DELA CRUZ, LLOYD ANTHONY B.

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CHAPTER 1 CORE CONCEPTS OF A RISK-BASED APPROACH TO CONDUCTING A QUALITY AUDIT
Review Question
1. Why auditors’ reports are important to users of financial statements?
Auditors' reports are important to users of financial statements because they inform users of
the auditor's opinion as to whether or not the financial statements are fairly stated or whether
no conclusion can be made with regard to the fairness of their presentation. Users especially look
for any deviation from the wording of the standard unmodified report and the reasons and
implications of such deviations. Having standard wording improves communications for the benefit
of users of the auditor's report. When there are departures from the standard wording, users are
more likely to recognize and consider situations requiring a modification or qualification to the
auditor's report or opinion.
2. What purpose is served by the Philippine Standards on Auditing
The purpose of this Philippine Standard on Auditing (PSA) is to establish standards and provide
guidance on the independent auditor’s report issued as a result of an audit of a complete set of
general-purpose financial statements prepared in accordance with a financial reporting framework
that is designed to achieve fair presentation. It also provides guidance on the matters the
auditor considers in forming an opinion on those financial statements. As described in PSA 200,
“Objective and General Principles Governing an Audit of Financial Statements,” “general purpose
financial statements” are financial statements prepared in accordance with a financial reporting
framework that is designed to meet the common information needs of a wide range of users.
3. Discuss the role of risk in audit process and how its existence is communicated to the user in
the audit report.
Risk is a concept used to express uncertainty about events and/or their outcomes that could
have a material effect on the organization. The role of risk in audit process gives a huge factor
to consider in auditing in order to assess what kind of strategy and methodology to be used in
conducting an audit. There are stages of risk-based audit process which are Risk assessment, risk
response and reporting. First phase involves the performance of preliminary engagement activities
to decide whether to accept/ continue an audit engagement, plan the audit to develop an overall
audit strategy and audit plan and perform risk assessment procedures to identify/ assess risk of
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material misstatement through understanding the entity. The second phase is about designing
overall responses and further audit procedures and implementing responses to assessed risk of
material misstatement. Lastly, evaluating the audit evidence and forming an opinion based on audit
findings and preparing the auditor’s report.
4. Prior to naming Cruz and Company as its auditors, Del Pelayo of Verbatim, Inc., met with
Gracie Cruz and inquired about the auditors who would work on Verbatim’s audit. Pelayo wants
Cruz to assign only persons who graduated from his alma matter.
Required: How should Grace Cruz respond?
Grace should not assign auditors in considering alma mater with the client as requested. It is
bias. Skills, expertise and independently of an auditor should be a basis of assigning auditors
who will work on Verbatim, Inc.
5. Describe the conditions under which an auditor is associated with financial statements
Auditors become associated in the financial statements once they are engaged and accepted the
contract to audit information obtained in the financial statements.
6. What factors should an auditor consider in determining whether financial statements are
presented fairly in conformity with applicable financial reporting standards?
There are many factors to consider if the financial statements are presented fairly in
accordance with applicable financial reporting such as the nature of the business, the complexity
of the transactions, the existence of large non-routine transactions, the control risk of Internal
Management, the flexibility and expertise of the internal management and their integrity in making
financial statements.
7. Why must the auditor refrain from explaining why he or she is independent?
The auditor should refrain from explaining that he/she is independent so that any opinions made by
the auditor may not be influenced by the relationship between them.
8. Define the following terms:
A. Audit Risk
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Audit risk is defined as ‘the risk that the auditor expresses an inappropriate audit opinion
when the financial statements are materially misstated. Audit risk is a function of the risks
of material misstatement and detection risk’. Hence, audit risk is made up of two components –
risks of material misstatement and detection risk.
B. Inherent Risk
Inherent risk is ‘the susceptibility of an assertion about a class of transaction, account
balance or disclosure to a misstatement that could be material, either individually or when
aggregated with other misstatements, before consideration of any related controls.’
C. Control Risk
Control risk is ‘the risk that a misstatement that could occur in an assertion about a class
of transaction, account balance or disclosure and that could be material, either individually
or when aggregated with other misstatements, will not be prevented, or detected and corrected,
on a timely basis by the entity’s internal control.’
D. Detection Risk
Detection risk is defined as ‘the risk that the procedures performed by the auditor to
reduce audit risk to an acceptably low level will not detect a misstatement that exists and
that could be material, either individually or when aggregated with other misstatements.’
9. A. What is audit risk model?
Audit risk model is a tool that is used by the auditors to understand the relationship
various risks arising from an audit engagement enabling them to manage the overall audit
risk.
B. How can the auditor use the audit risk model?
The audit risk model is used first by determining Inherent Risk, Control Risk and Detection
Risk then compute it using the formula AR=IR x CR x DR.

10. Describe the relationship between detection risk and evidence accumulation.
Detection risk and evidence accumulated are correlated because detection risk might be higher
because evidence collected are not sufficient to detect errors and frauds.
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11. Below are an auditor’s planned audit risk and assessment of inherent risk and control risk
for fie situations
Situation Planned Audit Risk Assessed Inherent Assessed Control Risk
Risk
1 1 20% 20%

2 1 100% 50%

3 4 20% 20%

4 5 100% 50%

5 5 100% 100%
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12. Last year you were assigned to minor parts of the audit of the sales and collections cycle
for Patrick Corporation. This year you have been assigned significant responsibility in the
audit of the sales and collections cycle. You recall that last year, the credit manager, Josie
Tan, treated you as if you were one of the clerks. In fact, you had to call her Ms. Tan” when
you went to ask him several questions. This year, she has become very friendly, Josie as he
now wants you to call him, has just invited you to join her for dinner at a very exclusive
private club in town. You were called away before you could give Josie a reply, but he did
indicate to you that last year he took you predecessor to such a dinner.
Required: How do you respond to Josie?
Independence means objectivity and freedom from bias. The auditor can favor neither the client
nor the third party in evaluating the fairness of the financial statements. The auditor must be
independent in fact and in appearance. Independence in fact means the auditor is unbiased and
objective. An auditor could be independent in fact if he or she owned a few shares of common stock
in an audit client, but might not appear independent to a third party. Independence in appearance
means that a third party with knowledge of the auditor’s relationship with the client would
consider the auditor to be independent. If users don’t perceive auditors to be independent then
the value of the audit is lacking.
13. The fairness of financial statements and the adequacy of internal controls are judged only
by reference to pre-established criteria. What serves as the criteria to judge the fairness of
financial statements and the adequacy of internal controls? Explain why “reference to
criteria” is important to the audit function and the results communicated by the audit
function.
An assertion is a positive statement about an action, event, condition, or performance over a
specified period of time. To have unbiased and clear communication, criteria must exist whereby
independent observers can assess whether such assertions are appropriate. GAAP provide those
criteria for financial statement audits. COSO provides criteria for evaluating the design and
operation of internal controls. Internal auditors may refer to management’s policies and
procedures in determining a department’s compliance with company policies. An internal revenue
agent will refer to the tax code to determine if taxable income is correctly computed. When
management prepares financial statements, they assert that those statements are fairly presented
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in accordance with GAAP. Generally accepted accounting principles become the criteria by which
“fairness” of a financial statement presentation is judged.
14. How does complexity affect (1) the demand for auditing services and (2) the performance of
auditing services?
Complexity affects the demand for auditing services because of the vast number of transactions,
information, and processing systems it requires a high demand of very skilled auditors because
companies do not want to face lawsuits if their financial reports are misrepresented.
Performance declines with increasing complexity only under combinations of low knowledge and
high accountability, or low accountability and high knowledge. Performance is unaffected by
increasing task complexity when auditors have high knowledge and high accountability, or have low
knowledge and low accountability. These findings contribute to a better understanding of the
conditions under which performance may (or may not) be adversely affected by task complexity.
15. Who is the most important user of an audit’s report on a company’s financial statements:
company management, the company’s shareholders, or the company’s creditors? Briefly explain
your rationale and indicate how auditors should resolve potential conflicts in the needs of
the three parties.
The auditor should resolve potential conflicts in the needs of the three parties by contributing
to conclusions that are free from bias. It requires independent in fact and in appearance. The
key point is that no matter who the client is, the auditor must make an objective, unbiased
judgment about the fairness of the financial statements and should not favor the interests of one
party over another.
16. How does an audit enhance the quality of financial statements and management’s reports on
internal control? Does an audit ensure a fair presentation of a company’s financial statements
or that internal control systems are free of material deficiencies? Explain.

The auditor has evaluated the entry-level controls, especially the control environment, and
has concluded that there are no material deficiencies in the control environment. The
financial group is competent, the audit committee is independent and plays an important
oversight role and the company has an effective internal audit activity that periodically
looks at internal control over revenue. If there are one or more significant or material
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deficiencies in controls, the auditor must define what types of misstatement could occur and
design audit tests to determine if they did occur. Further, the client has documented and
evaluated internal controls over revenue and receivables and has not found any significant
deficiencies. If there are no significant or material deficiencies minimal substantive testing
will be performed. The auditor will issue an audit report indicating that the financial
statements, in his or her opinion are fairly presented

17. In what ways does the practice of internal auditing differ from the practice of public
accounting? To whom is the internal auditing function responsible?
Internal auditors are company employees, while external auditors work for an outside audit firm.
Internal auditors are hired by the company, while external auditors are appointed by a
shareholder vote.
Internal auditors do not have to be CPAs, while a CPA must direct the activities of the external
auditors.
Internal auditors are responsible to management, while external auditors are responsible to the
shareholders. Internal auditors can issue their findings in any type of report format, while
external auditors must use specific formats for their audit opinions and management letters.
Internal audit reports are used by management, while external audit reports are used by
stakeholders, such as investors, creditors, and lenders.
Internal auditors can be used to provide advice and other consulting assistance to employees,
while external auditors are constrained from supporting an audit client too closely.
Internal auditors will examine issues related to company business practices and risks, while
external auditors examine the financial records and issue an opinion regarding the financial
statements of the company.
Internal audits are conducted throughout the year, while external auditors conduct a single
annual audit. If a client is publicly-held, external auditors will also provide review services
three times per year.
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18. Marion Watson & Co., CPAs, is planning its audit procedures for its tests of the valuation
of inventories of East Coast Manufacturing Co. The auditors on the engagement have assessed
inherent risk and control risk for valuation of inventories at 100 percent and 50 percent,
respectively.
a. Calculate the appropriate level of detection risk for the audit of this assertion, given
that the auditors wish to restrict audit risk for the assertion to 3 percent.
b. Calculate the appropriate level of detection risk for the audit of this assertion, given
that the auditors wish to restrict audit risk for the assertion to 5 percent.
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19. State whether each of the following statements is correct or incorrect concerning audit risk
and its components—inherent risk, control risk, and detection risk.
a. The risk of material misstatement is composed of the three components of audit risk.
Incorrect. The risk of material misstatements composed of inherent risk and detection risk.
b. Inherent risk is the possibility of material misstatement before considering the client's
internal control.
Correct.
c. Loss control risk means in increase in the risk of material misstatement.
Incorrect. A decrease in control risk, absent other changes, results in a decrease in the risk of
material misstatement
d. Detection risk does not exist when no audit is performed.
Correct. Detection risk is a function of the audit and its procedures. If there is no audit there
is no measure of detection risk.
e. Rather than restrict detection risk through the performance of more substantive
procedures, auditors assess it.
Incorrect. This is backwards. Auditors restrict detection risk through the performance of more
substantive procedures. Auditors assess inherent risk and control risk.
f. Absent any other changes, an increase in the risk of material misstatement results in an
increase in audit risk.
Correct.
g. Audit risk refers to the possibility that the auditors may unknowingly fail to
appropriately modify their opinion on financial statements that are materially or
immaterially misstated.
Incorrect. The error is the "or immaterially." Audit risk deals with material misstatements.
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h. Both inherent risk and control risk exist independently of the audit of financial
statements.
Correct.
20. In applying a top-down, risk-based approach to an audit, should the auditor start with the
ending account balances or does the auditor start with the significant processes that lead to
material account balances? Is one approach preferred over the other? Explain.
A top-down, risk-based approach requires to auditors to consider the materiality of account
balances and processes along with the risks that the account balance may be misstated. The
natural inclination is to begin the risk-based approach by looking at the financial statements
and working backward to identify individual account balances. This is the approach that is
suggested by PCAOB in AS 5. While this approach has advantages, the auditor should also look to
determine if management has implemented the risk analysis part of the COSO internal control
framework if they have that represents an appropriate staring point. Further, some processes may
be more important than account balances because some account balances may be significantly
understanding.
CHAPTER II RISK ASSESSMENT: PRELIMINARY ENGAGEMENT ACTIVITIES
Review Questions and Exercises
1. What factors should an auditor consider prior to accepting an engagement? Explain
Prior to accepting a client, the auditor should investigate the client. The auditor should
evaluate the client's standing in the business community, financial stability, and relations with
its previous CPA firm. The primary purpose of new client investigation is to ascertain the
integrity of the client and the possibility of fraud. The auditor should be especially concerned
with the possibility of fraudulent financial reporting since it is difficult to uncover. The
auditor does not want to needlessly expose himself or herself to the possibility of a lawsuit for
failure to detect such fraud.
2. List the four types of information the auditor should obtain or review as a part of gaining
background information for the audit and provide one specific example of how the information
will be useful in conducting an audit.
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The nature of the client, including the client’s application of accounting policies- the auditors’
understanding of this area will include the client’s competitive position, organizational
structure, accounting policies and procedures, ownership, capital structure, and product lines.
The understanding will also encompass an understanding of the owner’s business model and its major
business processes.
3. Name the three sources of business and industry information.
The industry, regulatory and other external factors- the factors included here are industry
conditions, such as competitive environment, supplier and customer relationships, and
technological developments. They also include the regulatory, legal and political environment, and
general economic conditions.
4. What information should a CPA firm seek in its investigation of a prospective client?
CPAs should investigate the history of the prospective client, including such matters as the
identities and reputations of the directors, officers, and major stockholders. They should also
obtain permission to obtain information from third parties for example, the client’s bankers,
legal counsel and predecessor auditors.
5. Discuss what is meant by the phrase "shopping for accounting principles.? " What mechanisms
have served to prevent this practice by management?
"Shopping for accounting principles" occurs when client management changes auditors to a CPA
firm that is more likely to sanction a disputed accounting principle. There is a requirement by
the SEC for previous auditors that have resigned or been discharged to provide a response,
indicating whether they agree with the company's form and providing any necessary details.
6. Many CPA firms are taking a business risk approach to audits. Define what is meant by
business risk. Provide an example of a business risk that could result in a risk of material
misstatement of the financial statements.
Understanding the process company management use to identify significant business risks and
ways to mitigate them are important to an auditing CPA firm. It's also important for CPAs to
evaluate their significance in relation to creating risks of material misstatement in the
financial statements.
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7. Can a standard audit plan be used for most engagements?
No, a standard audit plan cannot be used for most engagement. That is because every firm has
different financial situations. It is impossible to apply one firm's financial situation to
another.
8. “An audit plan is desirable when new staff members are assigned to an engagement, but an
experienced auditor should be able to conduct an audit without reference to it.” Do you
agree? Discuss.
The quotation is misleading because it implies that an audit plan is no more than checklists of
instructions for inexperienced auditors. Actually, audit plans are required on all audits
regardless of the amount of experience of the auditor.
9. What is an engagement letter? Why is its use recommended prior to the rendering of
professional services by CPAs?
An engagement letter is the agreement or understanding between the CPA and his/her client
concerning the nature of the engagement. It provides protection for the CPA in the event of
subsequent legal action alleging negligence or breach of contract. By committing the agreement to
writing, the engagement letter also minimizes future misunderstandings between the CPA and client
concerning the services to be performed by the CPA.
Exercise 1
Martinez, CPA, is approached by a prospective audit client who wants to engage Martinez to perform
an audit for the current year. In prior years, this prospective client was audited by another CPA.
Identify the specific procedures that Morgan should follow in deciding whether to accept this
client.
The procedures that Martinez should apply in deciding whether to accept this prospective audit
client would ordinarily include the following:
(1) Evaluate the CPA firm's independence with respect to the prospective audit client.
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(2) Explain to the prospective client the need to make inquiries of the predecessor auditor,
requesting that the client authorize the predecessor auditor to respond fully and to allow a
review of the predecessor's audit working papers.
(3) Make inquiries of the predecessor auditor concerning such matters as the integrity of
management, any disagreements with management as to accounting principles, the reason for the
change in auditors, and any other matters affecting the decision of whether to accept the
engagement.
(4) Make inquiries of other appropriate third parties regarding the history of the prospective
client and the reputations of its management and directors. These third parties may include the
client's bankers, legal counsel, and underwriters.
(5) Obtain a knowledge of the client's business activities and business environment. Sources of
this information include inquiries of management and others within the organization, inspection of
internal documents and records, the client's website, AICPA accounting and audit guides,
registration statements and Form 10-Ks filed with the SEC, interim financial statements, income
tax returns, and credit reports.
(6) Consider any special problems or unique risks likely to be associated with the engagement.
(7) Hold preliminary meetings with management and the audit committee to discuss such matters as
the scope of the services to be performed, timing of the performance and completion of the audit,
basis for the fee, and work that may be done by the client's staff in preparation for the audit.
Upon acceptance of the engagement, Morgan should issue an engagement letter summarizing the
arrangements reached with the client.
Exercise 2
Mary Dizon has been asked to accept an engagement to audit a small financial institution. Deming
has not previously audited a financial institution.
a. Describe the types of knowledge about the prospective client and its environment that Dizon
should obtain to plan the engagement
b. Explain how Dizon may obtain this knowledge
c. Discuss how this knowledge of the client and its environment will help Dizon in planning and
performing an audit in accordance with generally accepted auditing standards
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The nature of the client, including the client's application of accounting policies—The auditors'
understanding of this area will include the client's competitive position, organizational
structure, accounting policies and procedures, ownership, capital structure, and product lines.
The understanding will also encompass an understanding of the client's business model and its
major business processes.
The industry, regulatory, and other external factors—The factors included here are industry
conditions, such as the competitive environment, supplier and customer relationships, and
technological developments. They also include the regulatory, legal, and political environment,
and general economic conditions.
Objectives and strategies and related business risks—The auditors obtain an understanding of the
operating and financing strategies of management. They also obtain an understanding of
management's risk assessment process. This assists the auditors in identifying significant
business risks that may create risks of material misstatement of the financial statements.
Methods of measuring and reviewing performance—The auditors obtain an understanding of the
methods management uses to measure and review performance at various levels within the
organization. These methods are important to determining incentives of management and other
employees. The measures may also be used in designing effective analytical procedures.
Internal control—The auditors' understanding of internal control assists them in planning the
audit and assessing control risk.
Exercise 3
You are invited by John Berlin, the president of Cherry Corporation, to discuss with him the
possibility of your conducting an audit of the company. The corporation in a small, closely held
manufacturing organization that appears to be expanding. No previous audit has been performed by
independent certified public accountants. Your discussions with Berlin include an analysis of the
recent monthly financial statements, inspection of the accounting records and discussion of
policies with the chief accountant. You also are taken on guided tour of the plant by the
president. He then makes the following statement:
“Before making define arrangements for an audit. I would like to know about how long it will take
and about how much will it cost. I want quality work and expect to pay a fair price, but because
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this is our first experience with independent auditors. I would like a full explanation as to how
the cost of the audit is determined. Will you please send me a memorandum covering these points?
Write the memorandum expected requested by John Berlin

CHAPTER III PHASE 1- RISK ASSESSMENT: PLANNING THE AUDIT AND DEVELOPMENT OF OVERALL AUDIT STRATEGY
Multiple Choice
1) D
2) A
3) A
4) B
5) C
6) A
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7) C
8) C
9) D
10) D
11) D
Exercise 1
The following information shows the past two periods of results for a fictional company. Amos
Manufacturing and a comparison with industry data for the same period
a. From the preceding data, identify potential risk areas and explain why the represent
potential risk. Briefly indicate how the risk analysis should affect the planning of
the audit management
The Potential risk areas and its impact on the audit engagement for Amos Manufacturing are
as follows:
The company in the current year has increased its inventory holding levels by 57% as
compared to previous year. On the other hand, the corresponding increase in sales is just 10%. The
company has relatively blocked more cash in inventory than required being the increase in sales is
relatively minimal. The auditors in this case are required to extend their audit procedures for
inventory and check the cut off dates at year end to ensure the completeness of inventory levels.
The debt equity ratio for the company in the current year has crossed 60% which is
relatively on a higher side. For the industry the ratio stands close to 30%. This shows the
company is more dependent on debt sources for financing its operational activities. The auditors
in this case are likely to ensure that the company meets out all the terms and conditions that are
required for carrying out the debt. Further the auditors are likely to ensure that proceeds of the
debt are utilized for the purpose for which the debt has been acquired.
b. Identify any of the above data that should cause the auditor to increase the level of
professional skepticism
Exercise 2
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Auditors make materiality judgments during the planning phase of the audit in orer to be sure they
ultimately gather sufficient evidence during the audit to provide reasonable assurance that the
financial statements are free from material misstatements. The lower the materiality threshold
that an auditor has for an account balance, the more the evidence that the auditor has for an
account balance, the more the evidence the auditor collects. Auditors often use quantitative
benchmarks such as 1% of total assets or 5% of net income to determine whether misstatements
materiality affect the financial statements, but ultimately it is an auditor’s individual
profession judgment as to whether a given misstatement is or is not considered material.
A. What is the relationship between the level of riskiness of the client and the level of
misstatement in an account balance that an auditor would consider material?
The relationship of the level of riskiness and the level of material misstatement are directly
proportional. Therefore, client A misstatement with a misstatement of P5,000 is more material than
client B. Sampling of client A therefore needs to be separate and need more accurate analysis due
to more chances of false and misleading balances than client B which might be done to overstate or
understate the profits.
B. How might an auditor’s individual characteristics affect his or her professional judgments
about materiality? For example, assume that Client A has weaker controls over accounts
receivable compared to Client B (therefore, Client A is riskier than Client B). Assume that
Client B is similar in size to Client A and that the auditor has concluded that a
misstatement exceeding P5,000 would be material for Client B’s accounts receivable more
than, or less than the client of B? Further, which client will require more audit evidence
to be collected?
The purpose of the audit of financial statement is to enable the auditor to express an opinion
regarding whether the financial statement have been prepared in all material respect and in
accordance with regulation of GAAP. Every auditor is independent and carries individual approach
in establishing materiality level based on their professional judgment so at to detect
quantitative material misstatements. Thus, audit approach if every auditor will offer, it will
depend on the kind of study that the individual auditor has done according to their course of
study.
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C. Assume that one auditor is more professionally skeptical than another auditor, and that they
are making materiality judgment in part (a) of this problem. Compare the possible
alternative monetary thresholds that a more versus skeptical auditor might make for Client
A.
A more skeptical auditor will gather more critical assessment than the other auditor of the
validity of audit evidence and is more alert to evidence that contradict or bring into action,
CHAPTER IV RISK ASSESSMENT: PERFORMANCE OF RISK ASSESSMENT PROCEDURES
Exercise 1
Michael Reyes, CPA, is considering audit risk at the financial statement level in planning the
audit of National Bank (NB) Company’s financial statements for the year ended December 31, 20X1.
Audit risk at the financial statement level is influenced by the risks of material misstatements
(including 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 it increases
or decreases the risk of material misstatement and (2) whether it creates a risk of fraud.
Factor Effect on Risks Create recent years
of Material a Risk c. NB operates Decrease No
Misstatement of in a growing,
(Increase or Fraud? prosperous
Decrease) (Yes area and has
or No) remained
a. NB is a Decrease No profitable
continuing over the
audit client years
b. The banking Increase Yes d. Government Decrease No
industry has regulation
been and overview
significantly of the
impacted by banking
the downturn industry is
in the extensive and
economy in effective
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e. NB’s board of Increase Yes who also acts
directors is as a chairman
controlled by of the
Smith, the board’s audit
majority committee
stockholder, i. The Decrease No
who also acts accounting
as the chief department
executive has
officer experienced
f. Interest Increase Yes little
rates have turnover in
been very personnel
volatile during the
recently five years
g. Management at Increase Yes Green has
the bank’s audited NB.
branch j. During 20X1, Increase Yes
offices has NFB increased
authority for the
directing and efficiency of
controlling its
NB’s accounting
operations operations by
and is installing a
compensated new,
based on a sophisticated
branch computer
profitability system.
h. The internal Decrease No k. NB's formula Increase Yes
auditor has
reports consistently
directly to underestimate
Harris, a d the
majority allowance for
shareholder, loan losses
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in current Green's
year suggestions
l. Management Decrease No relating to
has been accounting
receptive to adjustments.

Exercise 2
Segregation of duties is an important concept in internal control. However, this is often a
challenge for smaller businesses because they do not have sufficient staff. Normally, the
segregation of duties deficiencies identified below results in either a significant deficiency or
a material weakness in internal control. For each segregation of duties deficiency identified
below as (1) – (6), do the following three tasks:
a. Indicate the risk to financial reporting that is associated with the inadequacy of the
segregation of duties.
b. Identify other controls that might mitigate the segregation of duties risks.
c. Identify possible tests of controls for the mitigating controls selected in b. above. The
inadequate segregation of duty situations to be considered are as follows:
1. The same individual handles cash receipts, the bank reconciliation, and customer complaints.
2. The same person prepares billings to customers and also collects cash receipts and applies them
to customer accounts.
3. The person who prepares billings to customers does not handle cash, but does the monthly bank
reconciliation, which, in turn, is reviewed by the controller.
4. The controller is responsible for making all accounting estimates and adjusting journal
entries. The company does not have a CFO and has two clerks who report to the controller.
5. A start-up company has very few transactions, less than $1 million in revenue per year, and has
only one accounting person. The company’s transactions are not complex.
DELA CRUZ, LLOYD ANTHONY B. Acctg
9A
February 9,
2021
6. The company has one computer person who is responsible for running packaged software. The
individual has access to the computer to update software and can also access records.

Issue Risk (a) Controls of Audit evidence

Mitigation (b) to identify
control
efficiency (c)

1 The same Over/Understatemen a) Review and Signed copies of

individual t of receivables approval of bank monthly bank
handles cash balance reported reconciliation reconciliation
receipts, the in financial by an statements
bank statement. appropriate identifying the
reconciliation, authority evidence of
and customer b) Monthly review and
complaints. confirmation of approval by an
customer appropriate
receivable authority.
balances by
sales person to Copies of
identify Acknowledged
disputes in a customer ledgers
timely manner providing
evidence of
confirmation of
their receivable
balances

2 The same person over/understatemen Application of Job description

prepares t of sales value Customer of employees to
billings to reported in Receipts should identify their
DELA CRUZ, LLOYD ANTHONY B. Acctg
9A
February 9,
2021
customers and financial be performed by roles in the
also collects statement another organization.
cash receipts over/understatemen individual who System generated
and applies t of cash balances is not involved Access control
them to reported in in collecting List identifying
customer financial customer the Job
accounts. statement receipts such as responsibilities
Receivables of employees
Officer
3 The person who Erroneous Bank Approved copy of
prepares financial Reconciliation bank
billings to reporting as bank should be reconciliation
customers does reconciliation is approved by statement.
not handle not approved by appropriate
cash, but does any independent level of
the monthly authority. authority such
bank as CFO.
reconciliation,
which, in turn,
is reviewed by
the controller.
4 The controller
is responsible
for making all
accounting
estimates and
adjusting
journal
entries. The
company does
not have a CFO
and has two
clerks who
report to the
controller
5 A start-up Over/understatemen Review of Accounting
company has t of balance accounting Records and
very few reported in records by an supportive data
transactions, financial independent such as customer
DELA CRUZ, LLOYD ANTHONY B. Acctg
9A
February 9,
2021
less than $1 statements as authority such Invoices, Bank
million in accounting records as Public reconciliation
revenue each might be altered accounting firm. statements,
year, and has which will go Purchase bills
only one undetected as the and other
accounting same person runs accounting
person. The the software and records
company’s has full access to
transactions all data and also
are not have the access
complex. rights to update
the software
6 The company has Over/understatemen Rights to update Review the
one computer t of balance the software and Access Control
person who is reported in access to List to obtain
responsible for financial records should information
running statements as be segregated regarding rights
packaged accounting records between two allotted to each
software. The might be altered different employee.
individual has which will go individuals
access to the undetected as the
computer to same person runs
update software the software and
and can also has full access to
access records. all data and also
have the access
rights to update
the software
DELA CRUZ, LLOYD ANTHONY B. Acctg
9A
February 9,
2021
CHAPTER V PHASE II RISK RESPONSE: DESIGNING OVERALL RESPONSES AND FURTHER AUDIT PROCEDURES
MCQ
1. B 9. C
2. D 10. D
3. A 11. A
4. C 12. D
5. B 13. A
6. C 14. D
7. A 15. C
8. D 16. C

Exercise 1
For each of the following controls, identify whether the control leaves a paper audit trail. Also
identify a test of control audit procedure the auditor can use to test the effectiveness of the
control.
a. An accounting clerk accounts for all shipping documents on a monthly basis and initials the
monthly shipping log.
Control: Independent checks on performance Objective: Completeness and Posting and summarization
b. Bank reconciliations are prepared by the financial controller, who doesn't have access to
cash receipts.
Control: Independent check on performance Objectives: Completeness, Existence, Accuracy
c. As employees checks in daily by using time clocks, a supervisor observes to make certain no
individual staff member 'punches in' more than one time card.
Controls: Independent checks on performance/Supervisor duty and Adequate Documents and
Records/Using time clocks Objectives: Existence and Accuracy
DELA CRUZ, LLOYD ANTHONY B. Acctg
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February 9,
2021
d. Vendors' invoices are approved by the financial controller after she examines the purchase
order and receiving report attached to each invoice.
Control: Independent check on performance Objective: Accuracy
e. The cashier, who has no access to accounting records, prepares the duplicate bank deposit
slip and delivers the deposit directly to the bank daily.
Control: Adequate Separation of duties/no control over assets and accounting records Objectives:
Completeness, Existence Control: Physical Control over assets and records Objectives: Timeliness,
Completeness, Existence
f. An accounting clerk verifies the price, extensions and additions of all sales invoices in
excess of P300 and initials the duplicate sales invoice when he has completed the procedure.
Control: Independent checks on performance Objective: Accuracy
g. All mail is opened and cash is prelisted daily by the president’s secretary who has no other
responsibility for handling assets or recording accounting data.
Control: Adequate Separation of duties Objectives: Accuracy, Existence, Completeness, Timeliness
Exercise 5
The following are three situations in which the auditor is required to develop an audit strategy:
1. The client has inventory at approximately 50 locations in the Philippines. The inventory is
difficult to count and can be observed only by traveling by automobile. The internal
controls over acquisitions, cash disbursements, and perpetual records are considered
effective. Thus, us the fifth year that you have done the audit, and audit results in past
years have always been excellent. The client is in excellent financial condition and is
privately held.
Required: For audit 1, recommend an evidence mix for the five types pf tests for the audit of
inventory and cost of good sold. Justify your answer. Include in your recommendation both tests of
controls and substantive tests.
DELA CRUZ, LLOYD ANTHONY B. Acctg
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2021
The auditor should obtain an understanding of the entity and its environment including its
internal control. Thus, the auditor will be able to assess the control risk and overall risk of
material misstatements. Since this is now the fifth year the auditor is performing the audit this
gives him/her a better understanding of the entity and its internal controls. The internal
controls over acquisitions, cash disbursements and perpetual inventory system are considered
effective. Check whether proper physical controls are placed on the inventory. Check accounting
records. Since the internal controls are effective, a small amount of testing on controls is
sufficient. Medium amount of testing for all four types of tests is sufficient except the
substantive analytical procedures. The substantive analytical procedures are performed because
they provide the likelihood of material misstatements. Test of controls and substantive tests of
inventory and cost of goods sold are done. These tests provide descriptive documentation of
understanding of internal controls. These tests are done to obtain sufficient appropriate audit
evidence.
2. This is the first year of an audit of a medium-sized company that a considering selling its
business because of severe underfinancing. A review of acquisition and payment cycle
indicates that controls over cash disbursements are excellent, but controls over
acquisitions cannot be considered effective. The client lacks receiving reports and a policy
as to the proper timing to record acquisitions. When you review the general ledger, you
observe that there are many large adjusting entries to connect accounts payable.
Required: For audit 2, recommend an evidence mix for the audit of acquisition and payment cycle,
including accounts payable. Justify your answer.
The auditor should obtain an understanding of the entity and its environment including its
internal control. In case of control risk assessment, the auditor should verify the accounting
records – the accounting records are the important source of audit evidence. The general ledger
shows many adjusting entries to correct accounts payable. Assess the control risk and determine
the extent of testing controls to be performed. Test of controls and substantive test of
acquisition and payment cycle should be extensive. This is because the controls over the
acquisition are not effective. Analytical procedures are inexpensive and hence, most of the
auditors perform them on almost all auditors. The test of details of accounts payable balances are
performed extensively.
DELA CRUZ, LLOYD ANTHONY B. Acctg
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2021
3. You are doing the audit of a small loan company with extensive receivables from customers.
Controls over granting loans, collections, and loans outstanding are considered effective,
and there is extensive follow-up of all outstanding loans weekly. You have recommended a new
computer system for the past two years, but management believes the cost is too great, given
their low profitability. Collections are an ongoing problem because many of the customers
have severe financial problems. Because of adverse economic conditions, loans receivable
have significantly increased and collections are less than normal. In previous years, you
have had relatively few adjusting entries.
Required: For audit 3, recommend an evidence mix for the audit of outstanding loans. Justify your
answer.
Auditor performs tests of controls and tests of balance for the audit of outstanding loans.
Auditor should examine the balance of outstanding loans, interest rates, allowance receivables,
uncollectible accounts balances. Auditor should assess the control risk and confirmation of
accounts payable balance. The auditor also tests of controls over the procedure of loan, rate of
interest, ability to pay the amount of the loan. Therefore, auditor performs tests of detail
balances and performs tests for net realizable value of outstanding loan.