CHAPTER 10: Understanding the Entity and its Environment

1. Which of the following is not among the risk assessment procedures that the
auditor should perform in obtaining an understanding of the entity and its
environment, including its internal control?
a. Inquiries of management and others within the entity.
b. Analytical procedures
c. Observation and inspection
d. Confirmation

ANSWER: D

2. In determining others within the entity to whom inquiries may be directed

and the extent of those inquiries, the auditor considers what information may
be obtained that would help him/her in identifying risk of material
misstatement. The term others does not include the:
a. Controller
b. Internal Auditor
c. In-house legal counsel
d. Major supplier of raw materials

ANSWER: D

3. The audit procedure that may be helpful in identifying the existence of

unusual transactions or events, and amounts, ratios and trends that may
indicate matters that have financial statement and audit implications is
a. Inquiries of Management
b. Observation and Inspection
c. Confirmation
d. Analytical Procedures

ANSWER: D

4. Observation and inspection procedures that may support inquiries of

management and others and also provide information about the entity and its
environment will involve the following except
a. Visits to entitys premises and plant facilities.
b. Walk-throughs
c. Reading minutes of board of directors meetings
d. Confirmation of Account Balances

ANSWER: D

5. The auditors understanding of the entity and its environment consists of an

understanding of the following aspects except
a. Industry, regulatory and other external factors including the applicable
financial reporting framework
 b. Nature of the entity including the entitys selection and application of
accounting policies
c. Measurement and review of the entitys financial performance
d. Entitys selection and screening process of marketing and production
personnel

ANSWER: D

6. PSA 315 (Clarified) requires that the auditor should obtain an understanding
of relevant industry, regulatory and other external factors including the
applicable financial reporting framework. Which of the following is not an
example of matters relating to regulatory environment that the auditor would
usually consider?
a. Regulatory framework for a regulated industry
b. Legislation and regulation significantly affecting the entitys operation
c. Taxation
d. Product technology relating to the entitys product

ANSWER: C

7. PSA 315 (Clarified) requires that the auditor should obtain an understanding
of relevant industry, regulatory and other external factors including the
applicable financial reporting framework. Which of the following is not among
the items that relate to industry conditions?
a. Energy, supply and cost
b. Cyclical or seasonal activity
c. Market and competition
d. Inflation and currency revaluation

ANSWER: B

8. PSA 315 (Clarified) requires that the auditor should obtain an understanding
of the entitys selection and application of accounting policies and consider
whether they are appropriate for its business and consistent with the
applicable financial reporting framework and accounting policies used in the
relevant industry. The understanding does not encompass
a. The methods the entity uses to account for significant and unusual
transactions
b. The effect of significant accounting policies in contractual or emerging
areas for which there is a lack of authoritative guidance or consensus.
c. Changes in the entitys accounting policies
d. Criteria in the selection of the companys chief accounting executive

ANSWER: D

9. PSA requires that the auditor should obtain an understanding of the entitys
objectives and strategies and the related business risks that may result in
material misstatement of the financial statements. Which of the following is
 not an example of business risks that may have financial consequences and
may affect the financial statements?
a. A contracting customer base due to industry consolidation that may
increase the risk of misstatement associated with the valuation of
receivables
b. Use of new IT
c. New accounting requirements
d. Contracting economy

ANSWER:

10.The risk of material financial statement misstatement may be greater when

the following conditions exist except
a. When there is greater management intervention to specify the accounting
treatment
b. When there is greater manual intervention for data collection and
processing
c. Complex calculations or accounting principles are involved
d. When there are sufficient personnel with appropriate accounting and
financial reporting skills

ANSWER: D

11.This involves developing an overall strategy for the expected conduct and
scope of the examination; the nature, extent, and timing of which vary with
the size and complexity, and experience with and knowledge of the entity
a. Audit planning
b. Audit procedure
c. Audit program
d. Audit working pen

ANSWER: A

12.Audit plans should

a b c d
Precede actions NO YES YES NO
Be Flexible YES NO YES YES
Be cost beneficial YES YES YES NO

ANSWER: C

13.Initial audit planning involves four matters. Which of the following is not one
of these?
a. Develop an overall audit strategy
 b. Request that bank balances be confirmed
c. Schedule engagement staff and audit specialists
d. Identify the clients reason for the audit

ANSWER: B

14.Which of the following procedures would a CPA ordinarily perform during

audit planning?
a. Obtain understanding of the clients business and industry
b. Review the clients bank reconciliation
c. Obtain clients representation letter
d. Review and evaluate clients internal control

ANSWER: A

15.Early appointment of the independent auditor will enable:

a. A more thorough examination to be performed.
b. A proper study and evaluation of internal control to be performed.
c. Sufficient competent evidential matter to be obtained.
d. A more efficient examination to be planned.

ANSWER: D

16.In developing the overall audit plan for a new client, factor not to be
considered is.
a. Materiality levels
b. The clients business, including the structure of the organization and
accounting system used.
c. The amount of estimated audit fee.
d. The audit risks and procedures to be performed to achieve audit
objectives.

ANSWER: C

17.In planning the audit engagement, the auditor should consider each of the
following except
a. Matters relating the entitys business and the industries in which it
operates.
b. The entitys accounting policies and procedures
c. Anticipated levels of control risk and materiality
d. The kind of opinion that is likely to be expressed

ANSWER: D

18.A CPA is conducting the first examination of a clients financial statements.

The CPA hopes to reduce the audit work by consulting with the predecessor
auditor and reviewing the predecessors working papers. The procedure is
a. Acceptable if the client and the predecessor auditor agree to it.
 b. Acceptable if the CPA refers in the audit report to reliance upon the
predecessor auditors work
c. Required if the CPA is to render an unmodified opinion.
d. Unacceptable because the CPA should bring an independent viewpoint to
a new engagement

ANSWER: A

19.Prior to beginning the field work on a new audit engagement in which a CPA
does not possess expertise in the industry in which the client operates, the
CPA should
a. Reduce audit risk by lowering the preliminary levels of materiality.
b. Design special substantive tests to compensate for the lack of industry
expertise.
c. Engage financial experts familiar with the nature of the industry.
d. Obtain a knowledge of matters that relate to the nature of the entitys
business.

ANSWER: D

20.The audit team gathers information about a new clients business and
industry in order to obtain
a. An understanding of the clients internal control system for financial
reporting
b. An understanding of how economic events and transactions affect the
companys financial statements
c. Information about engagement risk
d. Information regarding whether the company is engaging in financial
statement fraud

ANSWER: B

21.In performing an audit of financial statements, the auditor should obtain

knowledge of the clients
business sufficient to
a. Make constructive suggestions concerning improvements in internal
control
b. Identify transactions and events that may affect the financial statements
c. Develop an attitude of professional skepticism
d. Assess the level of control risk
ANSWER: B

22.Each of the following may be relevant to an auditor when obtaining

knowledge about the clients business and industry except
a. Discussion with people within or outside the entity
b. Reading publications related to the industry
c. Visits of the entitys premises
d. Performing tests of control
 ANSWER: D

23.To obtain an understanding of a continuing clients 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. Re-evaluate the clients internal control system
ANSWER: B

24.Which of the following statements is correct, when obtaining understanding

about the clients business?
a. The level of knowledge required of the auditor is ordinarily more than the
level of the knowledge possessed by management.
b. Preliminary knowledge about the entitys industry must be obtained after
accepting the engagement to determine whether the auditor has the
necessary knowledge to perform the audit
c. Following the acceptance of the engagement, the auditor should obtain
detailed knowledge about the clients business preferably at the start of
the engagement.
d. For continuing engagements, the auditor may no longer obtain knowledge
about the clients business anymore.
ANSWER: C

25.For initial engagements, PSA 510 does not require the auditor to obtain
evidence:
a. That the opening balances do not contain material misstatements that
materially affect the current periods financial statements
b. That the prior periods ending balances have been correctly brought
forward to the current period or, when appropriate, have been restated.
c. That appropriate accounting policies are consistently applied or changes
in accounting policies have been properly accounted for and adequately
disclosed
d. That the prior period financial statements were audited by an independent
CPA
ANSWER: D

26. Auditors frequently refer to the terms audit assurance, overall assurance,
and level of assurance to refer to
a. Detection risk
b. Audit report risk
c. Acceptable audit risk
d. Inherent risk
ANSWER: C
27.A measure of how willing the auditor is to accept that the financial
statements may be materially misstated after the audit is completed and an
unmodified opinion has been issued is the:
a. Inherent risk
b. Acceptable audit risk
c. Statistical risk
d. Financial risk
ANSWER: B

28.The risk that financial statements are likely to be misstated materially

without regard to the effectiveness of internal control is the:
a. Inherent risk
b. Audit risk
c. Client risk
d. Control risk
ANSWER: A

29.In a financial statement audit, inherent risk is evaluated to help an auditor

assess which of the following?
a. The internal audit departments objectivity in reporting a material
misstatement of a financial statement assertion it detects to the audit
committee
b. The risk the internal control system will not detect a material
misstatement of a financial statement assertion
c. The risk that the audit procedures implemented will not detect a material
misstatement of a financial statement assertion
d. The susceptibility of a financial statement assertion to a material
misstatement assuming there are no related controls

ANSWER: D

30.The risk that a material misstatement in an assertion will not be prevented or

detected on a timely basis by internal control is
a. Detection risk
b. Control risk
c. Inherent risk
d. Audit risk
ANSWER: B

31.The probability that an auditors procedure leading to the conclusion that a

material error does not exist in an account balance when, in fact, such error
does exist is referred to as
a. Prevention risk
b. Inherent risk
c. Control risk
d. Detection risk
ANSWER: D
32.The risk that the auditor may express an incorrect opinion on the financial
statement is called
a. Inherent risk
b. Detection risk
c. Control risk
d. Audit risk
ANSWER: D

33.A measure of the auditors assessment of the likelihood that there are
material misstatements in an account before considering the effectiveness of
the clients internal control is called
a. Control risk
b. Acceptable audit risk
c. Statistical risk
d. Inherent risk
ANSWER: D

34.Audit risk consists of all but the following components

a. Inherent risk
b. Substantive risk
c. Detection risk
d. Control risk
ANSWER: B

35.For a particular assertion, control risk is the risk that:

a. A material misstatement will occur in the accounting process
b. Controls will not detect am material misstatements that occurs
c. Audit procedures will fail to detect a weak control system
d. The prescribed control procedures will not be applied uniformly

ANSWER: B
36.Which of the following is the best definition of detection risk?
a. The auditor will compute audit materiality incorrectly
b. The auditor will fail to detect material misstatements that exist
c. The auditor will apply more audit procedures than are required in the
circumstances
d. The auditor will fail to modify the audit opinion on financial statements
that are materially misstated

ANSWER: B
37.The risk that the audit will fail to uncover a material misstatement is
eliminated
a. If a client has strong internal control
b. If a client is not publicly accountable entity
 c. When the auditor has complied with the Philippine Standard on Auditing
d. Under no circumstances

ANSWER: D
38.The audit risk model is used primarily
a. For planning purposes in determining how much evidence to accumulate
b. To test the effectiveness of controls
c. To determine the type of opinion to express
d. To evaluate the evidence which has been gathered.

ANSWER: A
39.The risk of material misstatement refers to:
a. Control risk and acceptable audit risk
b. Inherent risk
c. The combination of inherent risk and control risk
d. Inherent risk and audit risk

ANSWER: C
40.As the risk of material misstatement increases, detection risk should:
a. Increase
b. Decrease
c. Stay the same
d. Increase or decrease depending on materiality level

ANSWER: D
41.The risk of material misstatement differs from detection risk in that it:
a. Arises because audit procedures have been misapplied
b. Can be controlled and changed by the auditor
c. Can be assessed in quantitative and non-quantitative terms
d. Is controllable by the client

ANSWER: D
42. Inherent risk and control risk:
a. Are inversely related to each other
b. Are inversely related to detection risk
c. Are directly related to detection risk
d. Are directly related to audit risk

ANSWER: B
43.Which of the following is an incorrect statement?
a. Detection risk cannot be changed at the auditors discretion
 b. If individual audit risk remains the same, detection risk bears an
inverse relationship to inherent and control risk
c. The greater the inherent and control risk 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

ANSWER: A

44. The acceptable level of detection risk is inversely related to the

a. Assurance provided by substantive tests
b. Risk of misapplying auditing procedures
c. Preliminary judgment about materiality levels
d. Risk of failing to discover material misstatements

ANSWER: A

45. An auditor uses the assessed level of control risk to

a. Evaluate the effectiveness of the entitys internal control policies
and procedures
b. Identify transactions and account balances where inherent risk is
at a high level
c. Indicate whether materiality thresholds for planning and
evaluation purposes are sufficiently high
d. Determine the acceptable level of detection risk for financial
statements

ANSWER: C

46. On the basis of the audit evidence gathered and evaluated, an

auditor decides to increase the assessed level of control risk from that
originally planned. 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
b. Increase inherent risk
c. Decrease detection risk
d. Increase materiality levels

ANSWER: C

47. Which of the following statements is not true?

 a. Inherent risk is inversely related to the amount of audit evidence
whereas detection risk is directly related to the amount of audit
evidence required
b. Inherent risk is directly related to evidence whereas detection
risk is inversely related to the amount of audit evidence required
c. Inherent risk is the susceptibility of the financial statements to
material error, assuming no internal controls
d. Inherent risk and control risk are assessed by the auditor and
function independently of the financial statement audit
ANSWER: A

48. Which of the following would not be considered further audit

procedures?
a. Tests of control
b. Substantive analytical procedures
c. Tests of details of balances
d. Risk assessment procedures

ANSWER: D

49. Risk assessment procedures are performed by auditors during an

audit in order to:
a. Determine the risk of material misstatement in the financial
statements
b. Determine the acceptable level of audit risk
c. Determine the level of materiality
d. Determine whether engagement will be accepted

ANSWER: A

50. These consist of the analysis of significant ratios and trends

including the resulting investigation of fluctuations and relationship
that are inconsistent with other relevant information or deviate from
predictable amount
a. Financial statement analysis
b. Variance analysis
c. Analytical procedures
d. Regression analysis

ANSWER: C