Since 1977
AUDITING THEORY L. R. CABARLES/J.M. D. MAGLINAO
AT.2814—Considering Risks of Fraud, Error
and Noncompliance with Laws and Regulations (NOCLAR)
Suggested Readings:
1. PSA 240, The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements
2. PSA 250, Consideration of Laws and Regulations in an Audit of Financial Statements
3. Chapter 12, Auditing: A Risk-Based Approach, Part 1-Theory 2019 Issue—1st Edition by Cabarles/Ocampo/Valdez
DISCUSSION QUESTIONS
Fraud and Error
Fraud vs. Error
1. What differentiates fraud from an error?
a. Materiality.
b. Effect on misstatements.
c. Intent.
d. Frequency of occurrence .
2. The following are examples of error, except
a. A mistake in gathering or processing data from
which financial statements are prepared.
b. An incorrect accounting estimate arising from
oversight or misinterpretation of facts.
c. A mistake in the application of accounting
principles relating to measurement, recognition,
classification, presentation, or disclosure.
d. Misrepresentation in the financial statements of
events, transaction or other significant information.
3. The risk of not detecting a material misstatement
resulting from fraud is higher than the risk of not
detecting a material misstatement resulting from error
because
a. The effect of fraudulent act is likely omitted in the
accounting records.
b. Fraud is ordinarily accompanied by acts specifically
designed to conceal its existence, and auditors do
not make legal determinations of whether fraud
has actually occurred.
c. Fraud is always a result of connivance between or
among employees.
d. The auditor is responsible to detect errors but not
fraud.
Types of Fraud
4. The two types of intentional misstatements that are
relevant to the auditor’s consideration of fraud include,
misstatements resulting from fraudulent financial
reporting and misstatements resulting from
misappropriation of assets. Fraudulent financial
reporting least likely involve
a. Deception such as manipulation, falsification
(including forgery), or alteration of accounting
records or supporting documents from which the
financial statements are prepared
b. Misrepresentation in, or intentional omission from,
the financial statements of events, transaction or
other significant information
c. Intentional misapplication of accounting principles
relating to measurement, recognition,
classification, presentation, or disclosure
d. Embezzling receipts, stealing physical assets or
intellectual property, causing an entity to pay for
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MAY 2020
goods and services not received, or using an
entity’s assets for personal use.
5. Which of the following constitutes the fraud of larceny?
a. Misappropriation of assets that have been
entrusted to one’s care
b. Theft of assets
c. Theft of assets covered up by manipulation of
accounting records
d. Agreement between two or more persons to
commit a criminal act
6. Who is most likely to perpetrate fraudulent financial
reporting?
a. Members of the board of directors
b. Production employees
c. Management of the company
d. The internal auditors
7. Misappropriation of assets is normally perpetrated by:
a. members of the board of directors.
b. employees at lower levels of the organization.
c. management of the company.
d. the internal auditors.
8. In comparing management fraud with employee fraud,
the auditor’s risk of failing to discover the fraud is
a. Greater for employee fraud because of the higher
crime rate among blue collar workers
b. Greater for management fraud because of
management’s ability to override existing internal
controls that is always presumed to exist in an
audit of financial statements.
c. Greater for employee fraud because of the larger
number of employees in the organization
d. Greater for management fraud because managers
are inherently smarter than employees
Responsibilities for Fraud
9. Which statement(s) is(are) incorrect regarding the
auditor’s responsibility to consider fraud and error in
an audit of financial statements?
a. The auditor is not and cannot be held responsible
for the prevention of fraud and error being the
primary responsibility of both the management and
those charged with governance.
b. When planning and performing audit procedures
and evaluating and reporting the results thereof,
the auditor should consider the risk of
misstatements in the financial statements resulting
from fraud.
c. In planning the audit, the auditor should discuss
with other members of the audit team the
susceptibility of the entity to material statements
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in the financial statements resulting from fraud or 15. Which of the following issues is normally part of the
error and exercise professional skepticism, which is “brainstorming” session required by PSAs?
the best method of the auditor to detect fraud. a. b. c. d.
d. The auditor should design audit programs that will How assets could be
provide reasonable assurance that material errors misappropriated Yes Yes Yes No
and fraud will be detected in the ordinary course of How and where the entity’s
the examination. financial statements are
susceptible to material
10. When comparing the auditor’s responsibility for misstatements due to fraud Yes Yes Yes Yes
detecting employee fraud and for detecting errors, the The need for professional
profession has placed the responsibility: skepticism Yes No No Yes
a. more on discovering errors than employee fraud. The audit team’s response to
b. more on discovering employee fraud than errors. potential fraud risks Yes Yes No No
c. equally on discovering either one.
d. on the senior auditor for detecting errors and on Identifying and Assessing the ROMM due to Fraud
the manager for detecting employee fraud. 16. The fraud triangle consists of three components
(incentive or pressure, opportunity, and attitude or
11. Which of the following represents the primary rationalization). Which of the three components are
difference between an audit and forensic accounting? present in most every fraud?
a. An audit has the focused responsibility to detect a. All three factors are usually present when fraud
fraud in the client organization while forensic occurs.
accounting sets out to prevent fraud. b. Pressure and opportunity
b. An audit has no responsibility for fraud while c. Opportunity and rationalization
forensic accounting provides an audit specific to d. Rationalization and pressure
material fraud discovery.
c. An audit must follow Generally Accepted Auditing 17. Categories of fraud risk factors (whose presence often
Standards while the forensic accountant is bound has been observed in circumstances where frauds have
to Generally Accepted Fraud Standards. occurred) in relation to misstatements arising from
d. An audit utilizes sampling techniques to detect misappropriation of assets and fraudulent financial
material misstatements while forensic accounting reporting are opportunities, attitudes or
examines the entire population of fraudulent rationalizations, and pressures or incentives. Which of
transactions. the following creates an opportunity for fraud to be
committed in an organization?
Auditor's Fraud Consideration a. Management demands financial success or is
Risk Assessment Procedures aggressive in its application of accounting rules.
12. Sources of information gathered to assess fraud risks b. Poor internal control.
usually do not include: c. Commitments tied to debt covenants.
a. Analytical procedures. d. Finding loopholes in the accounting rules to
b. Inquiries of management and others within the achieve earnings targets.
entity.
c. Communication among audit team members. 18. The following are examples of circumstances that may
d. Review of corporate charter and bylaws. indicate the possibility that the financial statements
may contain a material misstatement resulting from
13. When planning the audit, the auditor should make fraud, except
inquiries of management in order to do the following, a. Transactions that are recorded in a complete or
except timely manner or are properly recorded as to
a. Obtain an understanding of management’s amount, accounting period, classification, or entity
assessment of the risk that the FSs may be policy.
materially misstated as a result of fraud. b. Unsupported or unauthorized balances or
b. Obtain an understanding of the accounting and transactions.
internal control systems management has put in c. Last-minute adjustments that significantly affect
place to address fraud and error. financial results or unusual journal entries.
c. Determine whether management and other within d. Tips or complaints to the auditor about alleged
the entity (e.g., internal audit function) have fraud.
knowledge of any actual, suspected or alleged
fraud affecting the entity. 19. The following are examples of circumstances that may
d. Provide useful information concerning the risks of indicate the possibility that the financial statements
material misstatements in the financial statements may contain a material misstatement resulting from
resulting from management fraud. fraud, except
a. Missing documents.
Engagement Team Discussion (‘Brainstorming’) b. Documents that appear to have been altered.
14. According to professional audit standards, how might c. Unavailability of other than photocopied or
an understanding of the nature of fraud that may occur electronically transmitted documents when
in the client organization best be identified by the audit documents in original form are expected to exist.
firm? d. Significant explained items on reconciliations.
a. Fraud training courses from actual corporate fraud
ex-criminals. 20. Which of the following is most likely to be presumed to
b. Conducting a brainstorming meeting with the represent fraud risk on an audit?
members of the audit team. a. Capitalization of repairs and maintenance into the
c. Circulating a survey to the client company property, plant, and equipment asset account.
employees for completion. b. Improper revenue recognition.
d. Discussions with other CPA firms. c. Improper interest expense accrual.
d. Introduction of significant new products.

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EXCEL PROFESSIONAL SERVICES, INC.
Responding to Assessed ROMM due to fraud
21. Statement 1: Auditors are required to perform
extended audit procedures to detect material errors
and irregularities if previously performed examinations
indicate that they may exist.
Statement 2: Audit procedures that are effective for
detecting an unintentional misstatement may be
ineffective for an intentional misstatement that is
concealed through collusion.
a. True, true c. False, true
b. True, false d. False, false
22. Which of the following is most likely to be an overall
response to fraud risks identified in an audit?
a. Supervise members of the audit team less closely
and rely more upon judgment.
b. Only use certified public accountants on the
engagement.
c. Place increased emphasis on the audit of objective
transactions rather than subjective transactions.
d. Use less predictable audit procedures.
23. Which of the following is most likely to be a response
to the auditor's assessment that the risk of material
misstatement due to fraud for the existence of
inventory is high?
a. Observe test counts of inventory at certain
locations on an unannounced basis.
b. Perform analytical procedures rather than taking
test counts.
c. Request that inventories be counted prior to year-
end.
d. Request that inventory counts at the various
locations be counted on different dates so as to
allow the same auditor to be present at every
count.
24. As part of designing and performing procedures to
address management override of controls, auditors
must perform which of the following procedures?
a. b. c. d.
Review accounting estimates
for biases Yes Yes Yes No
Examine all journal entries
above materiality Yes No Yes Yes
Examine adjusting entries Yes Yes No Yes
Review unusual transactions Yes Yes No No
25. Which of the following accounting issues is most likely
to raise an auditor’s professional skepticism about
earnings manipulation?
a. Progress payments
b. Allowance for doubtful accounts
c. Sales returns
d. Cash receipts
Conclusion and Reporting
26. Communication of a misstatement resulting from
fraud, or a suspected fraud, or error to the appropriate
level of management on a timely basis is important
because it enables management to take action as
necessary. Ordinarily, the appropriate level of
management is
a. At least equal to level of persons who appear to be
involved with misstatements or suspected fraud
b. At least one level above persons who appear to be
involved with the misstatement or suspected fraud
c. The audit committee of the board of directors
d. The head of internal audit department
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27. The auditor least likely obtains written representations
from management that:
a. It acknowledges its responsibility for the
implementation and operations of accounting and
internal control systems that are designed to
prevent and detect fraud and error.
b. It has disclosed to the auditor its knowledge of
fraud or suspected fraud affecting the entity
involving employees who have significant roles in
internal control only.
c. It has disclosed to the auditor its knowledge of any
allegations of fraud, or suspected fraud affecting
the entity’s financial statements communicated by
employees, former employees, analysts,
regulations or others.
d. It has disclosed to the auditor the results of its
assessment of the risk that the financial
statements may be materially misstated as a result
of fraud.
Withdrawing from Engagement Because of Fraud
28. The auditor may encounter exceptional circumstances
that bring into question the auditors ability to continue
performing the audit, including where
a. The entity does not take the remedial action
regarding fraud that the auditor considers
necessary in the circumstances, even when the
fraud is not material to the financial statements
b. The auditor’s consideration of the risk of material
misstatement resulting from fraud and the results
of audit tests indicate a significant risk of material
and pervasive fraud
c. The auditor has significant concern about the
competence or integrity of management or those
charged with governance that affect the auditor's
ability to rely on management's representations.
d. All of the above
Noncompliance with Laws and Regulations
(NOCLAR)
Definition
29. Which statement is incorrect regarding the auditor’s
consideration of laws and regulations in an audit of
financial statements?
a. Noncompliance refers to acts of omission or
commission by the entity being audited which are
contrary to prevailing laws and regulations
b. Noncompliance includes transactions entered into
by, or in the name of, the entity, or on its behalf,
by TCWG, management or employees.
c. Noncompliance includes personal misconduct of
the entity’s management or employees unrelated
to the business activities of the entity.
d. In the absence of evidence to the contrary, the
auditor is entitled to assume the entity is in
compliance with applicable laws and regulations
affecting the client.
Effect of Laws and Regulations on F/S
30. Which of the following would most likely be deemed a
direct-effect illegal act?
a. Violation of employment laws.
b. Violation of environmental regulations.
c. Violation of income tax laws.
d. Violation of civil rights laws.
31. Which of the following illegal acts should an audit be
designed to obtain reasonable assurance of detecting?
a. Securities purchased by relatives of management
based on knowledge of inside information.
b. Accrual and billing of an improper amount of
revenue under government contracts.
c. Violations of antitrust laws.
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EXCEL PROFESSIONAL SERVICES, INC.
d. Price fixing.
32. Which of the following statements is usually true?
a. It is easier for the auditor to uncover fraud than
errors.
b. It is easier for the auditor to uncover indirect-
effect illegal acts than fraud.
c. The auditor’s responsibility for detecting indirect-
effect illegal acts is similar to the responsibility to
detect fraud.
d. The auditor’s responsibility for detecting direct-
effect illegal acts is similar to the responsibility to
detect fraud.
Responsibility for Compliance with Laws and Regulations
33. Which of the following is incorrect about the auditor’s
responsibility for evaluating noncompliance by the
entity to laws and regulations?
a. It is the responsibility of management, with the
oversight of those charged with governance, to
ensure that the entity’s operations are conducted
in accordance with laws and regulations, including
compliance with laws and regulations that
determine the form or content of the entity’s
financial statements. This includes responsibility
for the prevention and detection of non-compliance
with laws and regulations.
b. An audit cannot be expected to detect
noncompliance with all laws and regulations.
Detection of noncompliance, regardless
materiality, requires considerations of
implications for the integrity of management or
employees
c. Generally, the further removed non-compliance is
from the events and transactions reflected in the
financial statements, the more likely the auditor is
to become aware of it or to recognize the possible
non-compliance. This is because an illegal act by
the client often relate to operating aspects rather
than accounting aspects.
d. In order to plan the audit, the auditor should
obtain a general understanding of the legal and
regulatory framework applicable to the entity and
the industry and how the entity is complying with
that framework.
The Auditor’s Consideration of Compliance with Laws and
Regulations
34. Which of the following is incorrect regarding the
auditor’s consideration of laws and regulations
applicable to the entity?
a. The auditor shall obtain a general understanding of
applicable laws and regulations to the entity.
b. The auditor shall identify and assess risk of
material misstatement of financial statements
relating to non-compliance with laws and
regulations.
c. The auditor shall obtain sufficient appropriate audit
evidence regarding compliance of all types of laws
and regulations applicable to the entity.
d. The auditor shall respond appropriately in
instances of identified or suspected non-
compliance with all types laws and regulations.
35. In considering indirect effect laws and regulations in an
audit of financial statements, an auditor shall
a. Inquire of management and those charged with
governance.
b. Inspect correspondences with regulatory
authorities.
c. Both a and b.
d. Neither a nor b.
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36. According to PSA 250 (Consideration of Laws and
Regulations in an Audit of Financial Statements), the
following are indications that noncompliance may have
occurred, except
a. Investigation by government departments or
payment of fines or penalties
b. Adverse media comment
c. Authorized transactions or properly recorded
transactions
d. Purchasing at prices significantly above or below
market price
37. Examples of the type of information that may come to
the auditor's attention that may indicate that
noncompliance with laws or regulations has occurred
least likely include
a. Payments for unspecified services or loans to
consultants, related parties, employees or
government employees.
b. Payments for goods or services made other than to
the country from which the goods or services
originated.
c. Unauthorized transactions or improperly recorded
transactions.
d. Payments with proper exchange control
documentation.
38. When an auditor identifies or suspects instances of
non-compliance with laws and regulations in relation to
of audit of financial statements, the auditor shall
the a. b. c. d.
Obtain understanding of the
nature of the act. Yes Yes Yes No
Evaluate possible effect of
noncompliance on financial
statements. Yes No Yes Yes
Discuss the matter with
management and TCWG. Yes Yes No Yes
Consider obtaining legal advice. Yes Yes No No
Evaluate other audit
implications. Yes Yes No No
39. Which of the following is incorrect about the auditor’s
responsibility for evaluating noncompliance by the
entity to laws and regulations?
a. When the auditor becomes aware of information
concerning a possible instance of noncompliance,
the auditor shall obtain an understanding of the
nature of the act and the circumstances in which it
has occurred and evaluate the possible effect on
the financial statements.
b. If the auditor has identified or suspects
noncompliance with laws and regulations, the
auditor shall determine whether the auditor has a
responsibility to report the identified or suspected
noncompliance to parties outside the entity.
c. The auditor shall document identified or suspected
non-compliance with laws and regulations but not
the results of discussion with management, and
where applicable, those charged with governance
and other parties outside the entity.
d. The auditor may withdraw from the engagement
when the entity does not take the remedial action
that the auditor considers necessary in the
circumstances, even when the noncompliance is
not material to the financial statements or affects
auditor’s ability to rely on management
representations.
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40. In assessing whether management has overlooked d. Evaluate the effect on the financial statements and
relevant laws and regulations, the auditor would may consider seeking legal advice especially when
perform all of the following except involving members of senior management,
a. Obtain written representations from management. including members of the board of directors.
b. Review relevant portions of grant and loan
agreements. 42. Which of the following is the auditor least likely to do
c. Confirm grant arrangements with granting when aware of an illegal act?
agencies. a. Discuss the matter with the client’s legal counsel.
d. Discuss laws and regulations with the entity's chief b. Obtain evidence about the potential effect of the
financial officer and legal counsel. illegal act on the financial statements.
c. Consider the impact of the illegal act on the
41. When an auditor becomes aware of a possible illegal relationship with the company’s management.
act by a client, the auditor should obtain an d. Contact the local law enforcement officials
understanding of the nature of the act to regarding potential criminal wrongdoing.
a. Increase the assessed level of control risk.
b. Recommend remedial actions to the audit
committee. - now do the DIY drill -
c. Determine the reliability of management’s
representations.

DO-IT-YOURSELF (DIY) DRILL

1. Audits of financial statements are designed to obtain d. Report the act to high-level personnel within the
reasonable assurance of detecting material client's organization.
misstatements due to
a. b. c. d. 6. The following are examples of circumstances that may
Errors Yes Yes Yes No indicate the possibility that the financial statements
Fraudulent financial Yes Yes No Yes may contain a material misstatement resulting from
reporting fraud, except
Misappropriation of Yes No Yes No a. Unwillingness by management to permit the
assets auditor to meet privately with those charged with
Direct-effect illegal acts Yes No Yes No governance.
b. Accounting policies that appear to be consistent
2. How will the results of the auditor's assessment of with industry norms.
fraud risk factors further affect the planned audit c. Frequent changes in accounting estimates that do
procedures? not appear to result from changed circumstances.
a. Audit procedures and fraud assessment do not d. Tolerance of violations of the entity’s Code of
relate. Conduct
b. The assessment may require a re-audit of previous
periods. 7. Brainstorming about the manner in which fraud may
c. By the assignment of qualified audit staff to risky be committed should include all of the following except
areas of the engagement. a. Consider factors that might affect management
d. Management will be called upon to assist in motivation to misstate the financial statements
coordinating audit procedures. b. Consider weaknesses in internal control that would
allow a fraud to take place or management
3. An auditor who discovers that a client's employees override of controls
paid small bribes to municipal officials most likely c. Consider the materiality of the individual account
would withdraw from the engagement if balances for substantive testing
a. The payments violated the client's policies d. Consider factors that may enable an individual
regarding the prevention of illegal acts. capable of committing a fraud to rationalize
b. The client receives financial assistance from a perpetrating it
federal government agency.
c. Documentation that is necessary to prove that the 8. In evaluating the effect of fraud upon the audit
bribes were paid does not exist. procedures the auditor should consider
d. Management fails to take the appropriate remedial a. The type of fraud that may occur.
action and reliance on management’s b. The potential significance and likelihood of
representation becomes doubtful. occurrence of fraud.
c. The pervasiveness of fraud detected.
4. Which of the following situations represents a risk d. All of the above.
factor that relates to misstatements arising from
misappropriation of assets? 9. Which of the following would the auditor likely to do
a. A lack of independent checks. when the application of planned audit procedures
b. A high turnover of senior management. indicates the possible existence of fraud or error?
c. A strained relationship between management and a. The auditor should resign from the engagement in
the predecessor auditor. order to avoid legal responsibility.
d. An inability to generate cash flow from operations. b. The auditor should discuss the matter with the
person believed to be involved with the
5. If an illegal act is discovered during the audit of a irregularities.
publicly held company, the auditor should c. The auditor should refer the fraud, actual or
a. Notify the regulatory authorities. suspected to the internal auditor.
b. Determine who was responsible for the act. d. The auditor should consider the potential effect on
c. Modify the extent of auditing procedures. the financial statements and other aspects of the

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EXCEL PROFESSIONAL SERVICES, INC.
audit, particularly, the reliability of management
representations.
10. Which of the following is not an example of a type of
defalcation?
a. A warehouse employee takes home two units of
electronic entertainment inventory each week
without authorization.
b. The president of the company utilizes the
organization's cash to add a floor to her 15,000
square foot house.
c. The chief financial officer of the company falsely
adds P20 million to the accounts receivable and
revenue accounts.
d. The treasurer of the company makes an
unauthorized wire transfer from the organization's
bank to a personal account in Grand Cayman.
11. Relative to internal controls, what is a primary risk of
fraud in the client company?
a. The risk that management overrides controls.
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.
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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.
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