6. In assessing inherent risk and control risk, the auditor must consider the types of errors or irregularities that might occur and their impact on the financial statements (materiality.) In evaluating materiality, the auditor should consider the impact of errors and irregularities both individually and in the aggregate. Auditing Standards require that the auditor design the audit to provide reasonable assurance of detecting errors and irregularities that are material to the financial statements. Auditing Standards require that audit risk and materiality be considered both in planning the audit and in evaluating audit results.
Control risk and inherent risk are also directly related to the setting of materiality thresholds. If, for example, application of analytical procedures (inherent risk analysis) leads the auditor to suspect earnings inflation, individual item materiality thresholds should be reduced accordingly (i.e., either the materiality percentage or the amount of unaudited income should be decreased.) Similarly, if control risk analysis leads the auditor to suspect numerous errors, aggregate materiality thresholds need to be lowered accordingly.
7. An auditor’s reaction to an immaterial error may differ from his or her reaction to an immaterial irregularity. Auditors generally accumulate the amount of individual immaterial errors to be sure that the aggregate of all errors is not material. In addition, the auditor is concerned about whether an error came from a misunderstanding or other cause that would have resulted in yet more errors during the period. An auditor is expected to report all irregularities to the audit committee or the board of directors and senior management.
8. Refer to pages 436 to 437 of the textbook. 9. Refer to pages 440 to 441 of the textbook. 10. Refer to page 430 of the textbook.
11. The factors that should be considered are the peso amount of the account, the likelihood of error, and the cost of auditing the account.
12. The auditor deals with both inherent risk and control risk during the planning phase of the audit. Inquiry of client personnel, study of the business and industry, application of analytical procedures, and documentation of the auditor’s initial understanding of internal control are all performed during the planning phase of the audit. Further study of internal control procedures may occur after the planning phase if the auditor wishes to further reduce the assessed level of control risk, and considers it economically feasible to do so.
Multiple Choice Questions 1. d 11. d 21. b 31. b 41. b 51. a 61. a 2. c 12. a 22. d 32. a 42. d 52. a 62. c 3. c 13. c 23. d 33. d 43. a 53. b 63. d 4. b 14. c 24. c 34. a 44. c 54. a 5. d 15. a 25. d 35. d 45. c 55. c 6. a 16. a 26. a 36. d 46. d 56. d 7. c 17. a 27. b 37. c 47. d 57. b 8. d 18. d 28. a 38. b 48. c 58. d 9. c 19. b 29. a 39. a 49. b 59. d 10. d 20. d 30. b 40. a 50. d 60. c Cases
1. a. Antonio’s activity is an irregularity (intentional distortion of financial statements) rather than error (unintentional mistake). It is also an illegal act on Antonio’s individual part.
b. The problem does not describe the kind of related party transactions discussed in PSA 550.
c. Yes, a weakness in internal control exists. It may be considered a material weakness because the compensating control (internal auditors’ work on slow-moving inventory) did not operate in a timely enough manner to detect the irregularity before it had gotten large.
If a material weakness in internal control exists, Brava & Campos are obligated to report it to management and/or the board of directors.
d. The problem description indicates that this element of the audit was conducted in a negligent manner. There’s nothing wrong about auditing a sample of the transactions, but Campos’ follow-up and explanation of the missing receiving reports leaves much to be desired. At the very least he could have reviewed the reports produced by Antonio at a later date, and he could have traced the purchases to the inventory records and perhaps noticed an over-stocking condition. The auditors had some evidence that an irregularity might exist, but they failed to apply extended audit procedures properly.
2. a. Yes. Nicolas was a party to the issuance of false financial statements and as such is a joint tortfeasor. The elements necessary to establish an action for common law fraud are present. There was a material misstatement of fact, knowledge of falsity (scienter), intent that the plaintiff bank rely on the false statement, actual reliance and damage to the bank as a result thereof. If
Fraud and Error 12-5
action is based upon fraud there is no requirement that the bank establish privity of contract with the CPA. Moreover, if the action by the bank is based upon ordinary negligence, which does not require a showing of scienter, the bank may recover as a third-party beneficiary (an exception to the strict privity requirement). Thus, the bank will be able to recover its loss from Nicolas under either theory.
b. No. The lessor was a party to the secret agreement. As such, the lessor cannot claim reliance on the financial statements and cannot recover uncollected rents. Even if he was damaged indirectly, his own fraudulent actions led to his loss, and the equitable principle of “unclean hands” precludes him from obtaining relief.
c. Nicolas was not independent. His report is improper and he is probably subject to disciplinary action by the professional organization or regulatory body. According to the ethics interpretation on actual or threatened litigation:
“An expressed intention by the present management to commence litigation against the auditor alleging deficiencies in audit work for the client is considered to impair independence if the auditor concludes that there is a strong possibility that such a claim will be filed.”