SVC CPA REVIEW

Leganes, Iloilo

AUDITING THEORY

ERRORS, FRAUD, AND NONCOMPLIANCES

1. The following are examples of error, except

A. A mistake in gathering or processing data from which financial statements

are prepared.
B. An incorrect accounting estimate arising from misinterpretation of facts.
C. A mistake in the application of accounting principles relating to
measurement, recognition, classification, presentation or disclosure.
D. Misrepresentation in the financial statements of events, transactions or other
significant information.

2. Which of the following would be classified as an error?

A. Mistakes in the application of accounting principles.

B. Preparation of records by employees to cover a fraudulent scheme.
C. Misappropriation of assets by client employees.
D. Falsification of accounting records.

3. Which statement is incorrect regarding misappropriation of assets or defalcation?

A. It involves theft of an entity’s assets.

B. It is often perpetrated by employees in relatively small amounts.
C. It cannot involve management.
D. It is often accompanied by false or misleading records in order to conceal the
fact that the assets are missing.

4. Which of the following statements are correct?

I. The responsibility for the prevention of fraud and error rests with both those
charged with governance and the management of the entity through the
implementation of adequate internal control systems.
II. An adequate internal control system will eliminate the possibility of fraud
or errors.
III. The auditor is responsible for the prevention of fraud and error.
IV. An annual audit, once carried out, can act as a deterrent to fraud and
errors.

A. I and II. C. II and III.

B. I and IV. D. III and IV.

5. The following statements describe the auditor’s responsibility to detect fraud.

Which of the statements are correct?

I. The auditor must assess the risk that material fraud may exist.
II. The auditor must extend auditing procedures to search actively for fraud.
III. The auditor is responsible for failing to detect fraud only when an
unmodified opinion is issued.
IV. The auditor is responsible for failing to detect fraud when the failure clearly
results from not performing audit procedures described in the audit
engagement letter.
V. The risk of not detecting a material misstatement resulting from fraud is
higher than the risk of not detecting a material misstatement resulting from
error.

A. I and V. C. I, III and IV.

B. I, II and V. D. I, II, III, IV and V.

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6. The subsequent discovery of a material misstatement of the financial statements
does not, in and of itself, indicate a failure to comply with PSAs. Whether the
auditor has performed an audit in accordance with PSAs is determined by the
following, except

A. The audit procedures performed in the circumstances.

B. The sufficiency and appropriateness of the audit evidence obtained as a
result of the audit procedures performed.
C. The absence of material misstatements in the financial statements.
D. The suitability of the auditor’s report based on an evaluation of the audit
evidence gathered.

7. An auditor should plan and perform an audit with professional skepticism, which
includes the following attributes, except

A. Recognizing that circumstances may exist that cause the financial

statements to be materially misstated.
B. Satisfied with less-than-persuasive audit evidence based on a belief that
management and TCWG are honest and have integrity.
C. An attitude that includes a questioning mind and a critical assessment of
audit evidence.
D. Ongoing questioning of whether the information and audit evidence obtained
suggests that a material misstatement due to fraud may exist.

8. When the application of audit procedures designed from the risk assessment
indicates the possible existence of fraud or error, the auditor should

A. Resign from the audit engagement.

B. Consider the potential effect on the financial statements.
C. Inform the persons suspected of fraud or errors.
D. Ignore the matter because it is management who is responsible for the
prevention of fraud and errors.

9. If an auditor was engaged to discover errors or fraud and the auditor performed
extensive detail work, which could the auditor be expected to detect?

A. Misposting of recorded transactions.

B. Unrecorded transactions.
C. Collusive fraud.
D. Counterfeit signatures on paid checks.

10. The auditor should resign from an engagement when he discovers material fraud,
and

A. The top management is the perpetrator of fraud.

B. The cashier is the perpetrator of the said fraud.
C. The extent of fraud cannot be ascertained.
D. The management takes remedial action regarding fraud.

11. Which of the following statement describes why a properly designed and
executed audit may not detect a material fraud?

A. Audit procedures that are effective for detecting an unintentional

misstatement may be ineffective for an intentional misstatement that is
concealed through collusion.
B. An audit is designed to provide reasonable assurance of detecting material
errors, but there is no similar responsibility concerning material fraud.
C. The factors considered in assessing control risk indicated an increased risk
of intentional misstatement, but only a low risk of unintentional errors in the
financial statement
D. The auditor did not consider factors influencing audit risk for account
balances that have an effect that is pervasive to the financial statements
taken as a whole.

12. In general, material irregularities perpetrated by which of the following is the most
difficult to detect?

A. Cashier. C. Controller.
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 B. Key-punch operator. D. Internal auditor.

13. An auditor will usually raise questions with respect to his client’s integrity if its
management is dominated by

A. One person. C. Many persons.

B. Two persons. D. Three or more persons.

14. 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 more members to the engagement.
C. Make a more extensive test of controls.
D. Raise the materiality level.

15. Which statement is incorrect regarding fraud risk factors?

A. Fraud risk factors are events and conditions that indicate an incentive or
pressure to commit fraud or provide an opportunity to commit fraud.
B. Fraud risk factors necessarily indicate the existence of fraud.
C. Fraud risk factors have often been present in circumstances where frauds
have occurred.
D. The presence of fraud risk factors may affect the auditor’s assessment of the
risks of material misstatement.

16. The fraud risk factors relating to misstatements arising from fraudulent financial
reporting due to perceived opportunities to commit fraud exclude

A. There is ineffective monitoring of management.

B. Financial stability or profitability is threatened by economic, industry or entity
operating conditions.
C. There is a complex or unstable organizational structure.
D. Internal control components are deficient.

17. The fraud risk factors relating to misstatements arising from misappropriation of
assets due to ability to rationalize the fraudulent action exclude

A. Tolerance of petty theft.

B. Disregard for the need for monitoring.
C. Disregard for internal control over misappropriation of assets by overriding
existing controls or by failing to correct known internal control deficiencies.
D. Lack of mandatory vacations for employees performing key control functions.

18. Which of the following circumstances would an auditor most likely consider a risk
factor relating to misstatements arising from fraudulent financial reporting?

A. Several members of management have recently purchased additional

shares of the entity.
B. The entity distributes financial forecasts to financial analysts that predict
conservative operating results.
C. Management is interested in maintaining the entity’s earnings trend by using
aggressive accounting practices.
D. Several members of the board of directors have recently sold shares of the
entity.

19. Which situation would usually indicate material misstatement due to fraud?

A. Confirmation replies are significantly different from the client’s records.

B. Several errors are detected and listed in computer generated exception
reports.
C. Sale of an equipment at a loss, even if it is not yet fully depreciated.
D. Bank reconciliation items include those that are still in transit.

20. Which of the following best describes the auditor’s responsibility to detect
conditions relating to financial stress of employees or adverse relationships
between a company and its employees?

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 A. The auditor is required to plan the audit to detect these conditions on all
audits.
B. These conditions relate to fraudulent financial reporting, and an auditor is
required to plan the audit to detect these conditions when the client is
exposed to a risk of misappropriation of assets.
C. The auditor is required to plan the audit to detect these conditions whenever
they may result to misstatements.
D. The auditor is not required to plan the audit to discover these conditions, but
should consider them if he or she becomes aware of them during the audit.

21. If the auditor believes the indicated fraud or error could have a material effect on
the financial statements, the auditor should perform appropriate modified or
additional procedures. The extent of such modified or additional procedures is
least likely to depend on the auditor’s judgment as to

A. The types of fraud or error indicated.

B. The reason of their occurrence.
C. The likelihood of their occurrence.
D. The likelihood that a particular type of fraud or error could have a material
effect on the financial statements.

22. If the auditor concludes that the fraud or error has a material effect on the
financial statements and has not been properly reflected or corrected in the
financial statements, the auditor should express

A. Either a qualified or adverse opinion.

B. Either a qualified or unmodified opinion.
C. An adverse opinion.
D. Either a qualified, adverse or disclaimer of an opinion, depending on
materiality.

23. The auditor’s responsibility with respect to those NOCLAR that do not have a
direct effect on the determination of the amounts and disclosures in the financial
statements is

A. To obtain sufficient appropriate audit evidence regarding compliance with the

provisions of those laws and regulations.
B. To undertake specified audit procedures to help identify non-compliance with
those laws and regulations that have a material effect on the financial
statements.
C. The same as that for those NOCLAR that have a direct effect on the
determination of the amounts and disclosures in the financial statements.
D. The auditor has no such responsibility.

24. Which is incorrect about the auditor’s responsibility of evaluating NOCLAR?

A. An audit cannot be expected to detect noncompliance with all laws and

regulations.
B. Noncompliance refers to acts of omission or commission by the entity being
audited which are contrary to prevailing laws and regulations.
C. Noncompliance includes personal misconduct of entity management or
employers though they are unrelated to the entity’s business activities.
D. Detection of NOCLAR, regardless of materiality, requires considerations of
the implications for the integrity of management or employees.

25. Which of the following statements concerning noncompliance is/are correct?

I. In order to plan the audit, the auditor should have a general understanding
of the legal and regulatory framework applicable to the entity and the
industry and how the entity is complying with that framework.
II. The determination as to whether a particular act constitutes or is likely to
constitute noncompliance is generally based on the understanding of the
auditor but can only be determined by an expert qualified to practice law.
III. Whether an act constitutes noncompliance is a legal determination that is
ordinarily within the auditor’s professional competence.

A. I only. C. I and III.

B. I and II. D. I, II and III.

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26. An auditor who discovers that client employees have committed a NOCLAR that
has a material effect on the client’s financial statements most likely would
withdraw from the engagement if

A. The NOCLAR is a violation of generally accepted accounting principles.

B. The client does not take the remedial action that the auditor considers
necessary.
C. The NOCLAR was committed during a prior year that was not audited.
D. The auditor already assessed control risk at the maximum level.

27. The most likely explanation why the auditor’s examination cannot reasonably be
expected to bring all NOCLAR by the client to the attention of the auditor is that

A. NOCLAR are perpetrated by management override of internal controls.

B. NOCLAR by clients often relate to operating aspects rather than accounting
aspects.
C. The client’s internal control structure may be so strong that the auditor
performs only substantive testing.
D. NOCLAR may be perpetrated by the only person in the client’s organization
with access to both assets and the accounting records.

28. Which of the following relatively small misstatements most likely could have a
material effect on an entity’s financial statements?

A. A petty cash fund disbursement that was not properly authorized.

B. An uncollectible account receivable that was not written off.
C. An illegal payment to a foreign official that was not recorded.
D. A piece of obsolete office equipment that was not retired.

29. The risk of not detecting NOCLAR is higher than fraud or errors because of the
following factors, except

A. Much of the evidence obtained by the auditor is persuasive rather than

conclusive in nature.
B. NOCLAR may involve conduct designed to conceal it, such as forgery and
collusion.
C. Persons involved in NOCLAR are usually smarter than those involved in
committing fraud and errors.
D. There are many laws and regulations, relating principally to the operating
aspects of the entity that typically do not have a material effect on the
financial statements and are not captured by the accounting and internal
control systems.

30. If the auditor suspects that members of senior management, including members
of the board of directors are involved in NOCLAR, and he believes his report may
not be acted upon, he would

A. Do nothing.
B. Issue a disclaimer of opinion.
C. Consider seeking legal advice.
D. Make special investigation in order to fully determine the extent of client’s
noncompliance.

31. When NOCLAR is identified, the auditor shall

I. Obtain an understanding of the nature of the act and the circumstances.

II. Evaluate the possible effect on the financial statements.

A. I only. C. Both I and II.

B. II only. D. Neither I nor II.

32. When NOCLAR is suspected, the auditor shall do the following except

A. Discuss the matter with the appropriate level of management, and where
appropriate, TCWG.
B. Consider the need to obtain legal advice.

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 C. If unable to obtain sufficient appropriate audit evidence, consider the effect
on the auditor’s report.
D. Consider withdrawing from the engagement.

33. Which statements are correct in relation to the auditor’s responsibility to

communicate and report identified or suspected NOCLAR?

I. Communicate to TCWG, unless they themselves are involved.

II. If management and TCWG are involved, consider reporting to next level of
authority like audit committee.
III. Where no higher authority exists, consider the need to obtain legal advice.
IV. If NOCLAR has a material effect and has not been adequately reflected in
the financial statements, express a qualified or disclaimer of opinion.

A. II, III and IV. C. II and III.

B. I, II and III. D. I, II, III and IV.

34. If the auditor has identified or suspect NOCLAR, the auditor should determine
whether law, regulation or relevant ethical requirements:

I. Require the auditor to report to an appropriate authority outside the entity.

II. Establish responsibilities under which reporting to an appropriate authority
outside the entity may be appropriate in the circumstances.

A. I only. C. I and II.

B. II only. D. Neither I nor II.

35. With respect to identified or suspected NOCLAR, which of the following matters
shall be documented by the auditor?

I. The audit procedures performed.

II. Significant judgments made.
III. Conclusion reached.
IV. The discussions of significant matters related to NOCLAR with
management, TCWG and others, and where applicable, their responses to
the matter.

A. I, II and IV. C. I, II and III.

B. II, III and IV. D. I, II, III and IV.

Notes:

Errors and Fraud

Misstatements in the financial statements can arise from:

a. Errors – refers to unintentional misstatement in financial statements,

including the omission of an amount or a disclosure.

 Mistake in gathering or processing data from which financial

statements are prepared.
 Incorrect accounting estimate arising from oversight or
misinterpretation of facts.
 Mistake in the application of accounting policies.

b. Fraud – refers to intentional act by one or more individuals among

management, those charged with governance, employees, or third parties,
involving the use of deception to obtain an unjust or illegal advantage.

 Fraudulent financial reporting (Management Fraud). An intentional

misstatement or omission of an amount or disclosure in the financial
statements to deceive financial statement users.
 Manipulation, falsification, or alteration of records or documents.
 Misrepresentation or intentional omission of transactions or events.
 Intentional misapplication of an accounting principle.

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  Misappropriation of assets (Defalcation). It involves the theft of an
entity’s assets.
 Embezzling receipts.
 Stealing physical or intangible assets.
 Causing an entity to pay for goods and services not received.
 Using an entity’s assets for personal use.

Management fraud – fraud involving one or more members of management or

those charged with governance.

Employee Fraud – fraud involving only employees of the entity.

Those charged with the governance and the management of an entity have
primary responsibility for the prevention and detection of fraud and error.

An audit is designed to provide reasonable assurance that the financial statement

taken as a whole are free from material misstatement, whether caused by fraud
or error.

Fraud Risk Factors – events or conditions that provide an opportunity, a motive

or a means to commit fraud, or indicate that fraud may already have occurred.

Fraud risk factors relating to misstatements arising from fraudulent financial

reporting:

1. Incentives/Pressures

a. Financial stability or profitability is threatened by economic, industry

or entity operating conditions.
b. Excessive pressure exists for management to meet the
requirements or expectations of third parties.
c. Information available indicates that the personal financial situation
of management or those charged with governance is threatened by
the entity’s financial performance.
d. There is excessive pressure on management or operating
personnel to meet financial targets established by those charged
with governance, including sales or profitability incentive goals.

2. Opportunities

a. The nature of the industry or the entity’s operations provides

opportunities to engage in fraudulent financial reporting.
b. There is ineffective monitoring of management.
c. There is a complex or unstable organizational structure.
d. Internal components are deficient.

3. Attitudes/Rationalizations

Fraud risk factors relating to misstatements arising from misappropriation of

assets

1. Incentives/Pressures

a. Personal financial obligations may create pressure on management

or employees with access to cash or other assets susceptible to theft
to misappropriate those.
b. Adverse relationships between the entity and employees with
access to cash or other assets susceptible to theft may motivate
those employees to misappropriate those assets.

2. Opportunities

a. Certain characteristics or circumstances may increase the

susceptibility of assets to misappropriation such as large amounts
of cash on hand, small inventory items, easily convertible assets
and small fixed assets.
b. Inadequate internal control over assets may increase the
susceptibility of misappropriation of those assets.

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 3. Attitudes/Rationalizations

Noncompliances (Illegal Acts)

Non-compliance – acts of omission or commission, intentional or unintentional,

committed by the entity, or by those charged with governance, by management
or by other individuals working for or under the direction of the entity, which are
contrary to the prevailing laws or regulations.

Noncompliance does not include personal misconduct (unrelated to the business

activities of the entity).

The two different categories of NOCLAR are as follows:

a. Noncompliance with the provisions of those laws and regulations generally

recognized to have a direct effect on the determination of material amounts
and disclosures in the financial statements (e.g., tax and pension laws).
b. Noncompliance with other laws and regulations that do not have a direct
effect (indirect effect) on the determination of the amounts and disclosures
in the financial statements, but on the operating aspects of the business, to
an entity’s ability to continue its business, or to avoid material penalties (e.g.,
compliance with the terms of an operating license or occupational safety).

For those NOCLAR that have a direct effect on the determination of the amounts
and disclosures in the financial statements, the auditor’s responsibility is to obtain
sufficient appropriate audit evidence regarding compliance with the provisions of
those laws and regulations.

For those NOCLAR that do not have a direct effect on the determination of the
amounts and disclosures in the financial statements, the auditor’s responsibility
is limited to undertaking specified audit procedures to help identify non-
compliance with those laws and regulations that have a material effect on the
financial statements.

End