Podcast
Questions and Answers
The objective of an auditor is to identify and assess the risks of material misstatement of F/S due to fraud.
The objective of an auditor is to identify and assess the risks of material misstatement of F/S due to fraud.
True
What is the difference between omission and misstatement?
What is the difference between omission and misstatement?
Materiality is the ______ of omission or misstatement in accounting information.
Materiality is the ______ of omission or misstatement in accounting information.
significance
There is a fixed dollar amount that defines materiality.
There is a fixed dollar amount that defines materiality.
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What is a loan covenant?
What is a loan covenant?
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Can an auditor justify ignoring a misstatement based solely on the 5% materiality threshold when qualitative factors are present?
Can an auditor justify ignoring a misstatement based solely on the 5% materiality threshold when qualitative factors are present?
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Which of the following is NOT a qualitative factor that can make a small misstatement material? (Select all that apply)
Which of the following is NOT a qualitative factor that can make a small misstatement material? (Select all that apply)
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Inherent limitations in auditing mean that some material misstatements of F/S may not be detected.
Inherent limitations in auditing mean that some material misstatements of F/S may not be detected.
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Management overrides of controls, existence of motive, and opportunity are indications that a misstatement was intentional.
Management overrides of controls, existence of motive, and opportunity are indications that a misstatement was intentional.
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What are common ways to commit financial statement fraud? (Select all that apply)
What are common ways to commit financial statement fraud? (Select all that apply)
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A 100% transactional based audit involves examining every single transaction in the financial records.
A 100% transactional based audit involves examining every single transaction in the financial records.
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Auditors are generally able to do 100% transactional based audits, making it easier to identify all material misstatements.
Auditors are generally able to do 100% transactional based audits, making it easier to identify all material misstatements.
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What is the expectation gap?
What is the expectation gap?
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What is collusion?
What is collusion?
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What is forgery?
What is forgery?
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Which of the following are components of the fraud triangle? (Select all that apply)
Which of the following are components of the fraud triangle? (Select all that apply)
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Auditors are required to report all errors to management, whether they are material or immaterial.
Auditors are required to report all errors to management, whether they are material or immaterial.
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Auditors are required to report illegal acts that could have a material impact on the financials, even if they are indirectly related.
Auditors are required to report illegal acts that could have a material impact on the financials, even if they are indirectly related.
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When an illegal act is discovered, what actions should the auditor take?
When an illegal act is discovered, what actions should the auditor take?
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Auditors are obligated to report illegal acts to regulatory authorities without the client's consent.
Auditors are obligated to report illegal acts to regulatory authorities without the client's consent.
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Public companies must file Form 8-K with the SEC within four business days if there is a change in auditor.
Public companies must file Form 8-K with the SEC within four business days if there is a change in auditor.
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Earnings management is always fraudulent or illegal.
Earnings management is always fraudulent or illegal.
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Which of the following is NOT generally a reason that a company might engage in earnings management? (Select all that apply)
Which of the following is NOT generally a reason that a company might engage in earnings management? (Select all that apply)
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Income smoothing involves manipulating accounting methods to make earnings appear more stable over time.
Income smoothing involves manipulating accounting methods to make earnings appear more stable over time.
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"Accounting can influence contractual outcomes" refers to companies manipulating their reports to impact contractual terms with external parties.
"Accounting can influence contractual outcomes" refers to companies manipulating their reports to impact contractual terms with external parties.
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Accounting management after the fact is generally less ethically problematic than doing it before the fact.
Accounting management after the fact is generally less ethically problematic than doing it before the fact.
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Proper accounting focuses on the substance of a transaction rather than its form.
Proper accounting focuses on the substance of a transaction rather than its form.
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Defenders of income smoothing argue that it presents a better measure of long-term profitability.
Defenders of income smoothing argue that it presents a better measure of long-term profitability.
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If the purpose of income smoothing is to provide a clear view of long-term profitability and help in better decision making, it can be considered ethical.
If the purpose of income smoothing is to provide a clear view of long-term profitability and help in better decision making, it can be considered ethical.
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Management might not be willing to disclose both actual and smoothed earnings to users, because it creates a risk of negative perception.
Management might not be willing to disclose both actual and smoothed earnings to users, because it creates a risk of negative perception.
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Earning management can be achieved by accounting for a sale as a lease.
Earning management can be achieved by accounting for a sale as a lease.
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Which of the following is NOT a type of financial shenanigan according to Howard Schilit?
Which of the following is NOT a type of financial shenanigan according to Howard Schilit?
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Accelerating sales from future periods into the current period is a common way to engage in operational earnings management.
Accelerating sales from future periods into the current period is a common way to engage in operational earnings management.
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What are ethical problems with pulling in sales? (Select all that apply)
What are ethical problems with pulling in sales? (Select all that apply)
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Revenue recognition is a key area where companies often engage in earnings management.
Revenue recognition is a key area where companies often engage in earnings management.
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What is the definition of "earned revenue"? (Select all that apply)
What is the definition of "earned revenue"? (Select all that apply)
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A high per-share stock price is generally considered an indicator of high-quality earnings.
A high per-share stock price is generally considered an indicator of high-quality earnings.
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What is Transparency?
What is Transparency?
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Which of the following is NOT a red flag that fraud may exist because of overly aggressive accounting? (Select all that apply)
Which of the following is NOT a red flag that fraud may exist because of overly aggressive accounting? (Select all that apply)
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Shifting current expenses to a later period can be a sign of earnings management.
Shifting current expenses to a later period can be a sign of earnings management.
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Financial statement analysis can be used to detect earnings management.
Financial statement analysis can be used to detect earnings management.
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If there are unexpected changes in interconnected items in the financial statements such as a company’s revenue and cash flow, it is a sign of earnings management.
If there are unexpected changes in interconnected items in the financial statements such as a company’s revenue and cash flow, it is a sign of earnings management.
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What are considerations when a company discovers an error in its financial statements?
What are considerations when a company discovers an error in its financial statements?
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The legal and professional obligations regarding changes to previous financial statements always depend on whether the change is due to an error correction, a change in accounting methods, or a change in an estimate.
The legal and professional obligations regarding changes to previous financial statements always depend on whether the change is due to an error correction, a change in accounting methods, or a change in an estimate.
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If a company violates GAAP when applying an accounting principle, it is considered an error.
If a company violates GAAP when applying an accounting principle, it is considered an error.
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Changes in accounting principles must be made only when required by new rules or when there's a voluntary change.
Changes in accounting principles must be made only when required by new rules or when there's a voluntary change.
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A company must file a preferability letter from its auditor when a change of principle is made voluntarily.
A company must file a preferability letter from its auditor when a change of principle is made voluntarily.
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A change in an accounting estimate is usually an indicator of earnings management, and the changes are generally immaterial.
A change in an accounting estimate is usually an indicator of earnings management, and the changes are generally immaterial.
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If data was previously available but not used, it is considered an error.
If data was previously available but not used, it is considered an error.
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If the data for the previous period is new, but that information was available and known, it is considered a change in accounting estimate.
If the data for the previous period is new, but that information was available and known, it is considered a change in accounting estimate.
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If data for a previous period is new, the company should disclose the change and present a comparative statement.
If data for a previous period is new, the company should disclose the change and present a comparative statement.
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The materiality of an error in financial statements is typically not based on qualitative factors.
The materiality of an error in financial statements is typically not based on qualitative factors.
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There are several different ways to report a correction of an error in financial statements. What are they? (Select all that apply)
There are several different ways to report a correction of an error in financial statements. What are they? (Select all that apply)
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Study Notes
Auditor Responsibility and Fraud
- Auditors are responsible for identifying and assessing risks of material misstatement due to fraud.
- Obtaining sufficient evidence is part of the process to adequately respond to potential fraud.
- Materiality is the impact of an omission or misstatement on a reasonable user's decision.
- Omission means failing to state something; misstatement is a false statement.
- Materiality isn't a fixed dollar amount; it's assessed as a percentage (e.g., 2% or 5%).
Loan Covenants and Materiality
- Loan covenants are conditions in loan agreements that borrowers must meet to avoid penalties.
- A misstatement of $200,000, even if below the 5% materiality threshold, might be considered material if it violates loan covenants.
- Qualitative factors, like the impact on loan covenants, can make a small misstatement material.
- Auditors should investigate the cause and require adjustments if the financial statements require changes.
Qualitative Factors Affecting Materiality
- Precise measurement capability of an item's estimate.
- Degree of imprecision inherent in an estimate.
- Changes in earnings or trends.
- Failure to meet analysts' expectations.
- Turning a loss into an income, or vice versa.
- Concerns about a company segment.
- Compliance with the requirements of regulations or contracts.
- Impacts on management compensation.
- Unlawful transactions.
Auditor's Responsibility (AU-C 240)
- Obtaining reasonable assurance that financial statements are free from material misstatement, caused by fraud or error.
- Unpredictable risk that material misstatements go undetected.
- Management's effort to override corrections and motive/opportunity for misstatement are red flags.
- Common ways to commit fraud are through intentional misstatements or omissions.
Auditor Responsibilities for Errors and Illegal Acts
- Auditors have a duty to detect material errors that would affect financial statements and to report them to management.
- Identifying illegal acts with direct or material financial statement impact is the auditor's responsibility.
- Direct violations affect financial statements, while indirect violations might not.
- Auditors report violations to management or regulatory authorities.
- Withdrawing from an engagement may be necessary if management does not take adequate corrective action.
Fraudulent Financial Reporting
- Earnings management: using accounting practices to achieve earnings targets.
- Earnings management strategies may target stock price, tax minimization, and mergers and acquisitions.
- Earnings management might influence contractual outcomes (e.g., loan covenants).
- "Income smoothing": adjusting earnings to present a consistent or stable picture.
- Ethical concern exists in income smoothing, as the intent behind these manipulations may not be ethical and can potentially mislead investors
Evaluating Internal Controls
- Clear financial statements without hiding anything important are needed for transparency.
- Frequent acquisitions and unusual growth rates might be unreliable and deserve inspection.
- Reliance on one-time income or earnings strategies might not be repeatable and require closer review.
- Comparing changes in revenue or expenses with changes in cash flow or inventory levels assist in determining consistent financial reporting
- Use financial statement analysis
Reporting Changes in Financial Statements
- If a change creates a material impact, companies must disclose these changes, including corrective actions previously attempted in the prior period.
- Filing a preferability letter is required in a public company.
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Description
This quiz covers the key concepts of auditor responsibilities concerning fraud and materiality in financial statements. It delves into how material misstatements can impact decision-making, especially in the context of loan covenants. Understand the importance of qualitative factors and the auditor's role in ensuring compliance.
