Auditing, 12e (Arens)
Chapter 6 Client Risk Profile and Documentation
6.1 Explain the importance of an adequate audit planning process
1) An effective audit is one that
A) reduces the audit risk to the targeted level.
B) ensures that there are no errors contained in the financial statements.
C) does not contain errors of a dollar amount higher than 5% of the net income of the company.
D) is completed on time and within budget.
2) When the auditor has properly planned and performed the audit to reduce risk to an acceptably
low level that is consistent with the objective of the audit, this means that the auditor has
conducted enough work to
A) reduce inherent risks to an acceptable level.
B) increase detection risk to a satisfactory level.
C) detect errors in internal controls so that control risk can be set higher.
D) detect material misstatements to the targeted level of assurance.
3) The audit plan includes the nature, timing and extent of audit procedures for the purposes of
risk assessment, including those that are linked to the individual audit assertions, as well as any
other audit procedures that are considered necessary. At what point in the audit process is the
audit plan finalized? When
A) the auditor has finished documenting internal controls.
B) the client risk profile has been completed.
C) risk assessments are complete.
D) inherent risk information has been gathered.
4) An important reason for adequately planning the audit engagement is to
A) help decide whether the engagement should be accepted.
B) enable the auditor to obtain sufficient appropriate audit evidence.
C) properly design the contents of the engagement letter.
D) keep audit risk as low as possible.
5) A measure of how willing the auditor is to accept that the financial statements may be
materially misstated after the audit is completed and an unqualified opinion has been issued is
the
A) inherent risk.
B) audit risk.
C) statistical risk.
D) financial risk.
6) One of the purposes of developing a client risk profile is to assist the auditor in
A) developing the pertinent audit procedures for tests of internal controls.
B) assessing the client’s business risk.
C) locating related parties that need to be disclosed.
D) deciding whether fraud or illegal acts have taken place.
7) A thorough understanding of the client’s business and industry and knowledge about the
company’s operations are essential for doing an adequate audit. Why do auditors need greater
knowledge about major customers and suppliers and related risks?
A) information technology connects these organizations, so that they affect each other
B) information technology provides rapid information about organizations
C) there is increased importance of human capital and other intangible assets
D) joint ventures and strategic alliances affect client business risks
8) Risks associated with specific industries may affect the auditor’s assessment of client business
risk and acceptable audit risk, and even influence client acceptance decisions. Which of the
following business would be the most risky for the auditor to accept as a new client? A client that
A) is a small manufacturer of metal and plastic parts, with steady profits, in business for 15
years.
B) is developing a computer game, expected to be ready in three years, and has no other
products.
C) has fifteen retail outlets in the clothing industry, with mid-range pricing, appealing to a large
population sector.
D) consists of a partnership of ten lawyers, operating out of three different cities in one province.
9) It is important for the auditor to obtain a good understanding of the industry of the client to
develop a client risk profile. If the auditor is looking at a client in the fashion clothing industry, a
risk specific to the industry would be
A) the high risk of poor governance and management oversight.
B) the high risk of defective products.
C) the high risk of obsolescence of their inventory.
D) the volatility in the stock market with regards to common stock.
10) An important reason for auditors to obtain a good knowledge of a client’s industry is that
A) payroll processing functions could differ from client to client.
B) control risks will vary from zero to 100% and can be better assessed in context.
C) detection risk must be set in accordance with the needs of the industry as well as of the
individual client.
D) organizations like city governments have unique accounting requirements that could be
complex.
11) How is lack of understanding of a client’s knowledge and industry linked to the auditor’s
business risk?
A) sales and collection processes need to be carefully documented so that the auditor can assess
the value of accounts receivable
B) failure to fully understand the nature of the client’s transactions could result in litigation
should the client fail
C) the auditor may not be adequately trained to understand the nature of the client’s business,
conducting a poor quality audit
D) there may not be sufficient expertise assigned to the audit engagement, resulting in a lack of
understanding of complex issues
12) There are many types of analytical procedures that the auditor can conduct during the
planning stage of the financial statement audit. What is the purpose of calculating key ratios for
the client’s business and comparing them with industry averages?
A) understand the client’s industry and business
B) assess going concern
C) indicate possible misstatements
D) reduce detailed tests
13) In order to assess if a company is a going concern, the auditor can calculate which of the
following ratios during the audit planning and compare with previous years and successful
companies in the industry?
A) debt to equity ratio
B) accounts receivable turnover ratio
C) percent of interest expense to sales
D) inventory turnover ratio
14) There are many types of analytical procedures that the auditor can conduct during the
planning stage of the financial statement audit. What is the purpose of comparing the gross
margin with those of prior years, looking for large fluctuations?
A) understand the client’s industry and business
B) assess going concern
C) indicate possible misstatements
D) reduce detailed tests
15) There are many types of analytical procedures that the auditor can conduct during the
planning stage of the financial statement audit. What is the purpose of comparing prepaid
expenses and related expense accounts with those of prior years?
A) understand the client’s industry and business
B) assess going concern
C) indicate possible misstatements
D) reduce tests of controls
16) The existence of advanced automated systems affects the audit process. Which of the
following characteristics is an indicator of the presence of an advanced automated information
system?
A) custom-designed operational or strategic information systems
B) use of packaged software to process sales both locally and across Canada
C) use of customer relationship management systems to manage sales information
D) numerically-controlled equipment used in the manufacturing process
17) The existence of advanced automated systems affects the audit process. Which of the
following characteristics is an indicator of the presence of an advanced automated information
system?
A) use of data communications (such as the Internet) to transfer transaction data
B) use of packaged software to process sales both locally and across Canada
C) use of customer relationship management systems to manage sales information
D) numerically-controlled equipment used in the manufacturing process
18) The existence of advanced automated systems affects the audit process. Which of the
following characteristics is an indicator of the presence of an advanced automated information
system?
A) electronic data interchange systems for purchase orders, sales invoices and payments
B) use of packaged software to process sales both locally and across Canada
C) use of customer relationship management systems to manage sales information
D) numerically-controlled equipment used in the manufacturing process
19) Mario, the owner of Clayton’s ice cream, is giving Steve, the manager of the audit, a private
tour of the production facilities. By doing the tour, Steve will
A) be better able to identify control risks.
B) understand the client’s business and operations better.
C) be able to gather audit evidence on operational efficiencies.
D) Steve should not be taking a tour alone with the owner as this could compromise his
independence.
20) Simon owns a clothing store, Simonello. Simonello recently purchased a material amount
fabrics from Simonique Inc., a textile company also owned by Simon. With regards to this
transaction, the auditors should
A) request a confirmation from Simonique that the transaction took place.
B) inspect the textile received in the warehouse to ensure that the amount sent equals the amount
ordered.
C) qualify the audit report as this puts into question management’s integrity.
D) verify that the business relationship is disclosed in the financial statements.
21) Jibbery Company has numerous transactions with related parties. For example, it has
borrowed money from shareholders, purchases raw materials from a subsidiary company, and
sells finished goods to its parent company. Which of the following describes one of the impacts
upon risk assessment of these transactions?
A) inherent risk would be set as low
B) inherent risk would be set as high
C) control risk would be set as low
D) audit risk would be decreased
22) Brandon is working on the audit of Michum Inc. In accordance with CAS 550 (related
parties), Brandon had obtained a management confirmation of all related-party transactions.
When auditing the purchasing cycle of Michum, Brandon found that the company had purchased
over $500,000 of merchandise from Elite Crust Inc., a company that is owned by the CEO’s
brother. The $500,000 purchase is a material amount and it was not included in the confirmation
provided by Michum. Brandon should
A) inform the audit committee.
B) qualify the audit report.
C) discuss this issue with the management of Michum.
D) reduce materiality to increase the likelihood of discovering other undisclosed related party
transactions.
23) Michum Inc. has related parties with a company owned by the CEO’s brother that comprise
about $500,000. There are also related party transactions with the owner (about $250) and with
two of the officers ($750 and $1,000) respectively. Which related parties should be identified and
included in audit documentation?
A) those with material transactions only
B) those that had transactions in the current year only
C) all related parties
D) only those that could lead to a conflict of interest
24) An effective board of directors helps ensure that the company takes only appropriate risks.
The audit committee can
A) reduce the likelihood of fraud and financial statement errors through oversight of the entity
level controls.
B) reduce the likelihood of financial statement errors by helping management of the company
with complex financial reporting issues.
C) reduce the likelihood of financial statement errors by helping management in the preparation
of the financial statements and related notes.
D) reduce the likelihood of overly aggressive accounting through oversight of financial
reporting.
25) The auditor will obtain a copy of the client’s articles of incorporation (if applicable) and
retain a copy in the permanent file. Important information in the articles of incorporation
includes
A) the interest rates currently being paid for bonds that have been issued.
B) voting rights of each class of shares issued by the company.
C) which shares have been redeemed by the company in the current year.
D) the interest rates that are being received on long term notes invested.
26) Which of the following would you expect to find in a corporation’s bylaws? The
A) kinds and amounts of capital stock authorized.
B) date of incorporation.
C) rules and procedures adopted by the shareholders of the corporation.
D) types of business activities that the corporation is authorized to conduct.
27) A code of ethics is an important document for organizational conduct. In response to the
Sarbanes-Oxley Act in the U.S., the SEC requires which of the following actions for
organizations that have not adopted a code of ethics?
A) explanation of why it has not done so
B) disclosure of actions undertaken to prevent and detect fraud
C) disclosure of all related parties in management and discussion documents
D) a cost-benefit analysis for immediate implementation of one
28) Which of the following is an important purpose of an organizational code of ethics and the
associated processes to ensure adherence?
A) make sure that there are no fraudulent or illegal transactions at the company
B) train employees in acceptable conduct at the organization
C) keep unethical employees from acting out unacceptable behaviour
D) provide a powerful signal of acceptable organizational conduct
29) The official record of the meetings of the board of directors and shareholders is contained in
the corporate
A) bylaws.
B) charter.
C) minutes.
D) license.
30) When reading the corporate minutes, the auditor extracted the approved annual salary for the
President, the Chief Executive Officer and other senior executives. What audit step would the
auditor likely conduct with this information?
A) trace the payroll amount to each individual officer’s payroll record
B) check that the payroll has been recorded into the correct bank account
C) verify that payroll cheques have two signatures for all large amounts
D) ensure that all overtime is approved and adequately documented
31) When reading the corporate minutes, the auditor obtained information regarding the loans
that were authorized for borrowing. What audit step would the auditor likely conduct with this
information?
A) trace the authorized amounts to the bank statements
B) verify that notes payable have been recorded
C) calculate interest payable as of the end of the year
D) contact a credit rating agency to determine the rating of the lender
32) Frontenac Construction, your audit client, is a construction company. In the initial planning
phase of the audit, you identified that it has many contracts with severe non-performance clauses
if any of the current constructions are not completed on the dates set in the contracts over the
next three years. As the auditor, you would set the inherent risk for sales and penalties as
A) high.
B) moderate.
C) low.
D) cannot be determined until more procedures are performed.
33) It is important that the policies, procedures and key decisions of senior management, board
of directors and audit committee be considered when developing a client risk profile because
A) they have a pervasive effect on the company.
B) they influence the most important decisions for the company.
C) it is required by accounting and auditing standards.
D) they have the effect of increasing client business risks.
34) In addition to direct impacts upon the financial statements, the auditor also needs to consider
indirect effects. An assessment of client objectives and strategies can reveal issues that could
lower income or cause contingent liabilities. Which of the following could cause lost sales,
increases in warranty expenses and product liability claims?
A) poor product quality
B) excessive advertising
C) ineffective projections
D) inaccurate budgets
35) Organizations with a good control environment are able to document their positive “tone at
the top” with a clear code of ethics. How would the auditor include the presence of such a code
of ethics in the risk assessment process?
A) increase inherent risks associated with violations of laws and regulations
B) lower inherent risks associated with violations of laws and regulations
C) increase control risks associated with violations of laws and regulations
D) lower control risks associated with violations of laws and regulations
36) A client’s performance measurement system includes key performance indicators that
management uses to
A) measure its profitability.
B) compare its performance with prior periods.
C) prepare the financial statements.
D) measure progress toward its objectives.
37) If the client has set unreasonable objectives or if the performance measurement system
encourages aggressive accounting, the auditor will
A) increase inherent risk of financial statement misstatements.
B) lower inherent risk of financial statement misstatements.
C) increase control risk of financial statement misstatements.
D) lower control risk of financial statement misstatements.
38) If management and salespeople are compensated on the basis of achieving high sales targets,
there is increased incentive to record sales before they have been earned. In such a situation, the
auditor will increase the extent of testing for which of the following transaction-related audit
objectives for sales?
A) cutoff and classification
B) classification and occurrence
C) occurrence and cutoff
D) completeness and cutoff
39) Your client, Macilbink Ltd., manufactures calendars, books and magazines. The printing
presses that they use are only three years old, yet new technology has been developed that would
result in cuts in ink and electricity costs by over 20%, while simplifying the set up process (the
new equipment can read in PDF files directly), making lower production runs more feasible.
Macilbink Ltd. is facing lowered demand for its products, and will need to change direction or
innovate to stay in business. The effect of the new printing technology has resulted in the
following risk assessment changes by Macilbink Ltd.’s auditors:
A) decrease control risk
B) increase control risk
C) decrease client business risk
D) increase client business risk
40) Vanovo Ltd. is a company that has purchased several companies in the retail sector.
Recently, Vanovo Ltd. purchased both a coffee and donut chain that also owned bakeries and a
submarine sandwich chain. Unfortunately, the planned synergies between these two retail chains
did not arise. What effect would this have on the financial statements of Vanovo Ltd., the parent
company?
A) the financial statements will be incorrectly calculated, and should be checked
B) the fixed assets and goodwill recorded at acquisition could be impaired
C) risk of material misstatement for payroll expenses will increase
D) costs of goods sold will likely be overstated for both of the new chains
41) The Sarbanes-Oxley Act requires management to certify that it has informed the auditor and
audit committee of any
A) related party transactions.
B) significant deficiencies in business practices.
C) significant deficiencies in internal controls.
D) specific business or industry risk.
42) The Canadian Auditing Standards state the the auditor must develop an audit plan. List and
explain the components that must be included in the auditor’s plan.
43) What is the purpose of developing a client risk profile? List the steps involved in developing
a client risk profile.
44) Black Rock Limited is a marble and tile outlet that has a large outdoor area as well as an
indoor showroom for a variety of rock, tile and marble. It is July and your firm has just been
appointed auditors for the September year end audit. The previous firm of auditors had
conducted review engagements. The company’s bank has asked for audited financial statements
for the current year end.
Required:
A) What is the purpose of obtaining knowledge of the client’s industry and business
environment? Identify at least three procedures that you could undertake in this area.
B) What is the purpose of obtaining knowledge of the client’s business? Identify at least three
procedures that you could undertake in this area.