PSA 240 - THE AUDITOR’S RESPONSIBILITY TO CONSIDER FRAUD IN THE AUDIT OF FINANCIAL

STATEMENTS

1. Grace, CPA, has discovered an illegal act during the audit of Mary Mining Company, a publicly-held
company. Accordingly, Grace should:
a. Notify the regulatory authorities
b. Determine who was responsible for the illegal act
c. Intensify the examination to identify all illegal acts
d. Report the act to high level personnel within the client’s organization and to the audit
committee

2. Which of the following is most likely to be a response to the auditor’s assessment that the risk of
material misstatement due to fraud for the existence of inventory is high?
a. Observe test counts of inventory of certain locations on an unannounced basis
b. Perform analytical procedures rather than taking test counts
c. Request that inventories be counted prior to yearend
d. Request that inventory counts at the various locations be counted on different dates so as to allow
the same auditor to be present at every count

3. Conrad, CPA, is conducting the 2009 audit of Manlolo Co., which specializes in the manufacture of
cellphone components. These cellphone have Internet and email capabilities and feature superior
mobile technology. In the performance of the audit, the following, except one, would be considered by
Conrad as Fraud risk factors. Select the exception:
a. Management does not engage in committing to analysts, creditors and other third parties to
achieving what appears to be unduly aggressive or clearly unrealistic forecasts
b. New accounting, statutory or regulatory requirements that could impair the financial stability or
profitability of the entity
c. A significant portion of management’s compensation is represented by bonuses, stock potions, or
other incentives, the value of which is contingent upon the entity achieving unduly aggressive
targets for operating results, financial position, or cash flow
d. Adverse consequences on significant pending transactions (such as a business combination or
contract award) if poor financial results are reported

4. Which of the following situations apply to errors as well as to fraud?

a. Mathematical or clerical mistakes in the underlying records & accounting data.
b. Misinterpretation of facts.
c. Misapplication of accounting principles.
d. Suppression of the effects of transactions from records or documents.

5. Material misstatements due to fraudulent financial reporting often result from:

a. An overstatement of revenues (such as premature revenue recognition)
b. An understatement of revenues (such as shifting income to a later period)
c. Both a and b
d. Neither a nor b

6. How do auditing standards consider the auditor’s responsibility for detecting fraud and errors?
a. Auditing standards make no distinction between the auditor’s responsibilities for searching
for errors and fraud.
b. The difficulty of detecting fraud changes the auditor’s responsibility from reasonable to limited
assurance.
c. The auditor should plan to discover material errors and all forms of fraud.
d. Auditing standards provide an implicit responsibility for the auditor to discover material
misstatements due to fraud.

7. An error in which an item is posted to the wrong personal account, or the incorrect calculation of an
amount constituting an original entry is a(n)
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 a. Error of omission c. Error of principle
b. Error of commission d. Compensating error

8. What differentiates fraud from an error?

a. Materiality
b. Intent
c. Effect on financial statements
d. Frequency of occurrence

9. Which of the following acts are considered fraud?

I. Alteration of records or documents
II. Misinterpretation of facts
III. Misappropriation of assets
IV. Recording of transactions without substance
V. Clerical mistakes

a. III only
b. I and III only
c. I, III, and IV only
d. All of them

10. A CPA, found guilty of act or omission of certifying financial statements of a business enterprise
containing an essential misstatement of facts or omission in respect of the transactions, taxable
income, deductions and exemption of his client, shall be punished by a fine of
a. Not less than P10,000 but not more than P30,000.
b. Not less than P25,000 but not more than P50,000.
c. Not less than P50,000 but not more than P100,000
d. Not less than P100,000 but not more than P250,000.

11. The risk of financial fraud may significantly increase if there is

a. A system of profit-sharing incentive plan
b. A substantial growth in sales
c. A change from manual processing to computerized system
d. Frequent changes in suppliers

12. The auditor-in-charge of engagement assesses risk of fraud higher than the average. The prudent
auditor is expected to
a. Assign more experienced auditors to the engagement
b. Assign a more members to the engagement
c. Make a more extensive test of controls
d. Raise the materiality level

13. A type of fraud in which an employee takes assets from an organization for personal gain.
a. Fraudulent financial reporting
b. Defalcation
c. Window dressing
d. Secret reserve

14. Which of the following is least likely a factor that increases potential for fraud?
a. Operating, financing and investing decisions are dominated by a single person.
b. Operating results are highly sensitive to outside economic conditions.
c. Audit client has been in the business and the leader of the industry for more than a decade.
d. Organization is decentralized without adequate monitoring

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 15. In assessing potential for fraud, the following are either likely or unlikely to increase risk of
misstatements of financial statements. Which of the following combinations best describes the
likelihood of potential for fraud?

A B C D
Many contentious or difficult accounting issues
are present Likely Likely Likely Unlikely
Significant and unusual related-party transactions
are present Likely Unlikely Unlikely Unlikely
Direction of change in entity’s industry is declining
with many businesses Likely Likely Unlikely Likely

16. Which of the following is an incorrect statement?

a. The amount of audit work should vary inversely with the likelihood of material
misstatements existing in the accounting records.
b. The better the organization’s control structure, the less likely it is that material misstatements will
be present
c. Complex or unusual transactions are more likely to be recorded in error than recurring or routine
transactions are
d. If misstatements are likely to occur in the recording process, the auditor should develop
procedures to detect misstatements.

17. In the regular audit of X Company, B, CPA, discovered a material fraud being perpetrated by the cashier.
What do you expect most of B, CPA to do?
a. Report the incident to the SEC
b. Communicate the existence and details of the fraud to the audit committee of the board of
directors and to management at least one level above that where the fraud has occurred.
c. Advice the shareholders of the client company regarding the fraud.
d. Make an extensive investigation in order to account for the extent of the fraud.

18. How do auditing standards consider the auditor’s responsibilities for detecting fraud and errors?
a. Auditing standards make no distinction between the auditor’s responsibilities for searching
for errors and fraud.
b. The difficulty of detecting fraud changes the auditor’s responsibility from reasonable to limited
assurance.
c. The auditor should plan to discover material errors and all forms of fraud
d. Auditing standards provide an implicit responsibility for the auditor to discover material
misstatement due to fraud.

19. What should the auditor do first when in an audit of a client entity, an illegal act has been identified?
a. Consider the effects of the illegal act on the financial statements
b. Communicate the matter with the audit committee of the board of directors
c. Submit a confidential report to the SEC
d. Consult the client’s legal counsel about the matter

20. Lapping is
a. Making the financial statements indicate a more favorable position by giving effect to tr5ansactions
is a period other than that in which these actually occurred
b. Done to inflate the cash position or cover the theft of cash by depositing at the end of the
accounting period a check drawing on one bank account in another bank account without making
the necessary deduction in the balance of the first bank
c. An irregularity that conceals cash shortages by a delay in recording cash collections,
retaining a customer’s payment on credit sales and covering up the shortage with
subsequent cash receipts
d. A kind of fraud committed by making entry of fictitious payments or failure to enter receipts
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 21. In general, material fraud perpetrated by which of the following are most difficult to detect
a. Cashier c. Internal auditor
b. Keypunch operator d. Controller

22. Certain management characteristics may heighten the auditor’s concern about the risk of material
misstatements. The characteristic that is least likely to cause concern is that management
a. Operating and financing decisions are made by numerous individuals
b. Commits to unduly aggressive forecasts
c. Has an excessive interest in increasing the entity’s stock price through use of unduly aggressive
accounting practices
d. In interested in inappropriate methods of minimizing earnings for tax purposes

23. In a financial statements audit, the auditor should consider categories of fraud risk factors. The auditor
is most likely to presume that a high risk of a declaration exists if
a. The client is a multinational company that does business in numerous foreign countries
b. The client does business with several related parties
c. Inadequate segregation of duties places an employee in a position to perpetrate and conceal
thefts
d. Inadequate employee training results in lengthy EDP exception reports each month

24. Which of the following characteristics most likely would heighten an auditor’s concern about the risk of
intentional manipulation of financial statements?
a. Turnover of senior accounting personnel is low
b. Insiders recently purchased additional shares of the entity’s stock
c. Management places substantial emphasis on meeting earnings projection
d. The rate of change in the entity’s industry is slow

25. Which of the following circumstances most likely would cause and auditor to consider whether
material misstatements exist in an entity’s financial statements?
a. Management places little emphasis on meeting earnings projections
b. The board of directors makes all major financing decisions
c. Reportable conditions previously communicated to management are not corrected
d. Transactions selected for testing are not supported by proper documentation

26. Which of the following circumstances most likely would cause an auditor to believe that material
misstatements may exist in an entity’s financial statements?
a. Accounts receivable confirmation requests yield significantly fewer responses than
expected
b. Audit trails of computer-generated transactions exist only for a short-time
c. The chief financial officer does not sign the management representation letter until the last
day of the auditor’s fieldwork
d. Management consults with other accountants about significant accounting matters

27. Which of the following inquiries are auditors required to make of management regarding fraud?
a. Whether management has ever intentionally violated the securities law
b. Whether management has any knowledge of fraud that has been perpetrated on or
within the entity
c. Management’s attitudes toward its employees
d. Auditors are not required to make inquiries of management relating to fraud

28. An entity’s financial statements were misstated over a period of years due to large amounts of revenue
being recorded in journal entries that involved debits and credits to an illogical combination of
accounts. The auditor could most likely have been alerted to this irregularity by
a. Scanning the general journal for unusual entries
b. Performing a revenue cut-off test at year-end
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 c. Tracing a sample of journal entries to the general ledger
d. Examining documentary evidence of sales returns and allowances recorded after year-end

29. Which of the following is most likely a fraud risk factor?

a. Management has a practice of conveying forecast information to analysts, creditors, and other
third parties
b. Turnover of management has been low throughout the preceding five-year period
c. Several claims against the senior management are outstanding alleging a violation of
the securities law
d. The company has shown the ability to generate a positive cash flow from operations, while
reporting earnings and earnings growth

30. A company showed a large restructuring charge on its income statement in 2004 and has experienced
a constantly rising earnings trend since that time. This would most nearly represent an example of
a. Using immaterial transactions to increase reported earnings to meet analysts’ expectations
b. Big bath accounting
c. Cookie jar reserves
d. Creative acquisition accounting

31. Which statement is incorrect regarding the auditor’s responsibility to consider fraud and error in the
audit of financial statements?
a. The auditor is entitled to accept records and documents as genuine
b. The auditor may be held responsible for the prevention of fraud and error
c. The auditor should consider the risk of material misstatements in the financial statements
resulting from fraud or error
d. The risk of not detecting a material misstatement resulting from error is lower than the risk of
not detecting a material misstatement resulting from fraud

32. Which statement is incorrect regarding the auditor’s communications of audit matters with those
charged with governance?
a. The auditor’s communications of matters include all audit matters of governance
interest
b. An audit of financial statements is not designed to identify all matters that may be relevant to
those charged with governance
c. The auditor’s communications with those charged with governance may be made orally or in
writing
d. None of the above

33. Which of the following is least likely fraud risk factor?

a. Rapid changes are occurring in the client’s industry, including rapid product development
b. The company has outsourced a portion of the internal audit function
c. Management knows of, but fails to correct, known reportable conditions on a timely
basis
d. Significant bank accounts bear interest at relatively low rates in tax-haven jurisdictions in which
the company transacts other business operations

34. In assessing potential for fraud, the following are either likely or unlikely to increase risk of
misstatements of financial statements. Which of the following combinations best describes the
likelihood of potential for fraud?
A B C D
Undue emphasis is placed on meeting projections Likely Unlikely Likely
Unlikely
Operating, financing, and investing activities are
made by different respective committees of the
Board of Directors Likely Unlikely Unlikely Unlikely

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 Reputation of the management is poor Likely Likely Likely
Unlikely

35. “Error” includes

.A Engaging in complex transactions that are structured to misrepresent the financial position or
financial performance of the entity.
.B Concealing, or not disclosing, facts that could affect the amounts recorded in the financial
statements.
.C An incorrect accounting estimate arising from oversight or misinterpretation of facts.
.D Intentional misapplication of accounting policies relating to amounts, classification, manner of
presentation, or disclosure.

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