c.

Report the matter to an appropriate level of management at least one level above
those involved.
d. Discuss the evidence with the client’s audit committee, or others with equivalent
authority and responsibility.
52. An auditor who discovers that client employees have committed an illegal act that has a
material effect on the client’s financial statements most likely would withdraw from the
engagement if
a. The illegal act is a violation of generally accepted accounting principles.
b. The client does not take the remedial action that the auditor considers necessary.
c. The illegal act was committed during a prior year that was not audited.
d. The auditor has already assessed control risk at the maximum level.

53. Before accepting an engagement to audit a new client, a CPA is required to obtain
a. An understanding of the prospective client’s industry and business.
b. The prospective client’s signature to the engagement letter.
c. A preliminary understanding of the prospective client’s control environment.
d. The prospective client’s consent to make inquiries of the predecessor auditor, if
any.

54. Before accepting an audit engagement, a successor auditor should make specific
inquiries of the predecessor auditor regarding
a. Disagreements the predecessor had with the client concerning auditing
procedures and accounting principles.
b. The predecessor’s evaluation of matters of continuing accounting significance.
c. The degree of cooperation the predecessor received concerning the inquiry of
the client’s lawyer.
d. The predecessor’s assessments of inherent risk and judgments about materiality.

55. Before accepting an audit engagement, a successor auditor should make specific
inquiries of the predecessor auditor regarding the predecessor’s
a. Opinion of any subsequent events occurring since the predecessor’s audit report
was issued.
b. Understanding as to the reasons for the change of auditors.
c. Awareness of the consistency in the application of GAAP between periods.
d. Evaluation of all matters of continuing accounting significance.
56. Which of the following factors would most likely cause a CPA to decide not to accept a
new audit engagement?
a. The CPA’s lack of understanding of the prospective client’s internal auditor’s
computer-assisted audit techniques.
b. Management’s disregard of its responsibility to maintain an adequate internal
control environment.
 AUDITING THEORY
EXERCISE 1
AUDIT ENGAGEMENT
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1. As the acceptable level of detection risk decreases, an auditor may

a. Reduce substantive testing by relying on the assessments of inherent risk and
control risk.
b. Postpone the planned timing of substantive tests from interim dates to the year-
end.
c. Eliminate the assessed level of inherent risk from consideration as a planning
factor.
d. Lower the assessed level of control risk from the maximum level to below the
maximum.
2. The risk that an auditor will conclude, based on substantive tests, that a material
misstatement does not exist in an account balance when, in fact, such misstatement does exist
is referred to as
a. Sampling risk.
b. Detection risk.
c. Nonsampling risk.
d. Inherent risk.
3. As the acceptable level of detection risk decreases, the assurance directly provided from
a. Substantive tests should increase.
b. Substantive tests should decrease.
c. Tests of controls should increase.
d. Tests of controls should decrease.
4. Which of the following audit risk components may be assessed in nonquantitative
terms?
Control risk Detection risk Inherent risk
a. Yes Yes No
b. Yes No Yes
c. Yes Yes Yes
d. No Yes Yes
5. Inherent risk and control risk differ from detection risk in that they
a. Arise from the misapplication of auditing procedures.
b. May be assessed in either quantitative or nonquantitative terms.
c. Exist independently of the financial statement audit.
d. Can be changed at the auditor’s discretion.
6. On the basis of the audit evidence gathered and evaluated, an auditor decides to
increase the assessed level of control risk from that originally planned. To achieve an overall
audit risk level that is substantially the same as the planned audit risk level, the auditor would
a. Decrease substantive testing.
b. Decrease detection risk.
c. Increase inherent risk.
d. Increase materiality levels.
7. Relationship between control risk and detection risk is ordinarily
a. Parallel.
b. Inverse.
c. Direct.
d. Equal.
8. Which of the following would an auditor most likely use in determining the auditor’s
preliminary judgment about materiality?
a. The anticipated sample size of the planned substantive tests.
b. The entity’s annualized interim financial statements.
c. The results of the internal control questionnaire.
d. The contents of the management representation letter.
9. Which of the following statements is not correct about materiality?
a. The concept of materiality recognizes that some matters are important for fair
presentation of financial statements in conformity with GAAP, while other matters
are not important.
b. An auditor considers materiality for planning purposes in terms of the largest
aggregate level of misstatements that could be material to any one of the
financial statements.
c. Materiality judgments are made in light of surrounding circumstances and
necessarily involve both quantitative and qualitative judgments.
d. An auditor’s consideration of materiality is influenced by the auditor’s perception
of the needs of a reasonable person who will rely on the financial statements.
10. Which of the following elements underlies the application of generally accepted auditing
standards, particularly the standards of fieldwork and reporting?
a. Internal control.
b. Corroborating evidence.
c. Quality control.
d. Materiality and relative risk.
11. In considering materiality for planning purposes, an auditor believes that misstatements
aggregating $10,000 would have a material effect on an entity’s income statement, but that
misstatements would have to aggregate $20,000 to materially affect the balance sheet.
Ordinarily, it would be appropriate to design auditing procedures that
would be expected to detect misstatements that aggregate
a. $10,000
b. $15,000
c. $20,000
d. $30,000
12. Which of the following would an auditor most likely use in determining the auditor’s
preliminary judgment about materiality?
a. The results of the initial assessment of control risk.
b. The anticipated sample size for planned substantive tests.
c. The entity’s financial statements of the prior year.
d. The assertions that are embodied in the financial statements.
13. Holding other planning considerations equal, a decrease in the amount of misstatement
in a class of transactions that an auditor could tolerate most likely would cause the auditor to
a. Apply the planned substantive tests prior to the balance sheet date
b. Perform the planned auditing procedures closer to the balance sheet date.
c. Increase the assessed level of control risk for relevant financial statement assertions.
d. Decrease the extent of auditing procedures to be applied to the class of transactions.

14. When issuing an unqualified opinion, the auditor who evaluates the audit findings should
be satisfied that the
a. Amount of known misstatement is documented in the management
representation letter.
b. Estimate of the total likely misstatement is less than a material amount.
c. Amount of known misstatement is acknowledged and recorded by the client.
d. Estimate of the total likely misstatement includes the adjusting entries already
recorded by the client.
15. Which of the following is an example of fraudulent financial reporting?
a. Company management changes inventory count tags and overstates ending
inventory, while understating cost of goods sold.
b. The treasurer diverts customer payments to his personal due, concealing his
actions by debiting an expense account, thus overstating expenses.
c. An employee steals inventory and the “shrinkage” is recorded in cost of goods
sold.
d. An employee steals small tools from the company and neglects to return them;
the cost is reported as a miscellaneous operating expense.
16. Which of the following best describes what is meant by the term “fraud risk factor?”
a. Factors whose presence indicates that the risk of fraud is high.
b. Factors whose presence often have been observed in circumstances where
frauds have occurred.
c. Factors whose presence requires modification of planned audit procedures.
d. Reportable conditions identified during an audit.
17. Which of the following is correct concerning requirements about auditor communications
about fraud?
a. Fraud that involves senior management should be reported directly to the audit
committee regardless of the amount involved.
b. Fraud with a material effect on the financial statements should be reported
directly by the auditor to the Securities and Exchange Commission.
c. Fraud with a material effect on the financial statements should ordinarily be
disclosed by the auditor through use of an “emphasis of a matter” paragraph
added to the audit report.
d. The auditor has no responsibility to disclose fraud outside the entity under any
circumstances.
18. An auditor is unable to obtain absolute assurance that
misstatements due to fraud will be detected for all of the following except
a. Employee collusion.
b. Falsified documentation.
c. Need to apply professional judgment in evaluating fraud risk factors.
 d. Professional skepticism.
19. The most difficult type of misstatement to detect is fraud based on
a. The overrecording of transactions.
b. The nonrecording of transactions.
c. Recorded transactions in subsidiaries.
d. Related-party receivables.
20. When considering fraud risk factors relating to management’s characteristics, which of
the following is least likely to indicate a risk of possible misstatement due to fraud?
a. Failure to correct known reportable conditions on a timely basis.
b. Nonfinancial management’s preoccupation with the selection of accounting
principles.
c. Significant portion of management’s compensation represented by bonuses
based upon achieving unduly aggressive operating results.
d. Use of unusually conservative accounting practices.
21. Which of the following conditions identified during fieldwork of an audit is most likely to
affect the auditor’s assessment of the risk of misstatement due to fraud?
a. Checks for significant amounts outstanding at year-end.
b. Computer generated documents.
c. Missing documents.
d. Year-end adjusting journal entries.
22. 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 at 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.

23. Which of the following is most likely to be an example of fraud?

a. Defalcations occurring due to invalid electronic approvals.
b. Mistakes in the application of accounting principles.
c. Mistakes in processing data.
d. Unreasonable accounting estimates arising from oversight.
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 projections.
d. The rate of change in the entity’s industry is slow.
25. Which of the following statements reflects an auditor’s responsibility for detecting
misstatements due to errors and fraud?
 a. An auditor is responsible for detecting employee errors and simple fraud, but not
for discovering fraud involving employee collusion or management override.
b. An auditor should plan the audit to detect misstatements due to errors and fraud
that are caused by departures from GAAP.
c. An auditor is not responsible for detecting misstatements due to errors and fraud
unless the application of GAAS would result in such detection.
d. An auditor should design the audit to provide reasonable assurance of detecting
misstatements due to errors and fraud that are material to the financial
statements.
26. Disclosure of fraud to parties other than a client’s senior management and its audit
committee or board of directors ordinarily is not part of an auditor’s responsibility. However, to
which of the following outside parties may a duty to disclose fraud exist?

To a government funding
To the SEC when the To a successor when the agency from which the
client reports an successor auditor makes client receives financial
auditor change appropriate Inquiries assistance
a. Yes Yes No
b. Yes No Yes
c. No Yes Yes
d. Yes Yes Yes

27. Under Statements on Auditing Standards, which of the following would be classified as
an error?
a. Misappropriation of assets for the benefit of management.
b. Misinterpretation by management of facts that existed when the financial
statements were prepared.
c. Preparation of records by employees to cover a fraudulent scheme.
d. Intentional omission of the recording of a transaction to benefit a third party.

28. What assurance does the auditor provide that misstatements due to errors, fraud, and
direct effect illegal acts that are material to the financial statements will be detected?
Direct
effect
Errors Fraud illegal acts
a. Limited Negative Limited
b. Limited Limited Reasonable
c. Reasonable Limited Limited
d. ReasonableReasonable Reasonable

29. Because of the risk of material misstatement, an audit of financial statements in

accordance with generally accepted auditing standards should be planned and performed with
an attitude of
a. Objective judgment.
b. Independent integrity.
 c. Professional skepticism.
d. Impartial conservatism.
30. Which of the following most accurately summarizes what is meant by the term “material
misstatement?”
a. Fraud and direct-effect illegal acts.
b. Fraud involving senior management and material fraud.
c. Material error, material fraud, and certain illegal acts.
d. Material error and material illegal acts.
31. Which of the following statements best describes the auditor’s responsibility to detect
conditions relating to financial stress of employees or adverse relationships between a company
and its employees?
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 in 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.
32. When the auditor believes a misstatement is or may be the result of fraud but that the
effect of the misstatement is not material to the financial statements, which of the following
steps is required?
a. Consider the implications for other aspects of the audit.
b. Resign from the audit.
c. Commence a fraud examination.
d. Contact regulatory authorities.

33. Which of the following statements is correct relating to the auditor’s consideration of
fraud?
a. The auditor’s interest in fraud consideration relates to fraudulent acts that cause
a material misstatement of financial statements.
b. A primary factor that distinguishes fraud from error is that fraud is always
intentional, while errors are generally, but not always, intentional.
c. Fraud always involves a pressure or incentive to commit fraud, and a
misappropriation of assets.
d. While an auditor should be aware of the possibility of fraud, management, and
not the auditor, is responsible for detecting fraud.
34. Which of the following factors or conditions is an auditor least likely to plan an audit to
discover?
a. Financial pressures affecting employees.
b. High turnover of senior management.
 c. Inadequate monitoring of significant controls.
d. Inability to generate positive cash flows from operations.
35. At which stage(s) of the audit may fraud risk factors be identified?
Obtaining Conducting
Planning understanding fieldwork
a. Yes Yes Yes
b. Yes Yes No
c. Yes No No
d. No Yes Yes
36. Management’s attitude toward aggressive financial reporting and its emphasis on
meeting projected profit goals most likely would significantly influence an entity’s control
environment when
a. External policies established by parties outside the entity affect its accounting
practices.
b. Management is dominated by one individual who is also a shareholder.
c. Internal auditors have direct access to the board of directors and the entity’s
management.
d. The audit committee is active in overseeing the entity’s financial reporting
policies.
37. Which of the following is least likely to be required on an audit?
a. Test appropriateness of journal entries and adjustment.
b. Review accounting estimates for biases.
c. Evaluate the business rationale for significant unusual transactions.
d. Make a legal determination of whether fraud has occurred.
38. Which of the following is most likely to be an overall response to fraud risks identified in
an audit?
a. Supervise members of the audit team less closely and rely more upon judgment.
b. Use less predictable audit procedures.
c. Only use certified public accountants on the engagement.
d. Place increased emphasis on the audit of objective transactions rather than
subjective transactions.
39. Which of the following is least likely to be included in an auditor’s inquiry of
management while obtaining information to identify the risks of material misstatement due to
fraud?
a. Are financial reporting operations controlled by and limited to one location?
b. Does it have knowledge of fraud or suspect fraud?
c. Does it have programs to mitigate fraud risks?
d. Has it reported to the audit committee the nature of the company’s internal
control?
40. What is an auditor’s responsibility who discovers man-agement involved in what is
financially immaterial fraud?
a. Report the fraud to the audit committee.
b. Report the fraud to the Public Company Oversight Board.
c. Report the fraud to a level of management at least one below those involved in
the fraud.
 d. Determine that the amounts involved are immaterial, and if so, there is no
reporting responsibility.
41. Which of the following is most likely to be considered a risk factor relating to fraudulent
financial reporting?
a. Domination of management by top executives.
b. Large amounts of cash processed.
c. Negative cash flows from operations.
d. Small high-dollar inventory items.
42. Which of the following is most likely to be presumed to represent fraud risk on an audit?
a. Capitalization of repairs and maintenance into the property, plant, and equipment
asset account.
b. Improper revenue recognition.
c. Improper interest expense accrual.
d. Introduction of significant new products.
43. An auditor who discovers that a client’s employees paid small bribes to municipal
officials most likely would withdraw from the engagement if
a. The payments violated the client’s policies regarding the prevention of illegal
acts.
b. The client receives financial assistance from a federal government agency.
c. Documentation that is necessary to prove that the bribes were paid does not
exist.
d. Management fails to take the appropriate remedial action.

44. Which of the following factors most likely would cause a CPA to not accept a new audit
engagement?
a. The prospective client has already completed its physical inventory count.
b. The CPA lacks an understanding of the prospective client’s operation and
industry.
c. The CPA is unable to review the predecessor auditor’s working papers.
d. The prospective client is unwilling to make all financial records available to the
CPA.
45. Which of the following factors would most likely heighten an auditor’s concern about the
risk of fraudulent financial reporting?
a. Large amounts of liquid assets that are easily convertible into cash.
b. Low growth and profitability as compared to other entities in the same industry.
c. Financial management’s participation in the initial selection of accounting
principles.
d. An overly complex organizational structure involving unusual lines of authority.

46. An auditor who discovers that a client’s employees have paid small bribes to public
officials most likely would withdraw from the engagement if the
a. Client receives financial assistance from a federal government agency.
b. Evidential matter that is necessary to prove that the illegal acts were committed
does not exist.
 c. Employees’ actions affect the auditor’s ability to rely on management’s
representations.
d. Notes to the financial statements fail to disclose the employees’ actions.
47. Which of the following illegal acts should an audit be designed to obtain reasonable
assurance of detecting?
a. Securities purchased by relatives of management based on knowledge of inside
information.
b. Accrual and billing of an improper amount of revenue under government
contracts.
c. Violations of antitrust laws.
d. Price fixing.
48. Which of the following relatively small misstatements most likely could have a material
effect on an entity’s financial statements?
a. An illegal payment to a foreign official that was not recorded.
b. A piece of obsolete office equipment that was not retired.
c. A petty cash fund disbursement that was not properly authorized.
d. An uncollectible account receivable that was not written off.
49. During the annual audit of Ajax Corp., a publicly held company, Jones, CPA, a
continuing auditor, determined that illegal political contributions had been made during each of
the past seven years, including the year under audit. Jones notified the board of directors about
the illegal contributions, but they refused to take any action because the amounts involved were
immaterial to the financial statements. Jones should reconsider the intended degree of reliance
to be placed on the
a. Letter of audit inquiry to the client’s attorney.
b. Prior years’ audit programs.
c. Management representation letter.
d. Preliminary judgment about materiality levels.

50. The most likely explanation why the auditor’s examination cannot reasonably be
expected to bring all illegal acts by the client to the auditor’s attention is that
a. Illegal acts are perpetrated by management override of internal control.
b. Illegal acts by clients often relate to operating aspects rather than accounting
aspects.
c. The client’s internal control may be so strong that the auditor performs only
minimal substantive testing.
d. Illegal acts may be perpetrated by the only person in the client’s organization with
access to both assets and the accounting records.
51. If specific information comes to an auditor’s attention that implies the existence of
possible illegal acts that could have a material, but indirect effect on the financial statements,
the auditor should next
a. Apply audit procedures specifically directed to ascertaining whether an illegal act
has occurred.
b. Seek the advice of an informed expert qualified to practice law as to possible
contingent liabilities.
 c. The CPA’s inability to determine whether relatedparty transactions were
consummated on terms equivalent to arm’s-length transactions.
d. Management’s refusal to permit the CPA to perform substantive tests before the
year-end.
57. An auditor is required to establish an understanding with a client regarding the services
to be performed for each engagement. This understanding generally includes
a. Management’s responsibility for errors and the illegal activities of employees that
may cause material misstatement.
b. The auditor’s responsibility for ensuring that the audit committee is aware of any
reportable conditions that come to the auditor’s attention.
c. Management’s responsibility for providing the auditor with an assessment of the
risk of material misstatement due to fraud.
d. The auditor’s responsibility for determining preliminary judgments about
materiality and audit risk factors.

58. Which of the following is most likely to require special planning considerations related to
asset valuation?
a. Inventory is comprised of diamond rings.
b. The client has recently purchased an expensive copy machine.
c. Assets costing less than $250 are expensed even when the expected life
exceeds one year.
d. Accelerated depreciation methods are used for amortizing the costs of factory
equipment.

59. Which of the following factors most likely would influence an auditor’s determination of
the auditability of an entity’s financial statements?
a. The complexity of the accounting system.
b. The existence of related-party transactions.
c. The adequacy of the accounting records.
d. The operating effectiveness of control procedures.
60. To obtain an understanding of a continuing client’s business in planning an audit, an
auditor most likely would
a. Perform tests of details of transactions and balances.
b. Review prior year working papers and the permanent file for the client.
c. Read specialized industry journals.
d. Reevaluate the client’s internal control environment.
61. Which of the following matters is generally included in an auditor’s engagement letter?
a. Management’s responsibility for the entity’s compliance with laws and
regulations.
b. The factors to be considered in setting preliminary judgments about materiality.
c. Management’s vicarious liability for illegal acts committed by its employees.
d. The auditor’s responsibility to search for significant internal control deficiencies.
62. During the initial planning phase of an audit, a CPA most likely would
a. Identify specific internal control activities that are likely to prevent fraud.
 b. Evaluate the reasonableness of the client’s accounting estimates.
c. Discuss the timing of the audit procedures with the client’s management.
d. Inquire of the client’s attorney as to whether any unrecorded claims are probable
of assertion.
63. Which of the following statements would least likely appear in an auditor’s engagement
letter?
a. Fees for our services are based on our regular per diem rates, plus travel and
other out-of-pocket expenses.
b. During the course of our audit we may observe opportunities for economy in, or
improved controls over, your operations.
c. Our engagement is subject to the risk that material misstatements or fraud, if
they exist, will not be detected.
d. After performing our preliminary analytical procedures we will discuss with you
the other procedures we consider necessary to complete the engagement.
64. Which of the following documentation is not required for an audit in accordance with
generally accepted auditing standards?
a. A written audit program setting forth the procedures necessary to accomplish the
audit’s objectives.
b. An indication that the accounting records agree or reconcile with the financial
statements.
c. A client engagement letter that summarizes the timing and details of the auditor’s
planned fieldwork.
d. The basis for the auditor’s conclusions when the assessed level of control risk is
below the maximum level.

65. An engagement letter should ordinarily include information on the objectives of the
engagement and
CPA Client Limitation of
Responsibilities responsibilities engagement
a. Yes Yes Yes
b. Yes No Yes
c. Yes No No
d. No No No

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