed sufficiently low to eliminate substantive testing for significant
transaction classes.
c. When assessing control risk, an auditor should not consider evidence obtained in prior
audits about the operation of controls.
d. Assessing control risk and obtaining an understanding of an entity’s internal control may be
performed concurrently.

14. Based on a consideration of internal control completed at an interim date, the auditor assessed
control risk at a low level and performed interim substantive tests. The records and procedures
would most likely be tested again at year-end if
a. Tests of controls were not performed by the internal auditor during the remaining period.
b. Internal control provides a basis for limiting the extent of substantive testing.
c. The auditor used nonstatistical sampling during the interim period testing of controls.
d. Inquiries and observations lead the auditor to believe that conditions have changed.
15. Although substantive tests may support the accuracy of underlying records, these tests
frequently provide no affirmative evidence of segregation of duties because
a. Substantive tests rarely guarantee the accuracy of the records if only a person who
performs incompatible functions.
b. The records may be accurate even though they are maintained by a person who performs
incompatible functions.
c. Substantive tests relate to the entire period under audit, but tests of controls ordinarily are
confined to the period during which the auditor is on the client’s premises.
d. Many computerized procedures leave no audit trail of who performed them, so substantive
tests may necessarily be limited to inquiries and observation of office personnel.

16. After obtaining an understanding of internal control and assessing control risk, an auditor
decided not to perform additional tests of controls. The auditor most likely concluded that the
a. Additional evidence to support a further reduction in control risk was not cost-beneficial to
obtain.
b. Assessed level of inherent risk exceeded the assessed level of control risk.
c. Internal control was properly designed and justifiably may be relied on.
d. Evidence obtainable through tests of controls would not support an increased assessment
of control risk.

17. The objective of tests of details of transactions performed as tests of controls is to

a. Monitor the design and use of entity documents such as prenumbered shipping form
b. Determine whether controls have been placed in operation.
c. Detect material misstatements in the account balances of the financial statements.
d. Evaluate whether controls operated effectively.

18. An auditor wishes to perform tests of controls on a client’s cash disbursements procedures. If
the controls leave no audit trail of documentary evidence, the auditor most likely will test the
procedures by
a. Confirmation and observation. c. Analytical procedures and confirmation.
b. Observation and inquiry. d. Inquiry and analytical procedures

19. Which of the following would not be a method used to conduct tests of controls?
a. Inquiry b. Walkthrough c. Confirmation d. Observation

20. The auditor is examining copies of sales invoices only for the initials of the person responsible
for checking the extensions. This is an example of a
a. Test of controls c. Dual purpose test
b. Substantive test d. Test of balances

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21. Which of the following types of evidence would an auditor most likely examine to determine
whether controls are operating as designed?
a. Confirmations of receivables verifying account balances.
b. Letters of representations corroborating inventory pricing.
c. Attorneys’ responses to the auditor’s inquiries.
d. Client records documenting the use of computer programs.

22. Which of the following procedures concerning accounts receivable is an auditor most likely to
perform to obtain evidential matter in support of an assessed level of control risk below the
maximum level?
a. Sending confirmation requests to an entity’s principal customers to verify the existence of
accounts receivable.
b. Inspecting an entity’s analysis of accounts receivable for unusual balances.
c. Comparing an entity’s uncollectible accounts expense to actual uncollectible accounts
receivable.
d. Observing an entity’s employee prepare the schedule of past due accounts receivable.

23. An auditor is least likely to test controls that provide for

a. Classification of revenue and expense transactions by product line
b. Approval of the purchase and sale of trading securities
c. Segregation of the functions of recording disbursements and reconciling the bank account
d. Comparison of receiving reports and vendors’ invoices with purchase orders
24. In a small company that doesn't employ an adequate number of employees to permit proper
division of responsibilities, effective internal control can be strengthened by
a. Direct participation by the owner of the business in the record keeping activities of the
business.
b. Employment of temporary personnel to aid in the separation of duties.
c. Delegation of full, clear-cut responsibility to each employee for the functions assigned to
each.
d. Engaging a CPA to perform monthly "write up" work.

25. Which of the following is true of the communication to management of material weaknesses in
accounting and internal control?
a. Communication must be in writing.
b. Oral communication of material weaknesses, when appropriate, would be documented in
the audit working papers.
c. The communication should indicate that the auditor had extensively examined the
accounting and internal control system of the client.
d. The auditors should indicate in the communication that the examination is primarily
designed to determine whether the accounting and internal control is adequate.

QUIZZERS

1. Transaction authorization within an organization may be either specific or general. An example

of specific transaction authorization is the
a. Approval of a construction budget for a new warehouse
b. Setting of automatic reorder points
c. Establishment of a customer’s credit limits
d. Establishment of sales prices

2. Internal control should provide reasonable (but not necessarily absolute) assurance which
means that:
a. The cost of control activities should not exceed the benefits.
b. Internal control is management’s, not auditor’s, responsibility.
c. An attestation engagement about management’s internal control assertions
may not necessarily detect all reportable conditions.
d. There is always a risk that reportable conditions may result in material
misstatements.

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3. Which of the following statements is an example of an inherent limitation of internal control.

a. Errors may arise from mistakes in judgments.
b. The effectiveness of control procedures depends on segregation of duties.
c. Procedures are designed to assure that transactions are executed as
management authorities.
d. Computers process large numbers of transactions.

4. Proper segregation of functional responsibilities calls for separation of the functions of

a. Authorization, execution, and recording. c. Custody, execution,
and reporting.
b. Authorization, execution, and payment. d. Authorization,
payment, and recording.

5. Which of the following is a responsibility that should not be assigned to only one employee?
a. Access to securities in the company’s safe deposit box.
b. Custodianship of the cash working fund.
c. Reconciliation of bank statement.
d. Custodianship of tools and small equipment.

6. Which of the following activities would be least likely to strengthen a company’s internal
control? a. Maintaining insurance for fire and theft.
b. Separating accounting from other financial operations.
c. Fixing responsibility for the performance of employee duties.
d. Carefully selecting and training employees.

7. As generally conceived, the “audit committee” of a publicly held company should be made up of
a. Members of the board of directors who are not officers or employees.
b. Representatives of the major equity interests (bonds, preferred stock,
common stock).
c. The audit partner, the chief financial officer, the legal counsel, and at least
one outsider.
d. Representatives from the client’s management, investors, suppliers, and
customers.

8. When considering internal control, the auditor’s primary concern is to determine

a. The reliability of the accounting information system.
b. The possibility of fraud occurring.
c. Compliance with policies, plans, and procedures.
d. The type of an opinion he will issue.

9. Of the following, the best statement of the CPA’s primary objective in considering internal
control is that the review is intended to provide
a. A basis for reliance on the system and determining the scope of other
auditing procedures.
b. Reasonable protection against client fraud and defalcations by client
employees.
c. A basis for constructive suggestions to the client for improving his internal
control system.
d. A method for ensuring that there is reasonable assurance that the financial
statements are reliable.

10. When an auditor assesses control risk below the maximum level, the auditor is required to
document the auditor’s
Basis for concluding that control Understanding of the entity’s internal
Risk is below the maximum level control structure elements
a. Yes Yes
b. No No
c. Yes No
d. No Yes

11. The sequence of steps in gathering evidence as the basis of the auditor’s opinion is

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a. Substantive tests, documentation of control structure, and tests of controls

b. Documentation of control structure, tests of controls, and substantive tests
c. Documentation of control structure, substantive tests, and tests of controls
d. Tests of controls, documentation of control structure, and substantive tests

12. In obtaining an understanding of an entity’s internal control structure, an auditor is required to

obtain knowledge about the
Operating effectiveness of Design of policies
Policies and procedures and procedures
a. Yes Yes
b. No Yes
c. Yes No
d. No No

13. Which of the following audit techniques most likely would provide an auditor with the most
assurance about the effectiveness of the operation on an internal control procedure?
a. Confirmation with outside parties c. Recomputation of account
balance
b. Observation of client personnel d. Inquiry of client personnel

14. Which of the following is the correct order for performing the auditing procedures A through C
below
A = Tests of Controls
B = Preparation of a flowchart depicting the client’s internal control structure
C = Substantive tests
a. ABC b. BAC c. ACB d. BCA

15. After considering a client’s internal control, an auditor has concluded that the system is well
designed and is functioning as anticipated. Under these circumstances, the auditor would most
likely
a. Cease to perform further substantive tests
b. Not increase the extent of planned substantive tests
c. Increase the extent of anticipated analytical procedures
d. Perform all tests of controls to the extent outlined in the preplanned audit
program

16. After considering internal control, an auditor might decide to

a. Increase the extent of tests of controls and substantive tests in areas where
internal control is strong
b. Increase the extent of substantive tests in areas where internal control is
weak
c. Reduce the extent of tests of controls in areas where internal control is
strong
d. Reduce the extent of both substantive tests and tests of controls in areas
where internal control is strong

17. To obtain an understanding of the relevant policies and procedures of internal control, the
auditor performs all of the following except:
a. Make inquiries c. Make observations
b. Design substantive tests d. Inspect documents and
records

18. In an auditor’s consideration of internal control, the completion of a questionnaire is most

closely associated with which of the following?
a. Separation of duties c. Flowchart accuracy
b. Understanding the system d. Tests of controls

19. Before relying on the system of internal control, the auditor obtains a reasonable degree of
assurance that the internal control procedures are in use and operating as planned. The
auditor obtains this assurance by performing planned
a. Substantive tests c. Transaction tests
b. Tests of controls d. Tests of trends and ratios

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20. After obtaining an understanding of a client’s controls, an auditor may decide to omit tests of
the controls. Which of the following in not appropriate reason to omit tests of controls? a. The
controls duplicate other controls.
b. The controls appear adequate.
c. Reportable conditions preclude assessing control risk below the maximum.
d. The effort to test controls exceeds the effort saved by not performing substantive tests.

21. In general, a material weakness in internal control may be defined as a condition in which
material errors or irregularities may occur and not be detected within a timely period by a. An
independent auditor during tests of controls.
b. Management when reviewing interim financial statements and reconciling account
balances.
c. Employees in the normal course of performing their assigned functions.
d. Outside consultants who issue a special-purpose report on internal control structure.

22. Internal control procedures are not designed to provide reasonable assurance that
a. Transactions are executed in accordance with management's authorization.
b. Access to assets is permitted only in accordance with management's
authorization. c. Irregularities will be eliminated.
d. The recorded accountability for assets is compared with the existing assets at reasonable
intervals.

23. A secondary purpose of the auditor's consideration of internal control is to provide

a. A basis for assessing control risk.
b. An assurance that the records and documents have been maintained in
accordance with existing company policies and procedures.
c. A basis for constructive suggestions about improvements in internal control
structure.
d. A basis for the determination of the resultant extent of the tests to which
auditing procedures are to be restricted.

24. The auditor's review of the client's internal control is documented in order to substantiate
a. Conformity of the accounting records with GAAP.
b. Adherence to requirements of management.
c. Compliance with generally accepted auditing standards.
d. The fairness of the financial statement presentation.

25. A consideration of internal control made during an audit is usually not sufficient to express an
opinion on an entity's controls because
a. Weaknesses in the system may go unnoticed during the audit engagement.
b. A consideration of internal control is not necessarily made during an audit
engagement.
c. Only those controls on which an auditor intends to rely are reviewed, tested,
and evaluated. d. Controls can change each year.

26. The accountant's report expressing an opinion on an entity's internal controls should state that
the
a. Objectives of the client's internal controls are being met.
b. Consideration of the internal controls was conducted in accordance with
generally accepted auditing standards.
c. Establishment and maintenance of internal control is the responsibility of
management.
d. Inherent limitations of the client's internal controls were examined.

27. The primary objective of procedures performed to obtain an understanding of internal control is
to provide an auditor with
a. Evidential matter to use in reducing detection risk.
b. A basis from which to modify tests of controls.
c. Knowledge necessary to plan the audit.

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d. Information necessary to prepare flowcharts.

PSA 400 – Risk Assessments and Internal Control

28. Which of the following is not part of the control environment?

a. Management philosophy and operating style.
b. Organizational structure and methods of assigning authority and
responsibility.
c. Information and communication systems.
d. The function of the board of directors and its committees.

29. When obtaining an understanding of the accounting and internal control system the auditor
may trace a few transactions through the accounting system. This technique is:
a. Reperformance test c. Walk-through test
b. Test of transactions d. Validity test

30. Which of the following least likely affects the nature, timing, and extent of the procedures
performed by the auditor to obtain an understanding of the accounting and internal control
systems of an audit client?
a. Materiality considerations
b. The auditor’s assessment of inherent risk
c. The level of acceptable detection risk
d. The size and complexity of the entity and of its computer system

31. The evaluation of deviations that were observed upon completing tests of controls
a. May require the need for doing more extensive understanding of control.
b. May require more extensive tests of controls.
c. Always requires documentation of the basis of assessment of control risk.
d. May require modification of the nature, timing, and extent of planned
substantive procedures.

32. The following statements are true about observation when used as tests of control procedures,
except.
a. The auditor may supplement his observations with other tests of control
capable of providing audit evidence.
b. Audit evidence obtained by doing observation pertains only to the point in
time at which the procedure was applied.
c. Observation of who applies a control procedure is useful as a test of control
procedures when evaluating control effectiveness of both computerized and
manual system
d. Ordinarily, making inquiries provides more reliable audit evidence than doing
observation when testing segregation of functional responsibilities.

33. Tests of controls may include the following, except:

a. Reperformance of internal control procedures
b. Inquiries about, and observation of, internal controls which leave no audit
trail.
c. Inspection of documentary support for transactions evidencing authorization
d. Analytical procedures involving comparison of operating expenses with
budgeted amount.

34. Tests of controls are performed to obtain audit evidence about the effectiveness of the
a. Operation of the internal controls at the time the tests are being applied.
b. Operations of the internal controls in eliminating fraud and errors.
c. Design of the internal controls in eliminating fraud and errors.
d. Design of the accounting and internal controls systems.

35. The auditor should consider whether the assessment of control risk is confirmed
a. Upon completion of understanding of internal control.
b. Upon completion of tests of controls
c. Before the final audit program is completed.

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d. Upon the conclusion of the audit, based on the results of substantive

procedures and other audit evidence obtained.

PSA 402 – Audit Considerations Relating to Entities Using Service Organizations

36. Which of the following is least likely considered by the auditor in determining the significance of
service organization activities to the client and the relevance to the audit?
a. Terms of contract and relationship between the client and the service
organization.
b. The material financial statement assertions that are affected by the use of
the service organization.
c. Client's internal controls that are applied to the transactions processed by
the service organization.
d. The control policies and procedures of the client of requiring that all
payments for goods and services be supported by receiving reports.

37. When the auditor considers that the service organization activities are significant to the client
and relevant to the audit and he concludes that it would be efficient to obtain audit evidence
from tests of control to support an assessment of control risk at a lower level. Such evidence
may be obtained by, except
a. Performing tests of the client's controls over activities of the service
organization.
b. Obtaining a service organization auditor's report that expresses an opinion
as to the operating effectiveness of the service organization's accounting
and internal control systems for the processing applications relevant to the
audit.
c. Visiting the service organization and performing tests of control.
d. Review the service contract between the client and the service organization.

38. Which statement is incorrect regarding the client auditor’s use of service organization auditor’s
report?
a. When using a service organization auditor’s report, the client auditor should
consider the nature of and content of that report.
b. The client auditor should consider the scope of work performed by the
service organization auditor and should assess the usefulness and
appropriateness of reports issued by the service organization auditor.
c. When a Type B report is to be used as evidence to support a lower control
risk assessment, a client auditor would consider whether the controls tested
by the service organization auditor are relevant to the client's transactions
(significant assertions in the client's financial statements) and whether the
service organization auditor's tests of control and the results are adequate.
d. Since Type A reports may be useful to a client auditor in gaining the required
understanding of the accounting and internal control systems, an auditor
may use such reports as a basis for reducing the assessment of control risk.

39. Which of the following is the least concern of the client auditor in reviewing the report of service
organization auditor on suitability of internal control design of the service organization?
a. The accuracy of description of the service organization's accounting and
internal control systems, ordinarily prepared by the management of the
service organization.
b. The systems' controls have been placed in operation.
c. The accounting and internal control systems are suitably designed to
achieve their stated objectives.
d. The type of documentation of the understanding of the service organization’s
control system.

40. Which of the following is least likely entitled to the report of the service organization auditor on
the suitability of the design and operating effectiveness of the service organization? a. Service
organization’s management c. Client’s auditors
b. Service organization’s customers d. Service organization’s stockholders

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True or False

1. As part of understanding internal, an auditor is not required obtain knowledge about the
operating effectiveness of internal control.
2. A CPA’s consideration of internal control in a financial statement audit is usually more limited
than that made in connection with an engagement to report on management’s written assertion
as to the effectiveness of internal control.
3. Proper segregation of duties reduces the opportunities for persons to be in positions to
perpetrate and conceal errors or fraud.
4. Management’s aggressive attitude toward financial reporting and its emphasis on meeting
projected profit goals most likely would significantly influence an entity’s control environment
when management is dominated by one individual who is also a shareholder.
5. It is important for the auditor to consider the competence of the audit client’s employees,
because their competence bears directly and importantly upon the achievement of the
objectives of internal control.
6. When obtaining an understanding of an entity’s internal control, an auditor should concentrate
on the substance of controls rather than their form because management may establish
appropriate controls but not act on them.
7. In obtaining an understanding of an entity’s internal control in a financial statement audit, an
auditor is not obligated to search for significant deficiencies in the operation of internal control.
8. An independent auditor might consider the procedures performed by the internal auditors
because they are employees whose work may affect the nature, timing, and extent of audit
procedures.
9. Internal control procedures are not designed to provide reasonable assurance that irregularities
will be eliminated.
10. When considering internal control, an auditor must be aware of the concept of reasonable
assurance, which recognizes that cost of internal control procedures should not exceed the
benefits expected to be derived from the control.
11. The auditor’s review of the client’s internal control is documented in order to substantiate
compliance with generally accepted auditing standards.
12. After obtaining an understanding of an entity’s internal controls, an auditor may assess control
risk at the maximum for some assertions because the auditor believes internal control activities
are unlikely to be effective.
13. The primary purpose of the auditor’s consideration of internal control is to provide a basis for
determining the nature, timing, and extent of audit tests to be applied.
14. After consideration of a client’s internal control, an auditor might decide to increase the extent
of substantive testing in areas where the controls are weak.
15. A consideration of internal control made during an audit is usually not sufficient to express an
opinion on an entity’s controls because only those controls on which an auditor intends to rely
are reviewed, tested, and evaluated.
16. Evidence about segregation of duties is best obtained by direct personal observation of
employees who perform control activities.
17. An auditor’s flowchart of a client’s accounting system is a diagrammatic representation that
depicts the auditor’s understanding of the internal control system.
18. The purpose of tests of controls is to provide reasonable assurance that the control procedures
are functioning as intended.
19. After documenting internal control in an audit engagement, the auditor may perform tests on
those controls that the auditor plans to rely on.
20. The auditor observes client employees in order to corroborate the information obtained during
the initial review of the system.

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AT-5906