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Michael Green, CPA, is considering audit risk at the financial statement level in planning the audit of

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National Federal Bank (NFB) Company’s financial statements for the year ended December 31, 20X1.

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Audit risk at the financial statement level is influenced by the risks of material misstatements (including
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fraud risks), which may be indicated by a combination of factors related to management, the

environment, and the entity. For each of the following factors, indicate whether they increase or decrease
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the risk of material misstatement and (2) whether they create a risk of fraud.
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-You are working with Bill Bond, CPA, and you are considering the risk of material misstatement in

planning the audit of Toxic Waste Disposal Company’s financial statements for the year ended December

31, 2005. IT is a privately owned entity that contracts with municipal governments to remove

environmental waste. Based only on the information below, indicate whether each of the following factors

would most likely increase (I), decrease (D), or have no effect (NE) on the risk of material misstatement.

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 1. This was the first year TWD operated at a profit since 2000 because the municipalities received increased

federal and state funding for environmental purposes.

Increases the audit risk; the terms and conditions of the increased funding have the potential for increasing audit

risk.

2. TWD's board of directors is controlled by Mead, the majority stockholder, who also acts as the chief

executive officer.

Increases the audit risk; there is a higher level of inherent risk. Mead can use his authority to perpetrate frauds in

the company.

3. The internal auditor reports to the controller and the controller reports to Mead.

Increases the audit risk; there is an increase in control risk. Mead can override internal controls in the company.

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4. The accounting department has experienced a high rate of turnover of key personnel.

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Increases the audit risk; new personnel may not be aware of the transactions that have taken place prior to their

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appointment. The change in personnel may be the moment when frauds take place. Increases the level of control

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risk and inherent risk.
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5. TWD's bank has a loan officer who meets regularly with TWD's CEO and controller to monitor TWD's

financial performance.
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Decreases the audit risk; the loan officer will typically evaluate the loan repayment capacity of TWD and this
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will reduce the inherent risk of the company.

6. TWD's employees are paid biweekly. Increases the audit risk; the repeated payments and the larger number of
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payments increases the possibility of making misstatements, errors and frauds.

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7. Bond has audited TWD for five years. Decrease the audit risk; Bond knows the weak points of TWD financial

system and so with his experience he will easily be able to detect material misstatements, errors and frauds.
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Recent Developments
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8. During 2004, TWD changed its method of preparing its financial statements from the cash basis to generally

accepted accounting principles. Decrease audit risks; The GAAP if followed correctly reduce the chances of

making material misstatements and errors. The GAAP will ensure that sound principles of accounting are

followed and if these principles are followed then material misstatements can be detected with greater ease that

what is possible in case of cash accounting.

9. During 2004, TWD sold one-half of its controlling interest in United Equipment Leasing (UEL) Co. TWD

retained significant interest in UEL.

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 Does not effect the audit risk; the size of the holding in a subsidiary does not affect the audit risk in TWD. In

case Bond does not audit the accounts of UEL then he can give a disclaimer to that effect in his final audit

report.

10. During 2004, litigation filed against TWD in 1996 alleging that TWD discharged pollutants into state

waterways was dropped by the state. Loss contingency disclosures that .

You have been hired to perform the audit of Hanmei, Inc.'s financial statements. When planning such an

audit, you often may need to access the profession's auditing standards to per form research. For each of

the following circumstances, select the topic most closely related in the Professional Standards topic on

the following page. A topic may be selected once, more than once, or not at all.

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Transactions

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a. Possible risk factors related to misappropriation of assets

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b. The relationship between materiality used for planning versus evaluation purposes

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c. Hanmei, Inc., has transactions with the corporation president's brother
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d. Comparing a client's unaudited results for the year with last year's audited results
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e. Requirements relating to identifying violations of occupational safety and health regulations

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f. The need to "brain storm" among audit team members about how accounts could be intentionally
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misstated

g. Details on considering design effectiveness of controls

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h. The importance of considering the possibility of overstated revenues (e.g., through premature revenue

recognition)
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Professional Standards Topics

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1. Analytical procedures

2. Materiality in planning and performing an audit

3. Consideration of fraud in a financial statement audit

4. Understanding the entity and its environment and assessing the risks of material misstatement

5. Consideration of laws and regulations

6. Management representations

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 7. Related parties

answer :

a. Possible risk factors related to misappropriation of assets- Consideration of fraud in a financial statement

audit

b. The relationship between materiality used for planning versus evaluation purposes- Materiality in planning

and performing an audit

c. Hanmei, Inc., has transactions with the corporation president's brother- Related parties

d. Comparing a client's unaudited results for the year with last year's audited results- Analytical procedures

e. Requirements relating to identifying violations of occupational safety and health regulations- Consideration of

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laws and regulations

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f. The need to "brain storm" among audit team members about how accounts could be intentionally misstated -

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Consideration of fraud in a financial statement audit
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g. Details on considering design effectiveness of controls- Understanding the entity and its environment and

assessing the risks of material misstatement

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h. The importance of considering the possibility of overstated revenues (e.g., through premature revenue
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recognition)- Consideration of fraud in a financial statement audit

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