Chapter 5 Discussion Questions
1. What is the purpose of audit “risk assessment”? What are its objectives, and why is it important in
assessing the likelihood that fraud may occur?
Risk assessment is the process of estimating the likelihood of adverse conditions occurring. It is a “what is the worst
that can happen” analysis? Auditors should conduct risk assessments on the likelihood of fraud, errors and
misstatements, ethical tone of top management, and the ability of the company remaining in business as a going
concern. If management is also conducting risk assessments, opportunities for frauds will be lessened as internal
2. Distinguish between an auditor’s responsibilities to detect and report errors, illegal acts, and fraud.
What role does materiality have in determining the proper reporting and disclosure of such events?
Auditors have a responsibility to plan and perform the audit to obtain reasonable assurance that the financial
statements are free of material misstatement. Reasonable assurance is obtained when audit risk (risk that the auditor
will issue a standard opinion when financial statements contain material misstatements) is at a low level. During the
planning phase of the audit the auditors should assess the risk of material misstatement whether from errors, fraud or
illegal acts. Based upon the assessment, they should perform their audit to provide reasonable assurance of detecting
The AICPA code places the welfare of the public as the auditor’s first responsibility but also allows confidentiality
as an obligation to management, board’s audit committee and to the SEC for some frauds. The code does not require
the auditor to detect or report fraud. The code requires CPAs to comply with PCAOB, SEC, other legal authorities,
3. AU 240 points to three conditions that enable fraud to occur. Briefly describe each condition. How
does one’s propensity to act ethically as described by Rest’s model of morality influence each of the
three elements of the fraud triangle?
AU 240 incorporates the fraud triangle of opportunity, pressure/incentives and rationalization in organizing
prevention. Opportunity is the act being possible or relatively easy including access to commit the fraud. Pressure
can be either an individual’s need for money or rewards and punishments applied to the employee by the firm;
For employee fraud, the fraud triangle makes a lot of sense in that reduction in opportunity and pressure are the
more efficient methods. Rationalizations can be tipping points for employee frauds as well as other crimes.
Rationalizations happen both before and after the act. There are basically two types of rationalizations: 1) no harm
The “no harm” rationalization allows immaterial size harm so that employees who have the opportunity and need
something of low value will misuse company assets without guilt. If you have a company postage code, a personal
letter that has to be mailed today and no personal stamps in your drawer, you might rationalize that 46 cents is too
small to harm a big company. The other “no harm” rationalization is more selective and more dangerous. Companies
who treat employees unfairly can expect employees with opportunity and unmet needs to self-correct their unfair
“No responsibility” rationalization has enormous leverage. If the company pressures employees to get results that
seem unreasonable, the company should expect cheating. Employees begin to feel justified when cheating the unfair
company or passing the cheating down to customers or suppliers. Giving employees an out from pressure, either
The other form of the not responsible is the “didn’t mean to do it” rationalization: this rationalizes accidental or
impulsive actions. Making things not impossible but difficult and delaying actions can be viewed as opportunity
Management fraud is very poorly deterred by the fraud triangle because top management has opportunity all the
time to do nearly anything it wants. Top managers rationalize their acts as “being forced to” or “doing no harm” or
“doing greater good” or “protecting everyone in the company from its demise,” often thinking the distress is
Personal pressures primarily include the top six red flags of drugs, sex, gambling, shop-alcoholic addiction, family
trauma and work betrayal. Key employees should be audited for effects of these pressures. Members of management
Rest’s Model
Briefly, if one is insensitive to committing fraud then it is more likely to occur
If one lacks the proper skills to evaluate the possibility of committing fraud under the circumstances,
4. Explain the content of each section of the audit report. Evaluate the importance of each section with
respect to the users of financial reports.
The auditors’ report begins with a title that includes the word “independent” and is addressed to the person or
persons who retained the auditors. Independence is the backbone of the audit so a clear statement sends a signal to
The standard report consists of an introductory sentence indicating the financial statements audited, followed by
Management’s Responsibility section includes a description of management’s responsibility for the preparation
and fair presentation of the financial statements in accordance with standards, including responsibility for the design,
Auditor’s Responsibility section includes a heading that expresses the auditor’s responsibility to express an
opinion on the financial statements based on the audit. It also includes to GAAS as established in the U.S. as the
basis for the audit. Other matters addressed include (1) an explicit discussion of how an audit involves performing
procedures to obtain audit evidence about the amounts and disclosures in the financial statements; (2) the procedures
selected depend on the auditor’s judgment and risk assessments of the likelihood of material misstatements in the
financial statements, whether due to error or fraud; (3) risk assessments involve consideration of internal control
A section with the heading of “Opinion” should be included. If an unmodified opinion is expressed, the opinion
5. Give one example each of when an auditor might render an unmodified opinion and include an
emphasis-of-matter paragraph and other–matter paragraph. What is the value of such paragraphs in
the audit report?
“Unmodified” is never itself seen in the opinion, but it represents the auditor’s opinion that the statements are both
fair and follow Generally Accepted Accounting Principles. Certain situations may call for adding an additional
paragraph: either an emphasis-of-matter or other-matter paragraph. An emphasis-of-matter is a paragraph in the
auditor’s report that refers to a matter appropriately presented or disclosed in the financial statements (e.g., going
concern, litigation uncertainty, subsequent events, etc.). It is added when, in the auditor’s professional judgment, the
The auditor should modify the opinion in the auditor’s report when (1) the auditor concludes, based on the audit
evidence obtained, the financial statements as a whole are materially misstated; or (2) the auditor is unable to obtain
“Qualified” acts as a caution to financial statement readers to take care when comparing the company’s current
statements to past statements and other companies’ financials. Qualification means the basis of qualification is
material, i.e., large enough or important enough that proper knowledge and understanding would, should, or at least
might, change investor assessments of the firm’s financial statements as a basis for investment or corporate
An adverse opinion states that the financial statements are not fairly presented. An adverse opinion can affect the
company negatively; trading on a company’s stock is suspended when an adverse opinion is received. The
A disclaimer is issued when auditors are unable to determine the overall fairness of the financial statements and
therefore cannot draw a conclusion. This scenario may occur when substantial or client-imposed scope restrictions
prevent auditors from gathering the necessary evidence to form an opinion. A disclaimer cannot be used to avoid
6. The following statement expresses the conclusion of XYZ auditors with respect to the company’s
investment in ABC. Assume that all amounts are material. What kind of audit opinion should be
rendered given this statement? Explain the reasoning behind your answer. XYZ’s investment in ABC, a
foreign subsidiary acquired during the year and accounted for by the equity method, is carried at XXX on
the statement of financial position as at December 31, 2013, and XYZ’s share of ABC’s net income of XXX
Limitations on the scope of an audit may create a situation in which the auditors are unable to obtain sufficient
appropriate audit evidence. Client-imposed limitations are very significant since they may have other implications
When a scope limitation is encountered, the auditors should attempt to obtain sufficient appropriate audit evidence
by performing alternative procedures. If those procedures provide the required evidence, no report modification is
necessary. If they do not, a decision needs to be made about whether a modified opinion (i.e., qualified) is necessary
7. Rationalization for fraud can fall under two categories: “no harm” and “no responsibility.” Assume
an employee is directed by management to reduce recorded expenses at year-end by insignificant
amounts individually, but which are material in total. How might the employee justify her actions if
questioned by the auditor with respect to no harm and no responsibility? What stage of moral
development in Kohlberg’s model is best illustrated by the employee’s actions? Why?
The employee is not embezzling or benefiting from this fraud; it is more of a management fraud of the financial
statement to meet market expectations. Thus, the employee would respond very well to auditor questioning since the
amounts did not personally benefit her. Of the two rationalizations the employee is probably using the “no
Management may be rationalizing that the amounts are individually immaterial so that there is no harm in reducing
the expense accounts. Management fraud is very poorly deterred by the fraud triangle because top management has
opportunity all the time to do nearly anything. Top managers rationalize their acts as “being forced to” or “doing no
8. Some criticize the accounting profession for using expressions in the audit report that seem to build
in deniability should the client commit a fraudulent act. What expressions enable the CPA to build a
defense should the audit wind up in the courtroom? How does your analysis relate to the opening
statement in the chapter by Abe Briloff?
Some of the expressions or statements in the audit opinion that enable the CPA to build a defense are “These
financial statements are the responsibility of the Company’s management;” “on a test basis;” “reasonable
One term not very well understood is “present fairly.” It has been said that fairness is in the eyes of the beholder.
Abe Briloff would like the auditor report to indicate that the client is using the fairest and most appropriate
accounting principles. In addition, he would like to know if the auditor agrees or disagrees with the principles
9. The audit report on General Motors for 2008 issued by Deloitte & Touche included the following
statement: “The corporation’s recurring losses from operations, stockholders’ deficit, and inability to
generate sufficient cash flow to meet its obligations and sustain its operations raise substantial doubt
about its ability to continue as a going concern.” Are you surprised to learn of this going-concern
alert at a company such as General Motors? What signs might the auditors look for prior to issuing
their report on the 2009 financial statements that help them reevaluate the going-concern
assessment?
Prior to 2008, it would have been very difficult to believe a corporation like General Motors could receive a going
concern alert. However, in late 2008 the depressed economy, huge debt holdings, union required pensions and post-
retirement benefits led GM to request a bailout from the government. Even after receiving the bailout money the
going concern alert was proper because some doubt existed whether GM would be able to return to profitable
10. Do you think the concept of materiality is incompatible with ethical behavior? Why or why not?
Materiality alone is not incompatible with ethical behavior. Many professions use estimates or confidence intervals
to determine amounts. Materiality is used in audits in order to keep a cost-benefit approach to accounts and amounts.
If cash balance is off $100, it could cost the auditors more than $100 to find and correct the error. However,
materiality can pose an ethical problem if the auditor finds material differences and corrections are never made.
11. How do materiality judgments affect risk assessment in an audit of financial statements?
Materiality thresholds change from engagement to engagement, for the same client, and even with the same audit
firm. The materiality threshold may be relatively high or relatively low given other factors, for example, if the
12. According to GAAS, the auditor must evaluate the control deficiencies that he has become aware of
to determine whether those deficiencies, individually or in combination, are significant deficiencies or
material weaknesses. What is the purpose of the auditor’s evaluation of internal controls in these
contexts with respect to conducting an audit in accordance with GAAS?
Strong internal controls of management help to mitigate the risk of potential misstatements in the financial
statements. If there are deficiencies in controls, it affects the necessary assurance needed from the auditors’
substantive testing. Deficiencies could also cause the auditor to do more testing or change the method of testing.