Excel Professional Services, Inc.

Management Firm of Professional Review and Training Center (PRTC)

(LUZON) Manila 87339344 * Calamba City, Laguna * Dasmariñas City, Cavite * Lipa City,
Batangas (0917) 8852769 * (VISAYAS) Bacolod City (034) 4346214 * Cebu City (032)
2537900 loc. 218 (MINDANAO) Cagayan De Oro (0917) 7081465 * Davao City (082) 2250049

AUDITING THEORY
AT.3010 – Considering the Risk R.C.P. SOLIMAN/ K.J. UY
of Frauds, Errors, and Non-compliance with Laws and Regulations MAY 2021

Reference:
a. PSA 240 (Redrafted), The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements
b. PSA 250 (Redrafted), Considerations of Laws and Regulations in an Audit of Financial Statements

DISCUSSION QUESTIONS
Fraud and Error
5. Who is most likely to perpetrate fraudulent financial
Fraud vs. Error reporting?
a. Members of the board of directors
1. What differentiates fraud from an error? b. Production employees
a. Materiality. c. Management of the company
b. Effect on misstatements. d. The internal auditors
c. Intent.
d. Frequency of occurrence . 6. Misappropriation of assets is normally perpetrated by:
a. members of the board of directors.
2. The following are examples of error, except b. employees at lower levels of the organization.
a. A mistake in gathering or processing data from c. management of the company.
which financial statements are prepared. d. the internal auditors.
b. An incorrect accounting estimate arising from
oversight or misinterpretation of facts. 7. In comparing management fraud with employee fraud,
c. A mistake in the application of accounting the auditor’s risk of failing to discover the fraud is
principles relating to measurement, recognition, a. Greater for employee fraud because of the higher
classification, presentation, or disclosure. crime rate among blue collar workers
d. Misrepresentation in the financial statements of b. Greater for management fraud because of
events, transaction or other significant management’s ability to override existing internal
information. controls that is always presumed to exist in an
audit of financial statements.
3. The risk of not detecting a material misstatement c. Greater for employee fraud because of the larger
resulting from fraud is higher than the risk of not number of employees in the organization
detecting a material misstatement resulting from error d. Greater for management fraud because managers
because are inherently smarter than employees
a. The effect of fraudulent act is likely omitted in the
accounting records. Responsibilities for Fraud
b. Fraud is ordinarily accompanied by acts
specifically designed to conceal its existence, and 8. Which statement(s) is(are) incorrect regarding the
auditors do not make legal determinations of auditor’s responsibility to consider fraud and error in
whether fraud has actually occurred. an audit of financial statements?
c. Fraud is always a result of connivance between or a. The auditor is not and cannot be held responsible
among employees. for the prevention of fraud and error being the
d. The auditor is responsible to detect errors but not primary responsibility of both the management
fraud. and those charged with governance.
b. When planning and performing audit procedures
Types of Fraud and evaluating and reporting the results thereof,
the auditor should consider the risk of
4. The two types of intentional misstatements that are misstatements in the financial statements
relevant to the auditor’s consideration of fraud include, resulting from fraud.
misstatements resulting from fraudulent financial c. In planning the audit, the auditor should discuss
reporting and misstatements resulting from with other members of the audit team the
misappropriation of assets. Fraudulent financial susceptibility of the entity to material statements
reporting least likely involve in the financial statements resulting from fraud or
a. Deception such as manipulation, falsification error and exercise professional skepticism, which
(including forgery), or alteration of accounting is the best method of the auditor to detect fraud.
records or supporting documents from which the d. The auditor should design audit programs that will
financial statements are prepared provide reasonable assurance that material errors
b. Misrepresentation in, or intentional omission from, and fraud will be detected in the ordinary course
the financial statements of events, transaction or of the examination.
other significant information
c. Intentional misapplication of accounting principles 9. When comparing the auditor’s responsibility for
relating to measurement, recognition, detecting employee fraud and for detecting errors, the
classification, presentation, or disclosure profession has placed the responsibility:
d. Embezzling receipts, stealing physical assets or a. more on discovering errors than employee fraud.
intellectual property, causing an entity to pay for b. more on discovering employee fraud than errors.
goods and services not received, or using an c. equally on discovering either one.
entity’s assets for personal use.
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d. on the senior auditor for detecting errors and on The audit team’s response
the manager for detecting employee fraud. to potential fraud risks Yes Yes No No

10. Which of the following represents the primary Identifying and Assessing the ROMM due to Fraud
difference between an audit and forensic accounting?
a. An audit has the focused responsibility to detect 15. The fraud triangle consists of three components
fraud in the client organization while forensic (incentive or pressure, opportunity, and attitude or
accounting sets out to prevent fraud. rationalization). Which of the three components are
b. An audit has no responsibility for fraud while present in most every fraud?
forensic accounting provides an audit specific to a. All three factors are usually present when fraud
material fraud discovery. occurs.
c. An audit must follow Generally Accepted Auditing b. Pressure and opportunity
Standards while the forensic accountant is bound c. Opportunity and rationalization
to Generally Accepted Fraud Standards. d. Rationalization and pressure
d. An audit utilizes sampling techniques to detect
material misstatements while forensic accounting 16. Categories of fraud risk factors (whose presence often
examines the entire population of fraudulent has been observed in circumstances where frauds
transactions. have occurred) in relation to misstatements arising
from misappropriation of assets and fraudulent
Auditor's Fraud Consideration financial reporting are opportunities, attitudes or
rationalizations, and pressures or incentives. Which of
Risk Assessment Procedures the following creates an opportunity for fraud to be
committed in an organization?
11. Sources of information gathered to assess fraud risks a. Management demands financial success or is
usually do not include: aggressive in its application of accounting rules.
a. Analytical procedures. b. Poor internal control.
b. Inquiries of management and others within the c. Commitments tied to debt covenants.
entity. d. Finding loopholes in the accounting rules to
c. Communication among audit team members. achieve earnings targets.
d. Review of corporate charter and bylaws.
17. The following are examples of circumstances that may
12. When planning the audit, the auditor should make indicate the possibility that the financial statements
inquiries of management in order to do the following, may contain a material misstatement resulting from
except fraud, except
a. Obtain an understanding of management’s a. Transactions that are recorded in a complete or
assessment of the risk that the FSs may be timely manner or are properly recorded as to
materially misstated as a result of fraud. amount, accounting period, classification, or entity
b. Obtain an understanding of the accounting and policy.
internal control systems management has put in b. Unsupported or unauthorized balances or
place to address fraud and error. transactions.
c. Determine whether management and other within c. Last-minute adjustments that significantly affect
the entity (e.g., internal audit function) have financial results or unusual journal entries.
knowledge of any actual, suspected or alleged d. Tips or complaints to the auditor about alleged
fraud affecting the entity. fraud.
d. Provide useful information concerning the risks of
material misstatements in the financial statements 18. The following are examples of circumstances that may
resulting from management fraud. indicate the possibility that the financial statements
may contain a material misstatement resulting from
Engagement Team Discussion (‘Brainstorming’) fraud, except
a. Missing documents.
13. According to professional audit standards, how might b. Documents that appear to have been altered.
an understanding of the nature of fraud that may occur c. Unavailability of other than photocopied or
in the client organization best be identified by the audit electronically transmitted documents when
firm? documents in original form are expected to exist.
a. Fraud training courses from actual corporate fraud d. Significant explained items on reconciliations.
ex-criminals.
b. Conducting a brainstorming meeting with the 19. Which of the following is most likely to be presumed
members of the audit team. to represent fraud risk on an audit?
c. Circulating a survey to the client company a. Capitalization of repairs and maintenance into the
employees for completion. property, plant, and equipment asset account.
d. Discussions with other CPA firms. b. Improper revenue recognition.
c. Improper interest expense accrual.
14. Which of the following issues is normally part of the d. Introduction of significant new products.
“brainstorming” session required by PSAs?
a. b. c. d. Responding to Assessed ROMM due to fraud
How assets could be
misappropriated Yes Yes Yes No 20. Statement 1: Auditors are required to perform
How and where the entity’s extended audit procedures to detect material errors
financial statements are and irregularities if previously performed
susceptible to material examinations indicate that they may exist.
misstatements due to Yes Yes Yes Yes
fraud Statement 2: Audit procedures that are effective for
The need for professional detecting an unintentional misstatement may be
skepticism Yes No No Yes

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ineffective for an intentional misstatement that is statements may be materially misstated as a

concealed through collusion. result of fraud.
a. True, true c. False, true
b. True, false d. False, false Withdrawing from Engagement Because of Fraud

21. Which of the following is most likely to be an overall 26. The auditor may encounter exceptional circumstances
response to fraud risks identified in an audit? that bring into question the auditors ability to continue
a. Supervise members of the audit team less closely performing the audit, including where
and rely more upon judgment. a. The entity does not take the remedial action
b. Only use certified public accountants on the regarding fraud that the auditor considers
engagement. necessary in the circumstances, even when the
c. Place increased emphasis on the audit of objective fraud is not material to the financial statements
transactions rather than subjective transactions. b. The auditor’s consideration of the risk of material
d. Use less predictable audit procedures. misstatement resulting from fraud and the results
of audit tests indicate a significant risk of material
22. Which of the following is most likely to be a response and pervasive fraud
to the auditor's assessment that the risk of material c. The auditor has significant concern about the
misstatement due to fraud for the existence of competence or integrity of management or those
inventory is high? charged with governance that affect the auditor's
a. Observe test counts of inventory at certain ability to rely on management's representations.
locations on an unannounced basis. d. All of the above
b. Perform analytical procedures rather than taking
test counts. Noncompliance with Laws and Regulations
c. Request that inventories be counted prior to year-
end. Definition
d. Request that inventory counts at the various
locations be counted on different dates so as to 27. Which statement is incorrect regarding the auditor’s
allow the same auditor to be present at every consideration of laws and regulations in an audit of
count. financial statements?
a. Noncompliance refers to acts of omission or
23. As part of designing and performing procedures to commission by the entity being audited which are
address management override of controls, auditors contrary to prevailing laws and regulations
must perform which of the following procedures? b. Noncompliance includes transactions entered into
a. b. c. d. by, or in the name of, the entity, or on its behalf,
Review accounting by TCWG, management or employees.
estimates for biases Yes Yes Yes No c. Noncompliance includes personal misconduct of
Examine all journal entries the entity’s management or employees unrelated
above materiality Yes No Yes Yes to the business activities of the entity.
Examine adjusting entries Yes Yes No Yes d. In the absence of evidence to the contrary, the
Review unusual Yes Yes No No auditor is entitled to assume the entity is in
transactions compliance with applicable laws and regulations
affecting the client.
Conclusion and Reporting
Effect of Laws and Regulations on Financial Statements
24. Communication of a misstatement resulting from
fraud, or a suspected fraud, or error to the appropriate 28. Which of the following would most likely be deemed a
level of management on a timely basis is important direct-effect illegal act?
because it enables management to take action as a. Violation of employment laws.
necessary. Ordinarily, the appropriate level of b. Violation of environmental regulations.
management is c. Violation of income tax laws.
a. At least equal to level of persons who appear to be d. Violation of civil rights laws.
involved with misstatements or suspected fraud
b. At least one level above persons who appear to be 29. Which of the following illegal acts should an audit be
involved with the misstatement or suspected fraud designed to obtain reasonable assurance of detecting?
c. The audit committee of the board of directors a. Securities purchased by relatives of management
d. The head of internal audit department based on knowledge of inside information.
b. Accrual and billing of an improper amount of
25. The auditor least likely obtains written representations revenue under government contracts.
from management that: c. Violations of antitrust laws.
a. It acknowledges its responsibility for the d. Price fixing.
implementation and operations of accounting and
internal control systems that are designed to 30. Which of the following statements is usually true?
prevent and detect fraud and error. a. It is easier for the auditor to uncover fraud than
b. It has disclosed to the auditor its knowledge of errors.
fraud or suspected fraud affecting the entity b. It is easier for the auditor to uncover indirect-
involving employees who have significant roles in effect illegal acts than fraud.
internal control only. c. The auditor’s responsibility for detecting indirect-
c. It has disclosed to the auditor its knowledge of any effect illegal acts is similar to the responsibility to
allegations of fraud, or suspected fraud affecting detect fraud.
the entity’s financial statements communicated by d. The auditor’s responsibility for detecting direct-
employees, former employees, analysts, effect illegal acts is similar to the responsibility to
regulations or others. detect fraud.
d. It has disclosed to the auditor the results of its
assessment of the risk that the financial Responsibility for Compliance with Laws and Regulations

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EXCEL PROFESSIONAL SERVICES, INC.

31. Which of the following is incorrect about the auditor’s noncompliance with laws or regulations has occurred
responsibility for evaluating noncompliance by the least likely include
entity to laws and regulations? a. Payments for unspecified services or loans to
a. It is the responsibility of management, with the consultants, related parties, employees or
oversight of those charged with governance, to government employees.
ensure that the entity’s operations are conducted b. Payments for goods or services made other than
in accordance with laws and regulations, including to the country from which the goods or services
compliance with laws and regulations that originated.
determine the form or content of the entity’s c. Unauthorized transactions or improperly recorded
financial statements. This includes responsibility transactions.
for the prevention and detection of non- d. Payments with proper exchange control
compliance with laws and regulations. documentation.
b. An audit cannot be expected to detect
noncompliance with all laws and regulations. 36. When an auditor identifies or suspects instances of
Detection of noncompliance, regardless of non-compliance with laws and regulations in relation
materiality, requires considerations of the to audit of financial statements, the auditor shall
implications for the integrity of management or a. b. c. d.
employees Obtain understanding of the
c. Generally, the further removed non-compliance is nature of the act. Yes Yes Yes No
from the events and transactions reflected in the Evaluate possible effect of
financial statements, the more likely the auditor is noncompliance on
to become aware of it or to recognize the possible financial statements. Yes No Yes Yes
non-compliance. This is because an illegal act by Discuss the matter with
the client often relate to operating aspects rather management and TCWG. Yes Yes No Yes
than accounting aspects. Consider obtaining legal Yes Yes No No
d. In order to plan the audit, the auditor should advice.
obtain a general understanding of the legal and Evaluate other audit
regulatory framework applicable to the entity and implications. Yes Yes No No
the industry and how the entity is complying with
that framework. 37. Which of the following is incorrect about the auditor’s
responsibility for evaluating noncompliance by the
The Auditor’s Consideration of Compliance with Laws and entity to laws and regulations?
Regulations a. When the auditor becomes aware of information
concerning a possible instance of noncompliance,
32. Which of the following is incorrect regarding the the auditor shall obtain an understanding of the
auditor’s consideration of laws and regulations nature of the act and the circumstances in which
applicable to the entity? it has occurred and evaluate the possible effect on
a. The auditor shall obtain a general understanding the financial statements.
of applicable laws and regulations to the entity. b. If the auditor has identified or suspects
b. The auditor shall identify and assess risk of noncompliance with laws and regulations, the
material misstatement of financial statements auditor shall determine whether the auditor has a
relating to non-compliance with laws and responsibility to report the identified or suspected
regulations. noncompliance to parties outside the entity.
c. The auditor shall obtain sufficient appropriate c. The auditor shall document identified or suspected
audit evidence regarding compliance of all types of non-compliance with laws and regulations but not
laws and regulations applicable to the entity. the results of discussion with management, and
d. The auditor shall respond appropriately in where applicable, those charged with governance
instances of identified or suspected non- and other parties outside the entity.
compliance with all types laws and regulations. d. The auditor may withdraw from the engagement
when the entity does not take the remedial action
33. In considering indirect effect laws and regulations in that the auditor considers necessary in the
an audit of financial statements, an auditor shall circumstances, even when the noncompliance is
a. Inquire of management and those charged with not material to the financial statements or affects
governance. auditor’s ability to rely on management
b. Inspect correspondences with regulatory representations.
authorities.
c. Both a and b. 38. In assessing whether management has overlooked
d. Neither a nor b. relevant laws and regulations, the auditor would
perform all of the following except
34. According to PSA 250 (Consideration of Laws and a. Obtain written representations from management.
Regulations in an Audit of Financial Statements), the b. Review relevant portions of grant and loan
following are indications that noncompliance may have agreements.
occurred, except c. Confirm grant arrangements with granting
a. Investigation by government departments or agencies.
payment of fines or penalties d. Discuss laws and regulations with the entity's chief
b. Adverse media comment financial officer and legal counsel.
c. Authorized transactions or properly recorded
transactions 39. When an auditor becomes aware of a possible illegal
d. Purchasing at prices significantly above or below act by a client, the auditor should obtain an
market price understanding of the nature of the act to
a. Increase the assessed level of control risk.
35. Examples of the type of information that may come to b. Recommend remedial actions to the audit
the auditor's attention that may indicate that committee.

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EXCEL PROFESSIONAL SERVICES, INC.

c. Determine the reliability of management’s a. Discuss the matter with the client’s legal counsel.
representations. b. Obtain evidence about the potential effect of the
d. Evaluate the effect on the financial statements and illegal act on the financial statements.
may consider seeking legal advice especially when c. Consider the impact of the illegal act on the
involving members of senior management, relationship with the company’s management.
including members of the board of directors. d. Contact the local law enforcement officials
regarding potential criminal wrongdoing.
40. Which of the following is the auditor least likely to do
when aware of an illegal act? - now do the DIY drill –

DO-IT-YOURSELF (DIY) DRILL

1. Audits of financial statements are designed to obtain b. Accounting policies that appear to be consistent
reasonable assurance of detecting material with industry norms.
misstatements due to c. Frequent changes in accounting estimates that do
a. b. c. d. not appear to result from changed circumstances.
Errors Yes Yes Yes No d. Tolerance of violations of the entity’s Code of
Fraudulent financial Yes Yes No Yes Conduct
reporting
Misappropriation of Yes No Yes No 7. Brainstorming about the manner in which fraud may
assets be committed should include all of the following except
Direct-effect illegal Yes No Yes No a. Consider factors that might affect management
acts motivation to misstate the financial statements
b. Consider weaknesses in internal control that would
2. How will the results of the auditor's assessment of allow a fraud to take place or management
fraud risk factors further affect the planned audit override of controls
procedures? c. Consider the materiality of the individual account
a. Audit procedures and fraud assessment do not balances for substantive testing
relate. d. Consider factors that may enable an individual
b. The assessment may require a re-audit of previous capable of committing a fraud to rationalize
periods. perpetrating it
c. By the assignment of qualified audit staff to risky
areas of the engagement. 8. In evaluating the effect of fraud upon the audit
d. Management will be called upon to assist in procedures the auditor should consider
coordinating audit procedures. a. The type of fraud that may occur.
b. The potential significance and likelihood of
3. An auditor who discovers that a client's employees occurrence of fraud.
paid small bribes to municipal officials most likely c. The pervasiveness of fraud detected.
would withdraw from the engagement if d. All of the above.
a. The payments violated the client's policies
regarding the prevention of illegal acts. 9. Which of the following would the auditor likely to do
b. The client receives financial assistance from a when the application of planned audit procedures
federal government agency. indicates the possible existence of fraud or error?
c. Documentation that is necessary to prove that the a. The auditor should resign from the engagement in
bribes were paid does not exist. order to avoid legal responsibility.
d. Management fails to take the appropriate remedial b. The auditor should discuss the matter with the
action and reliance on management’s person believed to be involved with the
representation becomes doubtful. irregularities.
c. The auditor should refer the fraud, actual or
4. Which of the following situations represents a risk suspected to the internal auditor.
factor that relates to misstatements arising from d. The auditor should consider the potential effect on
misappropriation of assets? the financial statements and other aspects of the
a. A lack of independent checks. audit, particularly, the reliability of management
b. A high turnover of senior management. representations.
c. A strained relationship between management and
the predecessor auditor. 10. Which of the following is not an example of a type of
d. An inability to generate cash flow from operations. defalcation?
a. A warehouse employee takes home two units of
5. If an illegal act is discovered during the audit of a electronic entertainment inventory each week
publicly held company, the auditor should without authorization.
a. Notify the regulatory authorities. b. The president of the company utilizes the
b. Determine who was responsible for the act. organization's cash to add a floor to her 15,000
c. Modify the extent of auditing procedures. square foot house.
d. Report the act to high-level personnel within the c. The chief financial officer of the company falsely
client's organization. adds P20 million to the accounts receivable and
revenue accounts.
6. The following are examples of circumstances that may d. The treasurer of the company makes an
indicate the possibility that the financial statements unauthorized wire transfer from the organization's
may contain a material misstatement resulting from bank to a personal account in Grand Cayman.
fraud, except
a. Unwillingness by management to permit the 11. Relative to internal controls, what is a primary risk of
auditor to meet privately with those charged with fraud in the client company?
governance. a. The risk that management overrides controls.

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EXCEL PROFESSIONAL SERVICES, INC.

b. The risk that management changes controls each

year.
c. The risk that management carefully enforces and
monitors controls.
d. The risk that the audit committee monitors
controls.

12. PSAs require auditors to document which of the

following matters related to the auditor’s consideration
of material misstatements due to fraud?
a. Reasons supporting a conclusion that there is not
a significant risk of material improper expense
recognition.
b. Procedures performed to obtain information
necessary to identify and assess the risks of
material fraud.
c. Results of the internal auditor’s procedures
performed to address the risk of management
override of controls.
d. Discussions with management regarding
separation of duties.

13. Which of the following is an example of a common type

of financial reporting fraud?
a. Capitalizing major overhauls to operating
equipment.
b. Deferring service revenue until it is delivered to
customers.
c. Recording sales for inventory sold with the right to
return, hence, fraud on revenue recognition is
always presumed to exist.
d. Excluding a contingent liability that has been
settled.

14. If an auditor believes a client may have committed

illegal acts, which of the following actions should the
auditor take?
a. Consult with the client’s counsel and the auditor’s
counsel to determine how the suspected illegal
acts will be communicated to stockholders.
b. Extend auditing procedures to determine whether
the suspected illegal acts have a material effect on
the financial statements.
c. Make inquiries of the client’s management and
obtain an understanding of the circumstances
underlying the acts and of other evidence to
determine the effects of the acts on the financial
statements.
d. Notify each member of the audit committee of the
board of directors about the nature of the acts and
request that they advise an approach to be taken
by the auditor.

15. If the auditor suspects that members of senior

management, including members of the board of
directors, are involved in noncompliance to laws as
regulations, 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.

- end of AT.3010 -

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